Last week oil prices surged past $78 a barrel for Brent crude, setting a high last seen in 2014. Many believe the recent rally is likely to continue and Bank of America Merrill Lynch have warned there is a real risk of $100 a barrel oil in 2019. That timeline could accelerate if geo-political conditions deteriorate. Despite the advancements of sustainable, ‘clean’, energy sources, oil and gas still powers the world economy, turning the wheels of industry. As such, oil price swings have a significant impact on financial markets and your investment portfolio.
Share prices across the world ebb and flow with the price of oil. That holds true not only for oil and gas companies, who of course see their profit margins soar when oil prices rise. For many other companies, from airlines to supermarkets and plastic packaging or component manufacturers, higher oil prices have a significant knock-on effect on overheads, reducing profit margins.
So what are the factors currently driving the oil price rally, how long will higher prices likely or potentially last, what can you invest in to potentially profit from higher prices or do to protect your investment portfolio against the negative impact?
The Factors Driving Oil Prices Higher
As little as a year or so ago there was a significant school of thought that oil would never again consistently trade at over $60 a barrel. The technology advancements that mean oil and gas can now be extracted from shale beds cheaply enough to be commercially viable has opened up a bountiful new supply tap. The USA’s shale industry was not only a valuable source of revenue for the country but a key geo-political lever, offering energy self-sufficiency. By 2019, possible sooner, the US is forecast to surge past Russia as the world’s biggest oil producer. Canada’s oil sands and Brazilian off-shore production are also growing quickly, adding to global output capacity.
Increasing supply, at least if it outstrips increasing demand, and it does, would be expected to bring oil prices down. So why are they rocketing up? The dynamic is being hit by a combination of strategic output cuts by OPEC, the consortium of major oil producing nations, in partnership with Russia, and geo-political events limiting potential output elsewhere (or the risk they soon will). The market does not believe increased US shale output, even combined with increasing output from Canada, Brazil and some other regions, can compensate for the supply drop from the wider market.
OPEC and Russia Supply Cuts
OPEC, the consortium which consists of 11 major oil producers from the Middle East, Africa and South America, in partnership with other non-OPEC oil producers led by Russia, agreed to cut their combined oil output from the beginning of 2017. A global supply glut had driven oil prices down to around $45 a barrel, hurting economies heavily dependent on oil.
The cuts have since been extended into 2018. The strategy is a tricky balancing act as all members of the consortium want a floor of at least $60 a barrel on oil prices but beyond that different nations have varying targets. Saudi Arabia wants higher prices. The de facto head of OPEC is relying on oil revenue to fund the huge investment the country is making in an attempt to diversify its economy. It’s also planning the world’s biggest ever IPO to sell off a share in Saudi Aramco, the national oil company. Higher oil prices will help it achieve a better price.
Russia, on the other hand, needs lower oil prices to balance its economy. While higher prices would of course boost revenues, it is worried about the increased output this would also lead to from the US shale industry. The cost of extracting shale oil is higher than for Russia and other traditional producers and higher prices are supporting the shale industry’s development and US producers gaining a higher share of export markets, particularly the fast-growing Asian economies.
How long the current solidarity on cuts will hold before Russia breaks rank, it is already showing signs of doing so, remains to be seen. The USA is also likely to lean on Saudi Arabia if petrol prices begin to spiral quickly but how effective this will be is also still an open question.
Venezuelan Oil Output Crisis
The head of Venezuela’s oil industry is a man named Major General Manuel Quevedo. He’s been in the position since November 2017, having previously held the roles of housing minister and national guard chief. When taking office Quevedo was not found wanting when it came to bravado. He promised to root and branch restructuring that would boost production by 1 million barrels of oil a day and a purge on corruption. Theft has always been a major issue for Venezuela’s oil industry.
It’s safe to say the Major General’s mandate has not proven to be a success. Rather than the 1 million barrels a day increase in production targeted, output has fallen off a cliff. It is down 450,000 barrels a day – a decline of almost a quarter of the previous total, equating to 23%. Large sections of the company’s management have quit their roles and workers stage daily protests in the cafeterias. International oil companies such as Total and Chevron, who have partnerships with the state-owned oil company Petróleos de Venezuela (PDVSA) are obviously very concerned and China and Russia, key international allies of the Venezuelan regime, want change.
With the prospect of fresh US sanctions being imposed on Caracas if the May 20th presidential election is not considered to meet democratic standards, and it probably won’t be, production could fall by as much as another 500,000 bpd. Many of the already strained joint venture partnerships with western companies who contribute crucial investment and know-how would likely collapse.
Iran Sanctions & Middle East Turmoil
The most recent driver of oil price was last week’s announcement that President Donald Trump has withdrawn the USA from the Iran nuclear deal and re-imposed sanctions on the regime. Iran is OPEC’s third largest producer. When Obama imposed sanctions on Iran in 2012, before they were lifted after the negotiation of the nuclear treaty Trump has withdrawn from, Iran’s oil exports dropped by over 1 million barrels a day, from 2.6 million bpd to 1.5 million. The impact may be less this time as previous sanctions were widely supported internationally. However, with Trump having hinted the USA may also impose sanctions on other nations who continue to trade with Iran, the full extent of the fallout is not yet clear.
Continued troubles in Iraq, the situation in Syria and general powder keg situation in the Middle East, where the USA, Israel, Russia, Turkey, Iran are all facing off through proxies, could worsen at any given moment. That would further disrupt oil supplies. Even if things don’t boil over, the continuing fear that they could will keep upward pressure on oil prices.
Investing for Higher Oil Prices
While making major changes to a long term investment portfolio on the basis of market conditions that could change relatively quickly is never advisable, the current situation of spiralling oil prices is significant enough to warrant attention. Should prices climb further and remain high for any length of time, it would have a significant impact on the wider global economy and the performance of major companies. It makes sense to hedge against that to at least an extent.
Let’s take a look at the investment classes and sub-classes that will benefit from high oil prices and those that will suffer. That will give you some direction when considering potential investment portfolio adjustments and hedges.
Direct Investment in Oil Price – ETFs
The most direct way to invest in the price of oil is through oil ETFs. Oil ETFs are cheap tracker funds backed by the commodity itself and will closely mimic its price movement. There are also ETFs that take short positions on oil for investors who may wish to take a contrarian position if they believe oil prices will drop again faster than the market anticipates.
Investing in an oil-backed ETF could be a good hedging strategy for investors who wish to protect their portfolio against soaring oil prices without making too many adjustments to the rest of their portfolio. If oil prices continue to rise the returns generated by an oil ETF would help balance out losses taken by other investments negatively impacted.
In equities, the energy sector stands to benefit most directly from rising oil prices. The share prices in the energy sector have surged over the current quarter as oil prices have increased. High oil prices promise increasing revenues for oil and gas producers and the prospect for dividends to be hiked significantly. Royal Dutch Shell has recently reported Q1 profits up by a whopping 41%. The boost will also allow for increased investment in exploration, existing active oil fields and R&D.
Investment in the energy sector can either take the form of choosing individual companies, investing in actively managed funds where a fund manager chooses a range of companies or through ETFs which track sector indices. The MSCI European Energy Index has gained 16% since the end of March and the S&P 500 Energy Index 14%.
Other Sectors to Benefit
There are other possible less obvious sectors that will benefit from high oil prices. Companies in the renewable energy and biofuels industry is one example. Insulation companies are also likely to see an uptick in demand as households look to reduce more expensive heating bills. Hybrid and electric car manufacturers are likely to see sales rise as the cost of petrol does. Finally, recycling and waste management companies will benefit from rising plastic prices which, made from oil, are directly correlated.
Sectors and Asset Classes That Will Suffer
The recent period of low oil prices has been a significant factor in the strength of global economic growth. Cheaper fuel and energy costs benefit a huge range of industries but have a particularly profound impact on companies for whom fuel or energy counts as one of their major overheads.
Airlines are one of the most obvious examples. Higher fuel costs first reduce profits, and margins are fine in this fiercely competitive industry. At a certain point higher fuel costs have to be passed through to ticket prices, which hits demand, especially for low cost carriers.
Semiconductor Manufacturers, for whom plastic components are a key overhead will see costs rise. Tyre manufacturers, whose base rubber material is made from oil, will be affected as will any other manufacturers producing products or components with a significant plastic or rubber composition.
Energy intense heavy industries such as aluminium or steel producers or chemicals manufacturers will be hit as will logistics, freight and transport companies.
Consumer goods companies, which use a lot of plastic packaging and have high distribution costs that vary on fuel prices will be impacted and even service industry companies whose heating bills are a major seasonal cost will see those spiral if high oil prices hold.
Emerging market economies, which have been providing investors with great returns recently, will also be negatively hit by high oil prices. Companies and economies are likely to see growth levels dip with higher overheads. The fact that US interest rates are also increasing could prove to be a particularly volatile combination for emerging markets.
Investors are limited in what they can, or should, do to counteract the negative impact of rising oil prices on international economies and sectors. The lack of certainty around how long the oil bull market will continue, and how quickly prices could abate if circumstances change, mean wholesale portfolio reconstruction would be unwise.
The most balanced approach, unless you need to access cash funds from an investment portfolio in the near future, would be to ride out the current period of increasing oil price. If you were happy with the long term prospects of your portfolio at the beginning of the year then they should still be solid. However, hedging through an allocation to oil and energy sector ETFs, funds and individual equities, if you are an experienced stock picker, could help smooth out the potential impact of high oil prices, particularly if they continue into next year and beyond.