City Insider: Oil price drop brings January cheer

City Insider - FT journalist David Stevenson on the travel industry

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In the first of a two-part analysis, City Insider David Stevenson considers the impact of a falling oil price on the economy, the markets and the travel sector

Global stock markets started the year in a sour mood. Maybe it’s because too many City types spent their post Xmas break stuck in those snowy traffic jams exiting the Alps.

Or maybe investors are (over)reacting to the collective outpouring of worry and fear that tends to come with the start of any new investing year – it’s a time for weighty research tomes forecasting the risks of investing to thump down on investor’s desks.

In fact, I’d go so far as to say I’ve never quite experienced such an odd contrast. Most signals from the real world suggest that both the UK and the global economy is in decent form (though not exactly storming ahead) and US investors in particular have had a great 2014.

As we’ll discover there is plenty of reason to be cautiously hopeful. But investors don’t seem terribly impressed.

Many are fixating on the downside risks – with most attention focused on oil, Greece and impending elections.

So given this slightly sour mood, what should the travel sector watch out for in the coming year?

The obvious big global story is the price of oil. The race to the bottom continued with US West Texas oil pushing below the psychologically significant $50 a barrel level last week while Brent prices hit $53.

This dramatic decline in prices is having a knock on effect throughout the commodity markets, with natural gas prices also falling – even industrial metal prices are declining.

The consensus among most City-based pointy heads is that this dramatic price decline will bottom out fairly soon, especially as OPEC members start to feel real pain.

Personally, I don’t believe a word of this – my guess is that oil prices could bottom out at around $20 a barrel. Yep, you read that right, prices have got much further to fall.

Paul Jackson, a respected City commentator who now works for a firm called Source ETFs has looked at the historical record for oil prices stretching all the way back to the 1870s. He discovered that recent price declines have only brought oil back to the top-end of the $20-$60 range in which real prices have been for 80% of the time since 1870.

According to Jackson, “measured in today’s prices, the post-1870 average is $43, with a median of $36”.

After every single spike in prices above that $20-$60 range, the real price came back not to the average nor to the median but to the lower end of the range and usually stayed there for decades.

Crucially, Jackson observes that big historical swings in price have usually come from some “combination of demand/supply shocks (the Pennsylvania Oil Rush in the 1860s/1870s, OPEC embargos in the 1970s, the Iran/Iraq war in the 1980s, Chinese demand in the early 2000s) and attempts to control the market (the Oil Creek Association in the 1860s/1870s, the Texas Railroad Commission in the post-war decades and OPEC since 1973).

“Even when powerful institutions try to intervene, the oil price eventually gravitates back towards the long-run norm.”

Now the important cautionary note to put with this is that oil prices could snap back quite quickly, especially as production costs have been steadily increasing.

It also doesn’t take much in terms of supply constraints to change the direction of the market. Jackson observes that a cut of four million barrels a day in supply in 1973 (7% of free world production) led to a quadrupling of prices.

“A market that does not seem to be in massive oversupply can easily change tone,” says Jackson, “especially since the fall in the oil price will itself boost demand for the product.”

Still, a collapsing oil price is largely good news despite global stock markets going into a funk in the New Year.

It amounts to a massive injection of liquidity into the developed world (and much of the developing world, for that matter, especially Turkey, Egypt, Indonesia, India and of course China).

Of course, oil businesses will go bust and loans be left unpaid and I have no doubt we can expect all sorts of geopolitical skulduggery to emerge (from Russia, in particular) but corporate profits will rise and consumers will spend more.

The most direct beneficiaries, of course, will be the airlines and cruise giants.

Fuel tends to amount to about a third of total operating expenses at the airlines and although most airlines hedge between 0% and 50% of their coming year demand (American Airlines has no hedging policy at all), a big fall in oil prices will feed through directly into bumper profits.

My guess is that a 50% decline in the original 2015 price estimates of $105 a barrel will push up EBITDA margins by as much as 10 points after a couple of quarters.

The key question then becomes what happens to capacity. We’re already seeing a steady stream of new aircraft deliveries to all major airlines and my guess is we’ll see a steady but noticeable increase in overall capacity in Europe.

This could prompt someone like Ryanair to start a price war – pushing some of its weaker competitors over the abyss.

The reverse is likely to happen among the big flag carriers – capacity is likely to be scaled back, allowing profits to rise, which should be good news for IAG.

Over in the cruise sector most of the big delivery programmes for new ships are pretty much locked in and I can’t see capacity being tweaked too much. Margins should bounce back up in the absence of a price war.

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