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10-dollar oil?

Bo Bejstrup Christensen explains why oil prices could fall even further and what the consequences might be.

By Bo Bejstrup Christensen, chief analyst at Danske Invest

I know – it’s a provocative headline. But just think: oil was trading at more than 100 dollars a barrel less than 18 months ago. In 2008 some perfectly intelligent people were screaming about an oil price of 200 dollars a barrel in the not too distant future. Some even believed we would soon run out of the black stuff. Today, you can barely sell a barrel for 40 dollars.

So, seen from that perspective, does 10 dollars still sound crazy? That is the first thing I want you to think about. Read further and find out why we view an oil price of 20 dollars as a perfectly realistic scenario just a little further down the line. You can also read our opinion on what that will mean for your investments.

US oil is in the driving seat – OPEC has been sidelined
Countless articles have been written about the US shale industry. First it was gas, then oil. US oil production is now hovering around 9 million barrels a day, putting it in the company of Saudi Arabia and Russia.

Sceptics initially said shale industry costs were very high, so a low oil price would quickly squeeze the Americans out of the game. But instead the US oil industry has surprised with its exceptionally swift and dramatic cost cutting – one year after the initial collapse in oil prices and production has only fallen by around 5% from peak, which indicates a dramatic increase in efficiency. Further falls in the oil price would of course put pressure on US production, but the key point is that the US shale industry has become the world’s swing producer. In contrast to conventional producers, the Americans can quickly ramp up and ramp down production as prices change.

Hence, if oil prices rise markedly in the short term, US producers can quickly increase production and thus put the price under pressure again. In our view, this effectively puts a ceiling on oil production and reduces OPEC to being a price taker who essentially has to maximise sales by maximising production. This argument is further reinforced by several of the OPEC countries needing oil revenue to keep their countries afloat.

Storage facilities are limited
Most observers agree that the oil industry is currently overproducing. Convention would essentially dictate that a period of low oil prices is needed to slow supply growth and strengthen demand. Then in a couple of years the two collide again – and lo and behold, oil prices rise.

But given the above dynamic with the US in the driving seat and OPEC as price taker, the short term risk is too much oil being produced, as storage capacity to absorb this overproduction is limited. Lately, for example, ships have been put into service as storage facilities to stockpile oil that is sold for future consumption. But at some point you will run out of storage and the oil will come onto the market – resulting in further short-term pressure on the oil price.

What if oil is superfluous?
But the really funny story starts here. The following quote is usually accredited to a former Saudi Arabian oil minister: “The stone age did not end because we ran out of stone, and the oil age will end long before we run out of oil.”

In 2014 California installed solar energy capacity equivalent to the total capacity installed in all of the US up to 2011. This year China has installed solar capacity equivalent to all of that in France. Solar energy is a new technology where costs have fallen by 10% a year. If that trend continues for just five more years, solar will be able to compete with natural gas, for example, in nearly all markets – and soon after that nothing will be able to compete with solar. This, coupled with such factors as the spread of financing for household solar panels means the overall cost is falling sharply. We just have to sort out the electricity network and battery technology and voilà – the world is running on green energy. Add to this the rapid advances in electric and hybrid cars, shared car schemes and self-driving cars and a picture emerges of a soon stagnating demand for oil.

Then the dynamic becomes even more interesting. 30 years ago the solar story sounded far more utopian than now and a country like Saudi Arabia could consider the oil beneath its sands an asset with permanent value. But what happens if oil becomes superfluous in just 10 years? Suddenly it makes sense to pump even more oil up now, while it still has value. Result – even more downward pressure on oil prices.

Stop – back to reality
OK, let’s take a step back. We do not foresee the dominance of electric cars happening tomorrow or a solar powered world the day after. We just want to challenge conventional thinking. However, that said, we really do foresee a rather bleak outlook for oil prices, and if anything they should fall further going forward.

Why is that important for your investments? 2015 has proved that a lower oil price is good news for a large portion of the global economy – especially the eurozone and Japan, but also the US, which is still a net oil importer. However, the impact of oil prices is asymmetrical, for while the service sector and private consumption benefit from a falling oil price, the energy industry and firms that deliver production equipment to the energy companies see their earnings take a hard knock. And these are precisely the companies that make up much of the equity and corporate bond market – especially in the US, where the decline in oil prices has created significant challenges for investors in 2015. And if oil prices are set to fall further in 2016, the seeds may be sown of some really bad news, as further falls in earnings and even bankruptcies may become a serious possibility.

That’s why we could find ourselves in the paradoxical situation where despite decent growth in the US, Japan and the eurozone, equity markets may struggle.

What should we do then? Despite positive expectations for the global economy in 2016, we currently have only a slight overweight in equities. Moreover, we are seeking exposure to assets that benefit from the lower oil price, including equities and corporate bonds in the eurozone, where the energy sector is less significant than in the US.

Our scepticism on oil prices (and China) means we continue to urge caution with respect to emerging market investments. Finally, we are also concerned about US corporate bonds, where the energy sector plays a major role. But what we want to do most of all is inspire you to think about where and how much risk you may be taking with your portfolio – and whether the portfolio excess return you achieve if the oil price does not fall outweighs the risk you run if the price of oil does fall significantly from here. Our view is clear – we do not believe it is worth the risk.

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