By Ashley Kindergan
Over the last 18 months, the price of a barrel of Brent crude has dropped from $115 to $35. And the effects of that steep decline have rippled far and wide: Spreads between high-yield bonds and Treasuries have opened up; U.S. inflation expectations have plummeted, and cyclical stocks have handily underperformed defensive ones.
Early on in the decline, the consensus opinion was that lower oil prices would serve as a catalyst for global economic growth. Consumers would save at the pump, companies would enjoy lower energy costs, and the only folks left holding the bag would be the energy companies (and energy-exporting countries) themselves. Fast-forward to 2016, however, and the consensus has been flipped on its head. At this point, most investors have come to see the continued weakness in the price of oil as a bad thing, and the lack of price support as an indication that global demand (for oil, and for anything else) is weak. Credit Suisse's global equity strategists do not share that view.
Low oil prices, say the bank's strategists, are the result of oversupply, not a lack of demand. Not only has the International Energy Agency stated that demand likely hit a five-year high in 2015, but oil prices have decoupled from the ISM Manufacturing Index, a key indicator of industrial activity. If oil prices were simply a reflection of global demand, the two would be moving together.
Still, it's easy to understand where the consensus comes from. Dramatic cuts to energy companies' operating and capital expenditures over the last 18 months have taken 1.4 percentage points off of global growth and 1 percent from U.S. growth. But Credit Suisse's equity strategists believe the worst of these cuts are over. And then there's the issue of U.S. consumers, who have been slow to spend their gasoline-savings windfall. Households saved a total of some $100 billion over the past year, despite seeing their bills for gasoline and motor fuels drop $55 billion, which means they not only banked their savings from low gas and oil prices, they saved even more on top of that. Credit Suisse believes that American consumers will do as they did in the 1980s, holding off on spending until they became comfortable that the oil price decline wasn't temporary. The bank's strategists think the personal savings ratio will drop from 5.5 percent to 4 percent this year, driving consumption up 1.6 percent. Ultimately, low oil prices should boost global growth by between 0.8 and 1.4 percentage points.
What's it going to take to turn the pessimists around? A leveling in the price of oil would be a start, and Credit Suisse believes a stabilization around $40 per barrel is, in fact, in the offing. Saudi Arabia, which had abandoned its traditional role as swing producer over the last 18 months, cut a deal February 16 with Qatar, Russia, and Venezuela to freeze production at January levels. The Kingdom has been trying to maintain market share in the face of rising non-OPEC production and keep the U.S. from achieving energy independence, which could conceivably jeopardize the superpower's military and political support. The new accord makes further production increases from the Kingdom unlikely. (U.S. shale oil production is relatively high cost, and if a prolonged period of low prices forces some American exploration and production companies out of business, the U.S. will naturally have to rely more on oil imported from Saudi Arabia.)
Why make a deal now? Credit Suisse's equity strategists believe that global oil prices above $35 and below $50 are in Saudi Arabia's best interests - low enough to put pressure on high-cost American producers, but high enough to alleviate the mounting fiscal pressure on the Saudi government. Though it has little debt (7 percent of GDP), healthy foreign exchange reserves (84 percent of GDP), and relatively strong economic growth (3.4 percent in 2015), the Kingdom's budget deficit is expected to reach 13.5 percent this year, despite a 20 percent reduction in government spending.
Stabilization in oil prices is one thing, but a sharp rebound that would turn investors bullish again on risky assets is quite another. Credit Suisse's equity strategists doubt oil prices will rise much above $50 over the next two to three years. That would be in keeping with historical norms, as the average price of oil since 1960 is just $45.
So is there an energy angle for investors looking to play the turn? Low-cost U.S. shale producers and European banks are well positioned in the case of any stabilization. Even a slight rise in oil prices reduces the risk associated with loans to energy companies and tends to push bond yields higher and reduce credit spreads, both of which are good for banks.
But it's not yet time to buy integrated oil and gas companies, despite their rock-bottom valuations, in large part because the median free cash flow yield among oil majors is just 1.7 percent. While oil companies would likely sell assets or issue new debt to avoid cutting or suspending dividends, the market is no longer rewarding companies that add to their debt loads, and assets are selling for bargain prices in the current environment. Meanwhile, companies that have actually cut dividends, such as Conoco Phillips and ENI, have underperformed their peers. Integrated oil companies also have relatively high production costs and would suffer disproportionately from any further price declines. Finally, the easy cuts to operating and capital expenditures have already been made, and any further reductions will likely start to cut into firms' long-term growth potential. For the largest energy companies, the path to recovery isn't yet clear.