Lower oil prices

Market Update


Oil prices remained under pressure during the quarter, hitting lows not seen since the Global Financial Crisis. At the end of 2015, prices had fallen by around 70% since mid 2014 (Figure 1).


Figure 1: Oil prices have declined significantly over the past couple of years.

(Source: Thomson Reuters Datastream)


Both technological advances and geopolitical forces have contributed to the declines. The primary catalyst being the US shale oil revolution, whereby improvements in oil-extraction technology have allowed the US to dramatically increase its production levels (Figure 2), albeit at higher cost than other major oil-producing nations.


Figure 2: US crude oil production and inventories have dramatically increased.

(Source: Thomson Reuters Datastream)


The second major factor has been the Organisation of Petroleum Exporting Countries’ (‘OPEC’) decision to maintain its production levels (and the fact that many OPEC nations continue to produce more oil than their quotas allow).


The erosion of price discipline

Historically, OPEC has held a balancing role in oil markets, cutting production to support prices during times of reduced demand or temporarily heightened supply. Specifically, Saudi Arabia is considered the ‘swing producer’ within the cartel that acts to increase or decrease production as needed. This is due to its status as the largest producer in OPEC (by far), its low cost of production and its ability to adjust production volumes with ease. However, in recent years Saudi Arabia has decided to maintain its production levels, for two main reasons:


  1. It has argued that although a decrease in its production would support prices, this would simply encourage higher-cost US producers to increase their production and would lead Saudi Arabia to cede further market share, and hence longer-term market influence, to the US.Rather, the Saudis have pledged to maintain their production under the premise that low prices will eventually force higher-cost US producers out of business. This strategy also allows the country to apply some pressure to its less-affluent Middle Eastern rivals.
  1. Saudi Arabia has asserted that it may be prepared to cut production, although only alongside equivalent cuts by other oil producing nations, both within and outside of the OPEC cartel.Again, this is to an extent reflective of Saudi Arabia’s unwillingness to surrender market share, particularly to its Middle Eastern neighbours (for example Iran, with which it often holds opposing political goals).
    This scenario was quickly rejected by other major oil-producing nations, including Iran, Iraq and Russia, who are equally keen to maintain their share of the market.


Saudi Arabia has been able to employ its current strategy because its considerable financial strength allows it to weather periods of lower oil revenues. However, this cannot be said for some of the less affluent oil-producing nations, including countries such as Iraq and Russia, which have been increasing their production. Furthermore, Iran is expected to significantly increase its supply to the global oil market over the next 12 months as the sanctions imposed on it by the US and European Union are lifted (following the resolution of issues surrounding the country’s nuclear programme earlier in 2015).


Pressure on the US

In line with Saudi Arabia’s goals, higher-cost US oil producers have come under increasing financial pressure as oil prices have dropped below their marginal cost of production. This can be seen in US corporate bond markets (Figure 3), which are anticipating a rise in defaults from companies whose medium-term solvency is in question. Even for companies that are financially and operationally healthy, this makes refinancing their debt more expensive.


Figure 3: Credit spreads in the energy sector of the US high yield corporate bond market have expanded significantly. This means that lower-quality US energy companies are having to pay more to access capital and reflects the fact that investors judge their creditworthiness as having declined.

(Source: Thomson Reuters Datastream)


US oil production has recently begun to adjust to lower prices, with production volumes having been in decline since early in 2015 (although they remain at historically-elevated levels). Increasing numbers of oil rigs have been put out of operation (Figure 4), contributing to a wider slowdown in US manufacturing activity growth, which is now negative.


Figure 4: The number of oil rigs in operation in the US has fallen as oil prices have declined.

(Source: Thomson Reuters Datastream)


With demand falling short of supply, global oil inventories continue to build (Figure 2). It is unclear how much global oil storage capacity still remains, but as unused storage becomes scarcer the downward pressure on oil prices will increase.


Market and economic effects

Given these issues, it is unsurprising that the global energy sector has heavily under-performed the broader market over the past couple of years (Figure 5).


Figure 5: The energy sector has lagged broader global equities significantly over the last couple of years.

(Source: Thomson Reuters Datastream)


Oil-related companies may eventually provide compelling investment opportunities, but we are mindful that they may currently represent value traps that could suffer further losses. US oil production is likely to continue to decrease as long as prices remain depressed, but it can easily be increased again if they recover. Likewise, production growth from elsewhere in the world is likely to offset declines in the US, at least in the near term, thereby providing a headwind to the possibility of any prolonged period of oil-price strength (notwithstanding any unexpected supply shocks).


The declines in oil prices have caused a significant transfer in wealth from the oil-producing countries, such as Russia and the OPEC nations, to the Western world. This is evident in the redistribution of economic growth that has been witnessed between these regions over the course of 2015. We expect this to continue in 2016, while lower oil prices will boost other areas of the global economy, such as the consumer sectors, in time.


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