The energy sector: Unsettled, but not in crisis
April 19, 2016
Since their earliest days, financial markets have been subjected to all manner of shocks. Among the more notable have been those caused by dramatic drops in commodity prices — energy prices, in particular. Today, as supply-and-demand dynamics are out of balance and markets contend with continued softness in oil prices, it appears that many investors have focused on the negative, rather than positive, economic effects of low oil prices. Although low-priced energy is usually considered an economic boon, it’s as if investors are convinced that cheap oil can’t provide any relief to a global economy that is growing at a snail’s pace.
Plenty of data support their view. Within the energy sector, earnings for the fourth quarter of 2015 have been underwhelming as exploration and production companies cut costs, seek efficiencies, and generally try to live within their means. In many cases, earnings statements are revealing that balance sheets are stretched and access to capital is constrained. They also explain why in this industry, layoffs have been announced, dividends cut, and budgets slashed.
The disappointing results reflect what has essentially become a global concern: Around the world, exploration projects worth $380 billion have been put on hold within the energy sector. What’s more, substantial cuts have been seen in global capital expenditures, and in the United States, spending on fixed assets is down by half from the prior peak. These cutbacks put pressure not just on the firms involved, but also down the supply chain, eventually reaching supporting players like transportation companies, banks, and other service providers.
Lower oil prices: Who is poised to benefit, who is less so?
While conventional wisdom — and previous experiences with falling energy prices — might imply that low prices would be more than offset by benefits to consumers, this has not seemed to be the case this time. Yes, there will likely be winners and losers, but ultimately it is difficult to calculate a singular net effect on the global economy. That being said, the list below puts a dividing line between many of the actors that tend to benefit from lower oil prices, and those that generally do not.
|Taking advantage of tailwinds
||Bracing against headwinds
- Automobile manufacturers
- Airline operators
- Producers of household staples (who may see their sales increase on the back of stronger consumer spending)
- Countries that are net oil importers (Japan, for instance)
- Consumers (whose budgets may benefit from lower heating costs and fuel prices)
- Financial services providers (on fears that low oil prices will create a meltdown akin to the mortgage crisis)
- Countries that rely on oil for a bulk of their exports (Russia, for instance)
- In the United States, states that depend on oil production for much of their commercial activity
What about the big producers?
Big oil companies have been reporting declines in financial performance, but even those that remain in the black are seeing their share prices punished. For example, on Feb. 2, 2016 the world’s biggest oil supermajor announced fourth-quarter profits (as well as full-year profits) that exceeded analysts’ expectations, yet investors sent its shares down 2% on the day (source: Dow Jones).
Why? Because overall earnings were less than they were for the same period one year earlier. Despite the company’s outperformance — particularly versus its large-company peers, which have posted outright losses — markets are showing little tolerance for even the slightest indication of weakness.
Firms that seemingly overcome (or at least accommodate) oil-price pressure are being rewarded by jeers, not cheers. The skepticism may be based on oil prices that dropped dramatically in early 2016. Despite an upswing of 40% by mid-March from their lows in mid-February — and despite bets being made by some investors that oil prices have finally hit bottom — there remain lingering concerns that the recovery may not last (source: Dow Jones).
The changing economics of oil: An emphasis on supply
Many of the developments discussed so far are attributable to this fact: supply and demand are adjusting to new price levels, particularly on the demand side. Global demand for oil has held up relatively well, but the supply side has been the main driver of the bear market. Here in the United States, for instance, as recently as 2010 total output was 5.5 million barrels a day. (Source: Dow Jones.) By 2015, output reached a record 9.7 million barrels a day. Two additional points to keep in mind when thinking about oil supply and its effects of prices:
- Certain producers — Saudi Arabia most importantly — are pumping at close to full capacity. Saudi Arabia’s plans were driven home in late February, when its oil minister said his country has no plans to reduce output and is ready to withstand prices as low as $20 a barrel if needed.
- Iran is poised to come online with potential output somewhere between 3 million and 4 million barrels a day.
Points for investors to consider
We believe that the behavior of asset prices within the energy sector is cause for real concern, and we think it warrants heightened risk monitoring. At the same time, we think it makes sense to keep in mind that the current malaise has not necessarily translated into a crisis.
It’s also worth remembering that by its very nature, the oil market can be prone to periodic disruptions, and today’s dislocation can be viewed as a natural part of a longer cycle. When you put it into historical context, today’s behavior is no more severe than prior downturns, such as those experienced as recently as 2008 and 1985.
Investors who are concerned about how their portfolios can be affected by the energy sector should consult with their financial advisors, who can help them get a clearer picture of the interaction between energy-related developments and broader securities prices. Topics for discussion might include:
- Despite increasing optimism about the strength of the U.S. consumer, is there reason to be concerned about real trouble for certain market participants? Our take: If crude oil spends a lot of time below $30 a barrel, the damage to government budgets may be greater than the savings enjoyed by consumers.
- Have energy stock valuations drifted far from fundamentals? Our take: For the most part, it appears that stocks are performing worse than the underlying fundamentals would warrant.
- Should I change my allocation to energy-sensitive holdings? Our take: The prospect for further market challenges could make it reasonable to focus on companies that have demonstrated an ability to withstand difficult environments and emerge stronger due to competitive advantages that include:
- a durable business model
- geographical diversification
- strong and consistent free cash flow.
The views expressed represent the Manager's assessment of the market environment as of April 2016 and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and their summary prospectuses, which may be obtained by visiting delawarefunds.com/literature or calling 800 523-1918. Investors should read the prospectus and the summary prospectus carefully before investing.
IMPORTANT RISK CONSIDERATIONS
Investing involves risk, including the possible loss of principal.
Past performance does not guarantee future results.
International investments entail risks not ordinarily associated with US investments including fluctuation in currency values, differences in accounting principles, or economic or political instability in other nations. Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility and lower trading volume.