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Oil may have a long slow burn before recovery

Added 14th January 2015

Analysts seem to be coming to a consensus that the price of oil will follow something like a backward checkmark trajectory, which calls for a very selective investment focus.

Oil may have a long slow burn before recovery
Forecasts by Goldman Sachs and Blackstone, for example, have oil plunging below $45 per barrel this year before recovering to roughly $65-$70 in 2016.
"Longer term, oil prices will settle at levels above where they are today. But it will take some time to happen," added Russ Koesterich, global chief investment strategist at BlackRock Investment Institute. 
"The reason is that despite low oil prices, you're not seeing any disruption of supply yet.
"The belief is that below $80 a barrel, many shale producers are not viable and [therefore] you'll see some reduction of supply. That hasn't yet happened because the technology behind fracking and horizontal drilling has improved. We see companies extract oil at lower and lower breakeven levels.
"Second, there's a different breakeven level for new rather than existing production. So at these [current price] levels what's likely to happen is less about eliminating a lot of production immediately, but more about curtailing future exploration."
Of course, curtailing future production will eventually send the price per barrel higher, but "this will take a while", he emphasised.

Oil and central banks

The effect of lower oil prices on monetary conditions depends on the central bank, Koesterich said. 
The US Federal Reserve, for example, has said it will look past falling oil prices as it is a transitory event and will focus on core inflation, which excludes the price of oil.
Other regions are more complicated. 
"In Europe, where the overall economy is much closer to outright deflation, even if the belief is that the drop in oil prices is transitory, it will have some impact on European Central Bank thinking. The danger is that the drop in oil prices may fuel further already low inflation expectations."

Low oil as growth driver

The negative impact of the oil price plunge on investment has been widely discussed. Hardest hit are energy exploration companies and countries with economies dependent on oil exports such as Russia, Iran and Venezuela. 
To this, it's possible to add investments in alternative energies as particularly vulnerable, since cheap oil tends to dampen interest into more costly fossil fuel alternatives.
Yet the plunge is a positive for many corporations in lowering fuel costs, for consumers who have more to spend, and for countries such as India and Indonesia that had been providing oil subsidies from the state budget when oil was expensive. 
The oil price decline is "one of several positive growth drivers", wrote Mark Tinker, head of AXA Framlington Asia, in a recent note to clients.
"One cent [reduction in the price] of gasoline equals an extra $1 billion in the US economy to be spent on something else - and the main beneficiaries tend to have a high propensity to consume.
"To date, this is like a $150 billion tax cut for the US.  
"Asia is also a beneficiary of lower oil prices as it is a large net importer, although it is interesting to note that the benefit in India and to some extent Indonesia and Malaysia is going to government, not consumers. They are taking the opportunity to reduce subsidies - benefiting government balance sheets but not benefiting consumers, something overlooked by some of the bulls."

Selective energy bets

Ajay Dayal, investment director at Legg Mason Global Asset Management, added that low prices are also a positive for the US oil industry, particularly the shale oil industry, which grew untamed in the last eight years and lacks efficiency.
"High-cost producers will be affected by the oil price decline and they are starting to consolidate. Consolidation is a good thing. It allows a bit of correction and creates a healthier oil and gas business in the US." 
Legg Mason invests in energy assets through affiliate Clearbridge Investments. 
The focus is on infrastructure assets like pipelines, storage facilities and drilling rigs, which work on multi-year contracts or fee-based revenue streams and are therefore less volatile as oil prices fall, he said.
"All companies are being tarred by the same brush. Clearbridge is selectively adding positions to companies that have been unduly affected by a fall in oil prices."

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