The Double-Edge of Cheap Oil

Prepared by Zach Ivey Bridgeworth Advisor Zach Ivey

The topic of oil is once again top of mind for many today as we have seen a new drop in the price of oil and further decline in oil related stocks. As recent as 2008, the talk in the energy industry and in Washington was on the topic of “Peak Oil,” the idea that global energy supplies had reached its limit and that demand would push prices even higher as we drained the last drop from the globe. I personally recall several folks around this time who were terrified of this “inevitable fact” and sincerely believed that we were staring at the end of the modern era. Oil prices went to $147 per barrel in 2008, but within a year were below $40 per barrel as the mortgage meltdown caused the steep recession of 2008 and 2009.

Oil Prices Through the Years

Around the early 2000’s, a handful of wildcatters desperately trying to make something of land that was deemed a waste by the big oil industry giants tried every possible way to get oil and gas out of the ground. By experimenting and using horizontal drilling and “fracking” (hydraulically fracturing shale to release oil/gas) techniques, they sparked an energy revolution in the U.S.  As we all now know, the United States is blessed with large reserves of oil and natural gas and the energy industry has boomed in places like Texas and North Dakota.

There are a few things to help one understand oil (or any commodity) and its price. First, the price of any commodity is heavily influenced by the supply/demand relationship. Production has increased substantially over the last several years (up 45% from 2008-2013) and yet the consumption (demand) has been more modest. When production is running behind demand, you see higher and higher prices. With just a small change in this equation, a tipping point of sorts, production exceeds demand and the price declines significantly. As an example of this, Brent oil prices were in the $80-100 per barrel range from 2010 until 2014 when it plunged from $113.50 (high in June 2014) to $48.40 in January 2015. The inventories were running about 0.3% behind demand in 2013 and that switched to about a 1% surplus of supply in 2014. Such a small change in the supply/demand relationship, but a huge change in the price.

Not As Simple as Supply/Demand

It should be noted, that supply and demand are not the only ingredients in the price. If you can remember back to 2008 when oil prices were running sky high and politicians were pounding tables about record profits of oil companies, the real enemy of the time was unnamed “speculators.” There are investors, many outside of the oil industry, who can and do try to make money on any trend in a commodity or financial security for that matter. These trades can exacerbate the pricing mechanism and drive prices away from their fundamental price (based on supply/demand). Another factor which impacts prices is the price of the U.S. dollar, as oil is priced in dollars. Despite what you might hear on talk radio, the U.S. dollar has appreciated significantly in the past year which has had the opposite effect on the price of oil. There are many other factors that go into the price of oil and decisions by producers, but the ones mentioned help create a framework for a better understanding of the price.

The reality is that it takes a lot of risk, effort, and money to get oil and gas out of the ground. At certain prices, it makes sense to make the effort to get the oil out of the ground; at lower prices, those projects aren’t profitable. Different companies and countries have different cost structures that effect what is profitable to do. Most energy companies do not speculate on which way the price is predicted to go, but rather approve projects based on the current price and hedge away some of their risk. Today, the amount of new oil rigs has declined very sharply in response to the decline in prices, so some “new” supply will stay out of the market (and stay in the ground). However, the existing rigs are still producing at around the same rate. OPEC, which controls the supply in the Middle East, seems content to keep prices pretty low for the time being as well and Iranian oil could re-enter the market putting further downward pressure on the price. The demand side is not predicted to pick up substantially, so low oil seems to be inevitable for the time being. I say this humbly because as we have just pointed out, it doesn’t take much to move closer to the supply and demand tipping point where you see a major change in the pricing equation. If global growth surprises to the upside and high cost producers trim production, we could see a shift. For these reasons, one should be careful if speculating or concentrating their investments based on any theme that is founded on the price of oil.

Impact of Low Oil Price

This brings us to the impact that low prices have on the economy and the market. First is a reminder that more of us are consumers of energy than are producers of energy. Those who were so worried in 2008 about “the end of the modern era,” due to a lack of energy, should be rejoicing in the overflow we have now. The political talking points just a few years ago were largely about relying so heavily on Middle-Eastern oil and funding people that hate us: that reliance has lessened. For European countries and others around the world that are not fortunate like the U.S. with an abundance of resources, low oil/gas prices are a blessing and huge tailwind for their economies. Obviously Russia, Brazil, and Canada, are huge exporters and are hurt from low oil, so there are losers in this equation. While those in the energy sector feel the pain of low oil, a much larger group of consumers/producers are feeling the benefits. Overall, lower prices are a net positive for economic growth.

Low oil prices do effect inflation. In general, inflation above 2% is viewed poorly, but not as negatively as the other side of the coin, deflation (falling prices). While most of us look at the Consumer Price Index (the broad measure) it’s important to dissect this number to notice that inflation apart from energy is evident and that deflation should not be a concern. Unlike falling home prices or other items, I do not lament finding lower prices at the gas pump. So while falling oil or low oil prices translates to lower general inflation, this doesn’t necessarily mean that the Federal Reserve won’t move quicker to raise interest rates if they see the other components of inflation increasing.

The effect on the stock market is uneven. As you can expect, oil and energy related stocks earnings are off nearly 56% this quarter. The rest of the S&P 500 earnings are up 9%, even with the  drag of a strong U.S. dollar. Some industries are actually direct beneficiaries of low oil prices. With this said, as was the case in 2014, the S&P 500 and other indexes may not accurately reflect the health of the overall economy and their performance may be impacted by low oil and struggling energy stocks. If history is any guide, the market has seen four instances in which oil has sold off by more than 50%. In every case so far (the jury is still out on 2014), the year following the decline was very good for the market. The high yield bond market has a large exposure to the energy sector, so this area as a whole has come under pressure as solvency fears increase. Clearly, this is a complicated subject and there are many bright people in the energy industry and in the financial industry trying to understand the repercussions of low oil prices and if they will remain low longer. At Bridgeworth, we will continue to monitor our positioning relative to oil/energy and keep a healthy dose of humility when it comes to predicting where oil prices might be in the future.

Zach Ivey, CFA, CFP®
Chief Investment Strategist

Federal Reserve Bank of Saint Louis Economic Research
LPL Research
Natixis Global Asset Management
Goldman Sachs

This commentary is provided for information purposes only and does not pertain to any security product or service and is not an offer or solicitation of an offer to buy or sell any product or service. Any opinions expressed are based on our interpretation of the data available to us at the time of the original publication of the report. These opinions are subject to change at any time without notice. Bridgeworth, LLC does not undertake to advise you of any changes in the views expressed herein. Unless otherwise stated, all information and opinions contained in this publication were obtained from sources believed to be accurate and reliable as of the date published or indicated and may be superseded by subsequent market events or other reasons.

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