What has caused this decline?

The decline in oil price can be attributed to oversupply and weakening demand. The price of oil is determined using simple principles – basically, when supply is low and demand is high, the price goes up and when supply is high and demand low the price goes down.

Following the 2007-08 Global Financial Crisis (GFC), historically low interest rates provided low cost capital to US producers who invested heavily in hydraulic fracturing, more commonly known as fracking. A method used to extract natural gas from shale rock formations, this has nearly doubled US production over the past few years.

As a result, the US is now a ‘net’ exporter of oil, becoming a direct competitor to the Organization of the Petroleum Exporting Countries (OPEC).

Historically, during periods of over-supply or decreasing demand, OPEC has reduced its output of oil to prop up the price. However, in order to maintain its’ market share, OPEC and in particular Saudi Arabia (its’ most powerful member) have so far committed to not cutting production.

Further supply is now expected to emerge following the lifting of economic sanctions on Iran which could drive prices even lower.

Concerns about slower growth in China, the world’s largest net importer of oil, benign growth in Europe and weak growth in many developing economies are further aggravating the problem.

So where to from here?

Recent reports seem to indicate that the solution to the supply problem may come from where it all began – low oil prices. Low prices result in low investment in production and exploration.

US shale producers need an oil price of between $40 and $60 a barrel to breakeven but with prices reaching as low as $US27 a barrel last week, it’s becoming tough even for them.

It is estimated that the rig counts in the US has fallen nearly 70 per cent from its peak and the Energy Information Administration now predicts that companies operating in US shale formations will cut production by a record 570,000 barrels a day in 2016.

This should over time solve the excess supply issues and lead to higher prices.

If you’re investing in oil stocks

A significant downturn in oil prices eventually results in a major recovery as shown by the following statisitics:

• The 79-per-cent decline from 2008 to 2009 was followed by a 274 per cent recovery;
• The 59-per-cent decline from 1996 to 1998 was followed by a 244 per cent recovery;
• The 66-per-cent decline from 1990 to 1993 was followed by a 90 per cent recovery;
• The 62-per-cent decline from 1985 to 1986 was followed by a 273 per cent recovery.

The question is a matter of when, rather than if the markets will eventually move higher. Don’t be too concerned by the current market, particularly if you have a diversified portfolio. Diversification across sectors and industries manages the risk of such downturns, helping to soften the blow.

We at Hewison Private Wealth firmly belief in diversification and out clients can rest assured knowing that portfolios are managed according to long term investment strategy and we will recommend the necessary adjustments as required.

The information provided above is general information only and individuals should seek specialised advice from a qualified financial adviser. Please contact Hewison Private Wealth for more information.