Falling oil prices worry institutional investors

Pension fund executives, money managers and consultants are keeping a close eye on the potential downward pressure on financial markets and institutional portfolios due to recent sharp falls in the oil price.

Money management executives cited a case of oversupply and a reluctance by the Organization of the Petroleum Exporting Countries to cut production as the price continues to plummet. The recent sharp falls in the oil price reflect OPEC putting the squeeze on non-OPEC producers (primarily shale oil), to see who will blink first,” said executives at Schroders PLC in a statement issued Jan. 6.

As Pensions & Investments went to press, the price of oil had dropped to $48.36 per barrel, from a high of $107.26 a barrel in June last year.

The impact of low oil prices is mixed, but already are being acknowledged and felt by institutional investors.

“There is a lot of concern from clients,” said Tapan Datta, London-based head of asset allocation at Aon Hewitt. He said discussions are taking place among investors, looking at how to “protect themselves if things go seriously wrong. There is no doubt that it should be considered.”

One of the main concerns for pension funds would be the link between falling oil prices and lower inflation.

Pension fund liabilities are where the oil price drop could “bite,” said Mr. Datta, with falling inflation leading to even lower bond yields, and a subsequent rise in liabilities.

“Everybody is worried that the price (of oil) doesn't seem to have a floor at the moment,” added Alastair Gunn, U.K. equities portfolio manager at Jupiter Fund Management PLC in London. “It is making equity holders quite jittery about dividends, and is making bondholders jittery about the risk of defaults.”

Pension fund executives are certainly paying attention. Ricardo Duran, spokesman for the $189.7 billion California State Teachers' Retirement System, West Sacramento, said the bulk of the fund's oil holdings are in the global equity and fixed-income allocations. As of Dec. 31, the $107.8 billion global equity portfolio invested about 5.9% in the oil and gas sector, covering areas such as exploration and production, refining and marketing, and storage and transportation, he said. That equates to about $7 billion.

Just less than 8%, or about $1 billion, of the $13.4 billion fixed-income credit portfolio is in oil, invested mostly in the independent and integrated energy sectors, in midstream holdings, oil field services and refining, he said.

“(The falling oil price) has exerted a downward pressure on the portfolio,” the spokesman added in an e-mailed comment.

CalSTRS executives are “closely monitoring the situation before determining what, if any, moves to make,” said the pension fund spokesman. “CalSTRS is a long-term investor and, while the drop in oil prices has been a cause for some concern, we have to balance that against growth opportunities the situation may create in other sectors of the economy in which we're also invested.”

“People are interested in what's happening and are worried about the dislocation that has happened,” said Hans Olsen, New York-based head of investment strategy within Barclays Bank PLC's wealth and investment management division.

“In the U.S., (oil) has been a great area for capital expenditure and jobs. But at the same time there is an enormous tax cut happening right now for consumers, especially in the U.S. There is a wealth transfer, which will have a positive impact elsewhere in the economy.” The reduced cost of running a car is “money that will end up being spent elsewhere,” he said.

There are both opportunities and pitfalls, said managers and pension fund executives.

“The sharp fall in oil services stocks and oil exploration stocks has tended to garner the greatest attention. Overall, however, our view is that the effect is neutral to mildly positive to the economy and our portfolio,” said Peter Wallach, head of the £5.8 billion ($8.8 billion) Merseyside Pension Fund, Liverpool, England. Mr. Wallach did not disclose precise figures for the fund's exposure to oil and energy.

While there are many “imponderables,” Mr. Wallach said it is important not to lose sight of the positives, with oil-importing countries, and transportation and consumer-driven sectors set to benefit.

On the equities side, Mr. Olsen predicted little pain, particularly for U.S. investors. “State pension funds in the U.S. have about 50% invested in public market equities. If you map to MSCI ACWI, the energy sector is about 8% of that.” He said that equates to a fairly small exposure, “and that is assuming these pension funds are hugging their benchmarks.”

It is a different story for the U.K. “Actual exposure to the energy sector is meaningful to the U.K. market,” said Mr. Datta. Weighting in the U.K. market to energy is only a little short of 15%.

That could spell trouble for passive U.K. equity investors should low prices hang around. “There is significant scope for the big oil producers to cut their (capital expenditure), benefiting their cash flow position,” said Matthew Tillett, London-based portfolio manager at Allianz Global Investors. “But if oil stays at $50 for the next five years, then there will be more of a problem. Dividends will certainly be at risk under this scenario. This would be problematic for the U.K. equity market — and those that invest in it — given it relies heavily on this sector for its dividends.”

But executives agreed a sustained period of low oil prices is unlikely.

For those invested in high-yield credit, the problem is more pressing. Mr. Olsen said 15% to 18% of the U.S. high-yield market is exposed to energy. “That is the thing that I'm watching for,” he said. “We are already seeing that impact hit — overall returns last year were fairly anemic ... but the longer energy prices stay at this level or continue to fall, the higher the probability of a problem in the U.S. high-yield market.”

The oil price decline also already has affected inflation. Figures released Jan. 7 by Eurostat, the European Union statistical office, showed the eurozone's annual inflation is expected to be -0.2% in December 2014, down from 0.3% in November. Eurostat attributed the fall to the drop in energy prices. Azad Zangana, London-based senior economist at Schroders, wrote in a commentary that day that the collapse in global oil prices has “had a big downward impact.”

But without a crystal ball to tell how sustainable this low oil price is, pension fund executives should keep in mind they are long-term investors.

“They can ride out the volatility as long-term investors,” said Jon Winslade, vice president, Europe, Middle East and Africa asset owners, channel management, at S&P Dow Jones Indices in London. “Staying where they are makes perfect sense for now. But if we do move into a new global paradigm of $50 or $40 per barrel, then that is where we will start to see pension fund executives playing around within their asset allocation.”