What’s happening to oil?

From 2011 to 2014 crude oil was in the price range of $80 to $110 a barrel. This price level led to a large increase in the supply of oil from the likes of the oil shale and the oil extraction revolution in North America.

Add to this a slowdown in China, a resurgence in supply from Iraq and now Iran, combined with oil producing countries pumping more oil as the price goes down in order to maintain revenues, has all led to a precipitous decline in the price of oil.

The oil price has now dropped $85 from June of 2014, ie 81 per cent in little over 18 months. The price is now below the GFC lows when it reached a low of just over $40 a barrel and is back to 2003 levels. Adjusted for inflation the price is even lower.

This large fall in the price of oil raises a number of questions. The first is whether the fall in oil prices is over.

In the short term the oil price could go lower as Iranian production comes on stream and if Chinese growth slows further.

In the past oil has often got stuck in a trading range from 5 to 10 years, so it is quite feasible that oil stays at these lower levels for an extended period.

What has happened to oil has also occurred to a number of other commodities such as coal and iron ore. Oil is a lot different to other base commodities though as it tends to be used up quickly and is more difficult to stockpile substantial amounts.

The interesting thing about oil is that demand has not actually declined, in fact demand is increasing and the lower price is likely to engender further increases in demand. Its vital role in transport also makes it very different to other commodities.

Potentially, demand could get hit if the world, and particularly China, goes into a recession, but the balance of probabilities is that this will not occur. Low rates combined with the positive impact from low oil prices will tend to be stimulating for the world economy, especially for countries such as the US, Japan and Europe. Thus, if demand holds up, the supply side will be the determining factor as to where oil prices go.

At current prices a lot of oil production is uneconomic and if the prices remain around current levels for a substantial period then much of this production will be shut down. This is exactly what the low cost producers are hoping for, but the prices have to be held down long enough for the production to shut down.

The lower prices will impact the financing of the junk bond market in energy debt – which could make it a lot harder to finance these projects in the future. It will also make energy companies be a lot more reluctant to get involved in projects such as shale oil – for instance BHP has written off around $20 billion in this space so far.

Another implication of the ultra-low fossil fuel prices is the impact upon renewable energy making more or most of these projects uneconomic without government subsidies.

As for the price of energy stocks, they have fallen substantially over the last year and look cheap on a number of multiples.

If oil prices stay down they are unlikely to rally much, but due to their leverage and their cost cutting any increase in the oil price could lead to a significant rally in these stocks.

With regard to other stocks, transport stocks, airline stocks and consumer expenditure stocks are all beneficiaries of the lower oil prices. In terms of emerging markets and importing countries such as Taiwan and South Korea, they will benefit from lower oil prices, whilst exporters such as Venezuela, Russia, Libya and Iraq will be losers.

In conclusion, the lower oil price will be positive for world economic growth, but will have a mixed impact upon countries and stocks depending how they are positioned.


Important
The information contained in this newsletter is provided on behalf of the IOOF group of companies and is intended for financial adviser use only. It is given in good faith and has been prepared based on information that is believed to be accurate and reliable at the time of publication. Any examples are for illustration purposes only and are based on the continuance of present laws and our interpretation of them at the time.