10th November 2014
The price of oil has dropped sharply in the last month as lukewarm global growth has reduced demand expectations even as supply remains steady. Erik Knutzen, chief investment officer, multi-asset at Neuberger Berman, discusses the implications for the economy and markets, and where oil prices are headed from here…
Oil prices have been easing since late June, but in October the trend accelerated in the wake of the International Energy Agency’s (IEA) downward revision of its 2014 global incremental oil demand growth forecast to just +700,000 barrels per day from +900,000 barrels per day in September.
Demand expectations for 2014 oil growth were as high as 1.3 million barrels per day as recently as June of this year, with the cuts due largely to eurozone, China and Japan weakness. Current estimates for 2015 call for demand growth of 1.1 million barrels per day, which we think is reasonable at this point, especially as lower fuel prices could stimulate demand from current sluggish levels.
At the same time, global oil production has remained stable, driven primarily by North American shale fields that have offset outages related to geopolitical unrest (primarily in Libya and Iran). However, adding to the weakness in oil prices, some of the previously offline Libyan barrels have recently returned to the market and OPEC, so far, has been reluctant to cut meaningful output in response to lower prices.
All told, Brent and WTI (the key oil trading classifications) are now around $83 and $78 per barrel, respectively, compared with their highs of $114 and $109 back in May/June, and are roughly 20% off their three-year averages.
Overall, we believe that lower oil prices will have a beneficial impact on the global economy. Reduced fuel costs dampen inflation, which is generally supportive of consumers and could drive consumer confidence and expenditures due to increased spending power. At the same time, cheaper energy reduces the cost of manufacturing and help exports of manufacturing-driven economies like China. In the U.S., oil prices at this level could boost GDP growth by as much as 0.4% per year.
Still, the downside of lower oil prices relates to their predictive function. In the current environment of extremely easy monetary policy, the fact that inflation remains relatively low and that commodity prices including oil have fallen so much is troubling from the standpoint of signalling the potential for deflation and/or recession. At a time when central banks have fewer tools at their disposal, it’s unclear what they will do if economies do not turn the corner.
In terms of countries/regions, weak oil prices are likely to have a negative impact on many energy producers. For example, Russia, Venezuela and Ecuador, Nigeria and Angola, and the Middle East are heavily dependent on oil revenues and will likely see pressure in the capital markets. On the other hand, energy importers and consumers in the U.S., Europe and Asia should benefit.
What about the Oil Sector?
For oil stocks, the recent price decline clearly isn’t happy news. And it’s generally believed that if oil prices fall—and stay below—$80, that could have serious impact on the economics of oil production, especially in the deep-water sector, where exploration costs are typically high and outcomes are largely unknown. It also highlights, however, a key insight for us: the importance of focusing on low-cost producers. We believe that many existing North American shale fields are profitable with oil below $80 or even $70 a barrel, and we continue to emphasize that there are “haves” and “have-nots” in the space, making security selection key.
Where To from Here?
To some degree, lower oil prices are likely to be self-correcting. Even if companies are profitable at current or lower levels, they may think twice before developing new resources—even in the shale industry. That’s what some commentators believe is behind the willingness of certain oil producing countries to continue pumping oil at un-economic levels. If current prices hold, however, OPEC could begin to rein in some production to help balance the market, perhaps as early as its upcoming meeting on November 27.
Overall, our base case is that Brent and WTI are likely to remain in the $80-$95 and $75-$90 range, respectively, over the next six to 12 months. As for the longer term, current prices should encourage a slowing in new shale development, which we anticipate will decelerate in 2016-18 even with more robust prices. This easing growth, combined with additional delays in international development and potentially higher demand due to lower fuel prices, could help oil return to structurally higher prices in a year or two.
In general, we believe that lower oil prices should be good for global equities, and that effects on the sovereign debt side will depend on the impacts to balance of payments and other factors. Unfortunately, any further investment takeaways are not “clean” given the relationship between oil declines and modest global growth.
Among energy stocks, large integrated players are seen as less volatile given their multiple revenue streams, balance sheet strength and high dividends. Exploration and development companies may face more turbulence given their leverage to prices, although low-cost producers could be attractive. Natural gas producers could also become appealing, having sold off with oil stocks despite largely unchanged natural gas fundamentals. Finally, “mid-stream” players, which transport oil and gas, typically do not take commodity price risk and have long-term contracts for revenues, and may provide a happy medium for some investors.
More broadly, we believe investment decisions should be made on an individual sector and security basis, taking into account exposure to energy prices from a cost perspective, counterbalanced by the potential for greater demand in some regions and countries. In essence, the particulars should continue to be based on individual research decisions.