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Investment Insights

Exploiting Opportunities Amid A Secular Commodity Downturn

Commodity prices could be pressured for several more years.

Shawn T. Driscoll, Portfolio Manager

Executive Summary

  • Commodities are still in the middle stage of a secular downcycle that may last several more years, driven by an imbalance between global supply and demand.
  • With the surge in U.S. oil production and productivity, we expect oil prices will average USD $40 to USD $50 per barrel longer term but could possibly hit USD $30 per barrel in 2019 or 2020.
  • Despite these challenges, there are pockets of opportunity, including specialty chemicals and other industries, that benefit from lower commodity prices.
Q. Why should investors consider a natural resources strategy for part of their portfolio?

First, there are always opportunities to invest in quality companies benefiting from broader commodity trends, even in a depressed era for commodities. Investing in natural resources has historically provided an effective hedge against inflation—and deflation for that matter.

Historically, natural resources equity performance has run somewhat counter to overall equity performance, so the sector can provide diversification and help offset weak performance in overall global equities. Commodities also can provide currency diversification because they have a negative correlation with the dollar. When the dollar strengthens, commodities tend to really struggle, but when the dollar weakens, they have tended to do extraordinarily well. 

Even when natural resources lag the overall market, we believe attractive performance can still be achieved. We don’t expect the energy sector to outperform broader equity markets for a sustained period, but there have been times, as in the second half of 2017 and early 2018, when energy prices and stocks surged due to any number of catalysts. Even from 1986 to 1999, a challenging period for commodities, there were several significant price rallies. So it makes sense to keep some allocation to resources for their potential diversification benefits. 

(Fig. 1) A Volatile Trend in Oil Prices
Wide fluctuation in oil prices since 2014
As of December 31, 2018 

Past performance cannot guarantee future results.
Sources: U.S. Energy Information Administration and Chicago Mercantile Exchange.
Note: West Texas Intermediate (WTI) reflects the U.S. price for oil, and Brent crude reflects the global oil price.
Both declined sharply from 2014 to mid-2016 before recovering, only to crash again toward the end of 2018. 

(Fig. 2) The Real Price of Oil Since 1861
Prices above USD $40 per barrel are unusual
As of December 31, 2018

Past performance cannot guarantee future results.
Sources: BP Statistical Review, Ned Davis Research, and data analysis by T. Rowe Price. 

Q. Oil prices have been on a roller coaster in recent years. U.S. crude oil prices fell from roughly USD $110 per barrel in June 2014 to about USD $26 per barrel in February 2016 and then recovered to USD $76 per barrel in October 2018 before plummeting to the mid‑$40s at year‑end. The Brent oil price, the global oil benchmark, followed a similar pattern in which it hit a four‑year high of USD $86 per barrel in October 2018 before falling to around USD $50 per barrel at year‑end. Then, prices suddenly rebounded at the start of this year. Given this volatility, what is your outlook for oil prices?

The rise in oil prices from early 2016 to October 2018 reflected strong global demand, production limits by the Organization of the Petroleum Exporting Countries (OPEC), political instability in the Middle East, and a weaker U.S. dollar. However, higher prices provided incentives for additional rigs to come online and increase production, pressuring prices.

Moreover, while demand has been very strong in recent years, we’ve been in a global oversupply market for some time, driven by the surge in U.S. shale oil production and productivity. U.S. exploration and drilling have increased dramatically since mid-2016, and oil prices above USD $50 per barrel incentivize the drilling of new wells.

While some market participants expect a return to higher oil prices, we expect prices for U.S. crude, or West Texas Intermediate, will average from USD $40 to USD $50 per barrel over the long term. That ultimately depends on the degree to which technological innovation in shale continues to improve productivity and compress drilling break‑even costs. However, when you look at a chart of real oil prices over the past century, prices above USD $40 per barrel (in 2014 dollars) are considered unusual.

Our current outlook for oil prices in 2019 is subdued. We believe that estimates for U.S. production are too low. There are more than 7,000 drilled and uncompleted wells that are waiting to bring production online once temporary infrastructure bottlenecks have been resolved. Productivity continues to increase, and we expect the cost curve to continue falling. The recent extension of the OPEC cuts may help keep prices from collapsing, but we do not believe the OPEC cut in production is bullish. The longer oil prices are above USD $50 per barrel, the more incentive it provides to increase supply, particularly North American shale.

Opening Quote Our current outlook for oil prices in 2019 is subdued. We believe that estimates for U.S. production are too low. Closing Quote

(Fig. 3) The Commodity Supercycle Ended in 2011
Relative commodity performance since 2000
Total return indexed to 100, December 31, 1999, through December 31, 2018 

Past performance cannot guarantee future results.
Sources: Standard & Poor’s and Morgan Stanley Capital International.
Note: Chart reflects performance of the S&P 500 Index, the MSCI All Country World Index (ACWI), and
the S&P Goldman Sachs Commodity Index since 2000.
MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI. 

(Fig. 4) Global Equity Sector Performance in 2018
Energy remains an index laggard
MSCI All Country World Index sector performance, December 31, 2017, through
December 31, 2018

Past performance cannot guarantee future results.
Source: RIMES.

While nominal prices below USD $40 per barrel are probably unsustainable for many producers, we believe that the all-in break-even costs of the lowest-cost producers are in the USD $50 per barrel range and falling—so the supply destruction needed for a sustained oil price recovery will not be easily achieved longer term.

When oil prices are above the incentive price to produce, it is very easy to saturate the market. Supply comes on, demand decelerates, and the next thing you know, you are at USD $30 per barrel oil. It would not surprise me if that happens this year or in 2020. That’s the future of oil, because of how much technology has changed and how quickly you can bring on low-cost supply.

We believe that the current scenario for oil/commodity prices resembles the 20-year bear cycle in the 1980s to 1990s. Again, this is due in large part to the emergence of short-cycle, low-risk, non-OPEC production of North American shale. And we’re only recovering less than 10% of the shale oil in place. We have a long way to go. The cost curve is also collapsing on a global scale, with many new offshore projects becoming economical even at lower prices, such as the Johan Sverdrup oil field just off Norway, which is expected to start producing toward the end of 2019. 

(Fig. 5) The Boom in U.S. Oil Production
U.S. field production of crude oil
As of December 31, 2018 

Sources: U.S. Energy Information Administration and T. Rowe Price. 

Q. In the oil bust of the 1980s, profit margins in the oil services industry fell below zero, and almost a third of publicly traded oil services and exploration and production companies went out of business. Over the past four years, 365 public and private energy companies in North America have filed for bankruptcy, according to the law firm Haynes and Boone. Do you expect to see more?

We’re probably not completely out of the woods, but near term it’s hard to push companies into bankruptcy with oil at around USD $50 per barrel. A lot of balance sheets have been cleaned up, and some of the companies that went bankrupt are back with clean balance sheets. But we expect oil prices will ultimately go a lot lower to balance long‑term supply and demand, which would result in more bankruptcies. There is so much hidden leverage in the business that a company can build up debt very quickly in a lower-price environment.

Important Information
The specific securities identified and described do not represent all of the securities purchased, sold, or recommended for the portfolio, and no assumptions should be made that the securities identified and discussed were or will be profitable.

This material is being furnished for general informational purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, and prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date written and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request.

It is not intended for distribution to retail investors in any jurisdiction.

USA—Issued in the USA by T. Rowe Price Associates, Inc., 100 East Pratt Street, Baltimore, MD, 21202, which is regulated by the U.S. Securities and Exchange Commission. For Institutional Investors only.

© 2019 T. Rowe Price. All rights reserved. T. ROWE PRICE, INVEST WITH CONFIDENCE, and the Bighorn Sheep design are, collectively and/or apart, trademarks of T. Rowe Price Group, Inc.

201901-714879

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