The new coronavirus had already provided a demand-side shock to energy markets, and Russia surprised investors by not agreeing to the production cuts proposed by Saudi Arabia last Saturday. This conflict led to authorities of both countries discounting oil prices on the market.
Unsurprisingly, this triggered a bloodbath in capital markets. In the early hours of Monday, Brent crude declined a staggering 30%. Even though prices recovered somewhat (about 8% Tuesday morning), the mid-day performance of energy commodities on Monday wasn't pretty.
Source: Bloomberg data as of March 9, 11 AM
The repercussions of falling oil prices are being felt by major equity markets in the world as well. According to data from Reuters, Singapore entered bear market territory, and the Dow is on the verge of following suit. These are trying times for investors, and energy sector stocks are collapsing.
| Company | Share price daily change on March 9 |
| Exxon Mobil Corporation (XOM, Financial) | -12.24% |
| Chevron Corporation (CVX, Financial) | -15.37% |
| Royal Dutch Shell (RDS.A, Financial) | -17.13% |
| TOTAL S.A. (TOT, Financial) | -17.84% |
| Occidental Petroleum Corporation (OXY, Financial) | -53.41% |
Source: Bloomberg
Amidst this chaos, the million-dollar question is whether investors should run for safety or look for opportunities. According to empirical evidence, the latter is the correct choice. However, to do this effectively, a thorough understanding of the sectors that would benefit from low oil prices is needed.
This is nothing like before, and oil could head even lower
Many popular media companies are comparing the current oil price crash to the Gulf War era in 1991. However, International Energy Agency director Fatih Birol disagrees.
“The situation we are witnessing today seems to have no equal in oil market history. A combination of a massive supply overhang and a significant demand shock at the same time.”
Goldman Sachs analysts share the same view. In a note to investors on Sunday, an analyst wrote:
“This (oil price war between Russia and Saudi Arabia) completely changes the outlook for the oil and gas markets, in our view, and brings back the playbook of the ‘New Oil Order’, with low-cost producers increasing supply from their spare capacity to force higher-cost producers to reduce output. Possible dips in prices to operational stress levels and well-head cash costs could see Brent trading at $20. At those levels, we will witness acute financial stress and declining production from shale as well as other high-cost producers. Those wondering what is the worst-case scenario for oil prices, consider that Brent traded at an all-time low of $9.55 a barrel in December 1998, during one of the rare price wars that Saudi Arabia has launched over the last 40 years, similar to just now.”
Because adverse factors are affecting both the demand and supply side, it seems likely that oil prices could remain suppressed for longer than investors initially thought. This changes the investing landscape dramatically, as investing in the wrong sectors could lead to a period of disappointing returns.
Airlines set to benefit immensely, but at signficant risk levels
It’s important to distinguish between the two external forces that are driving the performance of stocks at present: the new coronavirus and the oil price war. From these two, it’s more likely that COVID-19 will be short-lived in comparison to the pressure that is driving energy prices down. When this is incorporated into the investment decision-making process, it’s easy to realize that airlines will benefit immensely in the longer term, as expenditure on crude oil is one of the biggest costs for these companies. However, investors should be careful when considering betting on this sector for a couple of reasons.
First, there will be a significant drop in global travel activities in the short to medium term, which would not enable them to capitalize on low oil prices. Second, corporate travel activities might drastically reduce. Companies might no longer want to spend on travel as long as business activities remain subdued and margins remain compressed.
The cyclical nature of the industry might also prevent airline stocks from taking off, as the negative sentiment of investors will stay the same until economic growth resumes (which might take a couple of quarters at least).
There are, however, many airlines that will do well in the long term. Warren Buffett (Trades, Portfolio) recently invested more in Delta Air Lines (DAL, Financial). However, such an investment will only suit long-term oriented investors.
During the oil price crash in mid-2014, many companies representing this sector provided stellar returns to investors, while some industries lagged the broad market. This is a good indication of what to expect from airline companies if oil remains under pressure for a prolonged time period.
| Company/Index | Price-performance between June 20, 2014 and July 29, 2015 |
| S&P 500 Industrials Index | -1.3% |
| Delta Air Lines | 11.6% |
| Southwest Airlines (LUV, Financial) | 30.1% |
Source: Reuters
Investing wisely after carefully analyzing the fundamentals of airline operators could deliver very attractive returns in the next couple of years. However, it’s important to find companies that would generate strong earnings even if oil recovers significantly from the recent lows, as there’s a high probability of such an occurrence if coronavirus fears subside earlier than markets are factoring in. The demand side shock will cease to exist with the disappearance of the Covid-19 threat.
A win for transportation companies
Freight companies stand to benefit from low oil prices as well, but once again, reduced business activities could negatively impact the demand of this industry, which might offset the benefits of declining energy prices.
However, despite the spreading of the new coronavirus on a global scale, the International Monetary Fund, the World Bank and the Federal Reserve are modeling in a few basis points decline in global economic growth as governments around the world are intervening with monetary and fiscal policy directives. Therefore, I believe it is unlikely that business activities will remain subdued in the second half of this year. Under these circumstances, transportation sector companies become good plays to ride out the uncertainty in oil prices.
FedEx Corporation (FDX, Financial) is one company to keep an eye on, as fuel is one of its largest operating expenses. For example, for the fiscal quarter ended on Nov. 30, 2019, fuel cost accounted for approximately 5% of total revenue. This is an indication of the benefits the company would realize with oil prices plunging at a record pace. Truck companies are also poised to reap the rewards.
Good news for automobile manufacturers
The popularity of electric vehicles has soared in the last few years, driven by higher fuel costs and increased scrutiny of regulators to minimize damage to the environment. There is reason to believe that the demand for vehicles (especially electric vehicles) and energy prices are negatively correlated.
A research report prepared in 2009 by McManus Walter at the University of Michigan Transport Research Institute reports a sensitivity analysis that was conducted to measure the decline of automobile sales under various oil price scenarios. This study indicated that the higher the price of gasoline, the greater the loss of demand for new vehicles.
Source: Natural Resources Defense Council
With oil prices under pressure, it’s possible that the demand for vehicles will go up in the future, especially considering the expected growth in household disposable income across many regions of the world.
Takeaway: hunt for bargains in the right sectors
The oil price crash sent markets into free fall on Monday. Investor sentiment, which has already taken a hit from coronavirus fears, received another shock in the form of an oil price crash.
The key here is to objectively assess the impacts of these developments This is not the first time such a phenomenon has happened. Even though this could be nothing like we have seen before, chances are that energy prices will rebound in the long term as economic growth resumes. The prudent thing for investors to do is hunt for attractively priced companies in sectors that will benefit from low oil prices. At the same time, there’s no need to dump energy stocks either. Turning volatility into opportunity is critical to the success of an investor.
As Warren Buffett (Trades, Portfolio) once said, “The true investor welcomes volatility. A wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses.”
Disclosure: I do not own any stocks mentioned in this article.
Read more here:
- Warren Buffett Bets on Delta Air Lines Again
- Learning from Peter Lynch: How to Survive a Market Correction
- A Good Reason Why You Should Stay Invested Despite the Bloodbath
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