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Oil price under pressure

Jonathan Wright

Jonathan Wright - Fidelity Personal Investing

It may not be noticeable at the petrol pumps yet but the price of oil has dropped over 30% since October. Signs of oversupply in the United States and concerns over a slowdown in global economic growth led to the fall which has implications on all of us, whether we own a car or not.

Oil prices fell more than 5% in choppy trading yesterday as investors questioned whether production cuts planned for January would be enough to balance the recent oversupply of shale oil from the US. Fears of a slowdown in the global economy have further added to these worries, leading the price of Brent Crude to hit a 14 month low of $57 a barrel yesterday.

Earlier this month, the Organisation of Petroleum Exporting Countries, or Opec, and its oil producing allies agreed to cut production by 1.2m barrels a day, starting in January. This was led by Saudi Arabia, Opec’s largest producer, which needs higher oil prices to fund its ambitious domestic spending plans.

This attempt from the oil cartel to steer the price upwards will also boost its biggest rival, the US, which is now the world’s largest oil producer thanks to the rising use of shale oil.

While the US still has to import oil, it can now meet two-thirds of its own needs domestically whereas just over a decade ago it was one-third. Unlike conventional oil, shale can respond more quickly to a changing market. It does not need such large-scale investment as conventional oil so it is much easier to increase or decrease output in response to a changing oil price.

Those ‘in the know’ in the US keep a firm eye on the inventory levels at the storage hub of Cushing, Oklahoma, which recently saw levels rise by more than 1 million barrels from 11-14 December. This is indicating supply is increasing while demand is weakening.

When the oil price starts to get close to $50 a barrel, many shale producers are unable to make money, so the US will welcome production cuts from the Opec nations if it helps turn the oil price back upwards again.

All eyes will also be on the Fed today as it is widely expected US interest rates will rise by another quarter point to between 2.25% and 2.5%. Investors will also be keenly watching Fed governor Jay Powell in his press conference for what he has to say about the outlook for further rate hikes in 2019. Oil is a key driver of inflation which directly affects interest rates.

With the cost of oil priced in dollars, if an interest rate rise causes the dollar to strengthen, it will make the commodity more expensive for buyers outside of the US, especially those countries which rely heavily on imported oil such as China, Japan and India.

Even with the rise of renewable energies, oil continues to play an important role in the world economy as people and goods are transported by air, land and sea using this key commodity.

President Trump, a vocal critic of Opec has accused the group of “ripping off the rest of the world” by keeping oil prices “artificially high”. In the US, where fuel duty is far less than here in the UK, any increase or decrease in the underlying price of oil is more noticeable.

The US economy, so dependent on the confidence of its consumers, benefits from a falling oil price as dollars saved at the petrol pumps can be spent elsewhere in the economy. President Trump has described the recent price drop as a “big tax cut for America and the world”. He has already tweeted his opposition to an interest rate rise today warning it would be “yet another mistake”.

However while transportation costs may get cheaper for some, a lower oil price has a negative effect on the oil producers such as BP and Shell who will be forced to make savings to maintain their profit margins at a lower price.

With both companies paying a dividend yield of around 6.4%, which is almost 2 percentage points higher than the current FTSE 100 average, they are attractive companies for investors looking for a high dividend income. This could be in question if the oil price drops further over the coming months. Alternatively, if the production cuts do have the desired effect, this could be a buying opportunity for those prepared to take a long-term view.

Five year performance

(%)

As at 30 Nov

2013-2014

2014-2015

2015-2016

2016-2017

2017-2018

 Brent Crude Oil

-35.5

-38.6

11.4

29.5

-9.5

Past performance is not a reliable indicator of future returns

Source: Thomson Reuters Datastream, as at 30.11.18, in local currency with income reinvested 

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