#126 Oil

Aunty Ann came to visit me today. The flu went through our household last week and Darcy and I were down for the count, living in the company of tissue boxes, Benadryl, and cough drops. Aunty Ann came by to pick me up and take me for a quick grocery run. I’m just about all the way better, but Darcy’s family is still very considerate of me.

 

She came in to pick me up, not even taking off her boots, but we ended up chatting for about a half an hour first. Her car was running in the driveway the whole time, and so of course a comment had to be made “well, at least gas prices are low”. Gas prices in Edmonton have sunk into $0.73 per litre territory.

 

Gas prices and oil prices, while not a perfect dancing pair, make most of their significant moves in tandem. In September oil prices hovered around $115 per barrel. As I write OPEC’s basket price is treading just below $55 per barrel.

 

In an oil-driven economy such as Alberta, and even more specifically in an oilboom area like Lloydminster, falling oil prices are a very scary thing. The collapse has been sudden, and the future remains uncertain. Is $55 per barrel as low as prices will fall? The Oil Minister of Saudi Arabia suggested indifference at a $20 barrel of oil. And where will they eventually stabilize? What is ‘normal’ going to look like?

 

I don’t want to give the impression that I have a crystal ball, or the answers to all of these answers. But what I do have is the backstory on why this is happening, insight into possible implications, and some information that can help you make the right decisions for you and your family.

 

First question: how the heck did this happen? Answer: prices have been high over the past five years. While $110 per barrel was the stable mark, the idea of $200 per barrel was whispered at the fringes.

 

Lots of our oil in Alberta is relatively easy to get out of the ground, and experienced oilmen help to make sure it’s done safely and efficiently. Other parts of the world aren’t as fortunate. In North Dakota and Texas for example, oil trapped in shale is much harder – and much more expensive - to pull out. At $110 per barrel however, even shale oil extraction becomes profitable. Once thought to be unavailable, shale oil entered production and add to global output.

 

This has helped move the world into an oil surplus. When faced with a surplus, the natural course of action is to reduce production. Yet many of the world’s largest oil producers have responded to that suggestion with a simple “no”.

 

Second question: What are some of the implications of low oil prices? Answer: Stubborn over-production and abundant supply has pressured oil prices below extraction cost. The strongest implications will be felt by two main groups - high cost producers and oil-reliant economies.

 

A survey of eight large independent firms in 2013 suggests average operating costs of $10-20 per barrel. That’s once the well is already established. Shale oil wells deplete quickly, however, so in order to maintain the flow, new shale oil needs to be explored, and wells brought into production. Once the initial costs of bringing a well online are considered, Wood Mackenzie, a research consultancy, estimates a per-barrel break-even price of $65 to $70.

 

In the short term, this spells bad news for firms with a high cost of production, and investors in such. And by investors I don’t mean just tycoons with a cowboy tolerance for risk. According to Bloomberg, oil and gas exploration and production firms now make up 17% of America’s junk (“high yield”) bonds. Otherwise conservative investors who have been chasing yield will also feel some impact.

 

The second group most impacted by the low oil prices are economies reliant on the export of oil. And yes, that means us. Although low oil prices will slow the economy in our area, it’s not necessarily bad (unemployment rates are anemic), and the severity will be mitigated by the low Canadian dollar. OPEC prices are denominated in U.S. dollars, which means that our converted price (at $0.86 USD:CDN) is actually closer to $64 per barrel. Still not great, but better.

 

Third question: What can I do to help protect my family? Answer: that will depend on whether you are predominantly a producer of oil (or an investor in such), or a consumer of oil.

 

Consider your lifestyle. Do you drive to work? The Economist suggests that based on a $3,000 annual gasoline budget, most consumers will be saving $800 per year. This can be redeployed back into other areas of the economy, either through savings and investment, or spending in the retail sector. Some areas of the retail sector, notably automotive manufacturing, have a direct negative correlation to gas prices. When gas prices go down, people spend more on vehicles.

 

Consider your industry. While we have a lot of oilmen in our area, we also have a lot of agricultural producers, my inlaws included. Ag producers use a lot of fuel running their equipment, and will also benefit significantly from reduced oil prices. These savings will have a direct positive impact in our local area as equipment is modified and upgraded, and new shops are built.

 

Consider your investment portfolio. While every investment advisor will have their philosophy, ours is to limit home bias (investment in Canada) to no more than 20% of any portfolio – 30% at the very max. And within that, oil and gas is going to be even more limited. If you have a limited home bias in your portfolio, then even as prices continue to plunge, you should be able to weather most of the shock.

 

Consider our currency. The Americans are our biggest trading partner, and they love to buy our stuff. Oil and Gas are a big part of our economy, but so is manufacturing and agriculture. A low Canadian dollar means our dear friends to the south will be able to buy all sorts of wonderful Canadian product for a lot less.

 

If you are primarily a producer of oil, or an investor in such, the road ahead will be rocky, but our area is strong, and it should turn out okay. If you are primarily a consumer of oil, relish this opportunity! Review your budget, estimate your savings, and use it to make the world a better place (my favorites: pay down debt, increase savings, donate to charity).

 

Plummeting oil prices are a scary thing, and sometimes it’s hard to know where you stand. If you have questions on how correlated your investment portfolio is to the Canadian market, or for more information on financial planning can help you though major life decisions, speak with a CERTIFIED FINANCIAL PLANNER® today.

 

Written by Meagan S. Balaneski, CFP, R.F.P CERTIFIED FINANCIAL PLANNER®
Advantage Insurance & Investment Advisors

Investment Funds Representative
Manulife Securities Investment Services Inc.

The opinions expressed are those of Meagan S. Balaneski and may not necessarily reflect the views of Manulife Securities Investment Services Inc.