Reflecting on November
What has happened?
Brent crude futures fell by 22% in November. The weakness, which represents the worst month of returns in more than a decade, followed a 9% decline in October. As at 30 November, the price of oil was down 12.2% year-to-date, having, at one point, been up by almost 30%.
The recent weakness in oil came shortly after a period of strength as Brent crude futures reached their highest level since 2014 in early October. Set against expectations of robust demand, concerns over a lack of supply due to US sanctions on Iran and political turmoil in Venezuela, led to increasing calls that the oil price would return to above $100 per barrel. However, the supply and demand dynamics were suddenly altered when weak economic data led to doubts over the strength of global growth and, in turn, oil demand. At the same time, record production from US onshore producers and US President Donald Trump announcing certain waivers to his Iranian sanctions eased concerns over a lack of supply. The International Energy Agency (IEA) warned in November that the surge in production from the US and other non-OPEC nations, coupled with a lower demand forecast means that they now expect the market to be oversupplied in the first half of 2019.
What should you take away from it?
The most obvious and immediate implications of changes in the price of oil are for the share prices of the companies that operate in the energy sector. Between the 3 October high and the end of November, over which time the price of oil was down 32.0%, the MSCI World Energy Index fell 15.4%. In November, the index fell 4.1%, significantly outperforming Brent crude futures.
The Energy sector itself can be broadly split into three segments; the Integrated players, that have both upstream (Exploration & Production, often abbreviated to ‘E&P’) and downstream (refining, marketing, trading) businesses, the pure-play E&P names, and the oil services companies. Of those, it has been the latter that have experienced the weakest performance as the oil price has declined. The MSCI World Energy Equipment & Services Index is down 26.6% since 3 October and 11.6% in November, underperforming both the MSCI World Exploration & Production Index (-22.8% and -6.7%, respectively) and the MSCI World Integrated Oil & Gas Index (-11.4% and -2.6%, respectively).
This divergent performance is to be expected. Integrated businesses, relative to pure-play E&P companies, are provided with some degree of protection from a declining oil price through their presence along the value chain, including trading and refining businesses. Services companies, meanwhile, continue to struggle as many of the integrateds and E&Ps have sought to drive down costs and limit capital expenditures as they prioritise free cash flow generation.
At the time of writing, OPEC, the influential cartel of oil producing countries, is meeting in Vienna and is expected to lower production in order to attempt to support the price of oil. Suggestions are, however, that the cuts may be at the lower end of expectations, with the group’s de facto leader, Saudi Arabia, possibly reluctant to disappoint US President Donald Trump, a valuable ally given recent political events, who has been calling for lower oil prices. Aside from OPEC’s response, Trump’s waivers to Iranian sanctions are temporary and therefore supply might contract if they are not extended next year. Also, as the oil price moves lower, it makes less and less economic sense for companies to extract the commodity from the ground, potentially dampening supply.
On the demand side, weaker than expected economic data, the increasing flatness of the US yield curve and the ongoing trade dispute between the US and China continue to stoke concerns over global growth prospects and therefore oil demand. President Trump recently announced a ceasefire in his trade war with China and his confidence that an agreement can be reached in the first quarter of 2019, which might provide a fillip for the global economy. Furthermore, there have been signs that the US Federal Reserve is becoming more dovish in the face of tighter financial conditions, and a move away from its current commitment to gradually raising interest rates may prevent an inversion of the US yield curve.
We have seen over the last two months how quickly the market’s view on oil’s supply / demand equation can change as robust demand and falling supply was replaced by weakening demand and oversupply. This equation, however, remains highly complex and subject to considerable uncertainty, especially through the influence of politics, and while the direction of travel is unclear over the near term, we expect volatility to remain a feature of the oil price going forward.
Please speak to your Investment Manager for any further information.
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