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Where next for the oil price?

Tom Stevenson

Tom Stevenson - Investment Director

The oil price has always been volatile. The cost of crude is determined by the interaction of two very big numbers - global demand for oil and global supply. Relatively small movements in either of these can result in big shortages or a big glut. Throw geo-politics into the mix and it’s a recipe for sometimes rapid swings in the price of oil.

Even by the standards of this unpredictable market, the past month or so has been a rollercoaster ride. Having hit a high of $86 a barrel in October, oil came close this week to falling below $60. When you consider how important the oil price is to economic activity, inflation and interest rates, that’s a pretty unsettling backdrop.

So what’s been driving the market?

The biggest influence in recent weeks has been the re-introduction of US sanctions on Iran after Donald Trump withdrew from a 2015 Barack Obama-inspired deal that swapped nuclear co-operation on Iran’s part for a willingness to accept Iranian oil exports on America’s.

The expectation among energy investors was that the imposition of sanctions would remove an important part of global supplies from the market. In anticipation of that, the oil price rose to its highest level in several years and speculation mounted that the cost of crude could rise to $100 and beyond.

The reality has been rather different. Having briefly hit a multi-year peak, oil has tumbled by well over 20%, the usual definition of a bear market. Far from worrying about whether the oil price would start to squeeze the global economy, concerns are now focused on how oil companies will deal with a price that’s too low.

There are a couple of reasons why the price has fallen. First, supply from the usual sources has been strong. Not only have the US Shale fields been pumping hard, so too has the world’s biggest producer, Saudi Arabia. At the same time, demand for oil has started to moderate as the global economy starts to slow in the face of growing trade war concerns.

The cynical view of all this suggests that President Donald Trump has played a political blinder, keeping the oil price in check ahead of the recent mid-term elections.

By talking up the threat to supplies from his sanctions against Iran, the President has been able to twist the Saudis’ arm to open up the taps. He has been notably supportive of the country in the wake of the Khashoggi affair to ensure that the kingdom stayed on side.

At the same time, he has weakened the impact of the sanctions by allowing a number of countries, including big importers like India and Japan, to continue buying Iranian oil. These waivers have effectively made the Saudi production boost unnecessary.

Why does the oil price matter?

Oil is perhaps the most important of all commodities because we all use it, whether to heat our homes or fuel our cars. It is a key component in almost everything we use from plastics to fertilisers. The price of oil, therefore, has a massive and rapid impact on our lives. Allow it to rise too high and economic activity is squeezed and inflation stoked. Central banks like the Bank of England and Federal Reserve watch the oil price closely.

Maintaining oil at a reasonable price that doesn’t squeeze economic activity or fuel inflation is important. Donald Trump realises this, which is why he has gone to such elaborate lengths to strong arm his allies in the Middle East. At the same time, countries like Saudi Arabia need to keep the price high enough to balance their books at home. They want to keep the White House sweet but not at the expense of civil unrest at home. It’s a delicate balance.

From an investor’s point of view, too, a Goldilocks oil price - not too hot and not too cold - is important. Oil companies are a big source of dividend income for all of our pension funds so the price needs to be high enough that the likes of BP and Shell can make a decent profit. Fortunately, after years of cost-cutting, the oil majors can now make more profit with the oil price at $60 a barrel than they could a while ago when it was $100.

At the same time, the price can’t go too high. Higher fuel and heating bills quickly feed through to less disposable income. That’s obviously bad news for an economy that’s already growing too slowly for comfort.

So, after such a dramatic fall, we should probably expect the oil price to bounce back from here. The main producers, within OPEC and outside the suppliers’ cartel too, are due to meet in early December to decide what to do to stabilise the market. That almost certainly means that Saudi Arabia and Russia will choose to pump a little bit less than they have been. The price could quite easily be up above $70 a barrel within days.

Many funds have big oil company holdings, including several on the Select 50.

If you believe the oil price has fallen too far and want an indirect play on a recovery in the cost of crude you could look at:

The JOHCM UK Equity Income Fund, which has 17% of its assets in BP and Shell (its two largest holdings).

The Franklin UK Equity Income Fund, which holds more than 10% of its assets in the two UK oil majors (again, these are its two biggest investments).

Important information

The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Overseas investments will be affected by movements in currency exchange rates. Select 50 is not a personal recommendation to buy or sell a fund. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.