Divergence and adjustment: looking beyond the ‘new normal’.

Takeaways:  Euro-dollar divergence and the weak commodities outlook are on the agenda this week as we await new pronouncements from the ECB and OPEC – keeping the Fed’s next move always in mind. Given this week’s fever pitch of speculation, the ECB might need to take pretty radical action to move markets further and keep the deflation wolf from the door. In the absence of radical action from OPEC, it looks we’re ‘as we were’ in oil markets as we move into 2016. What does this mean on the ground for oilfield services, if ‘low and volatile’ is the ‘new normal’? Spoiler: waiting out low prices isn’t an option.

 First on the bill..

This is the first of two pivotal weeks that will set the tone for 2016. It does feel like a bit of a warm-up act, in the sense that the ECB and OPEC meetings are both being viewed through a dollar lens. Of course, each decision is vital in its own right and each actor in this drama has their own concerns uppermost; but any market impact will undoubtedly be influenced by the Fed’s decision on 17 December. It’s hard to ignore how just much now pivots around the dollar.  As Jim Reid of Deutsche bank commented this week:

“With so many dollar investors at a global level {the strong dollar] surely has to have had a big impact on mood [and] confidence. With the Fed and the ECB about to diverge it doesn’t look like momentum is going to change as 2015 turns into 2016.”

And so much of the discussion about the ECB’s next move has come in the context of dollar-euro divergence. As the quote above suggests, Fed tightening and further ECB loosening is ‘baked in’ to most to assumptions. For most investors, it’s just a matter of the degree and the fever pitch of ECB speculation in the last week has taken divergence to new levels. The gap between benchmark two-year U.S. and euro zone yields is at its widest since 2006; but the cost of swapping these funds into dollars is at its highest since 2012. It all makes for an interesting M&A equation for US companies buying in the Euro aisle. It’s almost never been cheaper to raise money in Euros – but there’s a big sting in the translation tail.

More pertinently for the ECB, it makes it difficult for them to move markets further unless their action is at least as radical as the extension to muni and regional bonds and tiered deposit rates of recent Reuters’ speculation. Currently 15% of all euro area government bonds and 26% of all German sovereign bonds of 2Y-30Y already trade below the ECB’s QE limit of minus 20 basis points. Indeed, there are some members wondering why further action is needed; although, the doves have further ammunition today in the form of barely there inflation of 0.1%, below expectations of 0.2%.  And this next headline won’t ease those deflation concerns….

 Fifth worst November for commodities since 1970

Asset performance in NovemberThe OPEC meeting this Friday seems unlikely to provide any significant boost to prices . Thus it seems likely – given US shale’s continuing resilience at these low prices – that we’ll move into 2016 much as we are, with significant supply glut.  The addition of weak Chinese data and the stronger dollar provided the additional drag to reduce Brent Crude prices by 10% last month, as commodities and their indices again fell to the bottom of the chart. Meanwhile the S&P GSCI Index had its 5th worst November on record since 1970. Year-to-date, the index is also on pace for its fifth worst year with only 1998, 2001, 2008 and 2014 losing more. Only three out of 21 commodities in the index were in the black in November – sugar, cotton and cocoa.  

It’s no wonder that this year’s UK bank stress tests look at lenders’ ability to withstand a severe emerging markets crisis.  We’re not talking black swans here. The main risks for 2016 have been well trailed. Brazil’s deepening recession underlines the commodities–emerging market connection.  It’s the potential for sustained feedback loops and just the sheer adjustment to a prolonged period of a stronger dollar, cheaper commodities that’s the great unknown. 

We have to start thinking along the lines that pre-2008 prices might not be normal – perhaps this is. In this new world, trading houses are obviously coming under pressure, with further consolidation likely along with some strategic exits and restructuring.

The great adjustment: oilfield services

The oilfield services sector is also facing a significant adjustment. Companies in the sector were showing signs of strain when oil traded at $100 a barrel. A quarter of the UK FTSE Oil Equipment, Services & Distribution sector issued a profit warning in 2012 and 2013 as the oil & gas industry responded to shareholder pressure for more capital discipline. In the year to date, almost 50% of the FTSE sector has issued a profit warning.  Many oilfield services companies are responding – as they did before – by cutting costs; however we believe a more fundamental change is required to protect the sector’s future.

Overall global capex is expected to drop by at least $220bn in 2015/16, with some EMEIA countries amongst the worst affected; however our latest analysis shows that opex and capex falls can vary significantly by country and by product and service.  For example, capex spending is still expected to increase in some areas like Angola and Brazil. This is a highly fragmented industry, with 1500  companies holding limited market share. Therefore, there are still options open to companies in the sector looking to secure value. In our view, companies need to decide where they are best placed to deliver value. That might be as a consolidator, to bring about a step change reduction in costs through synergies. By creating optionality, in order to spread the risk through access to new geographies, products or services. As a business that divests in order to focus investment on core businesses. Or companies may decide to exit completely. The one option companies don’t have in this market is to do nothing, if they want to protect and grow shareholder value.