Concentrated Pain, Widespread Gain DYNAMICS of LOWER OIL PRICES February 2015

concentrated pain, widespread gain DYNAMICS OF LOWER OIL PRICES february 2015

BlackRock Investment Institute Summary Oil prices are on a slippery slope. The pain of lower prices is acute and concentrated among oil-exporting nations and energy companies. The gains are widely dispersed and will likely be felt for a long time by oil importers and global consumers.

The massive wealth transfer is set to boost developed economies to varying degrees. And it is sure to amplify economic and market divergences in the emerging world. We debated the prospects for the oil price, winners and losers, and risks and opportunities in asset markets. Our main conclusions: Jean Boivin } The crude crash is dramatic—but not unprecedented. Falls of similar magnitude Deputy Chief Investment Strategist, in the past stimulated consumer spending, helping to reinvigorate global economic BlackRock Investment Institute growth. We think crude prices are bottoming and see them modestly higher next year.

Poppy Allonby } It would only take a moderate shift in demand to restore balance to the oil market. Portfolio Manager, BlackRock Spare production capacity amounts to just 4% of total demand, versus around Natural Resources Equities Team 18% in the mid-1980s, Energy Information Administration (EIA) data show.

Ewen Cameron Watt } Soft demand and a strong U.S. dollar have helped bring down the oil price, but Chief Investment Strategist, ample supply is the root cause of the decline. New technologies such as hydraulic BlackRock Investment Institute fracking unearthed plentiful supplies of U.S. shale oil while the Middle East kept up production despite conflicts ravaging the region. } Supply is here to stay: Key producer Saudi Arabia looks determined to keep pumping oil under new leadership. Overall U.S. supply is set to rise this year due to a backlog of wells and price hedges sheltering producers from the downturn. Declining capital spending (capex) and fewer drilling rigs in operation point to a slowdown in production growth in the second half of 2015 and beyond. } Cheap energy is a game changer for monetary policy in oil-importing nations, especially in emerging market (EM) economies. It reduces inflation, giving some central banks room to ease—and others leeway to raise rates more gently. Low oil prices also reduce the costs of energy and food subsidies, providing fiscal relief.

Robert Wartell } Low oil prices add to growing divergences in the developed world. The eurozone Head of BlackRock U.S. Leveraged and Japan are set to keep rates near zero and have rolled out bond-buying Finance Credit Research programs to halt disinflation. The U.S. Federal Reserve, by contrast, is likely to look beyond oil’s disinflationary effect and start hiking interest rates in mid-2015. Gerardo Rodriguez } Winners in this climate should be global consumers, oil importers such as India Portfolio Manager, BlackRock and Japan, and the transport and retailing industries. Oil-exporting nations and Emerging Markets Team companies with limited cash buffers and poor access to debt markets (think Venezuela or overleveraged U.S. shale plays) look to be the biggest losers. What Is Inside } The oil price slump is bludgeoning U.S. high yield energy issuers. Many have been outspending their cash flow and now face a crunch as financing dries Summary...... 2 up. They are in survival mode, resorting first to capex and job cuts. Most Supply and Demand...... 3–6 should be able to ride it out. Yet the longer lower prices hold, the greater the financial stress. Winners and Losers...... 7–11 } Valuations of global energy stocks have fallen, but selectivity is important. We Energy Assets...... 12–15 favor the “super majors” because of their strong balance sheets, high dividends and integrated business models. We would avoid most oil services firms for now.

The opinions expressed are as of February 2015 and may change as subsequent conditions vary.

[2] CONCENTRATED PAIN, WIDESPREAD GAIN SLUMPS AND REBOUNDS Supply and Real and Nominal Brent Crude Price, 1975–2015 $200

Lehman Iran Revolution Demand Collapse Inﬂation-Adjusted Oil Price 100 The crude crash affects asset prices and economies around the world. Energy generally has a modest weight in Gulf War benchmark indexes, yet there are standouts. Energy issuers 60 1980s account for around 15% of the U.S. high yield market. See the Oil Glut chart below. 40 PRICE PER BARREL The economic impact is broad but not always immediately visible. Energy accounts for just 1.2% of U.S. employment, Nominal Oil Price 20 for example, but energy booms stimulate growth in local

economies such as Texas or the Canadian province Asia Crisis of Alberta. 10 The size of the recent oil price slump is unusual—but not 1975 1980 1985 1990 1995 2000 2005 2010 2015 unprecedented. Similar sharp falls in the mid-1980s and during the 2008-2009 financial crisis were followed by swift World Real GDP Growth, 1975–2015 rebounds, both in the oil price and in real (inflation-adjusted)

global economic growth per capita. See the chart on the right. 3% On the demand side, cheaper oil helps consumers and businesses by lowering fuel costs. Indeed, our research 2 suggests a consumer-led demand recovery could come to the rescue (see page 10). On the supply side, low oil 1 prices force producers to cut output, setting the stage for a price recovery. 0 Y-O-Y CHANGE Y-O-Y -1 1980s Current WEIGHING OIL’S IMPORTANCE Oil Glut Crude Slide Energy Share of Fixed Income, Equities, GDP and Employment, 2015 -2

15% Lehman Collapse -3 1975 1980 1985 1990 1995 2000 2005 2010 2015

10 Periods With Nominal Oil Price Falls Over 50% World GDP Per Capita Sources: BlackRock Investment Institute, Thomson Reuters and Oxford Economics, January 2015. Notes: The inflation-adjusted oil price is in 2015 prices, using U.S. consumer price inflation. GDP data for 2014 and 2015 are based on Oxford 5 Economics forecasts.

0 BALANCING ACT U.S. High Global IG Global U.S. U.S. Yield Credit Equities Economy Employment It would take only small changes to supply or demand to restore balance to the oil market (and support prices) we believe. Exploration & Production and Oil Services Other Energy Sources: BlackRock Investment Institute, Barclays Capital, Thomson Reuters, Sure, the market is currently oversupplied (see page 4). Yet U.S. Bureau of Economic Analysis and U.S. Bureau of Labor Statistics, January spare capacity (wells that can produce but sit idle) today 2015. Notes: The U.S. economy share is based on GDP value-added for oil and gas extraction, mining support activities and petroleum and coal manufacturing as amounts to just 4% of total global oil demand, versus around a share of total private GDP. The U.S. employment share is based on oil and gas 18% of demand in the oil price downturns of 1983 and 1986, extraction, mining support services, petroleum and coal production and gasoline station employment as a share of total non-farm employment. Other energy EIA data show. includes integrated oil companies, pipelines and others in benchmark indexes.

supply and demand [3] CRUDE IMBALANCES SAUDI SWITCH Oil Supply vs. Demand, 1985–2015 Will oil producers cut supply to support prices? Saudi 2% Arabia, the senior partner of the Organization of the EXCESS DEMAND Petroleum Exporting Countries (OPEC), has often played a “swing role” in stabilizing prices. The country slashed 1 production in 2009 but has kept it steady this time around. Saudi Arabia appears fine with low oil prices for now. We do not see Riyadh changing course any time soon under 0 new leadership. Reasons:

} Saudi Arabia wants to protect its market share in the face Asia Crisis -1 of rising global production—and is wary of acting alone. The country has painful memories of losing market share EXCESS SUPPLY 1980’s Oil Glut when other nations did not match production cuts. -2 NET BALANCE AS SHARE OF GLOBAL DEMAND 1985 1990 1995 2000 2005 2010 2015 } This strategy forces high-cost producers (think shale, oil sands and deep water) to cut supply. Sources: BlackRock Investment Institute, IEA and Oxford Economics, December 2014. Notes: The line shows world oil demand minus world oil supply as a percentage of } The country is the world’s largest low-cost producer—and world oil demand. Data from Q3 2013 onward are estimates from Oxford Economics. has a $736 billion war chest of foreign exchange reserves to cushion the impact on its budget. swelling supplies } Low prices keep rival Iran under pressure. The Saudis view this as a nice knock-on effect, we think. Softening demand—particularly from slowing EM economies— has played a role in the oil price crash. We see this evidenced Lower oil prices will gradually turn the screws on higher-cost by earlier, across-the-board declines in metals and other producers. Their likely response? Cut capital spending, jobs commodities prices (see page 12). This suggests the oil price and costs. U.S. shale operators are particularly susceptible collapse is a catch-up, rather than a sign of further because they have relatively little capital invested and their deterioration in the global economic outlook. wells run dry fast. This will eventually lead to falling production—although we think 2015 will be more about Unexpected declines in demand accounted for around 35% declining rates of growth than an absolute contraction. to 40% of the fall in oil prices between June and December 2014, the International Monetary Fund (IMF) estimates. Demand for oil may recover as lower prices encourage more THE NEW SWING PRODUCERS consumption; U.S. gasoline sales hovered near 19-month Selected Countries’ Change in Crude Oil Production Since 2011 highs in November, the most recent EIA data show. 5 Saudi Yet a jump in supply is the bigger factor behind today’s oil market Arabia imbalance. Advances in hydraulic fracking uncorked a plentiful supply of U.S. shale oil and gas. Increased U.S. production Iraq more than offset declines in Iran and Libya. (Note: Marginal 2.5 producers such as Libya swing in and out of the market and Total affect prices accordingly.) See the chart on the right.

The U.S. accounted for 13.7% of global production in 2013, up U.S. from 9.8% in 2006. That helped it overtake Saudi Arabia as the 0 world’s top producer of petroleum liquids (including natural gas), according to the International Energy Agency (IEA). The MILLIONS OF BARRELS/DAY Iran U.S. production increase in 2014 was the fourth-largest by any country since 1965, according to BP and IEA data. Libya

Result: Oversupply stands at around 2% of global oil -2.5 demand—the highest level since the Asia crisis of 2011 2012 2013 2014 Sources: BlackRock Investment Institute and U.S. Energy Information the late 1990s. See the chart above. Administration, January 2015. Note: The bars show the change in average daily oil production based on monthly data.

[4] CONCENTRATED PAIN, WIDESPREAD GAIN A MATTER OF COST Estimated Cost Base and Output of Oil-Producing Areas, 2020

Oil Sands $100

80 Rest of World Onshore North America Deep Water Shale Offshore Shelf 60

Middle East Onshore 40 Russia Ultra Deep Water Extra Heavy Onshore 20 Oil

Average Breakeven BREAKEVEN PRICE RANGE ($/BARREL) 0 0 10 20 30 40 50 60 70 80 90 100 ESTIMATED 2020 PRODUCTION (MILLION BARRELS/DAY) Sources: BlackRock Investment Institute and Rystad Energy, January 2015. Notes: The boxes represent different oil sources. The width of each box shows the level of potential production in 2020; the height shows the breakeven range for 75% of the production from that source. Dots show the average breakeven prices. The breakeven price is the oil price that gives a zero net present value using a 10% discount rate. Numbers are based on an average of currently producing, under development and not-yet-sanctioned projects.

COST-BENEFIT ANALYSIS Oil bulls point to a 24% drop in the number of U.S. oil drilling rigs from a record peak in October. See the chart below. The North American shale operators have become the world’s EIA forecasts additional declines this year but argues these are new marginal producers because they are able to quickly unlikely to result in a big fall in production. A backlog of wells scale up—and down. The breakeven costs of the average after years of heavy drilling—three to seven months’ worth shale well are around $60 per barrel—way above the current at major U.S. shale areas—will keep oil pumping. spot price. This compares with just $26 per barrel for onshore Middle East oil. See the chart above. Note: Averages mask a lot of differences. For example, costs for North American WELLING OVER shale producers range from around $40 to more than $70 Number of U.S. Rigs Drilling for Oil, 1987–2015 per barrel, according to research firmR ystad Energy. 1,600 High-cost producers should feel the pinch soon if prices stay low. Yet production of established U.S. shale assets may take longer to slow than many expect. Consider: 1,200 } u .S. shale producers that tapped high yield debt markets have hedged as much as half of their 2015 output: The 800

higher the risk of the field, the greater the hedge. RIGS } Newer horizontal wells are more productive than older vertical ones. 400 } Shale producers are loath to give up cash flows. Once they have spent the money on upfront costs, the marginal cost of drilling extra holes is low. 0 1987 1991 1995 1999 2003 2007 2011 2015 We expect U.S. supply to increase in the near term. Yet Sources: BlackRock Investment Institute and Baker Hughes, January 2015. production growth should start to taper off in the second half.

“ U.S. shale added a spectacular amount of oil in a very short time. It was not just big; it was bigger than anybody thought.” — Robin Batchelor Portfolio Manager, BlackRock Natural Resources Team

supply and demand [5] how low can it go? OIL FUTURES GAZING Brent Oil Futures Curve, 2015–2019 Oil futures have slumped since OPEC members decided in late November to keep production steady despite falling prices. $110

Markets currently are pricing in a gentle recovery in prices to July 2014 $70 per barrel by 2017—but no return to the heady days of over $100 per barrel. See the chart on the right. Options markets suggest prices should end 2015 anywhere between 90 $28 to $112, according to the EIA. Once markets narrow this Nov 26, 2014 range of outcomes, energy assets should start to reprice. (Day before OPEC meeting)

Futures markets are in “contango,” meaning forward prices $ PER BARREL 70 are higher than spot prices. This is encouraging a buildup in

inventories as well as a topping up of strategic reserves in January 2015 countries such as China. U.S. crude inventories hit highs for

the month of January, according to EIA. Crude stored in 50 supertankers reached about half of the global capacity as 2015 2016 2017 2018 2019 estimated by investment bank Macquarie. Storage demand is SETTLEMENT DATE mitigating the oil price fall for now but should cap any rebound Sources: BlackRock Investment Institute and Thomson Reuters, January 2015. because stored crude is bound to come back to the market.

How low could oil go? The oil price could fall below current levels of around $45, but we believe we are close to a bottom—based GEOPOLITICAL GYRATIONS on past peak-to-trough declines. We expect a modest recovery Geopolitical risks could disturb oil markets. Consider: next year, but think a return to $100-plus prices is far-fetched due to advances in drilling technology (barring temporary } Iran and the international community aim to reach a spikes caused by supply disruptions). comprehensive deal by June that would see Tehran give up its nuclear ambitions in return for a phased lifting of innovation impact sanctions. We would assess the chance of a full deal at less than 50% due to opposition by hardliners in Iran. Hydraulic fracking has proved to be a disruptive force that U.S. Congress is promising more sanctions if no progress puts downward pressure on product prices, much like is made by March. Any deal, however, would likely put mechanization and computerization brought down food and downward pressure on oil prices—even though actual consumer prices. And fracking has only just started: Adoption Iranian production increases would take time. outside the U.S. could have a similar impact on global oil supply. } We do not see Islamic State as a near-term threat to oil Technological advances also have the potential to shrink oil production in Iraq’s south, but cheap oil could hurt Iraq’s demand. Examples are hybrid cars and lightweight aluminum budget and reduce its ability to fight the militant group trucks. These are part of a broad-based trend, as shown by a in the long run. Similar dynamics are at work in Nigeria. decline in energy intensity of the global economy. It took the We expect Libyan oil production to be volatile as a civil equivalent of 1 barrel of oil to generate $1,000 of GDP growth war rages on, with periods of supply disruptions— in 2011, versus 1.3 in 1990, the latest World Bank data show. and surges. Energy efficiency and its impact differ across the globe. } r ussia faces ongoing economic sanctions due to its Increasing urbanization and car use should support oil demand involvement in the escalating Ukraine conflict. We expect in EM economies. China’s economy is still relatively energy Europe to maintain current sanctions. Yet we see it stopping intensive, requiring the equivalent of 1.4 barrels of oil per short of additional measures that would directly target $1,000 of GDP in 2011. This suggests a recovery in Chinese Russia’s energy exports because these could further growth could deliver an outsized boost to global oil demand. weaken the eurozone’s economy.

“ A U.S.-Iran deal would be a historic event after 35 years of basically hostility. But it would take some time to implement the agreement—and for Iran to — Tom Donilon ramp up production.” Senior Director, BlackRock Investment Institute

[6] CONCENTRATED PAIN, WIDESPREAD GAIN SUBSIDIES SAVINGS Winners and Oil Subsidies as a Share of 2014 GDP 12% Losers 8 The slump in oil is a story of concentrated pain (net oil-exporting nations and energy companies)—and widely dispersed gain 4 (global consumers and oil-importing countries).

The price plunge effectively is a massive wealth transfer from producers to consumers. A back-of-the-envelope calculation 0 shows this is a big gift. The world was expected to consume $3.4 trillion of oil in 2015 assuming a $100 oil price, according Iran India China Saudi to EIA. Ergo, the 50%-plus price plunge should result in a Egypt Arabia Mexico Nigeria Indonesia

benefit of some $1.7 trillion to global consumers and oil- Venezuela

importing nations. Oil Importers Oil Exporters Oil exporters have savings rates 25% higher than importers, Sources: BlackRock Investment Institute, IEA and IMF, January 2015. Note: Data show oil subsidies for 2013 as a share of estimated 2014 GDP. according to research firmE vercore ISI. This means the redistribution of wealth to oil importers should result in a net rise in global consumption and economic activity— Lower oil prices enable countries to cut or end subsidies even as exporting nations suffer. for energy and food prices, easing budget pressures. Oil- The map below outlines the economic impact of a $50 decline producing nations are among the most generous, but oil in the oil price on individual countries. Gains (green) are importers such as Indonesia and India also used to spend dispersed across developed nations and most of the Asia- big on keeping a lid on prices. See the chart above. Pacific region. Losses (purple) are concentrated in oil-producing Subsidy cuts would partly erode the benefits of cheaper nations in the Middle East, Africa and elsewhere. oil for EM consumers.

OIL SPILLOVER Revenue Impact of $50 Oil Price Fall, 2015

SHARE OF GDP

-10% -3% 0% 2% 4%

Sources: BlackRock Investment Institute, EIA and IMF, January 2015. Notes: The map shows estimated revenues gained or lost from a $50 fall in the price of oil as a share of GDP. The impact is calculated by taking each country’s 2013 net imports of oil, multiplying this by $50 and then translating the total into a share of 2014 GDP.

winners and losers [7] losers and cushions PAIN POINTS Fiscal Breakeven Oil Price, 2015 Oil-producing countries are in for a rough time. This unfortunate bunch can be divided into three groups: Libya 1. Countries that have accumulated large amounts of Iran foreign assets: Saudi Arabia, United Arab Emirates and Algeria Norway. They can afford to fund budget shortfalls from Oman these piggy banks in the short run. Energy makes up 87% Iraq of Saudi Arabia’s goods exports. Yet foreign reserves and Saudi investment income cushion the budgetary impact of Arabia cheaper oil for now. See the table below. Qatar

2. Oil producers with smaller fiscal cushions such as Mexico, UAE

Malaysia, Bahrain, Oman and Colombia. They may have to Kuwait resort to combinations of fiscal austerity and increased borrowing. Many countries appear to be assuming oil prices 0 40 80 $120 higher than $60 to $70 per barrel in their revenue $/BARREL projections (they are loath to disclose details)—heralding Sources: BlackRock Investment Institute and IMF, January 2015. Note: The fiscal financial stress. Most, however, can easily tap capital breakeven is the oil price at which the fiscal balance is zero, based on IMF forecasts for 2015. markets because they have low external debt positions. 3. Countries with little cash and poor access to international debt markets. They are most vulnerable to sudden reversals Many are middle- or low-income countries running expansionary in capital flows and currency depreciations. Venezuela and budgets—often to meet social or political goals. The oil price Nigeria are prime examples. Energy makes up 97% of decline throws their budget plans and funding options upside Venezuela’s goods exports, yet its foreign reserves are a down. Forecast surpluses are swiftly turning into huge deficits. paltry 2% of GDP. Venezuela is ranked second to last and Even many of the world’s low-cost producers in the Middle Nigeria 41st of the 50 countries tracked by our East were banking on oil prices of $100-plus per barrel to BlackRock Sovereign Risk Index. balance their fiscal budgets. See the chart above.

ENERGY DEPENDENTS Key Statistics of Selected Energy Exporters, 2015

Short-Term BlackRock Energy Share External Debt Reserves Share External Debt Sovereign Risk of Goods Exports Share of GDP of GDP Share of GDP Index Rank

Iraq 99% 2.9% — 0.1% —

Algeria 97% 0% — 0% —

Venezuela 97% 14.3% 2% 2.1% 49

Kuwait 94% 2.2% 20% 0% —

Nigeria 88% 1.7% 6% 0% 41

Saudi Arabia 87% 0% 102% 0% —

Oman 83% 3% 21% 0% —

Kazakhstan 76% 3.5% 27% 0.1% —

Russia 71% 3.4% 20% 0.8% 22

Colombia 69% 10.7% 12% 0.8% 27

United Arab Emirates 65% 4.7% 8% 0.8% —

Sources: BlackRock Investment Institute, World Bank, Fitch, Moody’s and Bloomberg, January 2015. Notes: Energy exports are exports of oil, gas, coal and other energy sources. External debt figures are gross. External debt and reserves data are based on a composite of sources. Short-term debt is less than two years. Not all countries are tracked by the BlackRock Sovereign Risk Index.

[8] CONCENTRATED PAIN, WIDESPREAD GAIN winners and disinflation INFLATION BEATER Consumer Price Inflation and Oil Prices, 2005–2015 Most countries will likely see lower inflation, especially net Emerging Market Oil Importers oil importers in the emerging world. Consumer price index (CPI) 6% inflation in EM oil importers has plummeted to U.S. levels over the past three years, tracking the growth rate in oil prices. 4 And falling oil prices have dragged the eurozone back to the brink of deflation. See the chart on the right. U.S. 2 Falling oil prices are a game changer for oil-importing EM countries such as India. They drag inflation lower, allowing INFLATION CPI 0 Eurozone central banks to ease monetary conditions and stimulate their economies. China, the world’s No. 2 oil importer, is -2 another beneficiary. Cheaper oil could boost the country’s 2005 2007 2009 2011 2013 2015 GDP by between 0.4% and 0.7% in 2015, the IMF estimates. 120% Lower energy prices may trigger additional declines in Brent Crude Oil Price agriculture and food prices. Food production is energy intensive due to the use of fertilizers. The double gain to consumers from 60 declines in energy and food is a big positive for low-income countries with a high dependency on imports.

Countries with a high energy weight in their CPI baskets CHANGE Y-O-Y should be big winners. Poland, Hungary and Indonesia top this list at more than 15%, according to OECD and IMF data, with India and Malaysia not far behind. Turkey, South Africa and -60 South Korea should also benefit.Y ields in all these countries 2005 2007 2009 2011 2013 2015 look attractive in a near-zero-rate world. Even emerging Europe Sources: BlackRock Investment Institute, Thomson Reuters and local statistics agencies, January 2015. Notes: Emerging market oil importers are an unweighted appears a bargain for income-starved eurozone investors. average of China, Hungary, India, Poland, South Korea, Singapore and Thailand. We see commodity exporters such as Venezuela, Colombia, Argentina, Russia, Kazakhstan and Malaysia on the losers’ board. POLICY DIVERGENCE Cheaper oil should add to EM policy divergences and increase EM MANEUVERING ROOM dispersion in investment outcomes. Some oil exporters will The impact of cheaper oil on EM currency and credit markets likely be forced to tighten monetary policies to stem capital is a tug of war. The current account balances of commodity outflows and currency depreciations. importers will likely improve—a positive for local currency The impact on monetary policy in developed economies is bonds. Yet likely interest rate hikes by the U.S. Federal Reserve more subtle. Cheaper energy is exacerbating already falling risk eroding the yield advantage of these countries, putting inflation expectations. This makes it even harder for central downward pressure on their currencies. Higher U.S. rates drain banks in Japan and the eurozone to hit their inflation targets. global liquidity because they boost the value of the world’s Both have launched massive bond-buying programs to avoid premier funding currency, the U.S. dollar. outright deflation, boosting asset prices.

Conclusion: Cheaper energy hands EM countries maneuvering The Fed is a different story. We expect the U.S. central bank to room to ease monetary policy or tighten it more slowly, stick to its guns on raising rates in 2015, but see it going slowly softening the impact of Fed rate rises on their economies. and ending at a historically low level. Bottom line: Falling oil See Dealing With Divergence of December 2014 for details. adds to an already divergent trend in monetary policies.

“ U.S. consumers and much of emerging Asia will be stronger six months from now thanks to the lower oil price. There are more winners than losers.” — Russ Koesterich Chief Investment Strategist, BlackRock Investment Institute

winners and losers [9] U.S. CONSUMER WINDFALL u.s. housing and goodies Gallons of Gas Bought With U.S. Average Hourly Wage, 1991–2015 How about a consumption boost beyond gasoline savings? 15 U.S. housing and durable goods could be winners, our analysis of the 1985-1986 and 1997-1998 oil downturns suggests. Jan 2015 10.1 Gallons } Housing: Home sales surged during previous oil price crashes. The reason? Rising consumer confidence and cash flows— and a drop in mortgage rates driven by falling inflation.

10 } Durable goods: Purchases of big-ticket items surged on the

GALLONS two previous occasions. A sharp drop in the cost of consumer Jul 2014 5.7 Gallons financing was a key driver.

Caveat: Interest rates had much more room to fall during past oil price crashes. And consumers are more leveraged these days. Household debt stands at 76% of GDP, versus 5 48% in 1985, Fed data show. Yet there are signs the U.S. 1991 1995 1999 2003 2007 2011 2015 consumer is perking up. Confidence in January rose to its Sources: BlackRock Investment Institute, U.S. Bureau of Labor Statistics and U.S. Energy Information Administration, January 2015. Note: The line shows the U.S. highest level since 2007, according to The Conference Board. average total non-farm hourly earnings divided by the average U.S. gasoline price. Capital spending could also support growth this time around. Cheaper energy will likely boost productivity in energy-intensive priming the pump sectors such as chemicals—encouraging players in these industries to raise capex (offsetting cuts by energy producers). Lower oil prices represent a large tax cut for consumers in the developed world, particularly in the United States. The average hourly U.S. wage bought about 10 gallons of gasoline start your engines! in January, up from 5.7 gallons in mid-2014. See the chart Gasoline Use and Prices in Selected Countries, 2011–2015

above. The response should be swift: Any gasoline price 2,000 decline that is part of an extreme fall (over 15% in a quarter) tends to generate a bump in consumption in the next quarter that is four times as large as the effect of milder price falls, U.S. 1,500 we find. Canada Another reason to expect outsized U.S. consumption gains: U.S. drivers burn up far more gasoline than motorists 1,000

elsewhere. Japan, Europe and many emerging markets stand Saudi Arabia Australia to benefit less. Their consumers use less fuel and pay more

at the pump due to higher taxes. See the chart to the right. 500 Japan Germany U.S. dollar strength also reduces gasoline savings for consumers in countries with weakening currencies. Oil is YEAR) (LITERS PER PERSON USAGE U.K. China traded in U.S. dollars, mitigating the effect of any decline in 0 local currency terms. Yet the oil price crash has been so large 0 0.50 1 1.50 $2 that it swamps the currency effect in many nations. Oil has PRICE PER LITER fallen 49% in euro terms and 51% in yen since mid-2014, Sources: BlackRock Investment Institute, World Bank, globalpetrolprices.com and EIA, January 2015. Notes: Usage data are based on motor vehicle gasoline compared with a 57% decline in U.S. dollars. Bottom line: consumption for 2011 and 2012 (China and Saudi Arabia). Bubbles are sized by Cheaper oil delivers a big consumption stimulus globally. overall consumption. Gasoline prices are retail prices as of January 2015.

“ The relationship between energy prices and risk sentiment is not linear. Many oil exporters will see their foreign reserves decline, but the impact — Terrence Keeley on their appetite for risk assets will be muted.” Global Head of BlackRock Official Institutions Group

[10] CONCENTRATED PAIN, WIDESPREAD GAIN evaluating equities GAS GUZZLERS How to capitalize on the seismic shifts caused by the World Oil Consumption by Sector, 2012 crude crash? Industry Cheaper oil often improves the trade balances of energy- 8.5% importing nations. Equities in those countries tend to Other outperform, our research shows. We would focus on exporters 11.8% within this space, or companies that derive more than 50% of their revenues from outside their home market (we use lower Transport Non-Energy Use percentages for EM companies due to the paucity of listed % % 63.7 exporters). This investment idea should have legs: Valuations 16 of exporters are slow to reflect improving terms of trade, as opposed to rapid gains after currency declines, we find.

It also makes sense to favor: } Industries benefiting from lower operating costs, especially those that have not hedged their oil purchases. Transport Sources: BlackRock Investment Institute and IEA Key World Energy Statistics 2014. Note: The “other” category includes agriculture, residential, and commercial and public (airlines, trucking and logistics) is a prime beneficiary. services. Non-energy use refers to oil used as an input in other sectors and not as a fuel. The sector accounts for 64% of global oil use. See the chart on the right. } Sectors profiting from consumers having more disposable Caution: When we crunched the numbers on the overall income (retailers, restaurants and other consumer effect of oil price changes on industry sector valuations discretionary stocks). in the past 25 years, we found few differences beyond the simple fact that energy and materials shares outperform These stocks have rallied, yet we believe there is more to when oil prices rise. come as analysts upgrade their earnings expectations. Conclusion: This is very much a stock picker’s territory.

reserves reshuffle REDISTRIBUTION OF WEALTH The commodities price implosion is reverberating Forecast Change in Foreign Exchange Reserves, 2015 through the world of foreign exchange (FX) reserves $200 20% held at central banks and sovereign wealth funds. We expect global reserves to edge up 2% to reach a

total of $11.7 trillion by year end. This average masks a 100 10 lot of differences. (Looking at Chicago’s average annual temperature of 50 degrees Fahrenheit, you would never

know you need a winter coat.) Oil exporters will dig into LIONS 0 0

their reserves while energy importers will add to their BIL FX piles. See the chart to the right. China will benefit from lower oil imports, but slowing activity is likely to -100 -10 nudge down its reserve growth rate. How will the shift in reserves play out in financial -200 -20 markets? We expect isolated sales of risk assets as oil OPEC Non-OPEC Oil Importers China exporters plug budget holes and defend currencies. Yet Countries Oil Exporters (ex China) the overall impact should be minimal for now. More than U.S. Dollar Change (Billions) Percentage Change half of global reserves are in cash or cash equivalents— Source: BlackRock Investment Institute, January 2015. Notes: Based on BlackRock enough to preclude fire sales of less liquid assets. Plus, estimates. OPEC excludes Ecuador, Iran, Iraq and Venezuela. Non-OPEC exporters these institutions tend to premise their investment are Russia, Norway, Canada and Kazakhstan. Oil importers are U.S., Japan, India, decisions on opportunities, not on the price of crude. South Korea, eurozone, Singapore, Thailand, Turkey and Indonesia.

winners and losers [11] RESOURCES REGRESSION E nergy Assets Commodities-Related Asset Performance, 2011–2015 Commodities FX Equities Fixed 50% Income The oil price plunge and subsequent downturn in energy- related assets have been dramatic. Yet they are part of a larger 25 downward move in commodities prices. Agriculture, metals and currencies of commodities exporters already were in decline before oil started its descent in July 2014. These non- 0 yielding assets suffered due to a strengthening U.S. dollar and over-supply caused by years of buoyant prices. -25

Energy assets were the last dominos to fall—but fell the hardest. They had rallied in the previous three years and only -50 recently imploded. See the chart to the right. Metals Crude Oil Crude Before the crash, yield-hungry investors happily funded the Canada $ Australia $ Australia Brazil Real Brazil Agriculture Russia Ruble Russia

burgeoning energy sector as oil prices held firm. Revolving Krone Norway U.S. HY Energy HY U.S. Mining Equities Energy Equities Energy bank debt and high yield bonds became the instruments of IG Energy World Jan 2011 to June 2014 July 2014 to Jan 2015 choice for the ambitious U.S. shale explorer. Sources: BlackRock Investment Institute and Thomson Reuters, January 2015. Notes: Crude oil is based on the average of WTI and Brent prices; industrial Many North American shale players became addicted to the metals and agriculture are based on GSCI spot indexes. Equities are based on easy money. They made a habit of spending more than their MSCI World indexes. Fixed income is based on Barclays indexes. cash flow to expand reserves, increase production and make acquisitions, relying on Wall Street funding to close the gap. The falling oil price shattered this cozy arrangement and North American small caps, in particular, rode the wave in heralds a cash crunch for some companies. Borrowing costs the past decade. Cash flow from operations fell far short of have risen and access to capital has shrunk as a result of spending. See the left chart below. They sucked in capital to lower and more volatile oil prices. Access to cash is arguably the detriment of companies focusing on exploration outside more important than marginal costs or access to reserves in North America. Large caps largely balanced their books in this climate. We expect cash flows and capital expenditures this period, and were unwilling (or unable) to add much debt. to fall significantly this year.B oth dropped sharply in the See the right chart below. 2008-2009 financial crisis, as the charts below show.

BURNING CASH North American Energy Capex and M&A vs. Cash Flow, 2004–2014

SMALL CAP LARGE CAP $100

Acquisitions

PER BARREL OF OIL OF BARREL PER 75 Cashﬂow from Operations Acquisitions Cashﬂow from Operations 50 PER BARREL OF OIL

Capex Capex 0 2004 2006 2008 2010 2012 2014 2004 2006 2008 2010 2012 2014 Sources: BlackRock Investment Institute and Bernstein Research, January 2015. Note: The analysis is based on 55 North American exploration and production companies. The values show the total cash flow, capex, and money spent on acquisitions for each group divided by their total production in barrels of oil equivalent.

[12] CONCENTRATED PAIN, WIDESPREAD GAIN HIGH YIELD: SURVIVAL MODE CLIMBING THE MATURITY WALL U.S. High Yield Energy Maturity Schedule, 2016–2024 High yield energy issuers are either small, risky companies or large ones with weak balance sheets. U.S. shale producers $40 have, on average, hedged around half of their oil production Infrastructure for 2015, but very little beyond. 30 Oil Services High yield valuations largely reflect differences in asset quality, hedging levels and access to credit between companies. Reﬁning Bond prices of refiners and pipelines have held up well, while Exploration 20 and Production those of oil services and explorers have slid. See the table BILLIONS below. Yields of individual bonds are similarly dispersed.

If oil stays at low levels, some borrowers may default. The longer 10 low prices persist, the greater the pain. We do not see a wave of U.S. defaults in the next year, however. Shut off from new funding, companies will go into survival mode. They first 0 slash capex, negotiate lower servicing costs and prioritize 2016 2017 2018 2019 2020 2021 2022 2023 2024 the most profitable wells. Sources: BlackRock Investment Institute and Barclays, January 2015. Note: Companies in the Barclays High Yield Energy Index have no debt due in 2015. Revolving credit lines, the source of day-to-day funding for capex, appear to be safe for now. Commercial banks are using long-term oil price assumptions, rather than spot prices, when delayed deals determining the size of these revolvers. Their generosity is Mergers and acquisitions (M&A) in the energy sector has been likely to wane if lower prices persist, while rating downgrades on a boil in recent years, driven by large U.S. exploration will make raising long-term debt tough. Bottom line: Most companies selling non-core assets to reduce debt and producers should be able to ride out the storm—as long as streamline portfolios. Private equity investors have raised signs of a decline in crude supply show up by early 2016. almost $70 billion in energy funds since the start of 2012, Defaults elsewhere could come earlier. Moody’s expects a according to research firm Preqin, and will be in prime position 6% default rate among Latin American corporates this year to pick up the pieces. For now, they appear to be sticking to because of the commodities price downdraft, more than double quality assets only—and are holding out for bargain prices. its forecast 2.7% global default rate for speculative paper. M&A should dry up initially. Sellers are unwilling to dispose The good news: The sector’s maturity wall—when loans need of assets at what they currently see as fire-sale prices, to be repaid or refinanced—only hits in earnest in 2017. See preferring to wait for a rebound in oil prices. Activity could the chart above right. Stronger companies will have no trouble start to pick up in the second half of 2015 as some companies tapping the market, but financing will be dearer: 7.5% to 8% face a cash crunch and production hedges expire (only a versus less than 5% before oil prices slumped. handful of companies has production hedged into 2016).

DRILLING DOWN U.S. High Yield Energy Sector Overview, 2015

Number Outstanding Share of High Share of Six-Month Change of Issues Amount (billions) Yield Total Energy Total Current Yield (basis points)

U.S. High Yield 2,223 $1,315 6.5% 123

Energy 344 $199 15% 9.8% 434

Independent Energy 184 $113 9% 57% 11.2% 563

Oil Services 60 $28 2% 14% 13.1% 728

Refining 11 $5 0% 2% 7.1% 192

Infrastructure 88 $53 4% 27% 6.2% 158

Sources: BlackRock and Barclays, January 2015. Notes: Data are based on the Barclays U.S. High Yield Index. Current yields are no guarantee of future levels.

energy assets [13] INVESTMENT GRADE: DISPERSION RENEWABLES REVIEW What about the U.S. investment grade (IG) market? The Do lower oil prices spell the end of the boom in renewable segment has been hit, for sure. Yet a widening of spreads energy? Not really, in our view. by an average of 55 basis points can hardly be described Renewables such as wind and solar power have as carnage. See the table below. essentially decoupled from lower oil prices. Oil generated IG oil services firms are cutting staff (Schlumberger recently just 5% of world electricity in 2012, down from 25% in announced 9,000 redundancies) and capex. Offshore drillers 1973, according to the IEA. Coal (at 40% in 2012) and are in the toughest spot. They faced sagging demand from gas (22.5%) are much more important. And renewables integrated oil companies, an abundance of newly built rigs make up a big chunk of new power generation in many and falling day rates even before oil prices slid. IG oil services countries. Wind and solar power accounted for 46% of firms, however, tend to be top-quality credits. new U.S. power capacity in 2014 versus 51% for gas, according to research firm SNLF inancial. Explorers on average take a 14% hit to earnings before taxes and amortization for every $10 decline in the oil price below Second, renewables have become much more cost $80, our analysis of 15 U.S. IG companies shows (assuming competitive. The cost of solar power has fallen 78% in a 20% capex cut and level production). This average hides huge the five years ending in 2014, while the price tag of wind dispersion, making credit selection crucial. Considerations has declined 58%, according to Lazard research. Large- include cost structure, cash margins and hedge positions. scale wind and solar installations now beat most other Many have crimped capex—with more to come. sources of power generation on costs—even before subsidies meant to enhance environmental sustainability, Energy infrastructure credits, including master limited according to Lazard. partnerships (MLPs), should spring back due to the need to The trouble spot? Transport alternatives that compete transport hydrocarbons. The lion’s share of the sector’s directly with oil. Think vehicles running on biofuels, revenues is fee-based, we estimate, so it is shielded from batteries or natural gas. A prolonged period of low oil price falls (but not volume declines). Refiners stand to prices could set back development of alternative fuels. benefit as refined product prices typically lag declines in prices of underlying feedstock.

IG INTERNAL BLEEDING U.S. Investment Grade Energy Sector Overview, 2015

Number of Outstanding Share of Share of Six-Month Change Issues Amount (billions) IG Total Energy Total Current Yield (basis points)

U.S. Investment Grade 6,028 $4,760 2.8% -4

ENERGY 608 $412 9% 3.7% 51

Independent Energy 136 $102 2% 25% 3.7% 49

Integrated Energy 98 $94 2% 23% 2.6% 11

Oil Services 87 $52 1% 13% 5.3% 197

Refining 18 $18 0% 4% 3.8% 44

Infrastructure 269 $146 3% 36% 3.9% 35

Sources: BlackRock and Barclays, January 2015. Notes: Data are based on the Barclays U.S. Credit Index. Current yields are no guarantee of future levels.

“ This is a long-term opportunity to make money in selected U.S. exploration and production companies, especially given how bearish the crowd — Jessica Wirth Strine has become.” Portfolio Manager, BlackRock Global Opportunities Team

[14] CONCENTRATED PAIN, WIDESPREAD GAIN EQUITIES: DISCOUNTING DISCOUNTS ENERGY ON SALE Global Energy Equity Valuations, 1995–2015 We could see a slow-moving equity rally as news of idled capacity filters down.A small rise in the oil price could entice 1.4 contrarians undeterred by cuts to earnings forecasts. Ratio EXPENSIVE Valuations of energy stocks generally look attractive across the globe. Price-to-book values were less than 70% of the MSCI World Index average in January. The discount is greater than during the 1998-1999 Asia crisis, when Brent oil prices Average slipped below $10 per barrel. See the chart on the right. The 1 risk? Analysts may be overestimating future profits or the degree of any oil price snapback. And the global energy sector looks less cheap on a price-to-earnings basis, trading right in RELATIVE PRICE-TO-BOOK RATIO PRICE-TO-BOOK RELATIVE line with its 20-year average. CHEAP

U.S. energy valuations look even better on some metrics, as detailed in The Oil Plunge of January 2015. The energy 0.6 discount, however, hides a lot of variation. Integrated oil 1995 2000 2005 2010 2015 and gas companies, or “energy majors,” trade at steep Sources: BlackRock Investment Institute and MSCI, January 2015. Note: The green discounts—versus their own history, most other energy line shows the price-to-book ratio of global energy equities relative to that of the MSCI subsectors and world equities. Energy infrastructure World Index. trades at a premium. See the table below.

We prefer quality and avoid outfits that could run into funding It makes sense to bottom-fish for selected exploration troubles. Our favorites: the super majors. Valuations are low, companies in the expectation that oil markets should start the integrated model provides a buffer against oil price declines rebalancing in six to 12 months. Taking the plunge at this time and management teams appear focused on shareholder returns requires high conviction, so we would look for companies rather than adding reserves or increasing production. The with the following attributes: segment has a 4.5% dividend yield—well above sectors that 1. Improving recovery of reserves and return on investment investors have been chasing for yield such as U.S. utilities. per well in top-tier areas such as the U.S. Permian Basin. We would underweight oil services, especially those most 2. Expanding profit margins through the application of exposed to U.S. production and those with outdated equipment. technologies such as horizontal drilling. They may appear cheap, but we believe a lot more pain is to 3. Healthy balance sheets that are on their way to delivering come. Oil explorers are shifting into survival mode, cutting positive free cash flows within one to three years. capex and negotiating lower servicing rates.

ENERGY DISCOUNT Global Energy Equities Overview, January 2015

Oil and Price-to- PB Ratio P/E vs. World Equity Gas Sector Six-Month Book (PB) vs. 20-Year 12-Month 20-Year Dividend Weight Weight Total Return Ratio Average Forward P/E Average Yield

World Equities -4% 2.1 1 14 0.9 2.5%

Oil & Gas 7.5% -26% 1.4 0.7 13 1 3.9%

Integrated Oil 3.6% 49% -26% 1.2 0.6 10 0.8 4.5%

Exploration 2.1% 28% -29% 1.5 0.8 15 1.2 2.9%

Services 0.7% 9% -38% 1.6 0.6 12 0.7 3.3%

Infrastructure 1% 13% -6% 3.2 1.6 24 1.4 4.3% Sources: BlackRock Investment Institute and Thomson Reuters, January 2015. Notes: Data are based on the Thomson Reuters Datastream World Index. Current performance is no guarantee of future results.

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