Market Bulletin DECEMBER 2014

Transcription

1 Market Bulletin DECEMBER 214 AUTHOR Alex Dryden Market Analyst Adjusting to a world of lower oil prices The collapse in oil prices over the last few months has led to much contemplation by investors and market commentators about the reasons for such a dramatic and unexpected fall, and what it means for their investments. In this bulletin, we explore a few of the potential explanations for the decline, our thoughts on the direction of oil prices in the next 12 months, and the potential impact of a world of lower oil prices on different developed and emerging economies, as well as a on range of asset classes. Overview There are two main benchmarks for international oil prices: the West Texas Intermediate (WTI), which is a US measure, and Brent, which usually covers oil located outside of the US. The prices of these two benchmarks used to track each other pretty closely. But differences in the quality of the oil and anomalies in refining capacity mean that the price of a Brent barrel of oil is generally seen as a more accurate reflection of the true price. However, what is true of both benchmarks is that they have declined swiftly in recent months. WTI is down 32% since the start of the year (Exhibit 1), while Brent has fallen by 36%, and at approximately US$7 per barrel, is at its cheapest in five years. EXHIBIT 1: BRENT CRUDE AND WTI PRICES US dollars 13 $ Brent (US$/bbl) 12 WTI (US$/bbl) Source: FactSet, J.P. Morgan Asset Management. Data as at 28 November 214.

2 Market bulletin Macro implications There are a number of winners and losers in a world of falling oil prices, and one clear winner is the developed market consumer. Lower oil prices act as a tax cut for consumers via lower prices at the petrol pump: the 36% decline in oil costs since June means the global economy might now save US$2.bn a day in fuel costs. Our estimates suggest that a US$1 decline in the price of a barrel of oil translates into a.5% transfer in growth from oil exporters to oil importers. Exhibit 2 shows the growth and inflation impact of a 1% decline in oil prices around the world. As we can see, developed market economies stand to receive a.2% boost to GDP on the back of the decline in oil prices. EXHIBIT 2: IMPACT OF 1% DECLINE IN OIL PRICE %-PT 1 YEAR IMPACT, ASSUMES PURE SUPPLY SHOCK Growth Impact Source: J.P. Morgan. Data as at 28 November 214. Global DM EM Inflation Impact However, oil prices will increase disinflationary pressures around the world. A fall in global energy prices could take as much as.2% off annual inflation figures. Such a fall would have the most pronounced effect on headline consumer price inflation. An increase in deflationary pressures might result in central banks in the US and UK delaying the timing of the first interest rate rise into late 215. In Europe, investors are already concerned about the lack of inflationary pressure, with the headline consumer price index (CPI) figure standing at just.3% (y/y) in November. Our research shows that the impact of lower oil prices tends to take around four months to ripple through the economy and affect prices, so investors should be aware of a potential fall in headline inflation in Europe beginning in early 215. On the whole, a world of lower oil prices can help boost global growth, while providing the longsuffering consumer with some additional income via a cut in petrol prices. As we can see from Exhibit 2, the impact of a falling oil price on the emerging world is not quite as clear cut. Net energy importers such as Turkey, South Korea and India stand to benefit from falling global oil prices, while commodity exporters may be in for a bumpier ride. As shown in Exhibit 3, the fiscal balances of many commodity-exporting nations have been calculated on the assumption that oil prices would remain above US$1 per barrel, and, in some cases, above US$12 per barrel. Should lower oil prices persist, then emerging economies such as Venezuela may be forced to adjust their fiscal balances by cutting subsidies and social benefit programmes, which could trigger political and economic instability. Why did this all happen? The recent drop has caught investors off guard. Granted, there was a weakness in the economic data in areas outside of the US, but nothing to warrant the current decline in prices. Some of the decline could be explained by a reduction in geopolitical risk as Russia looks to have withdrawn from Ukraine while the tensions in Iraq are generally taking place far from the Majnoon and Halfaya oil fields in the south. However, much of the drop can be explained by supply-side factors rather than geopolitics or demand factors. Saudi Arabia is considered to be the swing oil producer, in that it will cut or expand production based on total global output to maintain a certain oil price. At the height of the Libyan crisis, for example, Saudi Arabia increased production to offset the fall in supply from Libya. As shown in Exhibit 4, production in Libya has recovered from 3, barrels per day in June of this year to 85, barrels per day in October. Such a surge in production meant that Organisation of the Petroleum Exporting Countries (OPEC) production moved above its quota of 3 million barrels per day for the last few months. EXHIBIT 3: BREAKEVEN OIL PRICES FOR SELECTED EMERGING MARKETS Oil prices: $75 Iran 6 Qatar Oman 4 Libya Iraq Kuwait Algeria 2 Saudi Arabia Russia Venezuela Change in fiscal breakeven oil price (29-14) -2 Bahrain Increasingly vulnerable to falling oil prices Fiscal Breakeven Oil Price (214-15) Source: Bloomberg, Reuters, IMF, J.P. Morgan Asset Management. The fiscal breakeven price is the required oil price needed for a government to run a balanced fiscal budget. Data as at 28 November Market Bulletin Adjusting to a world of lower oil prices

3 EXHIBIT 4: CRUDE OIL PRODUCTION IN MILLION BARRELS PER DAY 1 Saudi Arabia (LHS) 9 8 Libya (RHS) The US shale industry took on a considerable amount of debt in order to finance the boom that we have seen over the last few years. In 21, energy and materials firms made up approximately 18% of the Bloomberg US high yield index. Today, that figure stands at 29%. Such a large increase in debt has led some to become concerned about the risks of a potential spike in defaults in the US high-yield space. 6 5 US (LHS) 4 '9 '11 '12 '13 '14 Source: EIA, J.P. Morgan Asset Management. Data as at 28 November 214. Saudi Arabia may be front-running production due to the chance of an oil shock caused by the fighting in Iraq. However, an alternative view is that Saudi Arabia is deliberately holding the price down to dampen the supply from non-opec producing countries and, in particular, the US shale oil sector. Over the last few years, the supply of US shale oil has grown phenomenally: in 29, only 15, barrels of shale oil were produced each day in the US, while this number is set to exceed 3 million by 217. Such an increase in production has no doubt caught the attention of Saudi Arabia, which may be looking to regain market share by taking advantage of its low production costs (with some estimates putting it as low as US$1 a barrel), potentially putting the pressure on a few of its rivals in the process. Exhibit 5 shows the 13 largest shale oil basins in the US and their breakeven production points. The vast majority of these basins, accounting for over % of US shale output, are still technically profitable with the oil price at US$ per barrel. However, investors must remember that these production costs do not include important interest payments made by shale producers..5. The party line from the US oil industry is that US shale oil companies can survive this bout of low oil prices because many of the costs involved with shale oil are sunk costs, and the marginal cost of pumping oil out of the ground is relatively low. Under the scenario laid out by US oil representatives, there would be little or no risk to the long-term sustainability of many US energy companies, and low oil prices would simply damage profit margins. In this situation, we would have seen a sell-off in the equity price of these firms, but no subsequent sell-off in the debt component, with investors confident in the long-term sustainability of the firms. However, Exhibit 6 suggests that investors are not buying into that assessment of the situation. Markets have seen a sell-off in both the equity and the debt components of the capital structure of energy firms, suggesting that investors are concerned not just about the damage that low oil prices will do to profit margins, but also their ability to push firms into default. As worrying as this assessment might be for US high-yield bonds, there are some mitigating factors. Firstly, the break-even point for many US shale oil producers is likely to fall as advances in technology are made, potentially cutting costs and improving profit margins. Secondly, many oil and gas producers do not leave the price of these commodities to chance, and some, as shown in Exhibit 7, hedge a significant portion of their future production volumes in order to help them meet their debt service obligations. Thirdly, our estimates suggest that only 6% of high yield issuers have material direct exposure to oil prices. EXHIBIT 5: BREAKEVEN PRICE FOR US SHALE OIL PRODUCERS Broken down by basin 12 $ 1 Oil prices: $ Eagle Fords North Wolfcamp South Wolfcamp Delaware Bakken Niobrara Delaware Uinta- Vertical Mississippi Lime Delaware Basin Anadarko Basin Barnett Combo Ultica Horizontal Source: Reuters, IMF, J.P. Morgan. Data as at 28 November. J.P. Morgan Asset Management 3

4 Market bulletin EXHIBIT 6: EQUAL WEIGHTED INDEX OF US ENERGY FIRMS WITH BOTH EQUITY AND HIGH YIELD ISSUANCE 15 Debt Index Equity Index 45 position by overshooting their assigned quotas. A weaker and worse-disciplined OPEC could potentially lead to further declines in oil prices towards the $7 $6 per barrel range Nov-12 Feb-13 May-13 Aug-13 Nov-13 Feb-14 May-14 Aug-14 Nov-14 Source: Bloomberg, J.P. Morgan Asset Management. Includes all energy sector firms in the Bloomberg US High Yield index that also issue equity. Data as at 28 November. EXHIBIT 7: HEDGING DETAILS FOR SELECTED COMPANIES Company % of 215 Oil volumes hedged W. average price (US$ / Bbl) EP Energy 89% $91 Halcon 89% $87 Concho Resources 63% $88 Linn Energy 59% $94 Chesapeake Energy 55% $93 Source: Bloomberg, J.P. Morgan Asset Management. Data as at 28 November 214. The future trajectory of oil prices So, should investors see lower oil prices as a temporary phenomenon or one that is here to stay? Global oil prices are driven by a complex cross-current of global demand and supply dynamics, in an environment of heightened geopolitical risk. Such a mix can cause oil prices to move around dramatically in a short period of time. In 212, oil prices declined by 3% from March to June, but this trend quickly reversed in the subsequent three months. This could happen again, if the conflicts in Iraq or Libya escalate, or if economic growth picks up rapidly, with global oil prices heading back towards US$1 per barrel. The biggest downside risk for global oil prices is a disorderly decline in OPEC oil production. The cartel s hold on global oil prices is weakening. In the 197s, OPEC production accounted for 52% of global oil output, but has fallen to 39% today. Non-OPEC production, particularly in places such as the US and Russia, has picked up sharply over the same period, which has weakened OPEC s hand. This decline in OPEC control of the market has also been coupled with ill discipline on the part of OPEC members, who have regularly attempted to take full advantage of their privileged In the near term, oil prices look set to fall as OPEC gave no sign at its meeting in Vienna on 27 November that it would be cutting back on production. If the cartel wants to stabilise the price then a reduction of at least 1 million barrels a day would be required. Judging from the comments made by OPEC member states, there is concern over the current price of oil, but no plans to adjust production just yet. Despite the fact that the next formal OPEC meeting is not scheduled until June 215, it seems likely that members will attempt to reach an agreement via informal negotiations, meaning that rhetoric from OPEC member states may have a greater impact on the oil market over the coming months. A lack of an agreement by OPEC on adjusting oil output, coupled with sluggish global growth, could see oil prices continue their slide, with some forecasts suggesting US$7 per barrel for Brent crude by 1Q15 may be a possibility. Sector winners & losers There are also some key winners and losers on a sector-by-sector basis. As Exhibit 8 shows, a 1% decrease in the oil prices understandably hurts energy companies, which have to manage falling margins and potential shutdowns of unprofitable drilling operations. However, falling oil prices tend to benefit companies in the consumer discretionary sector. Because the fall in petrol prices acts like a tax cut for developed market consumers, they have more money to go out and spend, meaning that the recent fall in the oil price could provide a pick-up for retailers, especially with Christmas just around the corner. EXHIBIT 8: THE CHANGE IN EPS FOR SELECTED SECTORS ASSUMING A 1, 2 AND 3% FALL IN OIL PRICES 5 % Cons. Disc Energy 1% fall in oil 2% fall in oil 3% fall in oil Source: S&P, FactSet, J.P. Morgan Asset Management. Data covers quarterly time periods since 21. Data as at 28 November Market Bulletin Adjusting to a world of lower oil prices

5 Market Bulletin Our research also shows that there seems to be no statistically significant relationship between changes in the oil price and the earnings of industrial companies. However, sub-sectors such as airlines that sit within the industrials sector could see some upside. Currently, airlines are experiencing a short-term headwind due to fears over the spread of the Ebola virus. However, low oil prices would act as a long-term tailwind for airlines in the form of lower fuel costs. If oil stays at or around US$7 per barrel, it could add as much as US$2 to earnings per share for US airlines. If investors are concerned about fluctuations in the price of oil, one potential way to hedge against this is to invest in technology stocks. This is because there is no statistical relationship between changes in the price of oil and the earnings of technology stocks. This makes sense, as fuel costs tend not to make up a particularly significant portion of a technology company s cost structure. Investment implications The recent fall in the price of oil should boost GDP around the world, particularly in developed countries, although it will add to disinflationary pressures. The OPEC meeting on 27 November in Vienna resulted in no agreement to cut the cartel s output, suggesting that prices are likely to fall over the coming months as members attempt to reach an agreement via informal negotiations. The US shale industry is likely to come under some pressure from the recent fall in oil prices, due to a lack of competitiveness at prices below US$1. This raises the prospect of an increase in defaults in US high-yield bonds if low oil prices persist. The earnings of most equity sectors have a statistically insignificant relationship with oil prices. However, historically, US consumer discretionary companies tend to benefit from a pick-up in a consumer spending. Transport industries such as airlines also stand to benefit from lower fuel costs.

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