The rollercoaster ride in oil prices over the past three years may be old hat to investors familiar with the commodity’s historical sensitivity to macro events (see chart below), but oil price volatility is by no means endemic and several factors are now lining up to suggest a calmer period for crude may lie ahead.
For starters, global oil production appears more closely in line with demand following a prolonged search for a new equilibrium amid a breakdown in the Organization of Petroleum Exporting Countries (OPEC) cartel and increasingly productive oil extraction technologies in North America. In our view, a sustained global economic expansion should support consumption, while underinvestment in the energy sector likely limits the rise in future production even though technological advancements have lowered the breakeven cost of that production.
Many analysts also expect oil prices to stay in a narrower range over the next year, according to a June 2017 survey data from Bloomberg. Comparing the most recent distribution of estimates with previous points in history (see chart below), there is greater clustering around the mean and noticeably shorter tails, suggesting a lower likelihood of major price swings over the next year.
Given the strong correlation between oil prices and energy company earnings, it is not surprising that earnings estimates for the energy sector are moving closer together as well. The recent uptick in earnings revisions for the energy sector (see chart below) currently appears strong, but it is important to interpret this move with a grain of salt. The chart below also shows there is no apparent trend in energy earnings growth, which contrasts with other sectors in the Canadian equity market such as financials, consumer staples, telecoms, and utilities, which have exhibited an upward sloping trend over time.
The reemergence of a prevailing consensus might be positive if it means more predictable earnings growth and more stable dividends for an otherwise schizophrenic sector. Assuming oil prices stay in this narrow range, we believe there are some important implications of lower oil price volatility for investors:
- Energy could command higher valuation multiples, as investors would likely be more willing to pay a premium compared to history for earnings, dividend and share price stability.
- An above-average dividend yield (the MSCI Canada Energy Index is yielding an annualized dividend of 3.6% versus 2.9% on the overall MSCI Canada index, according to Bloomberg data as of July 31, 2017) and lower price volatility could make energy a more attractive sector for income-seeking investors in a low yield world.
- Banks, which lend heavily to the energy sector and represent a rather large share of the Canadian market, would see less earnings volatility if oil prices were to stabilize.
- With energy and financials accounting for nearly two-thirds of the MSCI Canada index, a combined strengthening of the two sectors could positively influence overall Canadian equity market performance.
Daniel Donato, analyst with BlackRock in Canada, contributed to this article.