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Crude Oil Collapse – Crude Oil Risks Remain High

OPEC strategy remains unchanged but supply worries remain

Despite the pain caused within OPEC from the Saudi/ UAE/ Kuwait strategy of “letting the market find equilibrium” the Gulf Arab states show no sign of relenting and cutting oil production. Demands for emergency meetings (requested by Iran and Venezuela) have been declined. Talks with non-OPEC resulted in Russia sticking to its position that its Siberian oil fields operate on constant flow and cannot be turned off.

OPEC policy is aimed at restoring its market share via knocking out expensive production. OPEC pumps around 31.5m barrels of global output at 93m barrels per day. The policy also reflects a realisation that production cuts would have little impact and fail to result in high prices because there is too much crude oil supply, which is still there:-

a) US Shale oil – the number of land drill rigs operating has declined to 670 from 1,609 last October. However the three areas accounting for over 90% of US shale oil production have seen so far only small declines in output; the Permian Basin 2.04m bbls/ pd, Eagle Ford 1.48m bbls/day and Bakken 1.16m bbls p/d. But the total shale oil production decline is only c. 92k bbls per day. This is relatively small 1.7% drop, in the total c.5.27m bbls per day pumped in US shale oil formations (US Energy Information Administration).

b) Iran – post the end of sanctions, Tehran can double its 1m barrels/ day OPEC export quota within six months. This new supply will be a major factor in 2016. Iran has seen production decline by 20% since 2010 and needs to ensure compliance with the conditions of the nuclear deal to meet its revised quota.

c) Libya under Gadaffi was pumping 1.5m barrels per day but since 2012 production has been between 400k- 460k. Recent talks to reopen oil pipelines to the ports of Zueitiana, Zawiya and Mellitah could result in Libyan output to nearer 800k barrels per day by 2016.

Heading into Q4 2015 and 2016 (next OPEC meeting is 4th December) the picture is that global oil supply is exceeding consumption by 3m bbls/ day (source: IEA) lifting global oil inventories. Demand is expected to grow by 1.6m bbls in 2015 and 1.4m bbls/ day in 2016 with demand and supply reaching equilibrium at the end of 2016. Only when inventories start to run down will oil prices recover.

OPEC strategy means clear winner/ loser categories

Which areas of the oil industry benefit from a low price/ high inventory? Primary beneficiaries have been oil storage companies, oil refiners, and consumers. US consumers saved $76bn in 2014 with a typical US household expected to save $1100-$1200 in 2015 if oil remains sub $50 (source: IHS).

Losers comprise oil majors (revenues and profits decline from lower oil prices), oil service companies (whose client oil co’s start cutting budgets), oil E&P (exploration and production) companies, OPEC, Russia, national oil co’s, sovereign wealth funds linked to oil receipts and a diverse list of countries deriving significant income from oil royalties/ production sharing agreements.

Whilst tempting in a review of global oil majors to see valuations as low compared to the past, it is clear that profitability is being damaged by the new oil norm. Share prices may be down 30% but profits are down by 50%+. For some 2015 dividends and earnings are converging; BP (EPS 24.47p/ annual dividend 25.7p). We are concerned at the lack of any stability in crude oil, and expect the sector will remain depressed in 2016.

Royal Mail Group….. BUY

Royal Mail Group operates via i) UKPIL (UK parcels and letters, MarketReach and ParcelForce) and ii) GLS (mail and parcels in the EU). Since privatisation in October 2013 at 330p the business has seen its revenue growth decline to 1% in both mail and parcels from 7% in 2013 and embarked on a corporate transformation programme costing between £120m-£140m pa which is primarily aimed at reducing staff overheads (£102m). Royal Mail has seen some loss of market share to more nimble competitors including UK Mail and TNT Post UK which are not bound by the Universal Service Obligation (to deliver to the whole of the UK).

Company Royal Mail Group
 Share Price (p) 465
Target Price (p) 540
52 Wk Hi/Low (p) 527/390
Shares O/S 1bn
Market Capitalisation £4.65bn
Avg Daily Volume 1.11m
Dividend Yield 4.46%

Key Catalysts

Royal Mail has significant fleet distribution and conveyance costs (2015 £821m – 5%) these are likely to decline by a further 5% in 2016 or c.£41m. These savings are in addition to the £80m cost savings from the transformation programme and financial savings from the recent €500m 2.375% bond issue and other bank facility savings. All together these comprise positive profit impacts during 2016.

Source; Fidessa plc

Key Risks to Price Target

i) Royal Mail Access contracts are governed by Ofcom which is tasked with regulating competition in the UK postal sector.

ii) Sensitive to fuel prices and distribution costs alongside structural changes in the mail market caused by email marketing.

iii) UK government is a likely seller of its 15% of Royal Mail Group shareholding a short term risk.

Wizz Air Holdings….. BUY

Wizz Air owns/ operates 63 A320 aircraft primarily to central and Eastern Europe on a network of 380 routes from 22 bases. In the UK it operates out of Luton Airport where it competes with Easyjet and Ryanair for the budget traveller. At the Paris Airshow in June the board signed a commitment for 110 new Airbus A321neo aircraft (worth $12.5bn) with new deliveries starting in November 2015. The board reported Q1 results, revenues of €332.5m (+12.7%) and net profit of €32.9m (+12.5%) and indicated their expectation for Wizz Air to report underlying net profit of between €175m and €185m for 2015. The profit forecasts are dependent on recent passenger growth (Q1: 4.9m +20.3%) continuing to rise, alongside improved efficiencies in load factor and costs.

Company Wizz Air Hldgs
 Share Price (p) 1907
Target Price (p) 2300
52 Wk Hi/Low (p) 1897/1250
Shares O/S 52.36m
Market Capitalisation £1bn
Avg Daily Volume 63k
Dividend Yield 0%

Source; Fidessa plc

Key Catalysts

Annual fuel costs (c.€450m) comprise c.38% of operating expenditure and is the major variable in the cost base. A decline in fuel prices is expected in 2015 and 2016 to assist profits but the net outcome will depend on hedging of the $/ € and the growth in ASK (available seat km). Overall we are impressed by the strong performance of the network (with new routes to Nice and Baden Baden added in August) and with passenger growth. We expect higher institutional ownership in 2015/2016 now Wizz is in the mid cap index.

Key Risks to Price Target

i) Pricing of air travel on short haul EU routes is increasingly competitive, average revenue per customer has declined 6.3% during Q1 2015.

ii) Sensitive to crude oil prices and other costs such as airport hubs outside of the control of Wizz

iii) Wizz Air IPO took place in February 2015, hence limited period/track record as a listed co.

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