FDx Advisors Blog

The broader impact of oil prices on investment management

February 25, 2015 Written by Tyler Mull

The fall in oil prices is due to expectations of a slowdown in global energy demand and a market that is most likely oversupplied. Viewpoints on the degree to which supply and demand dynamics are driving the current market movements differ, but many signs point to a market that is oversupplied rather than lacking demand. In a meeting on November 27, the Organization of Petroleum Exporting Countries (OPEC), led by Saudi Arabia, decided not to reduce production levels in the face of falling oil prices. This decision was in contrast to previous policies aimed at curtaining the supply of oil to maintain higher prices; the decision came as a surprise to the market and led to a strong downward movement in the price of oil.

Saudi Arabia has a low-cost production advantage and a high level of reserves, which allows them to withstand the lower prices. One theory is  their decision to maintain supply levels is politically motivated, since the low prices put great fiscal pressure on countries with which they share a tenuous relationship, Russia and Iran. Another theory is that the new policy may be an attempt to reign in market share from higher cost producers in response to new entrants into the market. In January, The Oil Report by the International Energy Agency (IEA) stated that Saudi Arabia’s oil minister Ali al‐Naimi’s reported stance is that it is “not in the interest of OPEC producers to cut their production, whatever the price is (IEA, 32).” This position may be the case for Saudi Arabia, but it is not necessarily true for the OPEC members with a higher average cost of production. Higher cost OPEC producers will have trouble funding their fiscal budgets at current prices. The IEA report states that Venezuela, Iran and Algeria have already had to cut production output (IEA, 15).

Technological advances in horizontal drilling and hydraulic fracking have boosted oil exploration and production in the U.S. and other non-OPEC countries. This increased production has likely been a large contributor to an oversupplied global energy market. On average, the OPEC producers have a production cost advantage over non-OPEC countries; in the short-run, it is expected that the level of non-OPEC production is likely to decrease. This expected decline is assuming that OPEC maintains their current production output levels and there are no short-term technological advancements that bring production costs down for non-OPEC producers. Maintaining the current production levels is not an easy policy for OPEC to adopt. In the short-run, it will be painful and it is not likely to be a sustainable long-term strategy. The low oil prices put a strain on the individual countries’ ability to finance their current and future government spending needs.

A market signal that oversupply is causing price reduction is that the price decrease in oil is taking place in a period when equity prices are rising. This relationship is in contrast to 2008, when oil prices and equities both declined, which signaled that the price reduction in oil was from a lack of demand. Market forces will push on higher cost producers and force them to close rigs that are no longer profitable. The IEA reports that there is no sign of a decrease in U.S. oil supply, but new data hint at a slowdown to come. The U.S. rig count currently stands at its lowest level since 2013 (IEA, 21). It is yet to be seen if the drop in the U.S. rig count will lead to a considerable drop in production and if a decrease in U.S. production will be enough to offset an oversupplied global market. The market will be anxiously awaiting OPEC’s next meeting to see how they respond to the continued fall in prices.

The price history of oil has provided periods of heightened volatility that sometimes last days, months, or years. Although many managers may not purport to predict the price fluctuations in oil as a part of their investment process, they do often analyze the ability of their holdings to withstand price changes in the oil market. In many cases, a manager does not recognize a particular source of volatility, such as stock price fluctuation related to the prices of oil, as a fundamental change to their investment thesis. In these instances, short-term swings in the market can provide new opportunities to enact their long-term strategy.

Both managers that use top-down and bottom-up analysis will continue to monitor the risks and potential rewards cheap oil presents in the coming months, as the market awaits OPEC’s next meeting in June.

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