The ugly side of slumping oil prices

Global equities tumble as investors fear profit erosion at energy firms, miners and banks

A man reaches for unleaded petrol at a fuel pump outside a Royal Dutch Shell petrol station in Hook, Basingstoke on Jan 20, 2016. PHOTO: AFP

For a long time, a no-brainer strategy to beat the market was to simply track how the US dollar was doing. Stock prices would shoot up whenever the greenback wobbled, and turn weak at the knees if the US dollar strengthened.

While that relationship continues to hold true to some extent - at least superficially - it has been superseded by another even more powerful correlation: the influence which oil prices seem to be wielding over the world's financial markets right now.

For much of last month, the main driver of stock market sentiment has been a tumbling oil price to about US$30 a barrel amid a host of concerns - from slowing global demand to the lifting of sanctions against Iran , which have exacerbated the supply glut. Rebounds in oil over the past week had sparked equity market rallies.

Indeed, superimpose the chart of oil prices over that of Wall Street's S&P 500 Index and you would find quite a good fit between the two.

Some investors may be surprised by the fact that falling oil prices could deal the world's stock markets such a big blow.

The classic premise is that cheaper oil prices should act as a stimulant to the world's economy, as consumers could fill their petrol tanks for less money. Those savings will put more dollars into their pockets and encourage them to spend more, thus boosting the profits of companies.

But cheap oil is failing to deliver the usual economic benefits. Instead, it is causing mayhem in the world's stock markets as investors focus on the damage it is causing to the bottom lines of energy companies, miners and banks.

For investors, one piece of significant collateral damage from plunging oil prices is the threat to the traditionally big dividends paid out by banks and firms in the formerly buoyant oil and gas sector.

Banks and energy-related firms form the building blocks of many widely-watched market barometers, such as the S&P 500, Hang Seng and even the Straits Times Index. Investors are thus feeling the chill of the fallout. Pointed questions are being asked about these firms' ability to keep the same level of dividend payouts as oil prices plunged 75 per cent from more than US$115 a barrel in the past 20 months.

Oil majors have been particularly hard-hit by sell-offs, despite slashing their capital expenditure in order to conserve their cash resources and continue paying out their mouth-watering dividends. One example is Royal Dutch Shell, which had shelved almost US$400 billion (S$568 billion) in spending on new projects.

This cutback in capital expenditure has, in turn, soured the appetite for stocks in the marine and offshore sector, which has been hurt by falling demand for the rigs rented to the oil majors and offshore supply vessels providing a wide range of services, such as handling the anchors for oil rigs.

For banks, the biggest threat is the damage which their balance sheets may suffer from bankrolling projects during the energy boom years. In their latest earnings reports, giant US lenders such as JPMorgan Chase and Wells Fargo said they were already setting aside billions in provisions to cover potential losses.

In our own backyard, OCBC Bank had said in October that it had restructured the loans extended to struggling oil and gas companies. Exposure to the sector had made up about 6 per cent of its loan book.

For yield-hungry investors who eagerly snapped up the high-yield bonds issued by energy-related firms, there is the added worry that the companies which issued them may default if their business turns sour. That concern weighs on stock market sentiment too.

But more than anything else, cheap oil may also be a symptom of the world's economic ills. After all, booming economies consume a lot of oil - and when economies stagnate, demand for oil falls too.

Last week, the US central bank acknowledged as much when it kept interest rates unchanged after observing that economic growth had slowed late last year.

Of particular concern is the state of China's economy - which had accounted for much of the rise in the demand for energy in recent years - as it makes its transition away from investments and heavy industry to a service-oriented economy.

Banks may face an even bigger threat on their balance sheets if faltering economic growth causes companies to fail and be unable to repay their loans.

Another related worry is the rise in retrenchment at firms amid faltering economic growth, especially those in the energy-related sector, as they slash expenses to counter lower earnings.

Among the worst hit by the oil crash are the emerging market economies, such as Brazil, Russia and Venezuela, powered by energy exports, which run the risk of blowing up into a full-blown financial crisis if oil keeps falling.

Unusually, even markets such as Japan, a major oil importer which should be enjoying a bonanzafrom falling prices, are facinga difficult time.

One explanation is that sovereign wealth funds whose sources of funds are mostly derived from hydrocarbons are being forcedto liquidate their equity holdingsin liquid markets such as Tokyoas redemption calls on themgrow from the falling oil pricesto raise funds to finance their countries' spending.

Amid this gloom and doom, the challenge for investors is to identify companies that will be able to preserve their dividend payouts in the face of falling oil prices.

For stock markets to soar again, there must be a loosening in the way equity prices are moving in lockstep with oil prices.

That will depend on the United States and other major economies turning in positive economic data to reflect the upside of cheap oil prices - and proof that consumers are spending their oil bonanza instead of hoarding the savings.

So far, the outlook does not look promising. Singapore, as the canary to the world's economy, reported a 7.9 per cent year-on-year drop in manufacturing output in December. Stock prices can expect more bumpy times ahead.

A version of this article appeared in the print edition of The Straits Times on February 01, 2016, with the headline 'The ugly side of slumping oil prices'. Subscribe