Home Stock & Shares Does The Oil Price Rout Mean Investors Must Quickly Adapt To A New Reality?

Does The Oil Price Rout Mean Investors Must Quickly Adapt To A New Reality?

by Paul
Crude Oil Price

Oil prices last week sank to their lowest levels in over 20 years last week and an increading number of analysts are reaching the conclusion they may never recover. WTI, the U.S. oil price standard, even slipped into negative territory with producers paying up to $37 a barrel for buyers to take it off their hands with storage spaces bursting at the seams. For many, a natural reaction is to welcome lower oil prices in the belief that they will lead to lower fuel costs and cheaper transportation, heating and electricity.

But with so much of the world economy and financial markets tied up with oil markets, the reality is far more complex. The transition towards renewables may be underway but it is still early in the process. The failure or distress of the world’s largest energy suppliers and sellers would have huge knock-on consequences elsewhere. Not least of all for investors.

BP and Shell are the UK’s two largest companies by some distance. The pair’s combined worth has historically accounted for a weighting of around 20% of the entire FTSE 100 – the benchmark index that tracks the 100 largest companies listed on the London Stock Exchange.

Because the world’s biggest energy companies have held such major weightings in indices, and historically been among the most lucrative and reliable payers of dividends, index trackers, pensions and a majority of funds stand to suffer badly from the major shock to the system an extended period of ultra low oil prices would mean.

What’s actually going on, will oil prices ever recover and what does the current and probable future new reality mean for investors? Even more importantly, is there anything you can do to mitigate the impact of a cheap oil future or even turn it to your portfolio’s advantage?

Why Oil Prices Have Fallen So Low And Why That Might Continue

The oil price rout that has unfolded over the past couple of months, accelerating over the last 2 weeks, is the result of a combination of two decisive factors. At their root, these two factors are the fundamental influences of supply and demand.

Oil supply has been high for some time as a result of North American shale and tar oil operations meaning the USA is now a net exporter of oil. Shale oil is much more expensive to extract than from other kinds of oil fields, especially the rich, easily accessible fields of the Middle East and productive deep sea resources. But for a number of years prices have been high enough to support the industry and production has soared.

Two years ago, increasing oil supplies saw OPEC+, an alliance between the major oil producers of the OPEC group led by Saudi Arabia and other major oil producers including Russia, agree to artificially cut their output. That tightened supplies, putting a floor under prices.

However, over the past year, those supply cuts were being gradually unwound. That was agreed on and largely supported by demand. Then the Covid-19 pandemic struck. Airlines grounded their fleets, economies around the world went into lockdown reducing travel and the heating and power required for large and public buildings like office towers, bars, restaurants, shopping centres and entertainment venues. Demand for oil abruptly fell through the floor.

Just as that doomsday scenario for the oil industry began to unfold, Saudi Arabia and Russia, then Mexico, started to argue about supply cuts. Disagreement between major oil producers on who should cut production by how much culminated in Saudi Arabia initiating a price war by upping production. With among the cheapest to extract and richest oil fields in the world, the Saudis wanted to show Russia and anyone else who didn’t want to toe the line that if they didn’t agree to cut supplies to prop up oil prices, they were not in a position to get into a price war with the industry’s dominant supplier.

The combination of plentiful supply and devastated demand led to the price of a barrel of Brent crude last week dropping to $20, its lowest level in over 20 years. And WTI’s price dropping into the negative as storage space ran out – a historical moment.

Will Oil Prices Recover And Under What Circumstances?

Oil producers have now managed to put their differences aside, at least for the time being, and have agreed on coordinated output cuts totalling a combined 9.7 million barrels a day beginning May 1st. Towards the end of last week some countries were talking about bringing that forward with immediate effect.

Some producers may have little choice. Royal Vopak, the world’s largest independent oil storage group, has announced publicly that it has almost run out of capacity. Gerard Paulides, its chief financial officer, told Bloomberg: “From what I hear elsewhere in the world, we’re not the only ones.”

WTI Crude Oil Price

wti-oil

Source: MacroTrends.net

With so much excess supply having built up and demand unlikely to quickly recover to pre-lockdown levels even when restrictions begin to ease in one country or region at a time over the coming weeks and months, how long might it realistically take for prices to rise to ‘healthy’ levels again?

Because Brent crude is ‘seaborne’, and traders can relatively easily ship it to where demand is highest, it hasn’t been hit quite as hard as WTI, because storage facilities are not such an issue. But its price is still rock bottom.

Schroders’ Mark Lacey, Head of Commodities, comments:

“The shock to the global oil market as result of Covid-19 restrictions is unprecedented. The oil market has never experienced a fall in demand of this magnitude. From what we are already seeing, this will have a long-term impact on the supply dynamics of the oil industry for many years to come. And despite recent cuts to production, the most important driver for any recovery will be demand.”

Fidelity Investments analyst Graham Smith sees two scenarios for how oil prices will move over coming months. The first is a relatively strong rebound when Covid-19 lockdowns end and transport gets back to normal. This relies on initially lower fuel prices leading to a surge in demand as consumers use their cars more both at home and, for example, trips to continental Europe to avoid planes and public transport.

Some U.S. shale producers may also be forced out of business, or to temporarily suspend production until prices return to profitable levels, reducing supply.

But in the second scenario, there may be a longer term shift away from fossil fuels. In this scenario, the world will have gotten used to using them less and tourism and travel stay depressed until a Covid-19 vaccine is widely available.

In both scenarios, however, Smith writes:

“it seems likely that oil prices will remain under considerable pressure until the coronavirus threat has passed, and that might not be for some time yet”.

What Does An Extended Period Of Low Oil Prices Mean For Investors?

Low oil prices have a positive and negative impact on different businesses. The positive is that lower fuel and energy prices mean businesses and consumers have more cash to spend on other things. As a result, low oil prices tend to push up consumption which is a boost for sectors such as retail, transport and leisure and entertainment. But for those sectors to benefit, lockdown also needs to end.

Energy Funds & Oil ETFs

Pure-play energy funds have unsurprisingly been hit hardest by the slump in oil prices and investors in passive oil-price tracker funds are nursing serious losses. The situation has been made worse by the fact many speculative investors had bet on earlier lows representing a bargain and that prices would recover relatively quickly when lockdown constraints were eased.

The United States Oil fund(USO) is the world’s largest oil price tracker and is down 78% for 2020 so far. The largest oil fund available to European investors, WisdomTree’s WTI tracker is down almost 70%.

Both funds are ETFs, which makes them particularly vulnerable to ongoing price depression.

The Financial Times raises the risk of the oil market moving into “contango” – an industry term for spot prices being below futures contracts. In this situation ETFs could be forced to sell the contracts they hold at lower prices and buy the next month’s contracts at higher prices in order to maintain their holdings.

Why this is so bad is explained by Saxo Bank’s head of commodity strategy Ole Hansen. He points out that oil-only ETFs are

“predominantly positioned at the front of the futures curve and will be exposed to rolling losses every month until the market fundamentals eventually stabilise”. A process he fears “could take several months”.

The result of this would likely be a repeat of a scenario that unfolded in 2009 when oil prices dropped to $30 a barrel. Investors piled into ETFs in the expectation of strong profits when prices recovered. The duly did, gaining 300% over the next year. However, profits were far less than the actual price gains, with a major portion lost every month servicing monthly rolling contracts.

While a first reaction may be to presume the renewables sector, and funds focused on renewables, will benefit from low oil prices hitting fossil fuels companies, the opposite is more likely to be the case. Low oil prices might hurt producers and traders, but they will encourage energy companies to produce more power from cheap fossil fuels. The economic parity reached or almost reached by some renewables will suddenly fall away.

The adoption of electric vehicles is also likely to stall if petrol stays significantly cheaper for a longer time. So stocks such as Tesla and manufacturers of electric car batteries and other renewables technologies may suffer.

Smith comments on the energy industry in particular:

“The industry may require a concerted push to force climate change back up the international agenda post coronavirus. Politicians face two choices: either to rebuild the old fossil fuel world as quickly as possible; or to capitalise on disconnects in the global economy to accelerate the energy transition. Only time will tell which it will be.”

Income Investors & Pension Funds

With the oil majors among the most relied upon dividend payers in financial markets, pension funds and private investors in income funds may well be in trouble. So far the biggest oil companies, like Shell and BP in the UK, have resisted cutting dividends but if prices stay depressed for an extended period of time, which the might well, it is likely to be only a matter of time.

Norway’s Equinor last week became the first ‘oil major’ to officially announce it is cutting its dividend. Together, BP and Shell account for 18% of all dividends paid out by the FTSE 100. The latter has cancelled its share buyback programme, which will weigh on its share price. That decision was taken to preserve the dividend due later this year but investors will be justifiably nervous that it can no longer be relied upon.

BP has decided to reduce capital spending by 25% this year to keep its financial powder dry and dividend safe. But even if dividends are maintained this year, that would be expected to change in 2021 if prices remain low. A Covid-19 vaccine is the practical condition under which demand levels might recover to those of a couple of months ago.

What Can Investors With Exposure To The Oil & Gas Industry Do To Mitigate The Impact?

With so much up in the air, the best thing investors can probably do is hedge their bets with diversity. It may be premature to give up hope of strong oil dividends coming back in the future by cutting their losses entirely now.

Actively managed funds may again prove their worth after a decade of losing out to passive index trackers. A FTSE 100 tracker can’t reduce its BP and Shell holdings but a fund manager can, which could mean actively managed funds can dodge the worst of the impact of low oil prices. And good managers will also take advantage of newly emerging opportunities that result.

A well-diversified portfolio is also a healthy portfolio and most experts argue that diversification is second only to time as an investor’s best friend.

Four sectors investors might consider raising their exposure to as a hedge against low oil prices are:

  • Airlines

Airline stocks have been absolutely hammered by the Covid-19 lockdown and share prices have fallen off a cliff. The risk is how well passenger numbers recover going forward but if they do low oil prices will help potentially bargain airline share prices recover more quickly as jet fuel will be cheaper. Easyjet, Ryanair and British Airways owner IAG could all be worth a look.

  • Transport

Shipping and freight companies will also be boosted by low oil prices feeding through to lower fuel prices. DHL, FedEx and United Parcel Services (UPS) are all examples of stocks in the transportation sector that could benefit. In the UK, Royal Mail has dropped over 40% since its 6-month high in December. In some regards the company’s share price looks cheap, but with serious doubts around long term prospects, even recent falls may not mean it’s a stock for UK investors to focus on. International options look better.

  • Consumer Discretionary

A broad sector that covers companies offering non-essential products and services that encompasses retail, travel & tourism, entertainment and leisure. The Covid-19 has been a plus for some companies in this sector, such as Netflix and video games companies including Activision Blizzard, Electronic Arts and Grand Theft Auto-developer Take-Two Interactive Software could all be worth a look. Hospitality looks like a sector to avoid for the time being and the work at home culture could see fast food chains go into decline.

  • Consumer Staples

A sector expected to benefit from lockdown on the whole is consumer staples, which includes foods & beverages, household goods and hygiene products. Two companies that looked attractive even before the recent market sell-off were FTSE 100 consumer staples giant Unilever and alcoholic drinks group Diageo. With their share prices down significantly, both look even more attractive now.

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