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Equivocal oil

22 January 2015

The new era of cheap oil has had its winners and losers, but, overall, investors and the world economy are set to benefit.

January has brought a chill wind for the global energy sector, and a blast of concern about global deflation as prices tumble by the week. But, for households, consumers and oil-reliant industrials, the rapid decline of the cost of oil is resetting assumptions and forecasts for 2015. Cheaper oil cuts two ways across global markets and economies, and, although some investors will be feeling the pinch, there are those who will gain – and could find welcome investment opportunities too.

Overall, the benefits for the world economy and growth, and therefore for investors, are far-reaching. The International Monetary Fund estimates that for each $10 a barrel fall in the price of oil, annual world growth is lifted by 0.2%. Oil, of course, is an essential ingredient for global goods from plastics to detergents, and the stuff that allows transport from factories to shops to homes. And the likelihood, as Goldman Sachs among others has recently noted, is that oil prices will continue to fall in 2015.

In the meantime, global energy producers have reacted swiftly to the 60% slide in oil price over the last six month, and, as Brent crude heads below $50 a barrel, have started to scrap or suspend billions of dollars-worth of projects. Royal Dutch Shell has abandoned plans for a $6.5 billion project with Qatar Petroleum and Premier Oil has delayed a $2 billion project off the Falkland Islands. The world’s largest oil services group, Schlumberger, has announced 9,000 job cuts and warned of more.

Embattled OPEC

Falling oil prices are having a major impact on emerging markets too. Saudi Arabia’s decision to oppose Organization of the Petroleum Exporting Countries (OPEC) production cuts triggered the recent fall, but, with oil accounting for up to 90% of the kingdom’s revenues, recent developments are expected to cause structural shifts and spending cuts. (The Saudi stock market has also slumped.) Russia, Venezuela and Nigeria face even larger budget cuts, as do other oil exporters.

The target of OPEC’s leading Middle East members is the North American shale boom. A combative US is, however, set to increase production this year and next. If the US sector can survive the assault of falling oil prices, the wider US economy will be handed cheaper and increasingly domestically produced oil too. In the US, a $1 drop in the price of a gallon of petrol will put an estimated $100 billion back into the hands into the hands of businesses and consumers.

Reverberations have been felt in the more expensive and mature oil sectors – particularly the UK’s North Sea. Conoco Philips, Total, BP and the Wood Group have already announced cuts. The UK Exchequer still leans heavily on North Sea revenues. The ramifications for Scotland are a concern, with oil consultant, Sir Ian Wood, warning of up to 40,000 job losses in the sector, many of which would be north of the border. Bank of England governor Mark Carney has maintained that lower prices are “substantially mitigated” for Scotland through its continued place in the union.

Disposable income

Schroders chief economist Keith Wade points out that, for America’s consumers, Brent crude at around $45 amounts to an extra 1% of disposable income. “Given that US consumers spend nearly all the income they get, this will flow through to consumer spending and into strong growth.” Economists believe that UK consumers – at least its 28 million car owners – will spend much of their fuel savings. More disposable income will help mortgage-holders and home buyers too.

Oxford Economics has estimated that, if oil falls to $40 a barrel, it could add 0.6% to the UK’s growth in 2015. That is good for the UK economy and the UK stock market and investors. Certainly, a slightly gloomy International Monetary Fund in Davos has said that falling oil prices will not prevent economic growth from slowing down across the world. But investors should keep in mind that these and other predictions are broad assessments rather than exact blueprints for the future.

British businesses, from logistics companies to supermarkets or retailers, are set to benefit from lower transport costs; food prices could fall as well. Airlines, travel and leisure sectors can also expect increased consumer expenditure, alongside cheaper fuel. Consequently, fund managers such as Majedie are confident for the world’s largest cruise ship sector, Carnival, whose fleet include P&O Cruises. And cheap fuel for the UK’s small to medium-sized businesses equates to a massive tax cut.

Choppy conditions

Understandably, the fall in oil prices has created volatility on the UK stock market. BP, BHP Billiton and Royal Dutch Shell, which make up around a quarter of the FTSE 100, have felt the effect of this turbulence in recent months. BP and Royal Dutch Shell could come under further pressure if the oil price remains low. Oil majors and suppliers– and their lenders too – have taken a knock on Wall Street and leading financial centres. There is already talk of major consolidation deals to cut costs.

But, as fund manager Schroders has noted, conditions, overall, at the start of 2015 are positive for markets and economies – and in particular for the UK. “In Britain, while the low inflation rate would ordinarily be seen as a sign of weakness in the economy, the external shock of low oil prices is likely to boost the disposable income of households, encourage greater spending, and raise economic growth for 2015,” says Azad Zangana, European strategist with Schroders.

In fact, Britain’s level of inflation has also been pushed by falling oil prices to the lowest level since 2000. And the Bank of England has hinted that, in these conditions, a further fall of inflation can be expected. However, the Bank’s governor Mark Carney has made it clear that he has no intention, for now, of shifting the low interest rates, even amid a threat of deflation. Falling oil prices look unlikely to shift the centrepiece of UK monetary policy: interest rates will remain low for the near future.

World boon

In the countdown to the general election in May, David Cameron, Britain’s prime minister, has not missed the opportunity to urge UK business to pass on falling energy prices to the UK’s consumers and voters. British Chambers of Commerce director general, John Longworth, has also highlighted that falling oil prices will benefit the UK economy if households and businesses can benefit from lower energy bills, fuel costs and airfares – and consume and invest more respectively.

Certainly, markets are uncertain as prices continue to fall. As Peter Harrison, head of investment for Schroders, observes, investors are nagged by the doubt that the world economy is “soggier than they thought”. But, overall, the consumption boom should outweigh producer’s woes. Low oil prices are good for economic activity: Western corporations and consumers, and Asian importers are already beneficiaries.  There are, as always, short-term winners and losers, and well-diversified investors should benefit over the long term – and reassure themselves that oil prices will recover.

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