Keeping an Eye on Oil

April 24, 2015

Oil prices have recently stabilized, following their rapid decline in late 2014, but volatility in this market will likely continue in the short term.

Currently, oil has bounced back to almost US$60 a barrel. (On March 25, the price of Brent crude oil, the global benchmark, stood at US$56 a barrel.) Moving forward, we expect volatility for global oil prices to continue as supply and demand factors remain imbalanced. Prices could fall in the second quarter as refineries shut for maintenance, curbing demand.

While the price for Brent has recovered somewhat, both West Texas Intermediate and Western Canada Select remain below the Bank of Canada’s expected level. The continuing low price for each could mean further downside risks to the domestic economy and, importantly, the relative performance of Canadian equities compared to their U.S. and international peers.

Taking a broader view reveals that oil prices have varied significantly over time—just over six years ago, we saw prices even lower than those witnessed in the latter part of 2014. In the seven months leading to January 2015, oil dropped by 60%, to less than US$47 a barrel for Brent.

Any substantial change in oil prices is factored into the analysis of many businesses that we invest in—including energy companies and those using energy, as well as service providers to this sector, such as rail companies and banks.

Impact on MD Funds and Portfolios

The decline in oil prices at the end of 2014 was a significant driver of relative returns for our various funds and pools.

The MDPIM US Equity Pool and the MD American Growth Fund performed very well during the pullback in oil prices in November. This is the result of active exposure to a strategy that only invests in companies with a more stable rate of growth (we define these in terms of a 10-year rate of Return on Equity [ROE]1 of over 15%). Both the pool and fund also benefited from a lower inflation rate. With the drop in oil prices, U.S. consumers and businesses have more money to spend on other things, such as information technology and food, with a smaller portion of their budget allocated to transportation or heat. This development has boosted other sectors of the economy and, ultimately, our specific investments.

The MDPIM Dividend Pool and the MD Dividend Growth Fund typically hold a large number of smaller Canadian energy companies and income trusts that have a very high dividend yield. While the income is high for these funds, it introduces greater exposure to the price of oil and the volatility that can occur from time to time.

Aside from more strategic positioning in these funds, all other investment decisions with regard to the funds are constantly being reviewed, as the drivers of corporate profitability and company valuations evolve.

Low Oil Prices Could Ultimately Spur Global Economic Growth

While the impact of lower oil prices is unwelcome news for some economic sectors, the news is not all negative. Writing on iMFdirect, the International Monetary Fund’s global economy forum, Rabah Arezki and Olivier Blanchard make the case that declining oil prices are a net positive for the global economy. “Overall, we see this as a shot in the arm . . . Bearing in mind that our simulations do not represent a forecast of the state of the global economy, we find a gain for world GDP between 0.3 and 0.7 percent in 2015, compared to a scenario without the drop in oil prices.”

In addition, lower oil prices can have a similar effect as a tax cut—leaving consumers with more money to spend, save and invest. Inflation is also less of a concern if oil prices remain low.

As we look further into 2015, lower oil prices will present challenges for Canada’s energy sector and, consequently, the overall economy. However, we remain optimistic about further growth in domestic equities. There is still potential for a faster-than-expected recovery in oil prices and continued access to cheap credit, leading to more robust consumer consumption. This is ultimately positive for the relative outperformance of Canada’s equity market.

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