Oil Price Declines Could Have Far-Reaching Effects | American Funds

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February 2015

Oil Price Declines Could Have Far-Reaching Effects

Analysts and Portfolio Managers Weigh Valuations Amid Ongoing Volatility

In 2014, oil prices posted their largest annual decline since the global financial crisis, losing more than 45% as weaker demand and strong global crude output created a supply glut. The collapse saw prices at a five–year low, battering energy shares — which finished 2014 nearly 13% lower — and weighing heavily on financial markets in oil–exporting countries. In our view:

  • Oil prices could continue to remain low — and may even continue to decline — before supply–demand imbalances are corrected.
  • Some oil companies have begun to show signs of better capital discipline, but many have room to improve.
  • Despite lower prices in the near term, demand fundamentals over the longer term should remain supportive of higher oil prices.
  • Market declines may provide some attractive entry points for investors.

It Isn’t Just Shale: Oil Production Growth Is a Global Phenomenon

While U.S. shale has certainly contributed to a steady rise in global supply, non-OPEC supply growth has also been robust in the face of increasing production from Saudi Arabia.

Annual World Oil Production, 1980–2014

Source: U.S. Energy Information Administration. Data for OPEC, Saudia Arabia and World production as of September 30, 2014. Data for U.S. production as of December 16, 2013. U.S. figures for 2013 and 2014 are forecasts.

Oil Could Stay Lower for Longer

With oil prices having plunged to multiyear lows, investors may be wondering about how an extended period of low prices may impact the global economy. Many of our portfolio managers and analysts believe that oil prices could continue to decline until production growth slows and demand increases, which could take some time. In the interim, low oil prices are a boon to consumers and oil–importing nations, but the impact on the global economy is likely to be mixed.

Among the most important influences on the oil price is the role played by Saudi Arabia, the world’s largest and lowest-cost producer of crude, in steering the global supply of oil. The kingdom generally takes a long-term approach to the precious commodity, says Lars Reierson, a portfolio manager and equity investment analyst who covers global energy exploration and production. “The Saudi Arabians like oil to be viewed as a stable, dependable source of energy, and so they don’t typically take precipitous action that will cause volatility. Instead they try and take the long-term view and promote themselves as a stabilizing force in the market.” In order to achieve a higher long-term equilibrium price, Saudi Arabia is willing to tolerate a lower price in the near term so that weaker producers are taken out by industry consolidation or otherwise. This will leave fewer global suppliers, and those companies can be expected to be more rational and disciplined in both their investments and production.

“There is little doubt that there will be industry consolidation and, as a result, better discipline in capital expenditure,” says energy analyst Darren Peers, “But the question is, at what pace and with how much collateral damage along the way?” Higher prices over the past few years encouraged excessive investment in oil exploration and production — to the point that some companies have used all their free cash flow and then some — is a primary reason that many of Capital’s portfolio managers and analysts have stayed away from energy companies, especially the companies that provide the rigs and other equipment for finding oil. “In the mining industry, we have seen many areas consolidate and managements understand the value of capital discipline, but we don’t see that broadly in the oil complex,” says portfolio manager Jody Jonsson.

Many U.S. and Canadian exploration and production companies have already announced capital expenditure cuts for 2015. However, production costs can vary by region, by company and even by well. Some companies can be profitable at $50 a barrel; others may have a breakeven price of as much as $80 a barrel.

For companies involved in shale oil extraction, the economics are different than for conventional oil producers. The upfront costs of hydraulic fracturing are high, but the ongoing costs of drilling in new areas are not formidable. So a decision to cut or slow production is dependent on the balance sheets of specific companies and how well they have managed their finances.

Moreover, many companies have hedged against falling oil prices — typically by locking in favorable prices through swaps or options — sometimes for as long as a year in advance. “Hedging programs, the ability of companies to cut back on activities in less profitable fields, and how much leverage a company has employed all matter. Lower oil prices will reduce production activity, but it could take up to a year for companies to cut back,” says Peers.

Demand Likely to Stay Strong

Low oil prices are likely to eventually spur demand for the commodity, which should help to balance the market in late 2015 or 2016. “Low oil prices are a massive global tax cut that will stimulate demand,” says energy analyst Jacinto Hernandez. “People tend to drive more when gas prices are lower, and they are more likely to buy bigger, less efficient cars.”

Moreover, demand for oil is likely to remain strong among developing economies. China and India increased their energy consumption by more than 40% between 2000 and 2010 as population growth and rising incomes boosted demand. Now the world’s second-largest consumer of oil, China has been the dominant source of crude-oil demand growth in recent decades. While China’s economic growth rate has slowed recently, it is still above 7%. Moreover, there is continued growth in demand from other developing economies. The International Energy Agency’s forecast for 2015 demand growth is above 1%.

Impact on Other Industries and Areas of Financial Markets

Looking beyond the energy sector, there are a number of potential benefits that arise from falling oil prices. One of the most important may be the impact on sustaining economic growth. Lower oil prices help the bottom lines of airlines, cruise operators, shipping companies and other businesses with significant fuel costs, including chemical manufacturers.

But lower oil prices are not a boon for all. North American railroads have been transporting increasing amounts of crude to refineries as domestic production has boomed and have benefited from the higher margin business of moving sand and pipe used in extraction. These revenues are at risk should production decline.

Bond markets could also experience negative market shocks in the face of lower prices. In 2013 and 2014 combined, an estimated $335 billion in high-yield bonds and leveraged loans was issued to fund the U.S. oil and gas sector. In addition, state-owned oil companies in several emerging markets also issued large amounts of debt.

The sudden rise in the default risk of this debt has led to somewhat greater fragility in corporate bond markets, says fixed-income portfolio manager Wesley Phoa. “Many new debt deals were accompanied by revolving credit facilities secured by company assets. If firms become stressed enough to draw down these bank facilities, or if banks start cutting lines of credit based on falling collateral values, the negative market shock could be amplified.”

Also worrisome is the impact that lower oil prices could have on the real economy in the U.S. But while employment in oil and gas-related industries has grown faster than in other industries over the past five years, those jobs have not had a material effect on the overall employment picture, says economist Darrell Spence. “If the recent decline in the oil price does end up having a more significant impact on the U.S. economy than I currently expect, it is likely to be because it has an unexpected negative impact on the financial system, and not necessarily because of direct impacts on employment.”

From a valuation perspective, many companies look attractive, including some of the major integrated oil producers, which have seen their valuations approach levels last seen in 1998 when oil prices were $10 a barrel. Many portfolio managers say they have room to increase their investments in oil-related stocks and bonds, but are being cautious. Rather than focus on the direction of oil prices in the near term, managers are continuing to seek opportunities in companies that are well positioned to benefit over the longer term. “Today, there are a number of companies where market perception has granted them a discount that is larger than we believe is warranted,” says Reierson. “Some have tended to historically be higher-beta companies, but if the cycle turns around and we can invest in them well, these should provide good opportunities for capital appreciation.”

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Investors should carefully consider investment objectives, risks, charges and expenses. This and other important information is contained in the fund prospectuses and summary prospectuses, which can be obtained from a financial professional and should be read carefully before investing. 

Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. This information is intended to highlight issues and not to be comprehensive or to provide advice.