Market Commentary

Q4 2014

The fracking revolution has been transforming the dynamics of the oil market for several years now, adding materially to world production. However, it has taken a surprisingly long time for the global oil price to recognise this. When it finally reached the tipping point, the degree of catch-up necessary was so large that the collapse in prices was inevitably precipitous. [CHART 1]

With the downtrend already well established, OPEC’s December meeting was clearly pivotal. The fact that OPEC failed to agree to a cut in production provided additional downward pressure sending the Brent price to a 5 ½ year low, some 50% below the year’s $115 high. It also effectively signaled the demise of the cartel and instigated a price war aimed at preserving market share. OPEC is viewing the U.S. as the “swing producer” and is clearly prepared to sacrifice price in order to curb the rapid growth of the fracking phenomenon. Oil sector share prices have, understandably, collapsed. [CHART 2]

However, although sub-$60 oil will slow exploration and development in the US, production this year will nevertheless increase from new wells commissioned during 2014 and from those currently nearing production. Operating costs of existing fracking projects are only around $30 per barrel and the lower price will thus do little to curb output. But new projects require around $65-$70 per barrel to justify development – and this is subject to securing funding, far more difficult in this new environment. Borrowing costs in the industry have already almost doubled. Thus, while the development of new projects will certainly be curbed, production growth will still be higher in 2015. [CHART 3]

Increased supplies and somewhat slower growth in world demand will probably be the most likely theme for some time to come. US stockpiles are at the highest level for this time of year in three decades. Total supply now comfortably exceeds demand. In terms of price war strategies in the global oil industry, it is game on . . .

But it is not just the oil industry itself that is affected: the entire geopolitical landscape has been upended. Major exporters like the Middle East and Russia have been severely impacted, and several smaller producing countries where oil provides the bulk of exports and tax revenues (like Nigeria and Venezuela) are even worse off. Nearly all have seen their currencies nose-dive. Most oil producing countries will be unable to meet their current budgets, requiring either expenditure cut-backs or increased borrowings.

On the other hand there are the countries which will benefit. Oil importers like Japan and India (and SA) are huge beneficiaries. In the US where oil imports and exports more or less offset each other, there will be increased unemployment and reduced capital outlays in the industry, but this will be offset by the boost to consumer spending from lower oil prices.

From the perspective of the international investor it is clear that all investment classes (equities, credit, interest rates, foreign exchange, and commodities) will be profoundly impacted. But the overriding major positive will be the improved outlook for world growth that lower oil prices will provide. This boost has come at a critical stage as the global economy (outside the U.S.) was showing distinct signs of flagging. With equity ratings somewhat stretched, a slowdown in global growth would have seriously challenged the outlook for world equities.

The likely implications are: Equities – further modest advances, based on an uplift in global economic growth, continuing monetary accommodation, prolonged low inflation and unappealing alternatives. Bonds – low yields and high risk of capital erosion as rates start rising, make this an area to avoid. Currencies – weaker for oil exporting countries and modest gains for importers (the U.S. dollar will remain strong). [CHART 4] Commodities – oil price to remain under pressure, and most other commodities will suffer from the firm dollar headwind and, in many cases, from oversupply.