Smart Money, Weekend AFR, January 2015
The oil price hasn’t just declined lately. It has collapsed. Not since the global financial crisis have we seen a decline as sharp as this: a more than halving of the oil price in the space of six months. It has forced governments, central banks and businesses into a whole new way of thinking about the future. And it should prompt investors to have a rethink too.
What does this mean for Australian investors? From the cost of filling up the car to the outlook for the economy and for interest rates, there are a host of consequences when the price of a single most important commodity in the world goes off a cliff. But, as with all such seismic shifts, there are opportunities for smart investors too, and one can find them all over the world.
A good place to start is by asking who benefits, and who suffers, in an environment of low oil prices.
“There are winners and losers,” says Guy Bruten, senior economist for Asia Pacific at AllianceBernstein in Melbourne. “Most obviously, the oil producers are the losers and the net oil consumers are the winners.”
In some countries, the outcome is plain to see. Selim Yazici, head of Turkish equities at BNP Paribas Investment Partners, says the fall in the oil price “is the single best thing that can happen to Turkey. Every $10 drop in the oil price improves the current account deficit by $4.5 billion.” For a country like Turkey, this makes a colossal difference: Citi Global Research estimates the country’s current account deficit will improve from 8% in 2014 to 5% in 2015, largely because of the change in the cost of oil, because it will be vastly cheaper to import it.
Turkey’s not an easy market for Australians to invest in directly, but we can apply its lessons to other markets that are more easily accessed. “It’s a huge positive for oil importers such as China, India, Japan and Korea,” says Shane Oliver, head of investment strategy and chief economist at AMP Capital. Indeed, the list of Asian countries that benefit from this (the Philippines, Thailand, Hong Kong, Singapore and – despite being an oil producer – Indonesia can be added to the names Oliver mentions) so thoroughly outweighs those that suffer (chiefly Malaysia) that an Asian equity portfolio may be worth considering after several years of underperformance relative to the developed world.
Many of those markets can be accessed individually: iShares, for example, offers index products covering Japan, South Korea and China, while there are mutual funds available focusing solely on China or India (Fidelity, for example, offers both in Australia, while China-specific funds are sold by Aberdeen Asset Management, AMP Capital, Challenger and Premium, among others, and India by Fiducian). Dozens of fund managers sell Asia Pacific equity funds: Morningstar tracks 35, with the Platinum Asia fund by far the biggest.
One problem with making such a decision, though, is that the oil price is only one of a host of things that will influence what share prices do next. “Figuring out exactly how much of a difference it’s going to make to relative growth outcomes among winners and losers, and to global growth generally, is problematic,” says Bruten.
Why? Well, take China. It receives a clear benefit from its oil import bill coming down – yet Standard Life ranks China as only one of the two major world economies it covers that is likely to experience slower economic growth in 2015 than 2014. No matter what happens to oil, “China’s slowdown should continue as the fading property sector weighs on economic growth,” says Alex Wolf at Standard Life. And that, in turn, doesn’t necessarily mean poor stock market performance: China will face exactly the same pressures this year as it already did last year, yet with a full-year return of 52% in 2014 – 25% of it in December alone – it was one of the world’s best performers. This is the sort of conundrum that you pay a fund manager fees to figure out, and gives us a clue why most investors go for a diversified regional fund rather than a country-specific one.
Or take India.
India imports almost 80% of its oil, so clearly benefits from lower oil prices because its import bill falls and, with it, its trade deficit. But there’s no point in investors looking at that in isolation: it has to be seen in the broader context of India’s new reform-minded government under Narendra Modi. “For investors, he has started to break the shackles of state-run organisations,” says Nitesh Patel, portfolio manager at Insync Funds Management in Sydney, which includes India in its Global Titans Fund. “While still early days, Modi will need to continue what he has achieved so far to be deemed a true reformer.” It is this – and the share price rally that’s already happened since Patel’s election – that an investor will need to consider at least as much as an oil price drop.
Across the world, it’s not as simple as saying: a low oil price on Monday means rich consumers and a soaring economy by Friday. Yes, a weak oil price should spur consumer spending because people have more money left over after filling up the car, but the transition between the two can be convoluted and takes time. And if it’s a slow process for the consumer, it’s slower still at the macro level. A low oil price might give central banks the chance to cut rates, for example, and in Asian countries it helps the budget because the amount those countries have to pay out in subsidies is lower, which means the government can spend more. But that’s not the sort of trend that plays out in a week or two. “We expect that, across Asia, the pass-through from the lower oil price to stronger growth will be a story for the second half of the year,” says Bruten, with existing headwinds continuing to retard growth until then. So timing will be key for investors.
Note that there’s likely to be a big difference between an Asian fund and a broader emerging market one, and most certainly a BRIC fund. (Morningstar tracks 51 emerging market equity funds available in Australia; the biggest are from Colonial First State, Aberdeen, Lazard and an index product from Vanguard.) The BRIC aggregation includes not only China and India, which ought to be helped by low oil prices, but Brazil and Russia, both oil producers – and Russia in particular is in a world of trouble.
The oil price is just one of many things Russia is wrestling with right now, from sanctions over its involvement in Ukraine to toxic investor sentiment worsened by the assumption of Russian involvement in the downing of flight MH17, structural problems in Russia, capital outflows and the plunging ruble. But, to say the least, the oil price doesn’t help: oil and oil-related products accounted for 68% of Russia’s exports in 2013, according to Market Vectors. “It’s very clear to us that the primary cause of Russia’s current troubles is a rapidly declining oil price, and that what happens to the oil price will play a major role in what happens to Russia over the next few months and years,” says Arjun Divecha, head of GMO’s emerging markets equity team in San Francisco.
It’s a car crash of an economy. Yet Divecha says GMO has a large overweight position in Russia – and this is another illustration that investors should think beyond the obvious. A low oil price might have brought countries like Russia low, but at the same time, does that create a bargain, especially if you think oil will one day go up again? GMO’s position is based on the cheapness of the assets; in what might seem an especially counterintuitive move, not only is it overweight Russia, but 90% of its Russian holdings are in oil and gas, which should suffer the most in this environment. Why? Because they are trading at valuations less than five times earnings while paying dividends of more than 5%, Divecha says. “We remain comfortable holding these very cheap assets – and perhaps adding to them if they decline further.”
And if GMO looks odd thinking this way, it’s not alone. Coutts, the blue-blooded British private bank, is also positive on Russia. “We believe the current geopolitical crisis and low valuations represent a potential buying opportunity,” says James Butterfill, global equity strategist. “We have maintained our portfolio positions in spite of the volatility.”
Beyond all these intricacies of individual country performance, there is a bigger question: in aggregate, is a low oil price good or bad for the world and its stock markets? This is likely a two-stage process. First, energy companies are hit, as has clearly been the case already; but then, lower oil costs ought to feed through to global growth. This all should, in theory, help to drag weak economies back into ruder health, though it will take time.
“Overall, our view is that lower oil prices are positive for world growth and this should filter through into the equity markets over the next year,” says Russel Chesler, director of investments and portfolio strategy at Market Vectors Australia. Indeed, despite America’s new-found role as an oil producer through shale technology, one of the countries that stands to benefit from cheaper oil is the US itself.
Some investors may want to play this through a focus on individual sectors instead of countries. “Energy stocks have already been negatively impacted, but the positive impact should help retailing, building material and industrial stocks – albeit it may take several months before this will start to show up,” says Oliver. Chesler adds that consumer discretionary was the best performing sector in the US in the fourth quarter, and expects retail to be encouraged by the increased disposable income that comes from spending less at the petrol pump.
What if you don’t want to try to analyse the ins and outs of who benefits from oil price movements, but just play the oil price itself? That’s easily done – whether you think it’s going up or down.
Some investors may feel that oil at below US$50 a barrel just can’t last – or not for the long term, anyway. It was double that as recently as July, so those with a patient mindset and some tolerance for the fact that it might get worse before it gets better may wish to be directly exposed to the oil price.
If so, BetaShares offers a crude oil index ETF in Australia, although with A$6.02 million in net assets as of January 9, it is not especially widely used. (This is probably partly because the oil price has been collapsing.) Cheap like most ETFs, it charges an annual management fee of 0.69%.
“It’s been reasonably quiet in the initial year since launch, but since the beginning of December it has more than quadrupled in size,” says Alex Vynokur, managing director at BetaShares Capital. “The interest has been on the long side: most people take the view that they don’t know exactly when the decline is going to stop, but they are starting to dip a toe in the water because in the longer term, prices are going to go up.”
Vynokur points out that there is a big difference between owning oil stocks and owning oil. “Traditionally Australian investors have obtained access to the oil thematic through stocks like Woodside Petroleum and Santos,” he says. But Woodside’s share market performance, he calculates, has a correlation of about 33% to the oil price, compared to 96% for the ETF. “If you are looking to play the oil game, you are going to get a much better outcome with an oil ETF than through stocks,” he says. “Oil stocks, like all equities, are subject to equity market risk and a range of corporate activities a company may undertake which have nothing to do with the oil price.”
It is worth considering, though, that a sign of health for most ETFs is that it is backed by the assets it is mirroring: that is, an index fund over the ASX 200 will hold the ASX 200. Clearly, short of having an oil tanker parked off Sydney Heads, BetaShares can’t be holding the underlying crude oil that backs this ETF, so it is instead synthetic, replicating the performance of crude oil without actually owning it. This one is a forward: the money you put in is invested in cash, which is held by a custodian, while the performance of the oil price index is replicated using a derivative. Synthetic exposure in an ETF is not ideal, but there’s not much choice in something like this, and as an added benefit, the cash generates interest.
A very important point for those investing in oil is that crude oil is quoted in US dollars, whereas an investor in Australia will be buying in Australian dollars. The BetaShares product is hedged, in order to take this imbalance out of the equation. In any unhedged product, one would be taking on not just movements in the oil price but the currency too.
What if you think oil is going to go down further? Contracts for difference (CFD) providers allow the investor to take a position on oil, whether upwards or downwards; they also allow leverage, meaning that if you have a strong view you can create a situation where your returns are magnified. The downside of this, of course, is that if you’re wrong, your losses are magnified too.
Where does the oil price go next?
Oil prices are already down more than 50% since the middle of 2014, a function of increasing supply (particularly US shale oil production) and reducing demand (weak global economic growth and in particular a slowdown in the emerging world), exacerbated by OPEC’s decision in November not to cut production.
What next? “History tells you that it can fall much further than you think until supply is finally cut,” says Shane Oliver at AMP Capital Investors. “So a fall back to around US$40 a barrel or just below – roughly a 75% fall from 2008 – is reasonably likely.”
One reason it is hard to predict is because of a certain level of gamesmanship among OPEC nations, and in particular the most powerful of them all, Saudi Arabia. Although Saudi’s economy suffers more than anyone’s in a period of low prices, Saudi is rich enough to withstand it; the tactic is widely thought to be that it will force other producers to cut or even shut down (particularly US shale oil operations), leaving Saudi and its peers with more of the market. But it can’t stomach this forever, and sooner or later prices will fall far enough for OPEC to cut production. When this happens, we can expect prices to start rising again.
Deutsche Bank strategist Michael Lewis reckons that crude oil below US$60 – and at the time of writing we are well below that level – “would imply significant default risk across energy names in the US high yield sector,” which obviously has consequences for investors in the US. “While lower oil prices outside of a recession are typically a welcome development given their positive implications for economic activity, there are concerns that the collapse in oil prices is moving into territory that could prove problematic for certain sectors of the US and global economy,” he says. But Lewis, unlike Oliver, doesn’t think we’ll see US$40 oil unless global growth is significantly weaker than people are now expecting, and thinks if prices head in that direction they will be easily stabilised by OPEC cutting production.
Even if it does so, it’s unlikely to happen before OPEC’s next major meeting in June, so it seems that low prices are with us for much of the year ahead at the very least.
Nevertheless, people do think that eventually we’ll see a bounce. Russel Chesler at Market Vectors Australia agrees with Oliver that prices could fall to US$40. “But in the second half of 2015 we see an inflection which should lead prices to trend back to our longer-term view of $90-$105 a barrel.”
Whatever the politics and short term pressures on the price, there’s no getting away from an unarguable truth about oil: it’s running out. “Longer term production from higher cost producers is required,” says Chesler, “as US shale oil and OPEC production growth will struggle to offset the depletion of oil reserves of about 5% to 9% per annum, and to meet even moderate global demand growth over the next several years.”
Impact on Australia
How about Australia? What does a low oil price mean for us?
“It’s a tricky question to answer, because there are lots of different moving parts,” says Paul Bloxham, chief economist at HSBC Bank Australia. “But the overall story is a positive one for growth in Australia.”
It’s tricky because Australia is an oil exporter, but at the same time imports more than it exports. Also, oil’s not the whole story: to the extent that the oil price declined is mirrored in other energy prices like coal and gas, that can tip the balance since Australia makes so much from those exports. “At the moment, the 50-odd per cent fall we’ve seen in oil prices has not translated into an equivalent in coal and gas,” says Bloxham. “So for now, we can think of the fall in oil prices as a net positive for Australia: it gives us cheaper energy, supports household disposable incomes, reduces the costs for most businesses in Australia that are reliant on petrol, and improves our trade balance and terms of trade.”
If other commodity prices do fall like oil has, that changes the picture. LNG in particular is going to be vitally important to Australia’s economy, and though prices haven’t dropped like oil’s, they have fallen. “The country’s LNG mega-projects worth billions have started to ramp up exports, but they are coming on stream with LNG at a much lower price than people had expected,” says Guy Bruten at AllianceBernstein. That will hit tax revenues. “The weaker oil price is another indication that Australia’s terms of trade are in steep decline.”
Nevertheless, for the moment, economists tend to put the boost to Australian GDP at about 0.7% if this level of oil price is sustained; for his part, Bloxham reckons a 0.6% boost to household disposable incomes.
Big themes like this take time to wash through the markets. “For Australian shares, the initial impact is negative, reflecting the worries about the impact on energy producers, and this is what we have been seeing with energy stocks down sharply,” says Shane Oliver at AMP Capital Investors. “However, over time the benefits to the economy in terms of lower business costs and a boost to household spending power should start to dominate and ultimately help drive the market higher.” Bloxham at HSBC reckons the result is “bad news for resource sector stocks, ambiguous for the banks, and good news for most of the rest.”
What about other asset classes? In bonds, Oliver notes several different possible impacts. A low oil price could mean an increased risk of credit rating downgrades, or even defaults, for energy producers. That, in turn, should mean higher yields on US energy companies and for the sovereign debt of countries like Russia that rely heavily on oil revenue.
Closer to home, there’s the fact that low oil prices tend to be reflected in other commodities, like gas. “The slump in gas prices will also have implications for the Queensland and WA governments, as their tax revenues are vulnerable, which could in turn mean further pressure on their credit ratings,” says Oliver. In theory, that’s a problem at a federal level too, if lower tax revenues from gas producers are added to the slump in mining-related taxation. “But this impact is being swamped by expectations for lower inflation and the possibility of further RBA easing,” says Oliver, which explains why yields on Australian government bonds have been heading lower, not higher. Putting it all together, he expects to see a bigger spread in yields between government bonds and those of WA and Queensland. Bruten, in turn, thinks the Australian bond market will perform well against US Treasuries.
Then there’s the currency. The oil price is only part of a range of elements affecting the currency – a crucial one, of course, is the RBA’s stated intention to lower the value of the Australian dollar – but “to the extent that lower oil prices are indicative of lower energy prices generally, the sharp fall in oil prices has also dragged down the A$,” says Oliver.
Nobody will be watching all this more closely than the Reserve Bank of Australia. “The RBA will be looking at this and saying it’s a good story overall, because it supports growth in the economy,” says Bloxham. “It supports Australia’s great rebalancing act: that growth has to shift from being led by the mining to the non-mining sectors.” It is likely to keep headline inflation low, which allows the Reserve Bank “to consider lower interest rates for longer – or even cutting rates.”
Bruten at AllianceBernstein is expecting “a couple of rate cuts in the first half of the year”, particularly as inflation falls.