Sunday, 15 February 2015

The Oil Price: Causes and Consequences

The significant reduction in the oil price is one worthy to write about given its far reaching implications, in both the economic and political world. In September 2013 a barrel of oil was worth $US110, with such a price extending to mid 2014 at $US107 per barrel. It has therefore fallen more than 50% over a six month period, with both the magnitude and the short time period taken creating notable ripples in the markets.

A Slippery Slope

I believe the oil price collapse can be primarily attributed to the price war. The high price of oil over the past three years has attracted higher-cost producers other than Saudi Arabia into the market. Naturally the competition encourages producers to develop existing facilities and make the most of technological advancements and efficient production techniques by undertaking exploration for further resources. In other cases, pressure from economic sanctions such as those imposed on the world’s 2nd global oil exporter, Russia, resulted in the highest output last year since the Soviet Union collapse. The increased oil supply around the world has therefore threatened the power of OPEC oil producers in dictating market prices. Furthermore the inflated price of $US113 per barrel shifted profitability towards renewable energy sources instead, such as solar, wind and LNG.

I also believe the market has focussed too heavily upon the supply side of the equation and trends in the weakening demand should not be overlooked. After all, the developing economy has demonstrated growth below the long term average since 2013. These factors overrode the presumptions of finite resources, a rapidly growing population and large wealth increases in Asia to trigger a downward spiral of oil prices.

Investor Issues

Such an oil price collapse raises questions in the Australian stockmarket. The ASX is traditionally energy intensive as Australians tend to assert greater reliance on the resource sectors than foreigners, given investor preference for lower currency and administrative risk (often experienced with direct investment in foreign stocks). Those investing in energy producer stocks (BHP Billiton, Rio, Santos, Woodside etc.) should be questioning how low will the price reach, and if any rebounds can be made from the low prices forcing out marginal energy players. While Middle Eastern producers can be sustainable with oil at $US30-40 per barrel, American and Eastern and Northern European producers are on different terms.

In fact, the oil price range settled upon also impacts other stocks in the market by encouraging the Central bank rates to remain low for longer, given the ability of commodity prices to pair low inflation with high consumption. Read more about the reasons and implications of the interest rate: 
However because the lower prices reduce business costs and consumer expenses, it acts as a stimulus to strengthen its own demand, and consequently oil prices. This market mechanism occurs whilst the higher-cost energy producers stall or cut back production to avoid losses, suggesting this outlook for the energy sector will change.

Despite this the OPEC cartel announced in 2014 that it will maintain the production levels (which had increased) regardless of the market price. According to Gaurav Sodhi, Intelligent Investor’s resource analyst, perhaps OPEC is aware that their unconventional sources such as shale oil and Canada’s tar sands deposits are presently undervalued. This can imply OPEC is attempting to force out competitors and subsequently allowing prices to return to $US60-70 in the interests of their own profit.

A Long Term Perspective

Therefore I believe investors who rely on a longer term strategy will profit from the oil price collapse. In the short term, there is an incentive for innovation in order to improve energy efficiency and productivity. However I am confident that in two to three decades, the demographics should change to favour these forward thinking investors, assuming any dysfunction in the political-economic sphere given global conflicts or government debts do not change the picture. It is true that there is a finite supply of commodities, coupled with a growing population and improved prosperity in developing nations. The UN forecasts the world population as 9.6 billion by 2050, suggesting that demand for resources including energy will rise by at least a third. The need for resources further multiplies as the population growth is more intense in areas of rising wealth.

Unlike manufactured goods and soft commodities like grain and dairy which are products from the development of arable land, hard resources such as iron ore, oil, gas and gold are unable to be replicated. Rather, the economics of natural commodities are a function of the cost of discovery and extraction and processing expenses, with the dollar and commodity price as variables. These costs can be easily observed through analyst reports. Also, as commodity prices drop, corporations are motivated to cut costs quickly, although based on past events costs rarely fall at the same rate as prices. Therefore low-cost producers such as BHP and Rio which specialise in iron ore should appeal to investors the most as costs are cheaper than the commodity and they hold significant cash on hand.

Other corporations that are capable of purchasing assets at the current discounted prices and have sufficient reserves to support any price collapses are New Hope and AWE. These companies are valued at less than twice their cash value, despite New Hope having $1 billion in cash and the oil producer, AWE, likewise being profitable with prices at these levels and having rejected a takeover in 2014. (None however in the worst recessions the optimal stocks to purchase would be ones valued at even less than their cash stockpile).

If oil prices do rise, investors in Santos and Origin Energy should also benefit. Their major LNG projects scheduled for this year runs for decades and therefore should produce large profits, at least more than that expected by those who over emphasise the low prices today.

Overall I am confident that investors can capitalise on the price collapse with highly selective opportunities. What is certain though is that these oil market machinations will certainly change the composition and strategy of portfolios.

Money Magazine, Wall Street Journal, Financial Times, Sydney Morning Herald

No comments:

Post a Comment