My F&M

The Price of Oil

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You’ve noticed the dramatic decline in the price of gasoline – the result of oil prices plummeting from over $100/bbl in June of 2014 to about $50/bbl today.  Some have suggested this decline will have the same impact as a tax cut of $500 million this year.  That’s huge – the equivalent of about one-sixth of federal tax receipts!  Before we celebrate a rebirth of consumer spending due to this “tax cut”, we should first review the less visible repercussions of this decline.  

The fall in oil prices, driven by oversupply, is largely due to the development of hydraulic fracturing (fracking) of shale oil in the United States.  But why did this come about?  After all, the technique has been around for some time.  A significant factor may have been the Zero Interest Rate Policy (ZIRP) adopted by our Central Bank.  Low interest rates have encouraged yield-starved investors to accept more risk to increase returns from investments. Much of the incremental shale drilling was financed with high-yield bonds (bonds below investment grade).  In the last six years, $400 Bil. in leveraged loans have been made to drillers and another $175 Bil. in high-yield bonds has been issued to the same group of borrowers.  

With a dramatic decline in oil prices, drilling activity is falling.  Fracking is a relatively high- cost method of producing oil.  With oil prices at today’s levels, that method is increasingly unprofitable.  We have already seen a few bankruptcies among the frackers and layoffs are beginning.  As drilling declines, rig counts also plummet.  Some steel companies have announced layoffs due to declines in orders for drilling pipe.  Further down the line, all the restaurants, apartments, and strip malls built to accommodate the influx of workers into the oil fields are also likely to be hit.   

A retrenchment in shale drilling could have significant repercussions.   Every net job created since June of 2008 has been in the shale states of CO, ND, PA, TX, and WV.  The number of jobs in the other 45 states is just now approaching 2008 levels.  A reduction in shale drilling jobs is just beginning.  As high-paying jobs in North Dakota and Texas begin to disappear, the lost incomes could offset other benefits from the oil price “tax cut”.  

What about a “tax cut” for Europeans?  There has not been a boom in oil production there!  Yes, Europeans will benefit from lower gas prices without the worry of substantial energy-related job losses, but oil prices are quoted in dollars.  While the dollar price of oil has fallen by half, the Euro (and the Japanese Yen) has also dropped 20% in value relative to the dollar!  So while the dollar price of oil has fallen significantly, the currency weakness of the Euro has offset some of that benefit.  

As usual, there are winners and losers from the falling price of oil.  We are not forecasting a weaker or a stronger economy as a result.  We are just pointing out that the recent drop in the price of oil is not an unambiguous positive for the economy.  Rather, it is complicated, and the simplistic answers are seldom useful.  What really matters to investors is diversification and valuation!