When Falling Oil Prices Are Bad News
While watching OPEC leader Saudi Arabia in recent days cajole members to cut production, I’m reminded of Ronald Reagan’s famous admonition to Jimmy Carter during their 1980 presidential debate: There you go again.
And there the Saudis go again. This week, the keffiyeh-wearing oil ministers of Saudi Arabia have been desperately twisting the arms of fractious OPEC members to tighten the spigots. A deal between OPEC and allies to curb output by 1.2 million barrels per day runs out at the end of this month. Oil prices have been tumbling, threatening the bottom lines of energy companies and the national treasuries of oil producing states.
Haven’t we seen this movie before?
Major oil-producing countries are scheduled to meet in Vienna July 1-2, after the biannual OPEC-led gathering had been postponed several times. The Saudis and their non-OPEC allies the Russians are expected to pressure those in attendance for further production cuts.
The Saudis already are cutting their output ahead of next week’s meeting. Not only do they seek a roll-over of existing production cuts but they want to deepen those cuts.
The fate of the overall bull market hangs in the balance.
Oil prices this year have been fluctuating with the ebb and flow of investor passions. As we face the start of the second half of 2019, you should be concerned about the waning fortunes of crude and copper. The following chart depicts prices over the past 12 months for copper (per metric ton) and the U.S. benchmark West Texas Intermediate (WTI), per barrel.
Source: Charles Schwab, Macrobond, London Metal Exchange
OPEC’s production cut has held firm, without the usual cheating. Saudi Arabia and Russia have stated their resolve in keeping a lid on production.
And yet, crude prices have continued to fall. Recent data point to an unexpected inventory build, amid a slowing global economy. That spells trouble for oil, which in turn is a bearish signal because Wall Street interprets robust oil prices as the sign of a healthy economy.
Oil prices are higher than they were in February 2016. That’s when they fell below $28 per barrel, a sharp reversal from their highs of about $110/bbl in mid-2014. During the prolonged energy slump of 2016-2017, the industry was awash in red ink and bankruptcies. Oil stabilized and rebounded for most of 2018, slumped in the fourth quarter (along with the broader stock market), and started 2019 on an upward trajectory.
As the above chart shows, crude oil’s roller coaster ride continues, with momentum now bearish again.
Is the energy recession coming back? WTI yesterday closed at $59.22/bbl. Brent North Sea crude, on which international oils are priced, closed at $65.38/bbl.
The recent slump in crude prices is weighing on the U.S. shale industry, with top executives predicting another round of bankruptcies in the sector.
According to a survey released June 26 by the Dallas Federal Reserve, falling oil prices have dampened spending and drilling among shale producers. To be sure, oil and gas production continued to rise in the second quarter, but it did so at a much slower pace, adversely affecting oilfield services companies. These services providers are the most sensitive to slowdowns in drilling and their margins are hurting.
Think the energy sector’s difficulties don’t affect the non-energy holdings of your portfolio? Think again. Because of the importance of energy to the overall economy, these woes threaten to spill over into other sectors. Bad news for oil could be bad news for you.
Dr. Copper’s prognosis…
Copper is a widely used commodity so sensitive to economic conditions, it’s viewed as a leading indicator. Because copper is a time-proven predictor of economic trends, the red metal is said to have a PhD in Economics. Hence the metal’s nickname “Dr. Copper.” And the prognosis from Dr. Copper is not encouraging.
Falling energy prices bring some good news, of course. Producers in the oil patch may be suffering, but lower energy costs help consumers and many businesses. Indeed, the government reports that 2019 summer gasoline prices will be lower than they were last year (see chart).
Source: U.S. Energy Information Administration (EIA)
The G-20 summit, which started today in Japan, holds the key. If President Donald Trump and Chinese Leader Xi Jinping reach a resolution on trade, the stock market and energy prices would probably spike higher. But it nothing comes of the G20 confab…well, look out.
Bank of America (NYSE: BAC) analysts stated on June 25 that oil prices could plunge to $30/bbl, if the U.S. and China don’t reach accommodation. For oil producers, the break-even point is roughly $40-$50/bbl, depending on the region.
President Trump has threatened to slap tariffs on the remaining $300 billion worth of Chinese imports if he’s dissatisfied with Xi’s offers on trade. This action could prompt Beijing to allow its national currency the yuan to weaken, making crude that’s priced in U.S. dollars more expensive in the world’s largest importer and weighing on demand growth. The Chinese government might also skirt around U.S. sanctions against major oil exporter Iran and resume imports from the country.
Weighing on energy prices have been stubbornly high global crude oil inventories and worries that U.S. shale production growth will continue to offset the production cuts mandated by OPEC. The shale production revolution in North America turned the U.S. into the world’s largest producer of oil.
America actually dethroned Saudi Arabia as the king of oil producers, a landmark that I thought I’d never see in my lifetime. That’s great news for U.S. energy independence, but the tenuous grip of Saudi Arabia on the oil cartel also undermines equilibrium in energy markets.
Another factor that’s beyond Saudi Arabia’s control is the current brinkmanship between the U.S. and Iran. An outbreak of military conflict in the Persian Gulf would disrupt oil supply and in turn lift prices. Iran is even threatening to close the Strait of Hormuz, which connects the oil-rich Gulf to international waters. Regardless, the supply-and-demand balance remains out of whack.
Fourth quarter redux?
The price of oil swooned in the fourth quarter of 2018 as investors worried about slowing global growth and a persistent glut of crude. The stock market followed suit. Will we see a repeat of this dynamic in 2019? With so many variables at play, it’s foolhardy to attempt a prediction.
But here’s a safe bet: Over the long haul, energy demand should pick up again and provide a sustainable tailwind for oil prices, especially in emerging markets as rising middle classes buy cars and other oil-guzzling amenities.
According to the Boston Consulting Group, China and India will be home to about one billion middle-class consumers by 2020. Emerging markets also have populations that are younger, and hence freer spending, than those in developed countries. As their living standards rise, these newly affluent people will consume more and more energy.
The picture is more complex for natural gas. The EIA’s Short-Term Energy Outlook predicts that natural gas supply will outpace demand this year, keeping a lid on prices.
For Henry Hub spot natural gas, EIA pegs its 2019 forecast at about $3.20/million British thermal units (MMBtu), down from an average price of $3.29/MMBtu in 2018. However, BP’s (NYSE: BP) long-term view for natural gas is bullish. The company forecasts that the world’s total energy demand will grow by a third through 2040. The majority of that new energy will derive from renewable power and natural gas.
The oil and gas sector has been volatile and a lasting turnaround has remained elusive. However, every portfolio should have exposure to energy. Oil is the world’s most valuable commodity and, despite the inroads of “green” energy, we still live in the Hydrocarbon Age.
Stick to energy companies with solid cash flow, low debt, strong balance sheets, and prolific oil and gas assets. They’re positioned to thrive when energy inevitably bounces back. But until then, brace yourself for more turbulence ahead. The energy sector faces challenges that the Saudis can’t solve in Vienna.
Questions about the energy sector and how it affects your portfolio? Drop me a line: firstname.lastname@example.org
John Persinos is the managing editor of Investing Daily.