Last week it cost me £70 to fill up my car, about £25 less than it cost 18 months ago and the first time in 10 years I have paid less than a pound per litre. For someone like me who does a lot of driving, looking at real estate around the UK, that should be good news. I have more in my pocket to spend and conventional economics says that the 30 million drivers like me in the UK should, therefore, boost consumer spending.
But that does not seem to be happening. Why?
Oil prices have fallen from $110 to $30 per barrel over the last 18 months. Demand has remained pretty constant but supply has increased significantly owing to the advent of large-scale fracking, particularly in the US, the response of Saudi Arabia and OPEC flooding the international market to reduce prices and the recent nuclear deal allowing Iranian oil exports. Globally, we are producing more oil than is needed and this month the Economist summarised the result:
The effect of this decline in prices has been dramatic in the 10% of the world economy made up of oil-producing nations. Russia has cut 10% of public spending, Saudi Arabia has cut both public spending and subsidies and Venezuela is in its worst recession for 70 years.
Those of us living in nations responsible for the remaining 90% of GDP benefit from lower prices of transport and manufacturing. But there is a significant proviso: such a sharp decline in oil returns and the knock-on effects on oil producers lead to declining confidence in global markets. Oil-producing firms have put $380bn of investment on hold, despite the fact that only 6% of global supply is uneconomic at $30 per barrel. Declines in oil revenues are contributing to the damage to global stocks, which are in bear market territory, having declined more than 20% from their recent peaks.
So, although consumers are feeling wealthier, having reduced their savings considerably in recent years to support consumption, there is an argument that households will want to rebuild savings, which is more difficult, as the fall in oil prices has caused inflation to sharply fall. Additionally, there are suggestions that employers are using the low rates of inflation to keep pay increases low, which also lessens consumer spending.
As with any market, oil prices are cyclical and most commentators agree that, as investment and supply declines, prices will recover. However, where $100 per barrel prices seemed to be the new normal five years ago, prices now look to be settling at a new lower long-term level. It is this major re-adjustment which is helping to depress global markets and making consumers nervous to increase spending.
What does this mean for UK real estate?
First, yields are at historic lows. Although the memory of the price correction, which followed quantitative easing and very low inflation post 2007, still looms large, the gap between real estate yields and the risk-free rate (10-15 year gilts) remains wide. In an environment of continuing ultra-low interest rates UK real estate provides an income stream in an established, regulated, transparent market with reasonable liquidity. It looks like a relatively safe haven, offering a healthy premium to gilts and cash and positive returns, unlike equities. This should encourage continuing net inflows into the sector, albeit at a slower rate than last year.
Second, the lack of consumer spending boost means that investment into the high street should remain limited. High street retail yields have compressed since 2013 in common with all real estate, but not as much as other sectors.
Third, investments with tenants linked to the oil industry will have their covenants carefully scrutinised and there is likely to be outward yield movement.
Finally, geographic areas dependent on oil or with an oil-related supply chain will be less appealing. This is particularly bad news for Aberdeen and is likely to further compound the damage that continuing political uncertainty in Scotland has done to reduce investment inflows.
Jos Seligman, Transaction Manager