Energy
UBS CIO Wealth Management Research
18 December 2014
Will there be blood?
The implications from lower oil prices
ab
This report has been prepared by UBS Financial Services Inc. (UBS FS). Please see important disclaimers and disclosures
that begin on page 8.
Energy
A different kind of "oil crisis"
“Strange, strange are the dynamics of oil and the ways of
oilmen.”
― Thomas Pynchon, Gravity's Rainbow
Since the beginning of the 20th century, oil has played a
crucial and at times confounding role in the world's affairs. While the dawn of the petroleum age ushered in
an era of extraordinary growth and opportunity, it also
made the world's economies increasingly dependent upon the changing fortunes within the oil patch. This vulnerability was made apparent by the energy crisis of the
1970s. Supply shortages - prompted in part by the OPEC
oil embargo - subjected much of the developed world to
both stagnant growth and rising inflation. Economies
that had become accustomed to abundant supplies of
cheap oil suddenly had an entirely new reality thrust upon them.
But today's "oil crisis" is very different. In contrast to the
production declines, supply shortages and surging energy
costs of the 70's, we are now confronted with rising
global capacity, inventory gluts and falling oil revenues.
Rather than fretting over the prospects for crude prices
breaching the $160 per barrel level, we are instead left to
ponder the implications from oil prices having dipped
below the $60 per barrel mark. Is the much hyped North
American energy revolution likely to suffer a premature
demise? Will the collapse in the Russian ruble trigger a
replay of the 1998 currency crisis? How will OPEC evolve
as pricing discipline breaks down and the cartel's effectiveness wanes?
To be sure, there are many winners from this steep drop
in crude prices. Keep in mind that the 45% decline in oil
prices since the end of July acts much like a tax cut for
consumers of energy. We estimate that a $10 sustained
decline in the price of oil increases household nominal
disposable income by 0.7% after one year, but some of
this is saved and some of the associated additional
spending falls on imports. The total boost to real GDP
growth amounts to 0.3% after one year. In contrast, the
lower oil price curtails business fixed investment spending
in the energy sector. Taking this as well as other effects
into account, the Fed's macroeconomic model points to a
total real GDP boost of 0.2% after one year. Emerging
market countries such as Singapore, Thailand and India,
which are largely dependent upon imported energy,
likewise enjoy an income windfall as energy costs have
fallen. To the extent the decline in oil prices also contributes to a further dampening of inflation, central bankers
now have even greater latitude to retain an accommodative policy stance – even as growth prospects improve.
Mike Ryan, CFA
Chief Investment Strategist
Wealth Management Americas
Fig. 1: US oil production
In thousands of barrels per day
Source: Energy Information Administration
"To be sure, there are many
winners from this steep drop
in crude prices."
UBS CIO WM Research 18 December 2014
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Energy
Still, such a sharp and sudden decline in the world's most
important commodity invariably raises concerns over the
health of the global economy, the stability of the geopolitical environment and the threat of contagion within
financial markets. It is our view that these fears are largely misplaced as we see few parallels to the recession-led
energy price swoon back in 2009. So to help address
these and other concerns, we provide the following in
this report:
(1) an assessment of the factors that contributed to this
recent price decline;
(2) a projection of likely dynamics within the energy sector in 2015;
(3) the implications for our tactical and thematic views;
(4) guidance on how investors not only can navigate
these shifting market dynamics, but also prosper
from their lingering impact.
So what really happened?
While a slowing of demand within the emerging markets
(most notably China) and overall improvements in energy
efficiency likely contributed to price declines, the recent
rout in oil was largely a function of supply dynamics.
Consider the following:
•
•
•
Following a spending spree that totaled more than
$2 trillion in energy related capital projects over the
past five years, the United States is now emerging as
the world's largest energy producer. With oil and
gas production now averaging about 11 million barrels per day, the US has transitioned from being the
marginal consumer of oil, to being the marginal producer of oil.
Faced with both growing economic competition from
booming American shale production and an escalating ideological/sectarian rivalry with Iran, Saudi Arabia struck a dual blow with the most potent weapon
at its disposal – sharply lower oil prices. By maintaining production at current levels, Saudi Arabia has
abandoned its traditional role as the global "price enforcer" and opted to put the squeeze on both North
American shale wildcatters and Iranian leaders.
Both other OPEC and non-OPEC producers – including Libya and Russia– have either restored production
as violence has eased or ramped up volumes as economic and budget pressures (i.e. economic sanctions)
have mounted.
Fig. 2: OPEC fiscal budget breakeven
USD/bbl
Source: International Monetary Fund, UBS
"…the US has transitioned
from being the marginal
consumer of oil, to being the
marginal producer of oil."
As we've already noted, this combination of somewhat
softer demand and booming supply has driven energy
prices to levels not seen since 2009 and caused sharp
price swings both within and across asset classes. So
what comes next? In the following sections we sort
through the dynamics within the energy sectors and lay
out the implications for both the real economy and global financial markets.
UBS CIO WM Research 18 December 2014
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Energy
Market dynamics: The search for equilibrium
Basic economics teaches us that a plentiful supply of any
commodity reduces a producer’s influence on price. So
while lower growth in demand from China and other
emerging markets may have contributed to a decline in
the price of oil, the surge in supply, especially from the
US, is the bigger culprit. The global market for oil is
clearly in disarray. Geopolitical considerations have undermined OPEC, which no longer functions as a cohesive
organization. As oil prices drift lower, member nations
are obliged to draw upon their financial reserves or run
the risk of social unrest. The first alternative leaves them
financially vulnerable; the second threatens the governing regime. OPEC (i.e., Saudi Arabia) has thus far been
reluctant to shoulder the entire burden of reducing
global oil supply growth but a meaningful supply response by US producers could prompt the organization
to revisit its production quotas in 2015.
Nicole Decker, Energy Sector Strategist
Katherine Klingensmith, Economic & Policy Strategist
Tom McLoughlin, Co-head of Fundamental Research
Fig. 3: Projected oil prices
3-month
view
Brent
(USD/bbl)
WTI
(USD/bbl)
12-month
view
2015
Average
54.0
80.0
70.0
50.0
75.0
65.0
Source: UBS
We expect prices to slide a bit further and to remain volatile until global supply is reduced. Our near-term projections for oil prices (see Fig. 3) reflect ongoing uncertainty
in the oil market and do not represent a hard price floor.
Global oil demand weakens seasonally in the first two
quarters of each year but the US supply is not expected
to correct that quickly in this instance. Any correction in
US production is more likely in the second half of 2015
after peaking in Q2. While the estimate for the oversupply of oil for 2015 averages 1.0-1.2 million barrels per
day (b/d), the second quarter surplus is a more daunting
1.8 million b/d. The second half of 2015 looks better
because we foresee a slowdown in the growth curve of
US supply and a recovery in seasonal demand (see Fig.
4).
While our long-term outlook (USD 80/bbl WTI) for oil is
unaltered by the current price volatility, there are risks to
our forecast. For example, the efficiency of US producers
to exploit tight oil supplies may further improve. The
jump in inventory could test global oil storage capacity
limits. This would cause severe pressure in the spot market, with the front-month potentially falling to USD
40/bbl in the first half of 2015. Lifting international sanctions on Iran would also add another 0.3–0.5 million
barrels per day to the market by 2H15, reducing the
chance of any recovery in the price of a barrel of oil. On
the upside, OPEC could reverse course and limit production, global demand could increase, or a flare up in Middle East geopolitics could cause supply constraints.
Fig. 4: Global oil supply and demand
Million b/d
Source: International Energy Agency, UBS
Note: Supply projections assume no OPEC cut in 2015.
UBS CIO WM Research 18 December 2014
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Energy
Market implications: "The diverging world"
amplified by falling oil
The theme of divergence that was headlined in our Year Ahead publication has only been amplified by the more recent
further decline in oil prices. In response, earlier this week we adjusted our tactical asset allocation position (see UBS
House View Update, "Oil prices fall further – tactical changes" on 16 December 2014).
To be clear, we continue to hold a positive stance on risk assets and believe that the roughly 5% decline in global equity markets over the past two weeks is unjustified. Economic growth momentum – particularly in the US – remains solid
and on balance lower oil prices should be supportive of the ongoing developed market economic expansion. Based in
part on lower retail gasoline prices, our UBS US economists recently increased their 2015 real GDP forecasts from 2.9%
to 3.1%. Furthermore, lower energy prices have contributed to falling inflation and perhaps more important to central
banks, falling inflation expectations. Net-net, this should allow for monetary policy to lean toward a flexible and accommodative stance and for a "Goldilocks" backdrop to continue to support US equity markets.
The recent changes to our tactical positioning maintained our "risk on" stance, but shifted more of our exposure from
credit to equities in order to both limit the potential fallout from lower crude prices while reaping the benefit from this
energy cost cut "windfall." The following table summarizes our current stance on the relevant asset classes, CIO
themes, and US equity sectors.
-- Jeremy Zirin, CFA, Head of Investment Strategy Research
Implications by market segment
Asset class
US equities
--Jeremy Zirin
CIO View
Remain
overweight
US high yield
--Barry McAlinden,
Leslie Falconio
Reduced
overweight –
16 Dec. 2014
Non-US developed
market equities
--Brian Rose
Emerging market
equities
--Jorge Mariscal
Raise allocation to
neutral –
16 Dec. 2014
Remain
underweight
Emerging market
bonds
--Jorge Mariscal
Increased
underweight –
16 Dec. 2014
Foreign exchange
--Katherine Klingensmith
Impact from fall
falling oil prices
US equities remain our most preferred equity region. Falling oil prices bolster the US economic recovery
and corporate earnings should remain healthy growing at a mid-to-high single digit rate over the next
several quarters. Valuations remain well supported by a continuation of this "Goldilocks" environment
of steady growth and limited inflationary pressure. Our six month S&P 500 price target remains 2100.
Greater upside exists for US small- and mid-caps.
In our base case of WTI trading between USD 50/bbl and USD 75/bbl in the coming quarters, US high
yield bonds should still prove an attractive investment. In this scenario, we expect high yield default
rates to only modestly increase over the next 12 months and for high yield bond spreads over treasury
bonds to tighten from its current level of 548bp. We trimmed our position earlier this week given potential downside oil price risks; energy represents 18% of the US high yield index.
We believe that the decline in global equity markets this month is unjustified given that economic fundamentals remain solid. Declining oil prices should be supportive of equity markets. In local currency
terms, we favor Swiss over UK stocks.
We continue to see a relatively subdued outlook for EM corporate earnings – the primary condition that
is missing in order to develop a more constructive thesis on EM equities. Lower oil prices should be a
net positive for EM oil consuming nations and support our overweight to India, but will be headwind
for EM oil-exporting countries which make up 16% of the MSCI EM index.
The presence of heavily oil-dependent countries such as Russia, Venezuela, and Colombia (a combined
weight of 10%) within the emerging market sovereign bond index means that volatility is likely to be
elevated and weakening risk-adjusted return prospects. This week, we moved to underweight emerging
market dollar-denominated sovereign bonds adding to our existing underweight in emerging market
dollar-denominated corporate credit.
Impact from falling oil prices: Oil-exporting countries have and will continue to see their currencies
come under pressure so long as oil remains below USD 80/bbl, especially the Russian ruble and the
Colombian peso. However, we do not expect a currency crisis similar to 1998 given many EM countries
have more flexible FX regimes, higher FX reserves and more proactive central banks. Lower oil prices
are generally supportive of the USD, corroborating our USD overweight. Our Canadian dollar overweight is threatened by oil price declines, but we still expect the CAD to outperform the EUR and CHF.
UBS CIO WM Research 18 December 2014
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Energy
Theme
North America (NA)
energy Independence
--Nicole Decker
CIO View
Long-term
positive
Investing in
Mexico
--Jorge Mariscal
Long-term
positive
Select sec
sectors
Consumer
Discretionary
--Jeremy Zirin
CIO View
Overweight
Energy
--Jeremy Zirin
Neutral
Impact from fall
falling oil prices
Our NA energy highlights investment opportunities from the US shift towards energy independence.
This includes not only energy producers and companies that facilitate the oil and gas exploration and
production process, but also non-energy companies which benefit from cheaper access to domestic
energy. While the theme is clearly influenced by changes in short-term oil prices, we expect crude prices
to normalize over time as marginal producers reduce drilling investment. Overall, we believe the longterm growth drivers behind this theme remain intact (see North American energy independence: reenergized, 18 Dec. 2014).
We continue to favor Mexican equities within EM and believe the economy's bright prospects and reform momentum will drive outperformance. Lower oil prices do not present a major threat to Mexico's
economic outlook and should only place limited pressure on public finances in 2015. Oil and gas are
approximately 0.46% of net exports and we do not expect foreign direct investment to be significantly
impacted in 2015 (see Investing in Mexico: Update: Benefit from reform in Mexico, 17 Dec. 2014).
Impact from fall
falling oil prices
Lower oil prices are a clear positive for the US consumer. While not all of the "tax cut" to the consumer
will be spent, US retailers should benefit from increased discretionary spending and the improving
health of US household balance sheets. Historically, the Consumer Discretionary sector has been the
top performer during economic periods which combine falling oil prices and positive domestic economic
momentum.
Our expectation for continued reductions in 2014 Q4 and 2015 earnings estimates and potential further oil price downside in the near term tempers our enthusiasm and keeps us at neutral. However,
long-term value is being created by the sharp decline in share prices. Once oil prices stabilize and moderately rise (as we expect over the next year), energy stocks offer value for longer term and risk-tolerant
investors. The sector currently trades at the same price to book value ratio as it did during the trough of
the 2009 financial crisis (1.6x).
CIO View Explanation
Overweight: Tactical recommendation to hold more of the asset class than specified in the moderate risk strategic asset allocation.
Underweight: Tactical recommendation to hold less of the asset class than specified in the moderate risk strategic asset allocation.
Neutral: Tactical recommendation to hold the asset class in line with its weight in the moderate risk strategic asset allocation.
For more information, see the most recent UBS House View: Investment Strategy Guide.
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Energy
Conclusion: Reaping the windfall
The sudden and sharp decline in energy prices has clearly
had its impact upon financial markets as participants
were forced to sort the beneficiaries of lower energy
costs from the casualties of falling oil revenues. We believe the downside from here for oil is limited and expect
prices to rebound as the supply overhang gets worked
off and demand continues to recover. But this will take
time. OPEC doesn't appear poised to limit supply in the
near term, and the slowing of North American Production will occur only gradually. So oil is likely to remain at
much lower levels through the first half of 2015 than
most economists and strategists have forecast.
This suggests the energy income "windfall" isn't likely to
be unwound anytime soon. So rather than representing
a threat to stocks, as a harbinger of slower growth, this
most recent decline in energy costs instead reflects an
extended "sweet spot" for risk assets as disposable income rises, business costs fall and policymakers are given
greater leeway to keep interest rates lower for longer.
We therefore recommend in the near term that investors
maintain a "risk-on" position, focusing in particular on
market segments, such as the consumer discretionary
sector and US small- and mid-cap stocks, that typically
benefit from improving economic conditions and lower
oil prices.
-- Mike Ryan, CFA
Chief Investment Strategist
Wealth Management Americas
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Energy
Appendix
Investors should be aware that Emerging Market assets are subject to, amongst others, potential risks linked to currency volatility, abrupt
changes in the cost of capital and the economic growth outlook, as well as regulatory and socio-political risk, interest rate risk and higher credit
risk. Assets can sometimes be very illiquid and liquidity conditions can abruptly worsen. WMR generally recommends only those securities it
believes have been registered under Federal U.S. registration rules (Section 12 of the Securities Exchange Act of 1934) and individual State
registration rules (commonly known as "Blue Sky" laws). Prospective investors should be aware that to the extent permitted under US law,
WMR may from time to time recommend bonds that are not registered under US or State securities laws. These bonds may be issued in
jurisdictions where the level of required disclosures to be made by issuers is not as frequent or complete as that required by US laws.
For more background on emerging markets generally, see the WMR Education Notes, "Emerging Market Bonds: Understanding Emerging
Market Bonds," 12 August 2009 and "Emerging Markets Bonds: Understanding Sovereign Risk," 17 December 2009.
Investors interested in holding bonds for a longer period are advised to select the bonds of those sovereigns with the highest credit ratings (in
the investment grade band). Such an approach should decrease the risk that an investor could end up holding bonds on which the sovereign
has defaulted. Sub-investment grade bonds are recommended only for clients with a higher risk tolerance and who seek to hold higher yielding
bonds for shorter periods only.
Please note that these bonds may not necessarily be registered with the US Securities and Exchange Commission nor blue-skyed in the US.
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UBS CIO WM Research 18 December 2014
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