Help clients look past volatile oil prices

This slide in oil prices has been occurring over the last several months. But in mid-October, volatility started to rock the energy sector.

At that time, a CIBC report found West Texas Intermediate crude (WTI) had “extended its two-month-long sell-off to an 18-month low near $85.”

On the upside, Western Canadian Select crude (WCS) was “no lower in domestic currency terms than in mid-August, taking into account differentials and the Canadian dollar’s slide.”

So analysts shrugged off oil price weakness, especially since “Canada is split between an oil-producing west and consuming east, and also trades heavily with another major energy user to the south,” added the report.

Problem is, oil prices have continued to plummet, mainly due to geopolitical tensions involving Saudi Arabia and its fight for market dominance. In particular, WTI has fallen from a high of about $107 per barrel in mid-June to below $80, says Maarten Bloemen, a portfolio manager for Templeton Global Equity Group.

Read: Saudi agenda a threat to OPEC, says analyst

And, as of November 4, reports USA Today, “A barrel of U.S. crude fell as low as $75.84…before rebounding to $77.19, down 2% for the day and the lowest closing price since October 4, 2011. [WTI] crude is now deeply in bear market territory, having tumbled nearly 30%” since the summer.

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The good news, says Bloemen, is “from a [historical] perspective, the average price of $79 per barrel is the support level we [also] hit in 2011 and 2012. Current prices are above the lows we hit in 2009 and 2010, where prices were at $70.”

Also, lower prices spur consumption, he adds. “If gas and oil prices hit $3 or less, then demand starts going up. That helps offset dips in commodities, and could boost the U.S. economy.”

Read: Tap U.S. economic growth

Dissecting current trends

The reality, says Bloemen, is “the supply side [of the sector] has outstripped the demand side for a while, but that didn’t matter because there was a lot going on regarding [oil production] in the Middle East. As a result, prices were stable.”

In fact, “over the last five years, we’ve averaged $100 per barrel for oil, and that’s quite remarkable, given global growth was mute. Then, people started to understand that although there was a lot of turmoil, there were no supply disruptions [and] there was an excess of about 1.5 million to 2 million barrels.”

Then, “the U.S. dollar strengthened due to the prospects of QE’s end and of higher interest rates, and the dip in prices began.”

Read: Look abroad for strong energy plays

The drop has been exacerbated by news that “Saudi Arabia and some of its partners are indicating they can live with [current] low prices,” adds Bloemen, as well as by the fact that those players are pushing for oversupply to be reduced across the globe.

Still, Peter Buchanan, senior economist at CIBC World Markets, says, “It’s important [for investors] to look at the broader context. Oil prices have softened in part because of supply issues, but also because the global economy hasn’t performed as solidly as people [have] expected.”

However, “Canada hasn’t historically been as vulnerable to increases or decreases in [oil] prices as other countries.” And, as such, Bank of Canada Governor Stephen Poloz’s recent prediction that energy sector weakness could cut domestic GDP by as much as a quarter point in 2015 “is probably a little larger than many analysts would expect at this point in time.”

Read: Why you should monitor energy trends

Further, any “effect of oil prices on Canada’s GDP will likely be non-linear, particularly over the medium term, since [prices] depend on how markets react.”

He adds, “Many of the projects happening in Canada now are viable at a price of around $80. If we saw prices dip to $60 or $70, then that would be another case entirely [since] the operating costs, not including other costs, of producing a barrel from existing oil sands costs $30 or $40.”

Exploration and production companies are more at risk, says Buchanan, because “planned investment is viable at the price level of $80. That said, oil from current projects won’t be produced for another five or ten years, so the real question is whether those producers are shifting their expectations for future prices based on the volatility of today.”

In the near term, he notes, “there’s certainly a negative trade effect given we are a net oil exporter. But if you start to look out a year or two, a decline in oil prices [represents] a sizable tax cut for the global economy. If lower prices persist on a sustained basis, however, it could affect E&P companies in the early stages of project planning.”

So far, though, “longer-term futures prices haven’t moved as much as spot prices. The futures market has been pricing in lower prices, and that’s supportive. But the lead time of those can be 10 years, so we’re keeping an eye on prices down the road.”

Read: How to choose energy stocks

As Bloemen predicts, oil companies will only panic when “cash flow starts to drop due to pricing. Then they [may] dial back high-end production at the top end of the market.” For all levels to be impacted, however, “prices would need to go all the way down to $40, and that’s quite dramatic.”

Is oversupply sustainable?

Even though “production and demand trends are lowering [global] prices,” says Buchanan, “we’re also looking at deterioration of investment in key producers in Europe.”

Russia and Iraq, for example, “have to invest in their aging fields and production facilities. And if that doesn’t occur, there could be greater tightness in markets” and support of higher prices.

As well, says Buchanan, unrest in Iraq could impede its ability to meet the International Energy Agency’s expectation that it’ll generate two to three million more barrels through the end of the decade.

Finally, “recent sanctions have affected Russia, which also has aging oil fields. In fact, it’s unclear whether Russia will receive the level of investment needed to support increased production,” especially if companies are looking at delving into frontier and shale production.

If supply and demand levels out, concludes Buchanan, “oil prices [could] rally back to $90 [as] the global economy improves. We’re also in the middle of the quiet period in the U.S., where refineries take downtime.”

Read: Energy sector driving domestic market

Still, says Bloemen, one factor markets are ignoring is the upcoming nuclear sanctions debate of the P5+1, a group of six world powers (the U.S., Russia, China, the U.K., France and Germany) that started negotiating with Iran in 2006 over its nuclear program.

On November 24—only days before the upcoming OPEC meeting in Vienna—that group may lift more oil production sanctions in Iraq, which could fuel market volatility, as well as Saudi Arabia’s fears of increasing competition.