Declining Oil Prices Present Buying Opportunities in Global Equity Markets
Given the recent profound decline in crude oil prices, the global energy sector and related industrial suppliers are currently facing significant earnings downgrades. In the equity markets, cautious positioning and an eye for higher quality companies with resilient balance sheets are clearly warranted, particularly in the energy sector. Driven by lower oil prices, the benefits of consumer spending power and lower industrial input costs, however, should provide a stabilizing influence to the overall economic landscape in the United States and abroad.
Since the beginning of the downturn in oil prices, we have positioned our equity portfolios toward higher quality companies with stronger balance sheets, while reducing positions in stocks with weaker fundamentals and higher leverage where estimates are trailing negative expectations. Although we have tempered our enthusiasm for the energy sector, lower energy costs continue to underpin buying opportunities in several equity sectors. In the United States, lower oil prices have translated to lower gasoline prices, leading to more money in consumers’ pockets to spend on smaller ticket items (convenience stores, groceries, clothing, and drug stores), in turn helping companies’ sales at the margin. As such, our expectation for rising consumer
spending will be a further catalyst to global economic growth.
SURGE IN SUPPLY, DROP IN DEMAND…NO PAUSE IN PRODUCTION
In just six years, oil production in the United States has risen substantially from an output low of five million barrels-per-day (mbpd), the lowest since 1946, to nearly nine mbpd, the most in nearly thirty years. The significant production surge can be primarily attributed to hydraulic fracturing or “fracking,” where energy producers inject liquids at high pressure into rock formations, creating fissures that allow oil and natural gas to be extracted. With strong production growth in the Bakken field (North Dakota), Permian Basin (West Texas), and Eagle Ford (South Texas), U.S. imports of crude oil have dropped 25%-30% since 2006. Meanwhile, due to slowing growth in China and a faltering recovery in Europe, global oil demand continues to erode. In fact, the International Energy Agency (IEA) has cut global oil demand projections for 2014 and 2015 three times recently.
The magnitude of the oil price decline will materially alter the landscape for future capital investment amongst energy producers. However, it is not likely to impact projects that have already been started and funded. This has come to the forefront more recently with ConocoPhillips announcing their 2015 capex would be 20% lower than 2014, highlighting the impact of declining oil prices. Projects scheduled for 2016 and beyond, however, are facing the risk of delays, if not outright cancellations. The degree of delays and cancellations simply depends on future oil price movements, cash flow generation, and the energy industry’s ability to manage production decline rates (estimating reserves and predicting production in oil reservoirs and oil fields).
In recent months, all eyes have been on OPEC for hints of possible production cuts. At the OPEC summit last November, no such agreement materialized, adding to the downward pressure on oil prices and heightening market volatility. This surprised a majority of market participants as oil prices and energy stocks sold off hard immediately following the announcement. Saudi Arabia, the largest OPEC oil exporter, led the push for no supply reduction and the resulting decision highlights its leadership position. Given their large cash reserve position, Saudi Arabia is the only OPEC member
that has the ability to cut sufficient production to realign supply and demand balances. Other OPEC members do not have the ability to cut production given their lack of financial reserves. Furthermore, while OPEC members have the lowest costs for producing oil, given that oil makes up a significant
portion of these government’s revenues, the market tends to refer to the oil price each country needs from a fiscal budget perspective. With a cost curve significantly lower than its global peers, perhaps this is an underlying reason why OPEC may be reluctant to reduce supply.
Rumors of a potential emergency OPEC meeting to reduce production and relieve some of the economic stress being endured have emerged, but both OPEC and an UAE official opposed, maintaining they will wait at least three months to review if the meeting is needed, even if oil prices fall as low as $40 per barrel. These comments highlight the region’s initiative to not lose further market share to non-OPEC countries, including the United States.
EMERGING MARKETS ARE OIL DEPENDENT
Emerging market countries, many of which are dependent on oil exports, also continue to face intensifying geopolitical uncertainty as higher oil prices are needed to balance their budgets. Indeed, some countries are beginning to feel the squeeze of the decline in oil prices. In Russia, for example, a country already faced with pressure from Western sanctions stemming from the crisis in Ukraine, the petroleum industry accounts for 54% of the country’s exports, highlighting the oil sensitivity of its economy. Since the start of November, the Russian ruble has depreciated approximately 30% driving Russia’s Central Bank to step in and drastically raise its interest rate to 17% (from 10.5%) in an attempt to stem the slide. The slide accelerated further, however, as the market viewed the move as further desperation. While the Finance Ministry stated they were prepared to sell as much as US $7 billion of reserves, the question is how long will such action contain the underlying issue? There is also a risk that Russia implements capital controls as they are likely going to
have to intervene in the currency market. Until the country can show some stability and/or make an effort to take its sanctions seriously, its economic growth is likely to be significantly and persistently stymied.
While our portfolios that have direct exposure to Russia remain underweight relative to indices, many companies domiciled outside of Russia have indirect exposure to this region. As a result, we have put additional focus on companies that generate a portion of their profit from within and will be negatively impacted. For example, we highlight a tobacco company, Japan Tobacco, which fits this profile and is likely to see downward pressure on profits, given its exposure to Russia and adverse currency effects. As a result, we have reduced our position in the stock as estimates need to move further downward given current foreign exchange rates and market expectations. Other regions, namely in emerging markets, which are most dependent on oil exports, will continue to face intensifying geopolitical uncertainty as higher oil prices are needed to balance their budgets. The best opportunities here continue to reflect “self-help” situations. At the country level, this means structural reforms; at the firm level it requires prioritizing return on capital, rather than growth at any cost. Caution and selectivity is still warranted for countries with high current account deficits and external funding needs given the recent weakness seen in many of their currencies.
MANEUVERING THROUGH THE CURRENT OIL ENVIRONMENT
Our research and market experience suggests that in times of significant oil price deterioration (mid 1980’s and late 1990’s), consolidation and cost cutting results. In such periods, energy companies with high debt or leverage problems are first to succumb to heavy share price weakness, making these
companies vulnerable to acquisitions or asset sales. Consolidation during such periods is driven by either the desire to gain crown jewels of weak(er) companies or to aggressively cut costs, especially overhead. In the late 1990s, for example, the domino effect was led by British Petroleum (BP) acquiring Amoco to gain access to Russia, expand its deep water operations, and grow its U.S. downstream segment. This was followed up by BP acquiring Atlantic Richfield (owner of Vastar Resources) for Prudhoe Bay consolidation and U.S. Gulf of Mexico leases. Other consolidations during the prior periods included:
- Total first acquired Belgian Petrofina to position itself to later buy Elf.
- Exxon acquired Mobil gaining access to Qatar natural gas and LNG development, plus realized significant cost cutting.
- Chevron acquired Texaco to consolidate California heavy oil and Indonesian heavy oil. At the time of announcement (fourth quarter 2001), this was positioned as a defensive move given both companies’ competitive position had declined significantly following the other mergers noted above.
Because of the low oil prices during the periods the acquisitions occurred, there were limited U.S. Justice Department objections such that mergers that would have been stopped three to five years earlier were approved. In all of the cases mentioned above however, costs were slashed significantly and marginal assets were sold to reduce debt and buyback shares. Such changes, combined with the inevitable climb in oil prices drove earnings per share (EPS) estimates higher for the next several years, ultimately driving share prices higher as well. Because of the large focus on cost cutting, however, the companies did not spend sufficiently to maintain their competitive edge, opening the door for independents to dominate the development of unconventional resources, including the aforementioned shale revolution in the United States.
OPPORTUNITIES FROM THE BOTTOM-UP
With the recent oil price decline, we believe companies will again look to consolidate and that the super majors will become more active in buying independent oil companies that improve their competitive positions. In turn, this will force further cost cutting, thereby lowering the cost to find and develop oil and natural gas ultimately leading to higher profitability (and higher share prices) when oil prices recover. Our stance is companies with strong fundamental attributes will have the ability to make such opportunistic acquisitions of assets and/or companies later in 2015 and into 2016, helping drive earnings growth for these companies.
We also see potential in our infrastructure holdings that will have access to acquire assets from companies that may be needed to raise cash. On the other hand, energy companies that are highly leveraged are posed to see a more challenging earnings revision period. In fact, we are already seeing clear evidence of reduced capital expenditures and pressure on energy companies to reduce dividends and share buybacks to preserve balance sheets.
Regardless of the region, sector or general market conditions, our bottom-up focus on sustainable earnings trends and valuations relative to expectations remains a constant across all portfolios, and helps rise above the fray of short-term “risk-on/risk-off” tendencies of many investors.
ABOUT PRINCIPAL GLOBAL EQUITIES
Principal Global Equities is a specialized investment management group within Principal Global Investors. We are fundamental investors, focused on bottom-up stock selection, providing client-focused investment solutions spanning equity markets worldwide. We are distinguished by a globally integrated culture that embraces collaboration, the unified adherence to a distinctive bottom-up stock selection investment philosophy and process, and the ways we leverage technology to consistently and effectively manage portfolios and client relationships.