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.