Cheap Oil: Good or Bad?

Weekly-Global-Market-Commentary 2.9.16

Falling oil prices are making investors nervous. In fact, lately the broader stock market is trading almost in lockstep with crude. After tumbling about fifty percent since the summer of 2014 through the end of December, oil has declined another twenty percent since the beginning of the year, taking global bourses down with it.

According to a recent Wall Street Journal article, the correlation between the S&P 500 and the price of oil has risen to ninety percent, the highest ratio in 26 years. Clearly, the world is fixated on the price of oil. But does this make sense?

Taking a big step back it really doesn’t. Lower energy prices are actually a boon for almost all industries except those involved in oil and gas exploration and production (E&P). The world’s largest economies including the U.S., China, Japan and Germany are net buyers of oil. When energy prices go down, the largest part of the global economy receives the equivalent of a major fiscal stimulus programme. What’s more, consumers see the improvement almost immediately at the gas pump without having to wait on tax refunds or government spending programmes to begin.

On the other hand, sudden unanticipated changes – even positive ones – can be disruptive in the short run. For example, many capital equipment makers are seeing less demand for energy extraction and transportation equipment as the E&P companies are forced to cut back on unprofitable drilling activity.

According to Standard and Poors, approximately 30% of capital spending, or about $890 billion had been dedicated to the oil patch, and a good portion of that amount was predicated upon at least $50 per barrel oil. With oil now trading near $30 per barrel, one has to wonder about the current value of those projects. Moreover, many of these projects were financed with debt which is looking increasingly riskier as prices stay soft. The latest worry is over banks which may have lent too much to resource extraction companies. Some of the largest European banks are trading at levels not seen since the financial crisis due to concerns about problem loans to commodities producers.

Also weighing in on the oil/bear market argument is the notion that lower commodities prices are the proverbial ‘canary in the coal mine’ for the global economy. Falling commodities prices are thus assumed to be predicting what might turn out to be an imminent downturn in the economy.
Indeed, the International Monetary Fund (IMF) has been steadily lowering its forecasts for global growth. China, in particular, appears vulnerable. At the same time, cyclical stocks such as those in the consumer discretionary, industrial and financial sectors have taken a greater-than-average beating this year while investors bid up the prices of more defensive companies such as utilities.

The argument for cheaper oil predicting a slower economy, however, really considers just the demand side of the equation (slower growth mean less need for energy), without taking into account an abundance of new supply. Fractured drilling, or “fracking”, has been a major source of disruption. Previously difficult-to-reach tight oil supplies in parts of America have now become economically accessible. With the U.S. becoming steadily less dependent on importing foreign oil the game is changing. However, fracking is merely another example of technology disrupting an established industry.

The bottom line is that oil prices should probably have less of an effect on the broader stock market than they currently do. In my opinion, investors have been increasingly leaning on oil for direction in response to a general confusion about the direction of the global economy. China’s inherent opacity with respect to its economic policies combined with America’s leadership vacuum has created a stressful backdrop.

For example, as I write this, America’s current president is introducing legislation to tax oil by $10 a barrel – thereby revoking a portion of the potential energy price benefit – in order to fund some of his pet projects. Many similar projects have failed miserably and all could be covered much more efficiently by the venture capital industry. Certainly, the bill will be squashed in Congress, but therein lies the problem. Talk about wasted energy!

These are interesting times. Economies have been driven more and more by monetary policy to the point of unprecedented, negative interest rates and massive quantitative easing (QE) throughout much of the developed world while developing markets, largely joined at the hip with China, struggle to reinvent themselves.

The vicissitudes of the energy market have given short term traders a focus. Market prices are either set by governments and cartels or determined by free market forces. In this case, the OPEC cartel’s unwillingness and perhaps inability to control oil prices is forcing the market to clear prices and this has not been a smooth process.

Looking ahead, investors can profit from these big swings. Cheaper oil should be considered within the context of the persistent evolution of technology which ultimately moves us forward. More efficient energy extraction has lowered the price of oil on a secular basis just as alternative energy sources including solar and wind power are slowly making us less reliant on fossil fuels. No one complains about the dramatic drop in semiconductor prices which now give us previously unimaginable access to computing power and information.

Many companies in the consumer discretionary sector are likely to profit in the months and years ahead. In late 2014, I wrote in this newsletter that this sector was a good place to begin making some investments; and indeed, the consumer discretionary sector was the best performing group in 2015. However, with markets swinging in favor of defensive industries this year, consumer stocks have sold off more than the averages year-to-date. From beaten down auto-related companies to oversold media concerns, we are seeing bargains once again. When the dust settles, the market leaders will reemerge as winners and get back in the race – and now with cheaper gas!

The information contained in this article is for information purposes only, and represent the views of the author. It is not intended as specific investment or financial advice, or a recommendation or solicitation to buy or sell any security. Any investments or strategies listed in this article may not be suitable for all investors. Past performance is not indicative of future performance, and as with any investment, prices may fluctuate. It is recommended that advice is sought from a qualified investment professional prior to implementing any financial plan. LOM has made every effort to ensure that the contents herein have been compiled from sources believed reliable, however LOM does not warrant the accuracy, adequacy, timeliness, or completeness of this information expressly disclaims liability for errors or omissions in this information.