The importance of oil
We think equities are currently facing five principal challenges: the widening of
high yield spreads; Chinese real estate; the gap between the Fed dots and the
forward curve; disruptive technology; and the fall in the oil price.
A stabilisation in the oil price is critical to the stabilisation of equities and
cyclicals. The fall in the oil price so far has been very closely correlated to the
fall in inflation expectations, cyclical underperformance and a rise in non-energy
high yield spreads. The market seems to interpret the fall in the oil price as
demand-driven, but we would argue that it has been primarily supply-side driven.
The problem is that commodity-related capex accounts for c30% of global
capex (with oil capex down 13% and mining capex down 31% in the past 12
months), and thus the fall in US and global commodity capex and opex has
taken at least c0.8% off US GDP growth in H1 2015 and c1% off global GDP
growth over the last year. The benefit in some regions has been slow to
materialise (because as in 1985/86, the consumer has saved some of the
windfall gains): Europe should experience the biggest benefit, as the starting
level of the savings ratio is high. We agree with the IMF that the fall in the oil
price should ultimately boost global GDP growth by c0.5%-1%, even
adjusting for the capex and savings headwinds.
We believe that the oil price will now stabilise. OPEC spare capacity is just
1.5mbd and Saudi Arabia has, at the current price, achieved its objective of
stabilising market share: non-OPEC output is forecast to fall by 0.5mbd in 2016,
while Saudi Arabia is running a budget deficit of c20% of GDP. However, we still
think consensus forecasts for end 2016 (at $65pb) could be too optimistic, as an
oil price at those levels would risk allowing high cost production to re-enter the
market.
Investment implications: 1) we reduce our underweight in IOCs (energy as
a share of market cap in Europe is close to all-time lows, positioning is cautious),
but we refrain from raising to benchmark until we see a FCF yield two years out
that covers dividends on a $50-60pb oil price. US E&Ps (e.g. Pioneer, Marathon
Oil) look better than IOCs. OFS could be vulnerable if oil capex follows mining
capex (i.e. falls another 20% relative to projections); 2) if oil stabilises, select
cyclicality should do well (employment agencies, Italian banks and Fiat);
3) we recommend select exposure to commodity-exporting GEM (Experian,
Iberdrola, Mondi); 4) we take airlines to benchmark from overweight (they
have been a double play on oil, and capital discipline seems to be waning), and
we believe the fall in oil is fully priced into UK retailing.