Oil s equilibrium in sight

Transcription

1 This is for adviser use only and should not be relied upon by retail investors MARCH 16 Oil s equilibrium in sight Probably the most remarkable global macroeconomic development of 15 was the great oil price crash. In the first few months of 16, oil prices went even lower to below US$30 per barrel. Although recovering some ground in recent weeks, prices remain low on a historical basis, with inevitable consequences for the oil industry. This perspective looks at the key drivers of the oil price crash, and explains why diminishing global supply amid steady demand growth will enable progress towards market equilibrium in 16. It examines the likely economic and investment implications of a sustained period of low oil prices. A HISTORICAL PERSPECTIVE History shows the scope for significant volatility in global oil prices. However, with a decline of over 30% since October 15 and about 50% since June 15 to below US$30 p/b recently, the severity of the most recent price slump has surprised even seasoned observers. As recently as October 14, the World Bank for example was forecasting an average WTI oil price of $96 p/b in The chart below shows that the three-year oil-price cycle starting in 14 is a contender for the weakest on record. This is also reflected in the comparison with longer-term averages, with the current US$36 p/b WTI price around 15% lower than the 30-year average of US$43 p/b, a third lower than the -year average of US$55 p/b and 55% lower than the 10-year average of US$79 p/b. 2 AT A GLANCE The oil price crash of 15 and early 16 was severe on almost any basis of comparison. Although recovering some ground recently, oil prices remain low on an historic and real basis. Given steady global oil demand growth, the oil price crash was largely a supply-induced event. Notably, strong oil prices over encouraged investment and boosted global oil supply. The US shale oil revolution was key as it added almost 4m b/d of supply cumulatively over Looking ahead, our base case is that low oil prices will curtail supply, enabling supply and demand to reach a balance in 16. A quick recovery in prices ahead of sufficient supply adjustment and uncertainties about new Iranian supply are risks to this view. Chart 1. Current three-year oil price cycle vs prior cycles Source: Bloomberg, March 16, Chart depicts WTI indexed to 100 for each cycle THE SUPPLY-SIDE VIEW 14-now Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Global oil prices averaged US$95 p/b from 11 to 14, with Brent crude averaging an even higher US$108 p/b in this time. This encouraged strong investment in oil production capacity, including from higher-cost oil sources such as the Canadian oil sands. Of particular note, the sustained period of strong oil prices coincided with the US shale energy revolution. According to EIA data, 3 this was the main reason behind a cumulative 3.9m barrel surge in US liquid fuels supply in the three years to end- 15, completely dwarfing supply growth from any other region.

2 To put the sheer scale of the US s cumulative 3.9m oil surge in period into perspective, it is worth noting that the world s fourth biggest oil producer, Iraq, produced around 4.0m barrels of oil in 15, which accounted for over 4% of total global oil production in the year. Chart 2. Non-OPEC crude oil and liquid fuels supply growth, Millions b/d The surge in US crude oil and liquid fuels production between 13-15, thanks largely to the shale revolution, was of comparable order to Iraq s total oil output in 15 US Brazil China Kazakhstan Source: EIA Short-Term Energy Outlook, February 16; * Sudan figures include those for South Sudan THE DEMAND-SIDE VIEW Despite the sluggish global economy and slowing Chinese economic growth, global demand for oil has held up relatively well. Fidelity energy analysts estimate that total global demand for oil in 15 increased at the fastest pace since 10. Perhaps, surprisingly, a key driver for this has been China, where oil consumption increased by 5.5% on our estimates in 15, the second-highest growth rate since 10. While industrial demand for oil was relatively weak in China in 15, this was more than offset by strong consumer demand with, for example, strong gains in petrol consumption. On top of this, China capitalised on low oil prices by boosting its strategic reserves, with a 100m barrel increase during the first half of 15 alone. The chart below shows that despite increasing oil import volumes, low oil prices have ensured significantly lower aggregate import outlays for China. However, while Chinese demand in the recent past has held up well, we believe it is reasonable to assume more modest growth rates in underlying demand for the next couple of years, owing in part to China s economic rebalancing away from energy-intensive fixed investment. On top of this, the pace of strategic reserves building is likely to slow somewhat compared with 15. As such, we expect that China s rate of oil demand growth should slow in the years ahead. Though Chinese demand was never as critical to the oil market compared with some other commodities (notably iron ore), the EIA estimates that China accounted for over 40% of incremental global liquid fuel consumption growth over 11 to 15. But it expects this to drop to an average of 22% in 16 and Chart 3. China monthly oil demand by volume and value 35 China monthly crude oil imports by volume, LHS (metric tonnes m) China monthly crude oil imports by value, RHS (USDbn) 25 (metric tonnes m) USD bn Source: China Customs, March 16

3 WHERE NEXT? Along with demand growth in China, we see robust oil demand growth elsewhere as well. The US and India made a particularly strong contribution in 15, and for the world as a whole, we expect another year of solid growth in 16. Thereafter, it is likely that the rate of growth will slow, in particular as a result of demand substitution in the transport sector. However, in 16, we think the global excess supply problem will be corrected owing to the non-economic viability of many oil sources. At the forefront of the global supply readjustment will be reduced US shale oil supply. Our bottom-up analysis of the US shale industry, based on coverage of all the major players, and on individual well data for almost all the basins, suggests a net m barrel reduction in US shale oil supply in 16. We expect this to be a key driver of the first net shrinkage in global oil supply since the crisis year of 09, with smaller reductions from many others regions, including China, Mexico, Ecuador and Nigeria. Chart 4. Fidelity US shale oil output projections Chart 5. Fidelity global inventory change projections 2.0 Shale y/y production growth (mboe/d) including NGLs 2.0 Inventory change (IEA 00-14, FIL est ) mboe/day mn barrels/day Source: Fidelity International, March 16. Mboe/d: millions of barrels of oil equivalent Source: Fidelity International, March 16 Also on the supply side, a recent agreement between Saudi Arabia and Russia could also be significant. Back in 14, the world s top oil producer and exporter Saudi Arabia convinced other OPEC members to abandon their usual effort to support prices by cutting output. The Saudis were instead keen to hurt higher-cost producers and possibly their regional foe, Iran, too. With the former objective at least looking like it has been achieved, in February, Saudi Arabia along with Russia, the world s second biggest oil producer, conditionally agreed to freeze oil production around current record levels. With a global market characterised largely by excess supply, our base-case expectation is that low oil prices in time will curtail global supply sufficiently for oil prices to recover. However, this base case is subject to risks. The likely timing of supply/demand realignment is of course key. The process is ongoing, and many industry observers think the rebalancing process could extend well into 17. However, our analysis suggests that a more balanced market could be reached as soon as the second half of 16. A major concern in this regard would be if the oil price recovers too quickly in anticipation of supply reductions. This is because strongly recovering prices could encourage production from some sources to be ramped again, preventing adequate supply adjustment. Another source of uncertainty regarding supply/demand rebalancing is the extent of increased oil supply coming from Iran following the recent easing of international sanctions against the country. Iran is a relatively low-cost producer and it claims it can fairly speedily increase production by 1m b/d to supply newly re-opened markets, which is at the upper end of consensus market expectations for a 0.5m-1m b/d increase. If Iranian supply transpires to be much higher than expected, this could be another factor that prevents/delays adequate global supply rebalancing with a negative effect on oil prices.

4 ECONOMIC IMPLICATIONS OF LOW OIL PRICES - A BRIEF OVERVIEW Oil prices are likely to remain low compared to history for the near term. However, over the next couple of years, we would not be surprised to see a return to the norms of the past decade, when oil (WTI) averaged US$80 p/b. This would be well above the current Bloomberg consensus of US$57 p/b WTI for 17 to 19. A more sustained period of low oil prices would be bound to have significant economic implications. In the broadest economic sense, lower oil prices tend to be disinflationary and are functionally similar to a wealth transfer from oil-exporting nations to oil-importing nations. In theory, then, big oil importers benefit from low oil prices while big exporters lose. However, in practice it is often not so simple, as correct analysis requires an assessment for each country of the impact of low oil prices on each of the major components of demand (consumption, investment, government spending and net exports). In the case of the US for example, as shown in Chart 6, consumers have benefited from lower gasoline and other fuel prices, but there is considerable uncertainty as to the extent that this extra money has been saved or spent. Moreover, while the US s net export position has benefited (owing to reduced oil imports), this and the benefit to consumers has been substantially offset by the collapse in energy sector investment. A further complication has been the potential exacerbation of deflationary risk and the interplay of this with monetary policy. In many countries, fuel items are also subject to extensive tax and subsidy regimes, which means that crude oil price developments are not directly transmitted to consumers or companies. Chart 6. US gasoline prices and US consumer energy spending share % of income Source: US Bureau of Economic Analysis, Bloomberg, NBER, Minack Advisors, March 16. Note energy spending share is the % of US consumer income spent on energy goods and services. SELECTED INVESTMENT IMPLICATIONS Energy spending share (LHS) While the overall macro-level impact of low oil prices can be subject to considerable debate for some countries, the sector and stock level implications tend to be more straightforward. Generally, areas for which oil is an input tend to benefit, while those areas where revenues are positively correlated with the oil price tend to lose out. Examples of low oil price sector/stock winners: Gasoline price (RHS) Autos low oil prices lower production costs and support demand for motor vehicles, particularly gas-heavy vehicles such as SUVs. Stock example: GM Agriculture low oil prices tend to bring down various farm operating costs, including farm machinery, fertiliser and transport costs. Stock example: Kubota Corp Chemicals since crude oil can account for a significant proportion of raw material costs in the sector, lower oil prices tend to be supportive for the operating margins of chemicals companies. Stock example: Akzo Nobel Airlines with fuel typically accounting for around a third of operating costs, low oil prices can be beneficial to airline operating margins and profits, to the extent notably that fuel purchases have not been hedged at higher price levels. Stock example: International Airlines Group (IAG) Cents per gallon (log scale)

5 Examples of low oil price sector/stock losers: Oil exploration and production (E&P) revenues at oil E&P companies are among the most strongly correlated with oil prices, and low oil prices can be particularly damaging for stocks and bonds in this sector, particularly those with relatively high break-even costs and high leverage. Stock example: Whiting Petroleum Energy capital goods lower oil prices mean lower investment in E&P, which means lower demand for energy capital goods, especially those companies most exposed to higher cost oil sources. Stock example: Diamond Offshore Drilling Alternative/clean energy low oil prices effectively reduce the economic appeal of a range of renewable/clean energy products. Stock example: Tesla Motors

6 REFERENCES 1. World Bank Commodity Markets Outlook, October Throughout this piece, any reference to the oil price refers to the WTI price unless otherwise stated. 3. EIA Short-Term Energy Outlook, February 16. IMPORTANT INFORMATION References to specific securities should not be taken as a recommendation and has been included for illustration purposes only. This document is issued by FIL Responsible Entity (Australia) Limited ABN , AFSL No ( Fidelity Australia ). Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity International. This document is intended for use by advisers and wholesale investors. Retail investors should not rely on any information in this document without first seeking advice from their financial advisers. This document has been prepared without taking into account your objectives, financial situation or needs. You should consider these matters before acting on the information. Please remember past performance is not a guide to the future. You should also consider the relevant Product Disclosure Statements ( PDS ) for any Fidelity Australia product mentioned in this document before making any decision about whether to acquire the product. The PDS can be obtained by contacting Fidelity Australia on or by downloading it from our website at This document may include general commentary on market activity, sector trends or other broad-based economic or political conditions that should not be taken as investment advice. Information stated herein about specific securities is subject to change. Any reference to specific securities should not be taken as a recommendation to buy, sell or hold these securities. While the information contained in this document has been prepared with reasonable care, no responsibility or liability is accepted for any errors or omissions or misstatements however caused. This document is intended as general information only. The document may not be reproduced or transmitted without prior written permission of Fidelity Australia. The issuer of Fidelity Australia s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN Reference to ($) are in Australian dollars unless stated otherwise. 16. FIL Responsible Entity (Australia) Limited. Fidelity, Fidelity International and the Fidelity International logo and F symbol are trademarks of FIL Limited.