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Published quarterly, the CFA Montreal newsletter is an online publication offering content that is both interesting and beneficial to our professionals. Offering exclusive interviews, opinion pieces, information about the Society’s events and activities, industry appointments and personalities, market outlook news, and articles on a wide variety of subjects, the newsletter aims to spur ongoing dialogue among professionals in the Montreal financial industry.
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Lower oil prices : what are the impacts on the canadian equity market?

An interview with Kelly Patrick, CFA. Mr. Patrick is Partner, Portfolio Manager- Global Equity and analyst on the global Energy sector at Jarislowsky Fraser. 

Near the end of 2014, oil prices fell to five-year lows and this trend continues so far. Was it difficult to predict this significant change?

Kelly Patrick: To some extent, yes, it was difficult to predict.  We had been quite cautious around the significant amount of US oil production growth, which we felt would have an impact on global pricing. What came as a surprise was OPEC’s new stance towards a more rigid defense of its global market share within the oil market. I think the decision not to cut supply at last November’s OPEC meeting was more unexpected and led to the significant decline we’ve seen.

Previous to that decision, people expected that OPEC, and primarily Saudi Arabia, would cut back production to allow for continued growth in other sources of non-OPEC supplies, as they had done in the past. Eventually, the growth in US on-shore production became so significant that the amount they would have had to cut to accommodate other sources was probably too high.

The impact is the strongest for the energy stocks. Have we seen the biggest part of their price decrease or is there a lot more to come? 

KP: The impact has been obviously very substantial on the energy stocks in all markets. Since last summer, the TSX Energy Index has declined over 30 % which is quite severe but is less than the overall decline in oil pricng. In our view, the valuations in stock prices reflect a long-term oil price which is higher than today’s spot price (US$ 45, on January 13th). If you believed that this was the long-term sustainable price for oil, which we do not, the equities would actually go down quite a bit more.

Currently, there is clearly a glut of oil in the market that is going to take some time to work through. But the market is probably correctly assuming that at US$ 45, it wouldn’t incentivize enough investment to replace existing production levels and supply would be affected.

Our view is that certain energy stocks have been hit too hard, particularly relative to the quality of their asset base. We think that some of them are well positioned to take advantage of this environment as they have good balance sheets, strong low-costs operations and strong management. We look at Cenovus Energy, Canadian Natural Resources and Suncor, that would be very interesting for long-term investors. 

In the Canadian equity market as a whole, are there some positive impacts coming from low oil prices?

KP:  Lower gasoline price puts more money in the pocket of the consumer, and as such you may have a little more for other items.  In this context, we would look at the consumer oriented stocks such as Metro or Loblaws.   That being said, Canadian consumers are relatively indebted and they may just choose to deleverage instead given the fairly moderate benefit. 

There is also a likely benefit in the transport sector, since over 2/3 of oil is used in transport both for consumers and commercial. Another knock-on effect is a lower Canadian dollar, which could benefit into the manufacturing sector as our exports become more competitive. On balance however, given the composition of the TSX index and Canadian economy, lower oil prices are a negative for the Canadian equity market and the Canadian economy as a whole.

Is there a similar effect in the United-States?

KP: It’s quite different actually. Our view is that, in the US, lower energy prices are net benefit to both the economy and the equity market. Lower transport costs within the economy and the savings consumers get from lower gasoline prices feed through much more directly in the US towards business spending and consumption. We have been relatively positive on the US recovery and this serves to accelerate the pace of recovery. The key difference is that Canada is a net exporter of petroleum, whereas the US is a net importer. So there is no real offset in the United-States as there is in Canada; the net benefit in the U.S. is more substantial.

In the next months, which indicators or policy decisions will you be particularly paying attention to?

KP: We are going to pay close attention to OPEC’s next meeting in June. The question is to know if OPEC and the Saudis will maintain their policy around market share, as they have talked more publicly about recently. The wild card will be the impact of countries like Venezuela or Iran, where probably it isn’t that easy to tolerate such lower prices from a social standpoint. What kind of influence will they have on Saudi Arabia within the cartel? We are paying close attention to the social impact of low oil prices within these countries that are heavily reliant on oil revenues to balance their budget, which include Russia.

From a global standpoint, we are also very interested to see what step is going to take the European Central Bank (ECB) in their fight against deflation. There is an expectation in the markets that they will embark in an easing program. So there would be a pretty significant disappointment if it didn’t happen. We will soon know more about the size of the program and ECB’s commitment towards fighting deflation from a monetary standpoint. 

(Interview by Fabrice Tremblay on January 13, 2015)