Brexit: the impact on global energy, July 2016

6th July 2016 - Tim Guiness, co-manager of the Guiness Global Equity fund, discusses the impact of Brexit on the global energy market

What does Brexit mean for oil price?

We have been stating since the start of the year that oversupply in the oil market is diminishing, via a combination of strong global oil demand growth, declining US shale supply, weaker production elsewhere in the non-OPEC community, and little growth in OPEC beyond Iran's expected recovery post the lifting of sanctions.

Being precise about the impact of Brexit is of course an exercise in futility, but examination of relevant scenarios provides some reassurance that the rebalancing of the oil market will not be materially affected. Assuming a 2% drop in UK GDP, as a result of EU exit negotiations, likely results in a c.1% fall in UK oil demand. Globally, this means demand dented by under 0.02%. Goldman estimate that even if European and US GDP fall 0.5% and 0.25%, as a result of Brexit, the total impact on oil demand would be around 0.15% of global demand. In other words, we would still expect to see global oil demand growth of over 1m barrels per day in 2016.

How relevant are movements in sterling, and foreign exchange in general, to the energy sector?

Since 23rd June, sterling has declined 12% against the US Dollar, from $1.48 to $1.30. We believe this has had a net small positive effect on underlying earnings for UK oil and gas companies, as the stronger dollar feeds through into US dollar-based production revenues, versus a small decrease in local production costs, so increasing the total profit margin per barrel.

What future for UK oil & gas production?

The prospect of Brexit raises questions over the future of UK oil and gas production, which is predominantly sourced from the North Sea. UK North Sea oil production currently averages around 1m barrels per day, having declined from a 1999 peak of around 2.9m barrels per day.

Brexit will result in a greater constraint on movement of labour in the industry, to and from the UK. However, the labour involved is predominantly skilled, and the impact here is likely an increased administration burden rather than anything more serious.

Brexit may though result in Scottish independence, given that Scotland wants to stay in the EU. If this occurred, the upheaval for North Sea oil and gas producers would be more significant, since new agreements would need to be reached between the rest of the UK and Scotland over ownership of assets, future decommissioning liabilities etc.
Ultimately, from the perspective of energy financing, the uncertainty that comes with Brexit negotiations is the biggest negative. As Shell CEO, Ben van Beurden, recently commented: "We want to know as accurately as possible what investment conditions will look like 10 or 20 years from now,". In common with many other industries, then, the greatest danger is investment in North Sea operations being diverted elsewhere (most operators in the region have global portfolios) until the terms of exit are known.

The direct impact of Brexit may be greater for utility companies, though, given how connected the UK's electricity and gas distribution markets have become with Europe. Brexit would not remove the physical interconnectedness that now exists, but it likely reduces the UK's ability to negotiate the delivery of electricity/gas at peak loading times of year. That said, energy markets are being globalised. If piped natural gas from Continental Europe becomes too expensive, expect to see the UK negotiating larger shipments of US or Middle Eastern LNG, for example.

Looking ahead into the second half of this year for energy equities

Pulling the various supply and demand factors together, we still expect the world oil market to rebalance during the second half of 2016. We remind investors that in the 1998/1999 cycle, this point of rebalancing coincided with the trough in oil prices and the trough in energy equities. Given the move in energy equities and oil prices so far this year, it would appear that oil prices and energy equities have already started to move ahead of the rebalancing point this time around.

The factors mentioned above make us increasingly confident in a longer-term recovery to around $75 per barrel. We believe that $75 per barrel is not a big stretch in terms of affordability; at this price the 'world oil bill' will still only represent 2.5% of world GDP versus a 20-year average of 3.2%.

Energy equities have outperformed the broad market in the first six months of 2016, but remember this in the context that the MSCI World Energy Index underperformed the MSCI World Index for 91 months to the end of December 2015.

As a group, we see energy equities screening very attractively on a number of longer-term valuation metrics. While we do not expect Brent oil prices to recover to $100 per barrel in the medium term, we do believe that the profitability of the energy industry can improve significantly, as a result of both oil price rising and sustained cost control. Both will be key drivers of improvements in return on capital in the sector, and valuation metrics.

If you believe, as we do, that a recovery in the oil price to $70+ per barrel  is likely, the case for accumulating energy equities at this level looks good.


Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Tim's views are his own and do not constitute financial advice.
Published on 07/07/2016

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