Crude oil prices are slumping and this is bad news for the FTSE 100. Oil companies have a heavy weighting in the index and as the price of oil falls, the index will be dragged down with it.
As a result, many investors are now asking ‘how much lower can oil go?’ But this question is not an easy one to answer.
Complex market
The oil market is not as simple as it first appears. While Brent and Western Texas Intermediate, or WTI, are the two most commonly quoted benchmarks, there are many other different oil types that trade at a discount, or premium to the two main benchmarks based on their quality.
For example, Canadian heavy crude, or to give it its full name, Heavy West Canadian Select — WCS — trades at a discount to WTI due to higher production costs and a shortage of pipelines to move supplies to refineries. The price of WCS is only a few dollars away from $40 per barrel, a discount of around $20 to WTI at time of writing. If WCS is selling for around $40/bbl, many Canadian oil sands projects could be put on hold.
Unfortunately, the average global breakeven price, according to this data from Morgan Stanley is around $50/bbl — that includes Saudi production and offshore projects. Russia’s average production cost is around $50/bbl, while the average cost of production for North American shale, oil sands and Arctic producers is approximately $65/bbl, $70/bbl and $75/bbl respectively. So, many of these projects are uneconomic at present. At time of writing, Brent is trading at $63.16/bbl.
For this reason, in the long term, the price of oil should recover as uneconomic, loss making projects shut down. What’s more, the world is still growing and over time, as supply falls and demand rises, global supply should rebalance with demand.
However, until prices start to pick up again, the market is going to do what it does best; panic.
Indeed, some trades are now starting to believe that the price of the Brent benchmark could follow WCS down to $40/bbl, which would render the majority of global production unprofitable.
Buckle up
As the price of oil has collapsed, the shares of BP and Shell have followed suit. The two oil giants make up 14.1% of the FTSE 100 index, with other companies. that have a link to oil, accounting for another 6% of the index. All in all, around a fifth of the FTSE 100 has a link to the oil market, which is bad news if in the short term, oil falls to $40/bbl.
Still, as I mentioned above, over the long term the price of oil should recover as the supply/demand imbalance is restored. However, until then the oil market is set for a period of turbulence.