Oil price will play a key role in returns

The sudden plunge in the price of oil late last year – the biggest slump since the financial crisis of 2007 to 2009 – took many market watchers by surprise.

Oil has been selling for over US$100 a barrel for many years, but it is now selling for about half that.

Commentators are reluctant to make a call on how long the oil price will stay low, or the level at which it may stabilise, but there is no doubt that the oil price will shake up financial markets this year.

The causes of the fall in the oil price are widely cited as the lower demand for oil and the better-than-expected supply of oil. Struggling European economies and slowing growth in China are typically blamed for the lower demand, while the production of shale oil, particularly in the United States, and the lack of disruptions to supplies, despite tensions in the Middle East, Russia and Ukraine, are advanced as the reasons for good supplies.

Colin Morton, the vice-president and portfolio manager of Franklin UK Equity Team, says that, over the medium term, the oil price will recover to a level that is above the cost of extracting oil.

He says low prices will boost the demand for oil, while companies will be careful about investing in production while the oil price remains low.

Although Morton says that Franklin, as a long-term investor, has not let the low oil price have a huge influence on its investment decisions, financial news agency Bloomberg this week quoted Kenneth Rogoff, a Harvard University economics professor, as saying that the low oil price is “a once-in-a-generation shock and will have huge reverberations” for economies and financial markets around the world.

Bloomberg published Oxford Economics’s analysis of the effect of a fall in the oil price to US$40 on 45 national economies. The biggest winner is the Philippines, where economic growth would accelerate to 7.6 percent on average over the next two years, whereas Russia’s economy would contract by 2.5 percent over the same period.

Mark Mobius, the executive chairman of the Templeton Emerging Markets Group, says that, over the long term, demand for oil will continue rising because of the increasing use of vehicles and plastics in emerging-market economies, particularly China and India.

Mobius says the slowing of economic growth in China was to be expected, because China’s economy is now growing off a higher base. However, he says, China is still urbanising and therefore requires resources such as oil.

Mobius says while lower oil prices will affect emerging-market countries that depend heavily on oil exports, such as Nigeria, Russia and Venezuela, some emerging markets, such as Indonesia, have used the lower prices to remove government subsidies for oil, which were a drag on government budgets.

Peter Brooke, the head of Macro Solutions at Old Mutual Investment Group, says South Africa is a big oil importer, so the lower oil price means the country will spend less on imports, which will help to reduce South Africa’s current account deficit and put money into consumers’ pockets. Both of these developments should be positive for South African financial markets.

Brooke says even if the oil price rebounds, the average oil price in 2015 is likely to be well down on that in 2014.