Drilling for opportunities in landscape of cheap oil

Joshua Freedman, co-manager BlackRock Natural Resources Growth and Income Fund

The rebalancing of the oil market is underway but will take time

Oil prices have been trending downwards ever since the market moved into oversupply in mid-2014. Robust US production growth, on the back of the shale revolution, boosted overall global oil supply at the same time as expectations for global economic growth weakened and with them, expectations for global oil demand. 

As oil prices fell, the market looked to Opec to cut production and defend prices, as the group had done in the past. However, in November 2014, Opec announced it would not cut production, which was taken as a change of strategy by the market, and caused oil prices to continue to slide.

The rebalancing of the oil market is now underway, but it will take time. While the global economic growth outlook remains uncertain, we appear to be past the point of maximum oversupply in the oil market and we expect it to tighten. The energy sector is under severe financial strain, with the US high yield market pricing in default rates at historical highs. Activity levels are being significantly curtailed, with $400bn of projects deferred in 2015 and the US drilling rig count down by two-thirds since the 2014 peak. Industry capital expenditure fell by approximately 20 per cent in 2015 and we expect further deep cuts this year. Data shows US production has fallen by 400,000 barrels per day since Q2 2015.

Current oil prices are unsustainable and too low to incentivise energy companies to make the investment required for future supply to meet growing global demand. Returns in the energy sector will need to improve to incentivise this investment; which means oil prices will have to rise and/or costs will have to fall further. Historically, the energy sector has performed very strongly when returns in the sector have started to improve.

This provides a supportive backdrop for the energy sector over the longer-term. However, near-term risks are significant and we expect to see a high level of volatility. As such, we would encourage investors to take a long-term view when considering the energy sector for a potential investment. Until we see more evidence that the rebalancing process is gaining pace, and in particular production outside the US is starting to decline, we expect energy equities to remain volatile. 

Our strategy has been to position our energy equity portfolios for a gradual recovery in oil, with a focus on companies with high quality assets and solid balance sheets. The energy sector remains an underweight for many investors and energy stocks currently trade at a historically high discount to broader equity markets. 

Michel Perera Chief Investment Strategist, EMEA, JP Morgan Private Bank

The best way to benefit from low oil prices is to seek any attractive valuations thrown off by the market rout

Over the last 150 years, oil has seen three periods of surging prices: WWI, the mid-1970s when Opec emerged, and the 2000s when China’s infrastructure programme led the country to consume 50 per cent of all world commodities. 

China’s capital spending was unique in history and is highly unlikely to be repeated. As China achieved most of its infrastructure goals, its commodity needs fell sharply. This coincided with a massive build-up of energy and mining capacity. Moreover, the price-supporting cartel Opec stopped functioning, as the US and Russia challenged Saudi Arabia for top producing spot. Too much supply, no willingness to cut production and falling demand is a lethal cocktail for oil prices.

The consensus oil price is around $40/b at year-end. We would be cautious near term due to the battle of wills among suppliers. Potential production agreements and emergency Opec meetings should be treated as rumours until confirmed.

Energy is over-represented in capital expenditures and stockmarkets. We have become much more fuel-efficient and the world economy does not benefit from an oil price fall as much as it suffered from oil price shocks in the past. US consumers have seen a halving of gasoline prices but have not yet spent all these savings. During price drops in 1986 and 1998 consumers took several months to start spending that windfall. They could follow the same pattern this time. 

Developed and non-commodity emerging economies should benefit from lower energy costs. While the hit to US shale oil is significant, energy jobs lost have only amounted to 94,000 compared to 2.5m jobs created by the economy in 2015. 

The high correlation between oil and stock prices is a recent phenomenon and we do not expect it to be long-lasting. Nevertheless, until other US economic sectors strengthen further, markets will worry.

We would not recommend de-risking portfolios to respond to the current volatility. Markets are discounting a high probability of a global recession, unlikely in our view, as we see more runway ahead in the cycle. In fact, the current oil crisis gives investors a unique opportunity to be contrarian. 

Our colleagues have modelled world growth depending on whether the oil price fall is due to excess supply or poor demand. If you assume the entire oil price decline is due to weak global demand, 2016 would turn into a global recession. If the oil price drop is entirely due to oversupply you would have a global boom and, in a 50-50 scenario, growth would surprise to the upside. Since we think most of the oil price fall is due to supply, we should see upside to growth this year and next.

The best way to benefit from low oil prices is to seek any attractive valuations thrown off by the market rout. We favour long-term asset allocations with the right risk-return ratios. Growth should be sought in cyclical recoveries in the eurozone and Japan helping consumer spending and quality dividend plays, in structural improvements in the healthcare, technology, telecom and consumer sectors and in a post-regulation environment in financial businesses, especially in the US. 

Steven Wieting Chief Investment Strategist, Citi Private Bank

Indiscriminate selling of risk assets has created buying opportunities

As petrol producers around the world accept low prices and pump oil – a better alternative than losing revenue entirely – a long bumpy road of oil price recovery is likely to lie ahead. 

Yet we see a recovery of moderate scope over time as a high probability, likely including gains in the second half of 2016. While far below recent years’ prices, Citi’s commodities research team believe a rebound toward $50 per barrel is possible.

The massive oil price decline is mostly a symptom of the near doubling in US oil output during the past four years, not any outright decline in demand. In fact, China, another key source of worry in the global economy, raised its oil imports sharply over the past year as it built a strategic petroleum reserve.

A recovery in the oil price is likely over the longer term, but ‘supply destruction’ is required. We estimate nearly half the world’s oil producers will be unprofitable in the long run if the oil price is below $50. In terms of economics, the industry does n0t have room for every high cost producer.

The beneficiaries of price declines are clearly consumers throughout the world. However, this benefit is very moderate but highly widespread. In contrast, the financial distress of a 75 per cent oil price decline is severe and concentrated for the petroleum industry, which constitutes a small minority of global businesses. However, petroleum is the dominant industry for some economies. Petroleum’s decline has driven recession there, and it will take healthy growth elsewhere to avoid notable overspills to the global economy. 

Along with other issues, this will likely cause central banks to reconsider their monetary policy outlook and move somewhat away from planned tightening steps (the US) and ease further (the eurozone and Japan).

Even for the US, the epicentre of the production boom, consumer savings have been almost equally offset by capital spending declines. The financial distress of producers and broader market reaction has likely made this a net negative for the US economy. 

Notably, financial markets have recently seen indiscriminate selling of almost all risk assets.  We think this creates opportunities as surplus energy is unlikely to drive a global recession in the broader backdrop.

We generally underweight petroleum-sensitive assets, but we would look for dislocations where low cost viable energy assets are sold at distressed prices. Such investments require a reasonably long-term view toward harvesting returns.

Financial markets expect the price of oil to be very volatile looking forward. Volatility is itself an asset that can be monetised in certain structures. Given the unusually high correlation of oil to other asset markets, it also can present a hedging opportunity.