insights-energy

Is the cure for low commodity prices even lower commodity prices?

In our title article we noted the benefit to consumers – and ultimately global growth – from the fall in oil prices. But mining companies and oil producers have taken a hit and much uncertainty remains over their returns in the months and years ahead. Commodity prices could get worse before they get better, and we remain wary when it comes to commodity-related assets.

The main driver of oil-price declines has been a supply glut. Substantial new supplies have come from the US since its ‘shale revolution’ and OPEC seems determined to supply as much oil as is needed to drive prices down to where it is uneconomical for US shale firms to produce it (i.e. they would make no profit). This is putting tremendous pressure on other producers too. 

While Saudi oil can be produced for $5 a barrel, it costs around $55 from Brazil’s deep-water Santos Basin and $100 from Canada’s oil sands. Shell and other oil majors have responded by reducing exploration to keep costs down and protect dividends, but general oversupply has continued.

Commodities in general remain under pressure, with Bloomberg’s broad commodity index down by more than 20% over the last year amid dollar strength (commodities are priced in dollars and a rising dollar makes them more expensive in other currencies) and weakness in China and other emerging markets.

As with oil companies, miners such as Rio Tinto and BHP Billiton have also cut back on spending in an attempt to maintain dividends. Glencore has suffered wild trading swings in 2015 given the added concern of a heavy debt load.

It’s a well-known phrase that the cure for higher commodity prices is higher commodity prices (which, as the theory goes, eventually curbs demand, leading prices lower). The risk is that the reverse may also be true – the cure for low commodity prices may be lower commodity prices. We remain cautious when it comes to assets that have a close relationship with commodity prices.

oil-price-vs-supply-graph

Source: Datastream

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