Finding the investment opportunities created by lower oil prices
Steven Wieting, Citi Private Bank
Oil prices are unlikely to recover anytime soon. This creates both winners and losers and there are investment opportunities to be found in both
On December 4, Opec scraped its largely symbolic maximum output ceiling, essentially stripping away the hopes of some that the cartel would cut production and act like the ‘central banker’ for the petroleum world, as it had in the past. In fact, Opec production has risen to near record levels even ahead of Iran's agreement to return to world petroleum markets this year. Opec's decision changed the dominant view of 2015 that it would hold production steady in the face of low prices, thus gradually forcing high cost oil producers to leave the business. Instead, the new tactic accelerated oil price declines anew (see chart). New talk of an agreement with non-Opec producers to reduce output is likely to remain just talk.
As petrol producers around the world accept low prices and pump oil – a better alternative than losing revenue entirely – the conditions appear to be in place to test the ‘lowest price possible’, at least for the time being. Given Opec's tactics, a long bumpy road of oil price recovery is likely to lie ahead, at least compared to past periods when oil prices recovered quickly. Yet we see a price 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 believes a rebound toward $50 per barrel is quite possible.
Citi Private Bank believes the massive decline in the oil price is mostly a symptom of the near doubling in US oil output during the past four years, not any outright decline in oil 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 that nearly half of the world's oil producers will be unprofitable in the long run if the oil price is below $50 per barrel. This estimate includes the cost of maintenance capital investment. Some yield oil at much higher prices, such as tar sands output. Thus the economics of the industry now doesn't have room for every high cost producer.
The beneficiaries of the oil 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 in both the developed and developing world. 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. Transportation firms that consume petroleum as their most significant cost of business have weakened as much as oil producers, for example. We think this creates opportunities as surplus energy is unlikely to drive a global recession in the broader backdrop.
We would look for dislocations where low cost viable energy assets are sold at distressed prices
We generally underweight petroleum-sensitive assets, for example emerging market and developed market shares and the bonds of oil-driven economies. We would not be indiscriminate buyers. 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.
In addition, 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.
In sum, this is all a far different outlook from the complacency that was priced into markets expecting very narrow price ranges for oil and other markets as recently as the fall of 2014. With it, there are opportunities in the making.
Steven Wieting is chief investment strategist at Citi Private Bank
