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Why oil is falling like it's 2008 again

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Why oil is falling like it's 2008 again

Not since the financial crisis has the oil price fallen as steeply as it has this month. Down 22% so far in November, oil is down more than 30% from its early October highs and has dropped from a year high to a year low in the space of just 27 days.

Fears over trade wars, slowing global growth and lower demand from the Middle East and China have all contributed to the plunge. But one man above all others has been the driving force: US president Donald Trump.

The prospect of US sanctions against Iran was one of the major factors behind the jump in the oil price above $80 a barrel, provoking Trump's ire.

But the introduction of those sanctions had the opposite effect, as the US softened their impact by granting exemptions to the sanctions to a number of the Middle Eastern state's biggest buyers. Fears over a big curtailment of supply that had driven the oil price higher did not materialise, sending the price of Brent crude tumbling.

The other factor was an increase in production, particularly from Saudi Arabia. Richard Robinson, manager of the Ashburton Global Energy fund, said Trump was pulling the strings.

'The oil market is quite complex. Countries can decide to pull inventories or use subterfuge on headline figures, making production appear stronger than it is,' he said.

'This is what US president Donald Trump was orchestrating when he met with Saudi crown prince Mohammed bin Salman in March, striking a deal to oversupply the market and bring oil prices down in time for the US midterm elections.'

The murder of Saudi journalist Jamal Khashoggi (pictured) then handed Trump more leverage. 'Trump has piled pressure on Saudi Arabia  to maintain high production, apparently demanding lower oil prices in return for not reacting too aggressively to the murder,' said Liz Dhillon, equity research analyst for wealth managers Quilter Cheviot.

On the FTSE 100, shares in Shell (RDSb) and BP (BP) are down more than 10% from their early October peaks, while mid- and small-cap oil stocks have been hit harder.

Premier Oil (PMO) has halved in value, Nostrum Oil & Gas (NOGN) has lost 44%, EnQuest (ENQ) is down 39% and Tullow Oil (TLW) has dropped 30%.

Tables turn for oil majors

Major oil companies which had been reaping the benefits of their cost-cutting, a product of the sustained bear market in oil from the summer of 2014 to early 2016, against the backdrop of rising oil prices have seen that dynamic change quickly.

That cutting of costs has led to lower production levels, a situation they will need to address, potentially against the backdrop of a lower oil price.

‘The oil majors are in this nice period that is not sustainable,’ said Stuart Rhodes, manager of the M&G Global Dividend fund.

‘They have been working on getting costs down in reaction to the oil price drop three years ago. The costs have been going down and the price [of oil] has been going up, and the free cashflow is healthy...so at this moment the dividends are covered but it’s not in perpetuity.’

He said the oil major's production levels have ticked ‘lower this year and the year after’ meaning they will have to invest money in new projects again.

‘The dividends look robust and coverage is good but you need to look out and see what spend will be required and that is when the dividend gets tight again,’ said Rhodes.

‘We do not own any oil companies and I would be worried about those that are raising their dividend too much and too quickly.’

Dividends look safe for now

The likes of BP and Shell were able to maintain their dividends as the price of oil plunged to a low of $27 a barrel in early 2016, and the actions they took following that crash should stand them in good stead should the current bear market in oil prove prolonged.

‘[The oil majors] pay attractive dividends that are sustainable,’ said James de Bunsen, multi-asset fund manager at Janus Henderson.

‘It has been pretty brutal in the last few weeks but the future is much better because the dividends are sustainable with oil at $50 to $60, but if it goes below that people will look at it harder.’

De Bunsen, holds Shell, BP, Total (TOTF.PA) and Eni (ENI.MI) in his portfolios.

‘What we like about the [oil majors] is that while oil prices are a large part of the business, they have lots of downstream business with refineries and service stations, and they are much less sensitive than pure exploration small caps,’ he said.

Citywire AA-rated Paul Mumford is a fund manager with a focus on much smaller oil stocks. And while the heavy falls for mid- and small-cap energy stocks over the last two months show their greater gearing to the oil price, it's not all doom and gloom for the sector.

Mumford has a heavy weighting to energy, which accounts for a fifth of his Cavendish Opportunities fund and 13% of his Cavendish AIM fund.

He highlighted Rockrose Energy (RRE), his top holding in both funds, whose shares have rallied 70% over the last six months.

He said small cap oil explorers like this only have to ‘find a medium size oil discovery from an exploration programme’ in order to cover their market cap ‘several times over’.

He argued Rockrose, which buys late-stage assets that need decommissioning, was ‘severely undervalued’. Despite producing 11,000 barrels a day, and having similar reserves and production as Faroe Petroleum (FPM), Rockrose is valued at just £100 million while Faroe is the subject of a takeover approach from Denmark's DNO (DNO.OL) that values it at £600 million. Mumford bought the shares at 127p and they are worth 646p today.

‘There are quite a lot of small companies on increasingly cheap valuations, he said. ‘There are a lot of hidden gems... but the sector has been out of favour for such a long time.’

All eyes on Opec

Crucial to any immediate recovery in the oil price will be the next Opec meeting on 6 December. Robinson said expectations of an agreement on production cuts were likely to bear fruit, largely because Saudi Arabia needs to. 

'Various reasons, including pipeline corrosion in one of its major oil fields, have hampered Saudi production capabilities, leaving it with anaemic spare capacity and low inventories – both at 10-year lows,' he said.

'In order to maintain its status of ‘swing producer’, the country is having to disguise its need for reducing unsustainably high levels of production as an OPEC cut, calling on the organisation to cut crude supplies at its next meeting in December. This supports our belief the oil price will recover.'

Longer-term, the seeds of an oil price recovery can be seen in the current bear market, argued Dhillon.

'There’s a significant time lag between deciding to invest in new production and actually getting oil out of the ground, so if oil companies are going to start replacing their reserves for beyond 2020, they need to start investing now,' she said.

'The risk is that the current decline in prices makes them less keen to do so, with this potentially forcing the oil price higher in the long term.'

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