09/10/06

Oil prices have grabbed the headlines in recent weeks, but are these sharp declines good news for investors?

At the start of the third quarter, investors had been worried about a series of risks to the supply and demand balance within the oil market. One by one these risks have eased or disappeared, whether in relation to US hurricanes, UN discussions with Iran, or BP's production from Alaska. For some time we had been concerned about the extent of speculative activity in the commodities markets. This also began to ease in September, as some hedge funds become forced sellers. The net impact of these developments has been spectacular. Global oil prices have fallen to their lowest levels since December, with US natural gas prices at their lowest since 2004.

There are important implications for both financial markets and for policy makers. US consumers will receive the equivalent of about a 1% boost to their disposable incomes, especially helpful for lower income households. The impact will be less in Europe – petrol prices are already lower but utility bills will take some time to react. A key issue for consumers is whether they see the decline as temporary, in which case they will ‘save' any gain or whether it is seen as permanent. In the latter case, it is a powerful argument for those investors who foresee a soft landing for the US, and indeed the world economy, into 2007.

Will oil prices stay at current levels, fall further, or snap back higher? This market has become notoriously difficult to forecast but some factors will be important. The degree of speculative interest in commodities has already been referred to. As a result, a number of technical analysts are warning of a potential sharp breakdown in the prices of industrial and precious metals as well as gold. Conversely it is unlikely that the major oil producers, led by OPEC and Russia, would like to see oil prices much below the high $50s per barrel. The rationale is clear; such economies have geared up major investment and social welfare programmes which otherwise could be sharply curtailed. Hence, OPEC has already signalled they are minded to curtail supply to put a floor under prices.

Could oil prices snap higher again? Undoubtedly if some of the risk factors re-appeared. Hurricanes or political developments in, say, Iraq or Nigeria have the capacity to take several hundred thousand barrels of oil off the production side. This is a damaging amount when the demand/supply balance is still historically tight, and indeed looks to continue that way into 2008. The good news is that as and when oil prices climb back into the $70-80 per barrel range, it is clear that demand destruction begins to appear. Although the level of government taxes on petrol is an important factor between countries, in general households are sensitive to the price of petrol at the pump. The prime example is consumers in the US who quickly started to seek out smaller, more fuel efficient cars when gasoline costs rose in 2004 and 2005.

Against that backdrop, the recent performance of financial markets is understandable but may be premature. As inflation expectations have declined – with more to come – and as the US economy has shown clearer signs of slowing into year end, money market investors have started to price in eventual rate cuts by the Federal Reserve, and little further action by the European Central Bank. US bond yields have led the way in this cycle, and are currently at their lowest level since March. Equities have also appreciated the combination of a growing likelihood of a soft landing for company profits, less of a squeeze on margins, and the benefits of a lower discount rate. US equities, for example, have returned to their May 2006 highs, despite the fact that energy company share prices are about 10% lower than where they were a month ago.

Market behaviour suggests that the majority of equity investors are quite relaxed about return prospects. To a large extent, we share that view. Critically, the earnings yield afforded by most equity markets still looks attractive relative to the corresponding bond yield alternative. Much depends though on whether modest profit growth can be delivered in 2007, in the face of the US economic slowdown. We believe it can be achieved, particularly if energy and other commodity prices stay under control. Should the slowdown gather momentum though, exacerbated by any snap back in oil prices, a rapid reappraisal by investors would be in prospect.

Andrew Milligan, Head of Global Strategy, Standard Life Investment

First published on scotsman.com on 9 October 2006.

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