Oil's winners and losers

The continuing decline in oil prices, to levels not seen for more than ten years, has been a major reason for investor nerves and market volatility in recent weeks. Sentiment has always been a major driver of stock prices and this is also true when assessing the impact of a lower oil price on environmental markets.

This is a complex picture and a sizeable knowledge gap has created a significant mismatch between sentiment and reality. For example, it is worth highlighting that far from being the death knell for the sector that some commentators predicted, many listed renewables companies proved resilient and among the strongest performers in our environmental strategy in 2015.

Slowing global GDP growth and improving energy efficiency are slowing the demand for oil. But supply side issues currently dominate. OPEC has decided that it will maintain high levels of production and capacity in Iran, and Libya is coming back on-line. Such high inventories have the potential to overwhelm storage capacity and lead to further price fall. Production from the U.S. shale industry is likely to decline this year - but not as much, or as quickly - as the OPEC producers would like to see.

Sergei Karpukhin | Reuters

A worker stands next to a pump jack at an oil field Sergeyevskoye owned by Bashneft company north from Ufa, Bashkortostan, Russia.

Oil's price decline started from north of $110 a barrel in mid 2014. In June 2015 it stood at $60 but has collapsed to a current level around $35. While analysts try to call the floor (Goldman Sachs is currently forecasting $20), it appears that low oil prices will prevail for the next couple of years. Futures currently indicate a trading range of $40-60 a barrel over this period, but most commentators are of the view that we will see a return to higher prices over the longer term.

So, what's the impact on environmental markets? We see a very limited correlation for these markets with the price of oil, but the relationship is complicated.

The winners:

The sectors set to benefit from low oil prices are those where oil is a significant input cost. These include companies manufacturing chemicals for water treatment, insulation materials, food packaging and some agricultural suppliers. Waste management and public transportation companies have substantial fuel costs and therefore tend to benefit in this environment.

As gasoline prices fall, the mix of auto sales is changing with higher sales of larger vehicles and SUVs which are fitted with more sophisticated filters and emissions control technology than smaller cars, providing opportunities for transport energy efficiency and pollution control companies.

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And losers:

Biofuels suffer from low gasoline prices. This is particularly acute for first generation bioethanol, produced from food crops such as the palm oil, sugar cane etc. where Impax has no exposure. The second generation advanced biofuels (extracted from biomass) are not affected as acutely as they are protected by a more benevolent regulatory mechanism in North America.

Investment opportunities in the water sector comprise the water utilities, infrastructure and treatment companies. Some of the water infrastructure companies also sell pumps, pipes and valves into the oil market and so have suffered some negative impact due to lower activity in this area.

The specialist oil recyclers which offer a range of services to meet the waste/dirty oil disposal and recycling for the engineering, automotive, marine and industrial sectors, are suffering lower volumes and prices, while some of the environmental consultancies are seeing fewer contracts from the oil and gas industry.

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Over the longer term, the oil industry may become a significantly smaller industry. At December's Paris Climate Agreement 195 nations pledged to keep global temperature rises to no more than 2 degrees Celsius above pre-industrial levels. This means that we may not be able to burn many of the assets that are currently valued on the balance sheets of oil companies. These assets will stay in the ground - effectively stranded.

However, the cost of oil extraction varies considerably – it will be the assets with the highest cost of extraction that are stranded first, e.g. Canadian tar sands, shale and arctic oil and companies active in these areas are likely to see their valuations significantly eroded. The actions of the lower cost oil producers (Saudi Arabia and other OPEC countries) to defend their market share aggressively even at these low price levels is consistent with a plan to maximize revenues in a world looking to constrain carbon emissions to maintain global temperatures below 2 degrees Celsius.

Currently we are focused on the winners. However, we expect some of the losers to present opportunities in the short to medium term as we gain confidence in a stabilization of oil prices.

Over the longer term, oil prices will start to rise, but investor interest in alternative sources and energy efficiency sectors has never been higher. The Paris Climate Agreement has further heightened awareness of many of the issues of burning fossil fuels and the recent stance from OPEC is interesting. It appears to be an acknowledgement from major producers that many fossil fuel assets will inevitably become stranded.

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Commentary by Jon Forster, senior portfolio manager, director at Impax. He co-manages the specialists strategy, which includes Impax's flagship fund, Impax Environmental Markets plc. Forster has over 19 years of investment experience working with both private and quoted companies. Following his graduation from Leeds University in Management Studies, he spent four years working on acquisitions at HSBC Investment Bank. Subsequently, he spent two years as a consultant to venture capital investor Alchemy Partners with particular focus on manufacturing and resource management companies before joining Impax in 2000. Follow the company @ImpaxAM.

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