The oil price has been on an epic downtrend over the past 18 month. It has gone from a high of over $110 a barrel to just under $30 a barrel. The mainstream media keep bombarding us with the facts that falling oil prices are great for the UK economy. And this is largely true because a low oil price has positive effects on the UK GDP growth figures.
But whilst falling oil prices does bring about many benefits such as cheaper fuel and lower energy bills, it does also bring many consequences to the UK economy. The biggest negative effects of a falling oil price is felt by savers, investors and retirees. Heck, I would argue that falling oil prices affects each and every one of us in a negative way. This is because some of the biggest oil companies in the world are based in the UK and the profits they make go to you and I through our pensions, ISA’s and index tracker funds.
Why low oil prices negatively affect the UK.
The UK is a net importer of oil as it uses more oil than it produces. Conventional wisdom tells us that as a result of being a net importer, a low oil price should be good for the UK economy. But arguments can be made that the UK needs higher oil prices. This may sound absurd but keep on reading to find out exactly why.
Whilst the UK is not blessed with vast oil reserves like in Brazil, Russia and Nigeria, it is home to some of the biggest oil and oil trading companies such as BP, Shell, Glencore and BHP Billion. These companies operate in regions with abundant oil so the swathes of cash they make in these overseas territories ends up flowing back to UK and into the pockets of ordinary UK citizens.
How exactly does the money flow back to the UK you ask?
When the companies above plus many other companies listed on the London stock exchange make a profit, they pay a part of the profit to investors in the form of dividends. So the more profit they make, the higher the dividend payment. And these dividend payments are made to you and I through our retirement accounts as seen below.
If on the other hand the companies make little or no profit, it can cut or even stop its dividend payments. And this is exactly what is happening right now as seen by Glencore’s dividend cut last year.With the current oil price hovering around $30 a barrel, many analysts fear that other oil companies will follow suite and start to cut its dividends. This is because many oil companies will not be making a substantial profit at current oil prices to maintain the dividend payments and thus a cut or complete stop in dividend payments will be a necessity.
How falling oil prices will affect you in a negative way
In the current low interest rate environment, many savers, retirees and investors have looked to dividend paying stocks to supplement their income. The majority of the high yielding dividend stocks are in the commodities and oil sectors so many people have shares in companies like BP, BHP Billiton (BLT) and Royal Dutch Shell (RDSB).
Even if you do not directly hold shares in these companies, you will indirectly hold them through your retirement account. When you have time, I want you to go though your pension portfolio and in specific I want you to see what assets you are invested in. Chances are, you are invested in funds that own a high proportion of BP, Shell and other oil related companies.If you own the FTSE 100 tracker fund, 12.15% consists of oil related companies. For the much wider FTSE All-Share index, oil and gas companies still make up 10.18% of the index.
With low oil prices the probability of dividend cuts are high and this have a negative effect on the income attained in your portfolio through dividends. Along with lower dividends brought about by a low oil price, you will also have the double whammy with a falling stock price thus knocking down your paper wealth.
Now you might argue that falling oil prices will be good for transport companies like airliners and thus these stocks will compensate for the fall in oil related stocks. The problem is that the FTSE100 is highly skewed in favour of oil related stocks. So even if airliners rise, you will still be hit if you own a FTSE100 index as most people due to the high proportion of oil stocks that index ‘owns.’
Just look at what has happened to the FTSE100 over the last year. It has gone from 6832 to 5779. A drop of almost 16%. It has fallen just like the oil price has.
Furthermore, over the past 10 years dividends have accounted for almost all the gains that the FTSE100 has experienced over that period. As oil companies have historically paid a higher proportion of dividends than the average London listed company, losing these dividends will be a massive loss to your wealth as you will have have lower retirement, savings and investment income.