The commodity price matters to such a large number of investors
Thursday 05 Dec 2019 Author: Tom Sieber

On 5 and 6 December oil producers’ cartel OPEC and affiliate nation Russia (often given the shorthand OPEC+) will meet to decide whether or not to prolong current production cuts beyond the slated expiration point in March 2020.

The level of supply versus demand has a major influence over determining the oil price, and the value of this commodity matters even if you do not invest in the oil sector directly.

In terms of the market impact, consensus analyst forecasts suggest BP (BP.) and Royal Dutch Shell (RDSB) will account for 17% of the FTSE 100’s profit and 20% of its dividends next year.

The price of oil also has a real impact on the economy. When oil prices go up, the increased cost of energy and fuel can act as a drag on growth.

Anyone with diversified UK equity exposure, through a tracker or exchange-traded fund, will likely also have exposure to the hydrocarbons sector.

WHAT COULD HAPPEN NEXT?

Most observers expect OPEC to extend the cuts, with perhaps more attention placed on whether this is until the meeting in June or the next December summit. 

A further question hanging over the conference in Vienna is whether deeper cuts will be contemplated. An extension or deeper cuts could be supportive for the oil price.

OPEC’s imminent decision could help set the tone for oil markets in 2020, although it is just one of several factors which may influence crude prices in the coming 12 months.

One of these factors is just how disciplined OPEC members and Russia will be when sticking to any agreed quotas. By opting not to produce as much oil as they theoretically could, they are foregoing potential revenue. Interestingly, Russia’s output in 2019 has averaged 11.25m barrels of oil per day according to figures from Reuters. That is around 70,000 barrels of oil per day above its agreed quota.

WHAT ABOUT THE SAUDI ARAMCO IPO?

Dominant OPEC member Saudi Arabia has every incentive to hold the line to support prices as it looks to tee up a favourable stock market flotation for state oil firm Saudi Aramco, the world’s most profitable company.

After international investors were apparently put off by the $2trn valuation target, a scaled-down listing is set to take place on Saudi’s domestic stock exchange.

Other influences on the oil price could include the impact of US sanctions on Iranian production.

These are all supply issues, so what about demand? At a micro level the introduction of new fuel standards for shipping could have some impact. The new IMO 2020 specifications are seen as driving demand for lighter sweeter types of crude which include the Brent and West Texas Intermediate benchmarks.

At a macro level, the rate of global growth will be crucial in determining demand and on a structural basis there is growing pressure to switch out of oil and into alternatives such as renewables which are perceived to be friendlier to the environment.


OUTLOOK FOR THE BIG OIL COMPANIES

So how might oil prices impact on constituents of the oil and gas industry? There are three oil and gas companies listed in the UK with market valuations in excess of £2bn, being oil majors BP and Shell and oil services firm Wood Group (WG.).

Earnings and cash flow at BP and Shell are closely tied to oil prices. Dividend cuts seem unlikely unless something very drastic happens. BP last cut its dividend in the wake of the Gulf of Mexico and Shell hasn’t cut its dividend since the Second World War.

The direction oil prices take may dictate if management at either company feels confident enough to increase returns to shareholders.

The imminent departure of chief executive Bob Dudley means BP will be under new leadership. Although there is likely to be some continuity given the current head of its upstream operations, Bernard Looney, is the man taking over. Looney may want to take time to get his feet under the table before doing anything too radical.

Forcing his hand could be increasing pressure from institutional investors amid  climate change concerns. Both BP and Shell face questions over their long-term strategy and some big investors could conceivably sell out of the space entirely in the coming years.

Shell is arguably doing more to address these issues. It is seeking to pivot towards gas as a cleaner alternative to oil. It has outlined a plan to take responsibility not just for the emissions caused by its own operations but also those generated when customers use its fuel. In contrast, BP has largely concentrated on becoming a more efficient and well-run but still traditional oil company.

Prospective investors must weigh these challenges with the short-term appeal provided by prospective yields of 6.5% at BP and 6.6% at Shell.

Wood Group’s merger with Amec Foster Wheeler, which completed in October 2017, gave the company exposure to a wider range of markets, reducing its reliance on oil.

The shares have been heavily targeted by short sellers amid concern over the state of the balance sheet, legacy contracts and the struggle to sell non-core assets.

A recent investor day suggested the company might seek to boost its footprint in the US shale sector. Rival Petrofac (PFC) also appears to be looking in this direction given its recent acquisition of US shale specialist W&W Energy Services. This could increase the sensitivity of both firms to fluctuations in the oil price.

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