BlackRock Investment InstItute

concentRated paIn, wIdespRead gaIn dYnamIcs oF loweR oIl pRIces

february 2015

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SummaryOil prices are on a slippery slope. The pain of lower prices is acute and concentrated among oil-exporting nations and energy companies. The gains are widely dispersed and will likely be felt for a long time by oil importers and global consumers.

The massive wealth transfer is set to boost developed economies to varying degrees. and it is sure to amplify economic and market divergences in the emerging world. We debated the prospects for the oil price, winners and losers, and risks and opportunities in asset markets. Our main conclusions:

} The crude crash is dramatic—but not unprecedented. falls of similar magnitude in the past stimulated consumer spending, helping to reinvigorate global economic growth. We think crude prices are bottoming and see them modestly higher next year.

} It would only take a moderate shift in demand to restore balance to the oil market. Spare production capacity amounts to just 4% of total demand, versus around 18% in the mid-1980s, energy Information administration (eIa) data show.

} Soft demand and a strong u.S. dollar have helped bring down the oil price, but ample supply is the root cause of the decline. New technologies such as hydraulic fracking unearthed plentiful supplies of u.S. shale oil while the Middle east kept up production despite conflicts ravaging the region.

} Supply is here to stay: Key producer Saudi arabia looks determined to keep pumping oil under new leadership. Overall u.S. supply is set to rise this year due to a backlog of wells and price hedges sheltering producers from the downturn. Declining capital spending (capex) and fewer drilling rigs in operation point to a slowdown in production growth in the second half of 2015 and beyond.

} Cheap energy is a game changer for monetary policy in oil-importing nations, especially in emerging market (eM) economies. It reduces inflation, giving some central banks room to ease—and others leeway to raise rates more gently. Low oil prices also reduce the costs of energy and food subsidies, providing fiscal relief.

} Low oil prices add to growing divergences in the developed world. The eurozone and Japan are set to keep rates near zero and have rolled out bond-buying programs to halt disinflation. The u.S. federal reserve, by contrast, is likely to look beyond oil’s disinflationary effect and start hiking interest rates in mid-2015.

} Winners in this climate should be global consumers, oil importers such as India and Japan, and the transport and retailing industries. Oil-exporting nations and companies with limited cash buffers and poor access to debt markets (think Venezuela or overleveraged u.S. shale plays) look to be the biggest losers.

} The oil price slump is bludgeoning u.S. high yield energy issuers. Many have been outspending their cash flow and now face a crunch as financing dries up. They are in survival mode, resorting first to capex and job cuts. Most should be able to ride it out. yet the longer lower prices hold, the greater the financial stress.

} Valuations of global energy stocks have fallen, but selectivity is important. We favor the “super majors” because of their strong balance sheets, high dividends and integrated business models. We would avoid most oil services firms for now.

The opinions expressed are as of february 2015 and may change as subsequent conditions vary.

Poppy AllonbyPortfolio Manager, BlackRock Natural Resources Equities Team

Gerardo RodriguezPortfolio Manager, BlackRock Emerging Markets Team

Jean BoivinDeputy Chief Investment Strategist, BlackRock Investment Institute

Robert WartellHead of BlackRock U.S. Leveraged Finance Credit Research

Ewen Cameron WattChief Investment Strategist, BlackRock Investment Institute

What Is Inside

Summary .............................................2

Supply and Demand .............3–6

Winners and Losers ............7–11

energy assets ......................12–15

[ 3 ]s u p p lY a n d d e m a n d

slumps and ReBoundsreal and Nominal brent Crude Price, 1975–2015

Sources: BlackRock Investment Institute, Thomson Reuters and Oxford Economics, January 2015. Notes: The inflation-adjusted oil price is in 2015 prices, using U.S. consumer price inflation. GDP data for 2014 and 2015 are based on Oxford Economics forecasts.

PR

ICE

PE

R B

AR

RE

LY-

O-Y

CH

AN

GE

$200

10

20

40

60

100

1975 1980 1985 1990 1995 2000 2005 2010 2015

1975 1980 1985 1990 1995 2000 2005 2010 2015

-3

3%

2

1

-1

-2

0

World GDP Per CapitaPeriods With Nominal Oil Price Falls Over 50%

Iran Revolution

1980s Oil Glut

Gulf War

Asia Crisis

Nominal Oil Price

Inflation-Adjusted Oil Price

LehmanCollapse

LehmanCollapse

CurrentCrudeSlide

1980sOil Glut

Supply and Demand

weIgHIng oIl’s ImpoRtance energy Share of fixed Income, equities, GDP and employment, 2015

Sources: BlackRock Investment Institute, Barclays Capital, Thomson Reuters, U.S. Bureau of Economic Analysis and U.S. Bureau of Labor Statistics, January 2015. Notes: The U.S. economy share is based on GDP value-added for oil and gas extraction, mining support activities and petroleum and coal manufacturing as a share of total private GDP. The U.S. employment share is based on oil and gas extraction, mining support services, petroleum and coal production and gasoline station employment as a share of total non-farm employment. Other energy includes integrated oil companies, pipelines and others in benchmark indexes.

15%

10

5

0

Other EnergyExploration & Production and Oil Services

U.S. High Yield

Global IG Credit

GlobalEquities

U.S.Economy

U.S.Employment

The crude crash affects asset prices and economies around the world. energy generally has a modest weight in benchmark indexes, yet there are standouts. energy issuers account for around 15% of the u.S. high yield market. See the chart below.

The economic impact is broad but not always immediately visible. energy accounts for just 1.2% of u.S. employment, for example, but energy booms stimulate growth in local economies such as Texas or the Canadian province of alberta.

The size of the recent oil price slump is unusual—but not unprecedented. Similar sharp falls in the mid-1980s and during the 2008-2009 financial crisis were followed by swift rebounds, both in the oil price and in real (inflation-adjusted) global economic growth per capita. See the chart on the right.

On the demand side, cheaper oil helps consumers and businesses by lowering fuel costs. Indeed, our research suggests a consumer-led demand recovery could come to the rescue (see page 10). On the supply side, low oil prices force producers to cut output, setting the stage for a price recovery.

World real GDP Growth, 1975–2015

BALANCING ACT It would take only small changes to supply or demand to restore balance to the oil market (and support prices) we believe.

Sure, the market is currently oversupplied (see page 4). yet spare capacity (wells that can produce but sit idle) today amounts to just 4% of total global oil demand, versus around 18% of demand in the oil price downturns of 1983 and 1986, eIa data show.

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sWELLING suPPLIEs

Softening demand—particularly from slowing eM economies—has played a role in the oil price crash. We see this evidenced by earlier, across-the-board declines in metals and other commodities prices (see page 12). This suggests the oil price collapse is a catch-up, rather than a sign of further deterioration in the global economic outlook.

unexpected declines in demand accounted for around 35% to 40% of the fall in oil prices between June and December 2014, the International Monetary fund (IMf) estimates. Demand for oil may recover as lower prices encourage more consumption; u.S. gasoline sales hovered near 19-month highs in November, the most recent eIa data show.

yet a jump in supply is the bigger factor behind today’s oil market imbalance. advances in hydraulic fracking uncorked a plentiful supply of u.S. shale oil and gas. Increased u.S. production more than offset declines in Iran and Libya. (Note: Marginal producers such as Libya swing in and out of the market and affect prices accordingly.) See the chart on the right.

The u.S. accounted for 13.7% of global production in 2013, up from 9.8% in 2006. That helped it overtake Saudi arabia as the world’s top producer of petroleum liquids (including natural gas), according to the International energy agency (Iea). The u.S. production increase in 2014 was the fourth-largest by any country since 1965, according to bP and Iea data.

result: Oversupply stands at around 2% of global oil demand—the highest level since the asia crisis of the late 1990s. See the chart above.

cRude ImBalancesOil Supply vs. Demand, 1985–2015

Sources: BlackRock Investment Institute, IEA and Oxford Economics, December 2014. Notes: The line shows world oil demand minus world oil supply as a percentage of world oil demand. Data from Q3 2013 onward are estimates from Oxford Economics.

NE

T B

ALA

NC

E A

S S

HA

RE

OF

GLO

BA

L D

EM

AN

D 2%

Asia Crisis

1980’s Oil Glut-2

-1

0

1

1985 1990 1995 2000 2005 2010 2015

EXCESS SUPPLY

EXCESS DEMAND

tHe new swIng pRoduceRs Selected Countries’ Change in Crude Oil Production Since 2011

Sources: BlackRock Investment Institute and U.S. Energy Information Administration, January 2015. Note: The bars show the change in average daily oil production based on monthly data.

MIL

LIO

NS

OF

BA

RR

ELS

/DAY

5

Saudi Arabia

Libya

Iraq

Iran

U.S.

Total

-2.5

2011 2012 2013 2014

2.5

0

sAuDI sWITCHWill oil producers cut supply to support prices? Saudi arabia, the senior partner of the Organization of the Petroleum exporting Countries (OPeC), has often played a “swing role” in stabilizing prices. The country slashed production in 2009 but has kept it steady this time around. Saudi arabia appears fine with low oil prices for now. We do not see riyadh changing course any time soon under new leadership. reasons:

} Saudi arabia wants to protect its market share in the face of rising global production—and is wary of acting alone. The country has painful memories of losing market share when other nations did not match production cuts.

} This strategy forces high-cost producers (think shale, oil sands and deep water) to cut supply.

} The country is the world’s largest low-cost producer—and has a $736 billion war chest of foreign exchange reserves to cushion the impact on its budget.

} Low prices keep rival Iran under pressure. The Saudis view this as a nice knock-on effect, we think.

Lower oil prices will gradually turn the screws on higher-cost producers. Their likely response? Cut capital spending, jobs and costs. u.S. shale operators are particularly susceptible because they have relatively little capital invested and their wells run dry fast. This will eventually lead to falling production—although we think 2015 will be more about declining rates of growth than an absolute contraction.

[ 5 ]s u p p lY a n d d e m a n d

a matteR oF costestimated Cost base and Output of Oil-Producing areas, 2020

Sources: BlackRock Investment Institute and Rystad Energy, January 2015. Notes: The boxes represent different oil sources. The width of each box shows the level of potential production in 2020; the height shows the breakeven range for 75% of the production from that source. Dots show the average breakeven prices. The breakeven price is the oil price that gives a zero net present value using a 10% discount rate. Numbers are based on an average of currently producing, under development and not-yet-sanctioned projects.

$100

Middle East Onshore

Average Breakeven

Deep Water

RussiaOnshore

UltraDeep Water

Oil Sands

80

60

40

20

0

BR

EA

KE

VEN

PR

ICE

RA

NG

E ($

/BA

RR

EL)

ESTIMATED 2020 PRODUCTION (MILLION BARRELS/DAY)

1000 10 20 30 40 50 60 70 80 90

Offshore Shelf

Rest of World Onshore North America Shale

Extra Heavy Oil

wellIng oveR Number of u.S. rigs Drilling for Oil, 1987–2015

Sources: BlackRock Investment Institute and Baker Hughes, January 2015.

RIG

S

1,600

1,200

400

800

0

1987 1991 1995 1999 2003 2007 2011 2015

“ U.S. shale added a spectacular amount of oil in a very short time. It was not just big; it was bigger than anybody thought.”

— Robin BatchelorPortfolio Manager,

BlackRock Natural Resources Team

COsT-BENEFIT ANALYsIs North american shale operators have become the world’s new marginal producers because they are able to quickly scale up—and down. The breakeven costs of the average shale well are around $60 per barrel—way above the current spot price. This compares with just $26 per barrel for onshore Middle east oil. See the chart above. Note: averages mask a lot of differences. for example, costs for North american shale producers range from around $40 to more than $70 per barrel, according to research firm rystad energy.

High-cost producers should feel the pinch soon if prices stay low. yet production of established u.S. shale assets may take longer to slow than many expect. Consider:

} u.S. shale producers that tapped high yield debt markets have hedged as much as half of their 2015 output: The higher the risk of the field, the greater the hedge.

} Newer horizontal wells are more productive than older vertical ones.

} Shale producers are loath to give up cash flows. Once they have spent the money on upfront costs, the marginal cost of drilling extra holes is low.

We expect u.S. supply to increase in the near term. yet production growth should start to taper off in the second half.

Oil bulls point to a 24% drop in the number of u.S. oil drilling rigs from a record peak in October. See the chart below. The eIa forecasts additional declines this year but argues these are unlikely to result in a big fall in production. a backlog of wells after years of heavy drilling—three to seven months’ worth at major u.S. shale areas—will keep oil pumping.

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oIl FutuRes gaZIngbrent Oil futures Curve, 2015–2019

Sources: BlackRock Investment Institute and Thomson Reuters, January 2015.

$ P

ER

BA

RR

EL

SETTLEMENT DATE

$110

July 2014

Nov 26, 2014(Day before OPEC meeting)

January 2015

90

70

50

2015 2016 2017 2018 2019

“ A U.S.-Iran deal would be a historic event after 35 years of basically hostility. But it would take some time to implement the agreement—and for Iran to ramp up production.”

— Tom DonilonSenior Director,

BlackRock Investment Institute

HOW LOW CAN IT GO? Oil futures have slumped since OPeC members decided in late November to keep production steady despite falling prices. Markets currently are pricing in a gentle recovery in prices to $70 per barrel by 2017—but no return to the heady days of over $100 per barrel. See the chart on the right. Options markets suggest prices should end 2015 anywhere between $28 to $112, according to the eIa. Once markets narrow this range of outcomes, energy assets should start to reprice.

futures markets are in “contango,” meaning forward prices are higher than spot prices. This is encouraging a buildup in inventories as well as a topping up of strategic reserves in countries such as China. u.S. crude inventories hit highs for the month of January, according to eIa. Crude stored in supertankers reached about half of the global capacity as estimated by investment bank Macquarie. Storage demand is mitigating the oil price fall for now but should cap any rebound because stored crude is bound to come back to the market.

How low could oil go? The oil price could fall below current levels of around $45, but we believe we are close to a bottom—based on past peak-to-trough declines. We expect a modest recovery next year, but think a return to $100-plus prices is far-fetched due to advances in drilling technology (barring temporary spikes caused by supply disruptions).

INNOvATION ImPACTHydraulic fracking has proved to be a disruptive force that puts downward pressure on product prices, much like mechanization and computerization brought down food and consumer prices. and fracking has only just started: adoption outside the u.S. could have a similar impact on global oil supply.

Technological advances also have the potential to shrink oil demand. examples are hybrid cars and lightweight aluminum trucks. These are part of a broad-based trend, as shown by a decline in energy intensity of the global economy. It took the equivalent of 1 barrel of oil to generate $1,000 of GDP growth in 2011, versus 1.3 in 1990, the latest World bank data show.

energy efficiency and its impact differ across the globe. Increasing urbanization and car use should support oil demand in eM economies. China’s economy is still relatively energy intensive, requiring the equivalent of 1.4 barrels of oil per $1,000 of GDP in 2011. This suggests a recovery in Chinese growth could deliver an outsized boost to global oil demand.

GEOPOLITICAL GYRATIONsGeopolitical risks could disturb oil markets. Consider:

} Iran and the international community aim to reach a comprehensive deal by June that would see Tehran give up its nuclear ambitions in return for a phased lifting of sanctions. We would assess the chance of a full deal at less than 50% due to opposition by hardliners in Iran. u.S. Congress is promising more sanctions if no progress is made by March. any deal, however, would likely put downward pressure on oil prices—even though actual Iranian production increases would take time.

} We do not see Islamic State as a near-term threat to oil production in Iraq’s south, but cheap oil could hurt Iraq’s budget and reduce its ability to fight the militant group in the long run. Similar dynamics are at work in Nigeria. We expect Libyan oil production to be volatile as a civil war rages on, with periods of supply disruptions— and surges.

} russia faces ongoing economic sanctions due to its involvement in the escalating ukraine conflict. We expect europe to maintain current sanctions. yet we see it stopping short of additional measures that would directly target russia’s energy exports because these could further weaken the eurozone’s economy.

[ 7 ]w I n n e R s a n d l o s e R s

Sources: BlackRock Investment Institute, EIA and IMF, January 2015. Notes: The map shows estimated revenues gained or lost from a $50 fall in the price of oil as a share of GDP. The impact is calculated by taking each country’s 2013 net imports of oil, multiplying this by $50 and then translating the total into a share of 2014 GDP.

oIl spIlloveRrevenue Impact of $50 Oil Price fall, 2015

SHARE OF GDP

-10% -3% 0% 2% 4%

Winners and LosersThe slump in oil is a story of concentrated pain (net oil-exporting nations and energy companies)—and widely dispersed gain (global consumers and oil-importing countries).

The price plunge effectively is a massive wealth transfer from producers to consumers. a back-of-the-envelope calculation shows this is a big gift. The world was expected to consume $3.4 trillion of oil in 2015 assuming a $100 oil price, according to eIa. ergo, the 50%-plus price plunge should result in a benefit of some $1.7 trillion to global consumers and oil-importing nations.

Oil exporters have savings rates 25% higher than importers, according to research firm evercore ISI. This means the redistribution of wealth to oil importers should result in a net rise in global consumption and economic activity—even as exporting nations suffer.

The map below outlines the economic impact of a $50 decline in the oil price on individual countries. Gains (green) are dispersed across developed nations and most of the asia-Pacific region. Losses (purple) are concentrated in oil-producing nations in the Middle east, africa and elsewhere.

suBsIdIes savIngsOil Subsidies as a Share of 2014 GDP

Sources: BlackRock Investment Institute, IEA and IMF, January 2015. Note: Data show oil subsidies for 2013 as a share of estimated 2014 GDP.

12%

8

4

0

Oil ExportersOil Importers

Vene

zuel

a

Iran

Egy

pt

Sau

diA

rabi

a

Indo

nesi

a

Nig

eria

Indi

a

Mex

ico

Chi

na

Lower oil prices enable countries to cut or end subsidies for energy and food prices, easing budget pressures. Oil-producing nations are among the most generous, but oil importers such as Indonesia and India also used to spend big on keeping a lid on prices. See the chart above. Subsidy cuts would partly erode the benefits of cheaper oil for eM consumers.

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Sources: BlackRock Investment Institute, World Bank, Fitch, Moody’s and Bloomberg, January 2015. Notes: Energy exports are exports of oil, gas, coal and other energy sources. External debt figures are gross. External debt and reserves data are based on a composite of sources. Short-term debt is less than two years. Not all countries are tracked by the BlackRock Sovereign Risk Index.

eneRgY dependentsKey Statistics of Selected energy exporters, 2015

Energy share of Goods Exports

External Debt share of GDP

Reserves share of GDP

short-Term External Debt share of GDP

BlackRock sovereign Risk

Index Rank

Iraq 99% 2.9% — 0.1% —

algeria 97% 0% — 0% —

venezuela 97% 14.3% 2% 2.1% 49

kuwait 94% 2.2% 20% 0% —

nigeria 88% 1.7% 6% 0% 41

saudi arabia 87% 0% 102% 0% —

oman 83% 3% 21% 0% —

kazakhstan 76% 3.5% 27% 0.1% —

Russia 71% 3.4% 20% 0.8% 22

colombia 69% 10.7% 12% 0.8% 27

united arab emirates 65% 4.7% 8% 0.8% —

LOsERs AND CusHIONs Oil-producing countries are in for a rough time. This unfortunate bunch can be divided into three groups:

1. Countries that have accumulated large amounts of foreign assets: Saudi arabia, united arab emirates and Norway. They can afford to fund budget shortfalls from these piggy banks in the short run. energy makes up 87% of Saudi arabia’s goods exports. yet foreign reserves and investment income cushion the budgetary impact of cheaper oil for now. See the table below.

2. Oil producers with smaller fiscal cushions such as Mexico, Malaysia, bahrain, Oman and Colombia. They may have to resort to combinations of fiscal austerity and increased borrowing. Many countries appear to be assuming oil prices higher than $60 to $70 per barrel in their revenue projections (they are loath to disclose details)—heralding financial stress. Most, however, can easily tap capital markets because they have low external debt positions.

3. Countries with little cash and poor access to international debt markets. They are most vulnerable to sudden reversals in capital flows and currency depreciations. Venezuela and Nigeria are prime examples. energy makes up 97% of Venezuela’s goods exports, yet its foreign reserves are a paltry 2% of GDP. Venezuela is ranked second to last and Nigeria 41st of the 50 countries tracked by our BlackRock Sovereign Risk Index.

paIn poIntsfiscal breakeven Oil Price, 2015

Sources: BlackRock Investment Institute and IMF, January 2015. Note: The fiscal breakeven is the oil price at which the fiscal balance is zero, based on IMF forecasts for 2015.

Libya

Iran

Algeria

Oman

Iraq

SaudiArabia

Qatar

UAE

Kuwait

$/BARREL

$1200 40 80

Many are middle- or low-income countries running expansionary budgets—often to meet social or political goals. The oil price decline throws their budget plans and funding options upside down. forecast surpluses are swiftly turning into huge deficits. even many of the world’s low-cost producers in the Middle east were banking on oil prices of $100-plus per barrel to balance their fiscal budgets. See the chart above.

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InFlatIon BeateRConsumer Price Inflation and Oil Prices, 2005–2015

Sources: BlackRock Investment Institute, Thomson Reuters and local statistics agencies, January 2015. Notes: Emerging market oil importers are an unweighted average of China, Hungary, India, Poland, South Korea, Singapore and Thailand.

CP

I IN

FLAT

ION

Y-O

-Y C

HA

NG

E

6%Emerging Market Oil Importers

U.S.

Brent Crude Oil Price

Eurozone

-2

0

2

4

2005 2007 2009 2011 2013 2015

-60

0

60

120%

2005 2007 2009 2011 2013 2015

“ U.S. consumers and much of emerging Asia will be stronger six months from now thanks to the lower oil price. There are more winners than losers.”

— Russ KoesterichChief Investment Strategist,

BlackRock Investment Institute

WINNERs AND DIsINFLATION Most countries will likely see lower inflation, especially net oil importers in the emerging world. Consumer price index (CPI) inflation in eM oil importers has plummeted to u.S. levels over the past three years, tracking the growth rate in oil prices. and falling oil prices have dragged the eurozone back to the brink of deflation. See the chart on the right.

falling oil prices are a game changer for oil-importing eM countries such as India. They drag inflation lower, allowing central banks to ease monetary conditions and stimulate their economies. China, the world’s No. 2 oil importer, is another beneficiary. Cheaper oil could boost the country’s GDP by between 0.4% and 0.7% in 2015, the IMf estimates.

Lower energy prices may trigger additional declines in agriculture and food prices. food production is energy intensive due to the use of fertilizers. The double gain to consumers from declines in energy and food is a big positive for low-income countries with a high dependency on imports.

Countries with a high energy weight in their CPI baskets should be big winners. Poland, Hungary and Indonesia top this list at more than 15%, according to OeCD and IMf data, with India and Malaysia not far behind. Turkey, South africa and South Korea should also benefit. yields in all these countries look attractive in a near-zero-rate world. even emerging europe appears a bargain for income-starved eurozone investors.

We see commodity exporters such as Venezuela, Colombia, argentina, russia, Kazakhstan and Malaysia on the losers’ board.

Em mANEuvERING ROOmThe impact of cheaper oil on eM currency and credit markets is a tug of war. The current account balances of commodity importers will likely improve—a positive for local currency bonds. yet likely interest rate hikes by the u.S. federal reserve risk eroding the yield advantage of these countries, putting downward pressure on their currencies. Higher u.S. rates drain global liquidity because they boost the value of the world’s premier funding currency, the u.S. dollar.

Conclusion: Cheaper energy hands eM countries maneuvering room to ease monetary policy or tighten it more slowly, softening the impact of fed rate rises on their economies. See Dealing With Divergence of December 2014 for details.

POLICY DIvERGENCE Cheaper oil should add to eM policy divergences and increase dispersion in investment outcomes. Some oil exporters will likely be forced to tighten monetary policies to stem capital outflows and currency depreciations.

The impact on monetary policy in developed economies is more subtle. Cheaper energy is exacerbating already falling inflation expectations. This makes it even harder for central banks in Japan and the eurozone to hit their inflation targets. both have launched massive bond-buying programs to avoid outright deflation, boosting asset prices.

The fed is a different story. We expect the u.S. central bank to stick to its guns on raising rates in 2015, but see it going slowly and ending at a historically low level. bottom line: falling oil adds to an already divergent trend in monetary policies.

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u.s. consumeR wIndFallGallons of Gas bought With u.S. average Hourly Wage, 1991–2015

Sources: BlackRock Investment Institute, U.S. Bureau of Labor Statistics and U.S. Energy Information Administration, January 2015. Note: The line shows the U.S. average total non-farm hourly earnings divided by the average U.S. gasoline price.

GA

LLO

NS

15

10

5

1991 1995 1999 2003 2007 2011 2015

Jul 20145.7 Gallons

10.1 GallonsJan 2015

“ The relationship between energy prices and risk sentiment is not linear. Many oil exporters will see their foreign reserves decline, but the impact on their appetite for risk assets will be muted.”

— Terrence KeeleyGlobal Head of BlackRock Official Institutions Group

staRt YouR engInes!Gasoline use and Prices in Selected Countries, 2011–2015

Sources: BlackRock Investment Institute, World Bank, globalpetrolprices.com and EIA, January 2015. Notes: Usage data are based on motor vehicle gasoline consumption for 2011 and 2012 (China and Saudi Arabia). Bubbles are sized by overall consumption. Gasoline prices are retail prices as of January 2015.

0

1,000

1,500

2,000

500

US

AGE

(LIT

ER

S P

ER

PE

RS

ON

PE

R Y

EA

R)

0 0.50 1 1.50

PRICE PER LITER

$2

U.S.

Canada

Australia

Japan

China

Germany

U.K.

Saudi Arabia

PRImING THE PumP Lower oil prices represent a large tax cut for consumers in the developed world, particularly in the united States. The average hourly u.S. wage bought about 10 gallons of gasoline in January, up from 5.7 gallons in mid-2014. See the chart above. The response should be swift: any gasoline price decline that is part of an extreme fall (over 15% in a quarter) tends to generate a bump in consumption in the next quarter that is four times as large as the effect of milder price falls, we find.

another reason to expect outsized u.S. consumption gains: u.S. drivers burn up far more gasoline than motorists elsewhere. Japan, europe and many emerging markets stand to benefit less. Their consumers use less fuel and pay more at the pump due to higher taxes. See the chart to the right.

u.S. dollar strength also reduces gasoline savings for consumers in countries with weakening currencies. Oil is traded in u.S. dollars, mitigating the effect of any decline in local currency terms. yet the oil price crash has been so large that it swamps the currency effect in many nations. Oil has fallen 49% in euro terms and 51% in yen since mid-2014, compared with a 57% decline in u.S. dollars. bottom line: Cheaper oil delivers a big consumption stimulus globally.

u.s. HOusING AND GOODIEs How about a consumption boost beyond gasoline savings? u.S. housing and durable goods could be winners, our analysis of the 1985-1986 and 1997-1998 oil downturns suggests.

} Housing: Home sales surged during previous oil price crashes. The reason? rising consumer confidence and cash flows—and a drop in mortgage rates driven by falling inflation.

} Durable goods: Purchases of big-ticket items surged on the two previous occasions. a sharp drop in the cost of consumer financing was a key driver.

Caveat: Interest rates had much more room to fall during past oil price crashes. and consumers are more leveraged these days. Household debt stands at 76% of GDP, versus 48% in 1985, fed data show. yet there are signs the u.S. consumer is perking up. Confidence in January rose to its highest level since 2007, according to The Conference board.

Capital spending could also support growth this time around. Cheaper energy will likely boost productivity in energy-intensive sectors such as chemicals—encouraging players in these industries to raise capex (offsetting cuts by energy producers).

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RedIstRIButIon oF wealtHforecast Change in foreign exchange reserves, 2015

Source: BlackRock Investment Institute, January 2015. Notes: Based on BlackRock estimates. OPEC excludes Ecuador, Iran, Iraq and Venezuela. Non-OPEC exporters are Russia, Norway, Canada and Kazakhstan. Oil importers are U.S., Japan, India, South Korea, eurozone, Singapore, Thailand, Turkey and Indonesia.

$200

100

0

-100

20%

10

0

-10

-20

U.S. Dollar Change (Billions) Percentage Change

BIL

LIO

NS

-200Oil Importers

(ex China)ChinaNon-OPEC

Oil ExportersOPEC

Countries

gas guZZleRsWorld Oil Consumption by Sector, 2012

Sources: BlackRock Investment Institute and IEA Key World Energy Statistics 2014. Note: The “other” category includes agriculture, residential, and commercial and public services. Non-energy use refers to oil used as an input in other sectors and not as a fuel.

63.7%16%

11.8%

8.5%

TransportNon-Energy Use

Other

Industry

REsERvEs REsHuFFLE The commodities price implosion is reverberating through the world of foreign exchange (fX) reserves held at central banks and sovereign wealth funds.

We expect global reserves to edge up 2% to reach a total of $11.7 trillion by year end. This average masks a lot of differences. (Looking at Chicago’s average annual temperature of 50 degrees fahrenheit, you would never know you need a winter coat.) Oil exporters will dig into their reserves while energy importers will add to their fX piles. See the chart to the right. China will benefit from lower oil imports, but slowing activity is likely to nudge down its reserve growth rate.

How will the shift in reserves play out in financial markets? We expect isolated sales of risk assets as oil exporters plug budget holes and defend currencies. yet the overall impact should be minimal for now. More than half of global reserves are in cash or cash equivalents—enough to preclude fire sales of less liquid assets. Plus, these institutions tend to premise their investment decisions on opportunities, not on the price of crude.

EvALuATING EquITIEs How to capitalize on the seismic shifts caused by the crude crash?

Cheaper oil often improves the trade balances of energy-importing nations. equities in those countries tend to outperform, our research shows. We would focus on exporters within this space, or companies that derive more than 50% of their revenues from outside their home market (we use lower percentages for eM companies due to the paucity of listed exporters). This investment idea should have legs: Valuations of exporters are slow to reflect improving terms of trade, as opposed to rapid gains after currency declines, we find.

It also makes sense to favor:

} Industries benefiting from lower operating costs, especially those that have not hedged their oil purchases. Transport (airlines, trucking and logistics) is a prime beneficiary. The sector accounts for 64% of global oil use. See the chart on the right.

} Sectors profiting from consumers having more disposable income (retailers, restaurants and other consumer discretionary stocks).

These stocks have rallied, yet we believe there is more to come as analysts upgrade their earnings expectations.

Caution: When we crunched the numbers on the overall effect of oil price changes on industry sector valuations in the past 25 years, we found few differences beyond the simple fact that energy and materials shares outperform when oil prices rise.

Conclusion: This is very much a stock picker’s territory.

[ 1 2 ] c o n c e n t R at e d p a I n , w I d e s p R e a d g a I n

ResouRces RegRessIonCommodities-related asset Performance, 2011–2015

Sources: BlackRock Investment Institute and Thomson Reuters, January 2015. Notes: Crude oil is based on the average of WTI and Brent prices; industrial metals and agriculture are based on GSCI spot indexes. Equities are based on MSCI World indexes. Fixed income is based on Barclays indexes.

50%

-50

-25

Nor

way

Kro

ne

Rus

sia

Rub

le

Cru

de O

il

Commodities FX Equities FixedIncome

Met

als

Agr

icul

ture

Bra

zil R

eal

Aus

tral

ia $

Can

ada

$

Ene

rgy

Equ

itie

s

Min

ing

Equ

itie

s

U.S

. HY

Ene

rgy

Wor

ld IG

Ene

rgy

July 2014 to Jan 2015Jan 2011 to June 2014

0

25

Sources: BlackRock Investment Institute and Bernstein Research, January 2015. Note: The analysis is based on 55 North American exploration and production companies. The values show the total cash flow, capex, and money spent on acquisitions for each group divided by their total production in barrels of oil equivalent.

BuRnIng casHNorth american energy Capex and M&a vs. Cash flow, 2004–2014

PE

R B

AR

RE

L O

F O

IL

Cashflow from Operations

Acquisitions

Cashflow from Operations

Acquisitions

LARGE CAP

PE

R B

AR

RE

L OF O

IL

$100

75

50

25

SMALL CAP

0

2004 2006 2008 2010 2012 20142004 2006 2008 2010 2012 2014

CapexCapex

energy assetsThe oil price plunge and subsequent downturn in energy-related assets have been dramatic. yet they are part of a larger downward move in commodities prices. agriculture, metals and currencies of commodities exporters already were in decline before oil started its descent in July 2014. These non-yielding assets suffered due to a strengthening u.S. dollar and over-supply caused by years of buoyant prices.

energy assets were the last dominos to fall—but fell the hardest. They had rallied in the previous three years and only recently imploded. See the chart to the right.

before the crash, yield-hungry investors happily funded the burgeoning energy sector as oil prices held firm. revolving bank debt and high yield bonds became the instruments of choice for the ambitious u.S. shale explorer.

Many North american shale players became addicted to the easy money. They made a habit of spending more than their cash flow to expand reserves, increase production and make acquisitions, relying on Wall Street funding to close the gap.

North american small caps, in particular, rode the wave in the past decade. Cash flow from operations fell far short of spending. See the left chart below. They sucked in capital to the detriment of companies focusing on exploration outside North america. Large caps largely balanced their books in this period, and were unwilling (or unable) to add much debt. See the right chart below.

The falling oil price shattered this cozy arrangement and heralds a cash crunch for some companies. borrowing costs have risen and access to capital has shrunk as a result of lower and more volatile oil prices. access to cash is arguably more important than marginal costs or access to reserves in this climate. We expect cash flows and capital expenditures to fall significantly this year. both dropped sharply in the 2008-2009 financial crisis, as the charts below show.

[ 1 3 ]e n e R g Y a s s e t s

Sources: BlackRock and Barclays, January 2015. Notes: Data are based on the Barclays U.S. High Yield Index. Current yields are no guarantee of future levels.

dRIllIng downu.S. High yield energy Sector Overview, 2015

Number of Issues

Outstanding Amount (billions)

share of High Yield Total

share of Energy Total Current Yield

six-month Change (basis points)

u.s. HIGH YIELD 2,223 $1,315

ENERGY 344 $199 15%

Independent energy 184 $113 9% 57%

Oil Services 60 $28 2% 14%

refining 11 $5 0% 2%

Infrastructure 88 $53 4% 27%

6.5%

9.8%

11.2%

13.1%

7.1%

6.2%

123

434

563

728

192

158

clImBIng tHe matuRItY wallu.S. High yield energy Maturity Schedule, 2016–2024

Sources: BlackRock Investment Institute and Barclays, January 2015. Note: Companies in the Barclays High Yield Energy Index have no debt due in 2015.

$40

30

Exploration and Production

Refining

Oil Services

Infrastructure

20

10

02016 2017 2018 2019 2020 2021 2022 2023 2024

BIL

LIO

NS

HIGH YIELD: suRvIvAL mODE High yield energy issuers are either small, risky companies or large ones with weak balance sheets. u.S. shale producers have, on average, hedged around half of their oil production for 2015, but very little beyond.

High yield valuations largely reflect differences in asset quality, hedging levels and access to credit between companies. bond prices of refiners and pipelines have held up well, while those of oil services and explorers have slid. See the table below. yields of individual bonds are similarly dispersed.

If oil stays at low levels, some borrowers may default. The longer low prices persist, the greater the pain. We do not see a wave of u.S. defaults in the next year, however. Shut off from new funding, companies will go into survival mode. They first slash capex, negotiate lower servicing costs and prioritize the most profitable wells.

revolving credit lines, the source of day-to-day funding for capex, appear to be safe for now. Commercial banks are using long-term oil price assumptions, rather than spot prices, when determining the size of these revolvers. Their generosity is likely to wane if lower prices persist, while rating downgrades will make raising long-term debt tough. bottom line: Most producers should be able to ride out the storm—as long as signs of a decline in crude supply show up by early 2016.

Defaults elsewhere could come earlier. Moody’s expects a 6% default rate among Latin american corporates this year because of the commodities price downdraft, more than double its forecast 2.7% global default rate for speculative paper.

The good news: The sector’s maturity wall—when loans need to be repaid or refinanced—only hits in earnest in 2017. See the chart above right. Stronger companies will have no trouble tapping the market, but financing will be dearer: 7.5% to 8% versus less than 5% before oil prices slumped.

DELAYED DEALs Mergers and acquisitions (M&a) in the energy sector has been on a boil in recent years, driven by large u.S. exploration companies selling non-core assets to reduce debt and streamline portfolios. Private equity investors have raised almost $70 billion in energy funds since the start of 2012, according to research firm Preqin, and will be in prime position to pick up the pieces. for now, they appear to be sticking to quality assets only—and are holding out for bargain prices.

M&a should dry up initially. Sellers are unwilling to dispose of assets at what they currently see as fire-sale prices, preferring to wait for a rebound in oil prices. activity could start to pick up in the second half of 2015 as some companies face a cash crunch and production hedges expire (only a handful of companies has production hedged into 2016).

[ 1 4 ] c o n c e n t R at e d p a I n , w I d e s p R e a d g a I n

Sources: BlackRock and Barclays, January 2015. Notes: Data are based on the Barclays U.S. Credit Index. Current yields are no guarantee of future levels.

Ig InteRnal BleedIngu.S. Investment Grade energy Sector Overview, 2015

Number of Issues

Outstanding Amount (billions)

share of IG Total

share of Energy Total Current Yield

six-month Change (basis points)

u.s. INvEsTmENT GRADE 6,028 $4,760

ENERGY 608 $412 9%

Independent energy 136 $102 2% 25%

Integrated energy 98 $94 2% 23%

Oil Services 87 $52 1% 13%

refining 18 $18 0% 4%

Infrastructure 269 $146 3% 36%

2.8%

3.7%

3.7%

2.6%

5.3%

3.8%

3.9%

-4

51

49

11

197

44

35

RENEWABLEs REvIEWDo lower oil prices spell the end of the boom in renewable energy? Not really, in our view.

renewables such as wind and solar power have essentially decoupled from lower oil prices. Oil generated just 5% of world electricity in 2012, down from 25% in 1973, according to the Iea. Coal (at 40% in 2012) and gas (22.5%) are much more important. and renewables make up a big chunk of new power generation in many countries. Wind and solar power accounted for 46% of new u.S. power capacity in 2014 versus 51% for gas, according to research firm SNL financial.

Second, renewables have become much more cost competitive. The cost of solar power has fallen 78% in the five years ending in 2014, while the price tag of wind has declined 58%, according to Lazard research. Large-scale wind and solar installations now beat most other sources of power generation on costs—even before subsidies meant to enhance environmental sustainability, according to Lazard.

The trouble spot? Transport alternatives that compete directly with oil. Think vehicles running on biofuels, batteries or natural gas. a prolonged period of low oil prices could set back development of alternative fuels.

“ This is a long-term opportunity to make money in selected U.S. exploration and production companies, especially given how bearish the crowd has become.”

— Jessica Wirth strinePortfolio Manager,

BlackRock Global Opportunities Team

INvEsTmENT GRADE: DIsPERsION What about the u.S. investment grade (IG) market? The segment has been hit, for sure. yet a widening of spreads by an average of 55 basis points can hardly be described as carnage. See the table below.

IG oil services firms are cutting staff (Schlumberger recently announced 9,000 redundancies) and capex. Offshore drillers are in the toughest spot. They faced sagging demand from integrated oil companies, an abundance of newly built rigs and falling day rates even before oil prices slid. IG oil services firms, however, tend to be top-quality credits.

explorers on average take a 14% hit to earnings before taxes and amortization for every $10 decline in the oil price below $80, our analysis of 15 u.S. IG companies shows (assuming a 20% capex cut and level production). This average hides huge dispersion, making credit selection crucial. Considerations include cost structure, cash margins and hedge positions. Many have crimped capex—with more to come.

energy infrastructure credits, including master limited partnerships (MLPs), should spring back due to the need to transport hydrocarbons. The lion’s share of the sector’s revenues is fee-based, we estimate, so it is shielded from price falls (but not volume declines). refiners stand to benefit as refined product prices typically lag declines in prices of underlying feedstock.

[ 1 5 ]e n e R g Y a s s e t s

Sources: BlackRock Investment Institute and Thomson Reuters, January 2015. Notes: Data are based on the Thomson Reuters Datastream World Index. Current performance is no guarantee of future results.

eneRgY dIscountGlobal energy equities Overview, January 2015

World Equity Weight

Oil and Gas sector

Weightsix-month

Total Return

Price-to-Book (PB)

Ratio

PB Ratio vs. 20-Year

Average12-month

Forward P/E

P/E vs. 20-Year Average

Dividend Yield

WORLD EquITIEs 2.1 1 14 0.9 2.5%

OIL & GAs 7.5% 1.4 0.7 13 1 3.9%

Integrated Oil 3.6% 49% 1.2 0.6 10 0.8 4.5%

exploration 2.1% 28% 1.5 0.8 15 1.2 2.9%

Services 0.7% 9% 1.6 0.6 12 0.7 3.3%

Infrastructure 1% 13% 3.2 1.6 24 1.4 4.3%

-4%

-26%

-26%

-29%

-38%

-6%

1.4

0.6

1

RE

LATI

VE P

RIC

E-T

O-B

OO

K R

ATIO

1995 2000 2005 2010 2015

Ratio

Average

EXPENSIVE

CHEAP

Sources: BlackRock Investment Institute and MSCI, January 2015. Note: The green line shows the price-to-book ratio of global energy equities relative to that of the MSCI World Index.

eneRgY on saleGlobal energy equity Valuations, 1995–2015

EquITIEs: DIsCOuNTING DIsCOuNTs We could see a slow-moving equity rally as news of idled capacity filters down. a small rise in the oil price could entice contrarians undeterred by cuts to earnings forecasts.

Valuations of energy stocks generally look attractive across the globe. Price-to-book values were less than 70% of the MSCI World Index average in January. The discount is greater than during the 1998-1999 asia crisis, when brent oil prices slipped below $10 per barrel. See the chart on the right. The risk? analysts may be overestimating future profits or the degree of any oil price snapback. and the global energy sector looks less cheap on a price-to-earnings basis, trading right in line with its 20-year average.

u.S. energy valuations look even better on some metrics, as detailed in The Oil Plunge of January 2015. The energy discount, however, hides a lot of variation. Integrated oil and gas companies, or “energy majors,” trade at steep discounts—versus their own history, most other energy subsectors and world equities. energy infrastructure trades at a premium. See the table below.

We prefer quality and avoid outfits that could run into funding troubles. Our favorites: the super majors. Valuations are low, the integrated model provides a buffer against oil price declines and management teams appear focused on shareholder returns rather than adding reserves or increasing production. The segment has a 4.5% dividend yield—well above sectors that investors have been chasing for yield such as u.S. utilities.

We would underweight oil services, especially those most exposed to u.S. production and those with outdated equipment. They may appear cheap, but we believe a lot more pain is to come. Oil explorers are shifting into survival mode, cutting capex and negotiating lower servicing rates.

It makes sense to bottom-fish for selected exploration companies in the expectation that oil markets should start rebalancing in six to 12 months. Taking the plunge at this time requires high conviction, so we would look for companies with the following attributes:

1. Improving recovery of reserves and return on investment per well in top-tier areas such as the u.S. Permian basin.

2. expanding profit margins through the application of technologies such as horizontal drilling.

3. Healthy balance sheets that are on their way to delivering positive free cash flows within one to three years.

blackrock.comwant to know more?

BLACKROCK INvEsTmENT INsTITuTEThe BlackRock Investment Institute leverages the firm’s expertise across asset classes, client groups and regions. The Institute’s goal is to produce information that makes blackrock’s portfolio managers better investors and helps deliver positive investment results for clients.

eXeCuTIVe DIreCTOrLee Kempler

GLObaL CHIef INVeSTMeNT STraTeGISTS ewen Cameron Watt and russ Koesterich

eXeCuTIVe eDITOrJack reerink

Unless indicated otherwise, all publications mentioned are issued by BlackRock Investment Institute and can be found on its website.

This material is part of a series prepared by the BlackRock Investment Institute and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of February 2015 and may change as subsequent conditions vary. The information and opinions contained in this paper are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This paper may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this paper is at the sole discretion of the reader.

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Investment involves risk. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation, and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are often heightened for investments in emerging/developing markets or smaller capital markets. Investments in non-investment-grade debt securities (“high yield” or “junk” bonds) may be subject to greater market fluctuations and risk of default or loss of income and principal than securities in higher rating categories. Investments in the natural resources industries can be significantly affected by events relating to those industries, such as variations in the commodities markets, weather, disease, embargoes, international, political and economic developments, the success of exploration projects, tax and other government regulations, as well as other factors. The information provided here is neither tax nor legal advice. Investors should speak to their tax professional for specific information regarding their tax situation.

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