Oil like other commodities is priced using a function of supply and demand, but it has been shown historically to be very difficult to accurately forecast.
The below chart takes the spot price and adds the ‘tails’ of consensus oil price forecast over the next 3 and 12 months. Hardly filling me with confidence.
So, last week came the release of Goldman Sachs updated research and oil price forecast and along with it some sensational headlines suggesting oil to reach $20 a barrel. It is only much further down the articles if at all that there is any mention this, in GS’ opinion, is a worst case scenario.
With closer inspection Goldman Sachs don’t class this as their base case, they have reduced their 2016 prediction from $57 to $45 a barrel whilst the 2017 forecast remains unchanged at $60 a barrel. Their rationale for this does on the face of it seem reasonable, a supply glut coinciding with a slower growth in demand. The fact remains that this is still the same GS that in 2008 were predicting oil could reach $200 a barrel in 2009. Their base case a more modest $105 was still far too optimistic with Oil trading in the range of c$30–c$80 throughout 2009.
So how can they, not just GS, get it so wrong so often?
If it was a simple supply demand relationship they may get a lot closer but life isn’t simple. Geopolitics, economics, technology and geology all factor into the final price and it is hard to reliably forecast any one of these. That’s before you consider major events such as war or disruption to the transit of oil. You could easily argue that a correct forecast owes as much to luck as skill.
What we do know though is that the price of oil is far lower than it has been, down c60% over two years. Whilst this could be seen as a tailwind for oil importing nations it is a headwind for oil exporters. It also impacts on individual companies; some may benefit but others undeniably will be challenged by this.
Earnings growth for UK companies is contracting at about 13% over a year and 18% annualised over 6 months. However when you strip out oil/gas and basic material companies it is closer to minus 7% and 8% respectively. This isn’t great but by targeting our investments away from those facing heightened downward earnings pressure we should see better returns.
We have for a time now been underweight and reducing our exposure to areas that have significant exposure to oil and other commodities for that matter. We have also been focusing on smaller companies where we see better earnings growth potential.
We don’t tend to invest in commodities and whilst not wanting to fall into the trap of forecasting an oil price (let’s face it there are enough incorrect estimates out there) we do need to be cognisant of what this means for our investment choices.
By positioning our UK equity portfolios in those areas we think have better attention, and avoiding those where we see the most risk, we have recently seen substantially different performance to the UK market. For example, over the 6 months to 14 September our small-cap biased UK Dynamic portfolio UK funds returned 9.89% whilst the FTSE 100 was down 7.76% over the same period. Even the more large cap UK Conservative Equity portfolio made a positive return of 0.87% in this period.
There is of course no guarantee that this big difference in performance can be repeated, but we continue to believe positioning in this way gives a potential for higher risk adjusted returns over the coming months.
The content contained in this blog represents the opinions of Equilibrium investment management team. The commentary in this blog in no way constitutes a solicitation of investment advice. It should not be relied upon in making investment decisions and is intended solely for the entertainment of the reader. You should be aware that the value of an investment can go down as well as up, and no guarantees as to the future performance, income or capital growth are given expressly or by implication.