Oil prices have tumbled recently — a drop of this magnitude hasn’t been seen since 2008/09. Headlines point to both supply and demand concerns, including increases in non-OPEC (Organization of the Petroleum Exporting Countries) supply; Saudi Arabia’s decision to keep producing despite lower prices; and lower short-term demand due to economic weakness in China and Europe.
Commodity prices typically trade near their marginal production cost, within a low band at break-even levels and a high band where consumers respond to high prices by changing their habits (e.g., opting to take transit instead of driving). These factors have disproportionately weighed on the price of oil and dragged it far below where it should be: between US$85 and US$95 a barrel. As a result, valuations in the energy sector have declined, presenting investment opportunities.
What influences oil prices?
A report by Wall Street research firm Sanford Bernstein shows global demand for oil is highly correlated with world GDP growth. A 1% change in GDP correlates to about a 1% change in oil demand. The research also shows global GDP growth above 2.4% is required for demand growth. The International Monetary Fund’s estimate for 2015 global GDP growth is 3.8%, implying oil demand should top 1%. Another factor not captured by this data is how lower prices affect demand. Sanford Bernstein estimates each 20% drop in the price of Brent crude (the benchmark price for oil worldwide) stimulates about a 1% rise in demand. Combined with anticipated GDP growth, this means we could see 1% to 2% growth in demand for oil in 2015.
Read: Benefits considerations for weathering the oil slump
Non-OPEC suppliers have upended oil markets: U.S. shale production has now risen to 3.7% from 0.5% in 2008. (The U.S. is the biggest supplier with the ability to increase and decrease supply to influence prices.) This imbalance is exacerbated by Saudi Arabia’s decision to keep producing. At prices below US$60 a barrel, non-OPEC producers will likely slash capital expenditures, resulting in lower output.
Wood Mackenzie, a consultancy specializing in energy, metals and mining, says U.S. shale projects are economical at US$65 to US$70 a barrel, so the industry is unlikely to maintain production if low prices persist. Also, shale oil well projects generally face high decline rates: average output falls by 60% to 70% during Year 1. U.S. exploration and production companies’ debt has risen over the past decade, limiting their financing options. Their capital expenditure budgets should shrink in 2015, dampening supply.
Read: Alberta’s hiring binge is over
The wild card is OPEC, which produces about 30% of the world’s oil. In the mid-1980s, OPEC controlled a big portion (15%) of spare capacity (the volume of production that can be quickly brought to market). It was able to influence prices and displace marginal U.S. producers. Today, OPEC’s spare capacity is just 3% of global supply, so it has less ability to successfully manage supply — and prices.
The opportunity
TD Securities has tracked the price-tobook value for the S&P/TSX energy sector for more than 35 years. The magnitude of today’s valuation decline approaches previous major downturns (1986, 1992, 1998 and 2009). Now, at less than 1.6 times the book value, the sector looks attractive. At prices below US$60 a barrel, oil is effectively at break-even levels, with limited downside.
Read: Falling oil prices affect HR strategies
But investors must be vigilant and not compromise on quality. A focus on companies with a prudent approach to capital allocation and strong balance sheets is key. These operators will be well-positioned to sustain weak oil prices and to keep generating positive cash flows despite them.
While short-term price volatility may continue, economic principles will prevail in the long run, eventually bringing oil prices to marginal cost levels. In the meantime, the market will provide opportunities for contrarian investors to position their portfolios for the inevitable price recovery.
Teresa Lee is a portfolio manager and managing director, investments, with Sionna Investment Managers. teresa_lee@sionna.ca
Get a PDF of this article.