Falling oil prices dampen Christmas cheer for Stock markets

Posted by Liz Rees in Market commentaries category on 17 Dec 15

What’s happened to the oil price?

Oil prices have continued to fall following the latest OPEC (Organisation of Petroleum Exporting Countries) meeting at which ministers failed to agree on output restrictions, the usual method employed to tackle oversupply, and actually scrapped its production ceiling. Some commentators believe this is a tactic to crush competition from the US shale industry. Oil prices have now more than halved in the past 18 months returning to the levels of the financial crisis. Brent crude, the global oil benchmark, touched a 7 year low of $36.33 on the 14th December. The strength of the dollar and hedge fund traders taking short positions has added to the pressure.


How is it affecting the global economy?

The oversupply in the market is largely a result of lacklustre global economic growth which has resulted from the slowdown in China, a leading importer of oil. The effect has extended to the broader commodities market with Anglo American being the latest major company to announce a cut in its dividend.

Highly indebted US shale producers are struggling to operate profitably at current price levels leading to fears of rising defaults in the energy sector which when combined with mining and materials makes up around 17% of the high yield bond market. This has lead to a sell off in the wider corporate bond market. Another worry is the expectation of imminent US interest rate increases which will put further pressure on companies’ ability to service their debt.

Global growth forecasts have been reduced over the course of the year and forecaster Oxford Economics has recently cut its 2016 global GDP growth estimate to 2.6% which is below both the consensus and the long term average.

Will it continue to fall?

Many experts believe we are in for a prolonged period of low oil prices. Goldman Sachs suggest a move to below $30 is on the cards and possibly even as low as $20. Neptune Fund Managers research predicts that we face a decade or more of depressed oil prices. They argue that more efficient shale extraction techniques will reduce the marginal cost of oil production- estimated by the World Bank to be $80-90- which has historically been considered as the long term equilibrium price for oil. Neptune believes this will lead to a lower break- even price of around $36 a barrel and that current price-related falls in shale output, triggered by OPEC’s stance, will prove temporary. Even those adopting a more bullish stance on the prospects for oil are generally not anticipating a strong recovery in the price in the near term.

Who are the main winners and losers?

On the positive front, lower cost oil provides a boost for countries which rely on importing supplies to meet their needs. Japan, India and even the US are leading economies which fall into this category. Conversely, those countries with economies highly dependent on oil exports including Russia, Nigeria, Venezuela and Mexico are facing severe falls in their national income.

Cheaper energy costs are positive for consumers and the wider economy which benefit from lower petrol and heating costs. These price cuts have been compounded by a mild winter reducing the demand for heating oil and overproduction of diesel by refineries. Savings on these essentials means businesses have greater cash flow to invest in future growth opportunities while consumers have more money available to spend on other items including luxury goods.

Messages from the December Climate Conference in Paris

This major convention resulted a climate deal which commits 195 countries to reducing pollution. This is likely to put further cost pressure on fossil fuel producers and industries that depend on them and provides opportunities for renewable energy suppliers. However, the International Energy Agency expects fossil fuels to still account for around 75% of energy demand by 2030 with demand for coal being flat, oil growing slightly and natural gas accelerating. This makes it clear to see why Royal Dutch Shell is keen to conclude its takeover of British Gas and reduce dependence on oil alone.

Is there a case for preferring active over passive funds?

The Oil and Gas and Resources sectors still account for around 15% of the FTSE 100 (FTSE Group as at Nov 30 2015) compared with nearer to 20 % the start of the year. Buying a passive fund would have exposed you to the full extent of the downside whereas many active funds choose to have little or no exposure to these sectors. Furthermore, a good active fund manager will seek out those companies which benefit from lower oil prices such as retail and leisure activities, travel and transport and automotive related business.

What’s the outlook for stock markets from here?

The outlook for countries heavily reliant on oil exports appears difficult. In the UK the FTSE 100 could be vulnerable to further oil shocks affecting sentiment. Risks are increasing of dividend cuts from oil majors which have maintained their dividends this year on the prospect that the oil price would rebound. BP has previously commented that at around $60 a barrel dividends could be maintained, yet the oil price has been closer to $40 a barrel for most of this year.

However, it is not all doom and gloom. In the long term, a low oil price should have a positive effect on growth. There will be a lag effect because increased spending, both business and consumer, takes time to feed through whereas the cuts made by oil producers to their own production and investment plans is made with more immediate effect. Wage growth has started to pick up recently which should provide a further fillip to consumer confidence and spending.

In conclusion, there will be winners and losers in the current uncertain environment and investors should take extra care in selecting funds which have a clearly defined investment process and are focusing on those companies best placed to benefit from market trends.

Important Information: We do not give investment advice so you will need to decide if an investment is suitable for you. If you are unsure whether to invest, you should contact a financial adviser.