Commodity prices have been a tale of two markets this year. Industrial metals have borne the brunt of slowing global activity, while the oil price has soared. It is hard to believe that barely three years ago, it was languishing below $30 a barrel.
The chart below shows the copper price — widely viewed as the barometer for the health of global economy — diverging notably from the oil price, which recently hit its highest level since 2014.
For now, one thought dominates the oil market psyche: US plans to impose a second round of sanctions on Iran in November, forcing governments and companies around the world to stop buying Iranian oil.
Add to this the impact of the looming US hurricane season, falling output from a politically and economically troubled Venezuela, plus supply disruption in Libya and you have a recipe for buoyant oil prices continuing.
This begs the question: is $80 the new base level for oil, or could we see a spike higher to $90, or even $100 a barrel in coming months?
It would be remiss to talk about the oil price without mentioning US shale gas. In recent years, new technology has enabled huge capacity expansion, promoting the US to the number one spot for oil production. A further uptick in shale gas supply, at least over the medium term, could rein in price rises.
However, over the shorter term, the infrastructure can’t keep pace — US pipelines are running at full capacity, and until new pipelines are built, there’s a lag in the amount of oil that can make its way from America into international markets. That’s part of the reason why there’s such a big gap between the price of Brent crude, the international benchmark, and the main US market, West Texas Intermediate (WTI).
This “bottlenecking” should be resolved with the construction of new pipelines and eventually US supply will find its way back into international markets, impacting the price downwards. There’s the rub. Although the oil price could potentially spike into triple digit territory, investors should expect any such uptick to be shortlived — not least if Opec steps up production.
This is arguably a good thing. History shows that once oil passes the $100 mark it becomes a drag on global growth, hurting consumers. Peak oil doesn’t bode well for emerging markets, already under pressure from higher rates and a rising dollar. For some countries, notably Russia, costly crude is a positive. For big importers, like India and China, it can be a major tax on growth, particularly in a rising-dollar environment because the cost of oil rises even faster in local currency terms.
It’s also hard to square peak oil with the likelihood of a full-blown trade war between the US and China. A drop in global demand seems inevitable.
Yet none of this changes the simple fact that, viewed over the course of the past year, oil is in an uptrend. Many investors in equity funds will have benefited from it too, since oil majors feature in numerous fund portfolios owing to their size and proven ability to pay attractive dividends year after year. However, the thesis for investing in these companies is becoming more nuanced.
Both Shell and BP did a good job in cutting costs during the lean years, limiting capital spending while generating enough cash to maintain their dividends. But this means projects won’t be coming on stream as quickly as expected. As the flow of oil from existing assets decreases over time, a pick-up in drilling is needed to maintain supply. Yet many oil companies have “don’t allow the cost base to take off” baked into their corporate culture.
Some will be better at maintaining capital discipline than others. For now, dividends look well covered and we could even see dividend growth — BP increased its dividend in the last quarter for the first time in three years.
As for the emerging level of investor interest in oil service companies, proceed with caution. While the expectation is that higher oil prices will bode well for the sector, this is already reflected in the share prices of some. It would be premature to expect a rerun of the massive growth witnessed a few years ago.
Investors should remember that commodities are a good way of diversifying a portfolio with a high equity content.
Holding some exposure to oil as the economic cycle matures makes sense. Have a look at the top 10 holdings of global, UK, US and European equity funds for those with a higher weighting towards oil stocks. The top five holdings of the Invesco Perpetual Global Equity Income Fund, run by Nick Mustoe, Invesco’s chief investment officer, include Royal Dutch Shell, BP, Chevron and Total. Likewise, the Jupiter Distribution Fund, a balanced fund, has a significant slice in BP and Royal Dutch Shell, which manager Alastair Gunn has held for some time, holding firm to his thesis that the oil majors capital discipline bodes well for two of the UK’s largest dividend payers. Alternatively, there are a number of commodity-focused ETFs available.
When the economy moves into the late cycle, as it is now, risky assets such as shares can move in the opposite direction to oil, especially as a higher crude price acts as a drag on growth, eats into company profit margins and weighs on consumer spending. For these reasons, some exposure to oil, could be a slick way of balancing your portfolio.
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