My F&M

Revisiting Low Oil Prices and the Financial Markets

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A year ago we wrote about the falling cost of energy – specifically the price of oil as it fell to about $50 a barrel.  At the time low oil prices were viewed by the financial markets as a blessing, some suggesting the benefit was equivalent to a $500 million a year tax cut (about one-sixth of federal tax receipts).  We were more cautious, warning that there were always winners and losers from the falling price of any commodity.

When oil prices fall, it is bad for producers, especially those with highest operating costs as their margins get squeezed first.  This is especially acute in the shale oil states in the U.S. and the oil sands of Canada.  Many such projects were started when oil traded above $100 a barrel.  With prices so low today, few new production sources are being tapped; however many existing wells continue to produce as upfront costs have already been paid.

On the positive side, consumers obviously benefit from low gasoline prices.  This should eventually creep into increased retail sales and help consumer product manufacturers.  But consumers seem to view the low prices as temporary and have not increased spending even as household budgets have become more accommodating.  For now, consumers are using low gas prices to increase their savings as evidenced by an increase in the personal savings rate from 4.6% in November 2014 to 5.5% in November 2015.

Transportation companies (airlines, shipping companies and cruise lines) and manufacturers that rely on oil as a component of production (petrochemical, fertilizer, and synthetic fibers) should also benefit.  However, the full impact of low cost oil is usually not realized immediately as much of their oil needs are contracted for well in advance.  But with prices steadily declining over the last eighteen months, the benefits are now increasingly being realized and that benefit will persist well after prices rebound. 

In the last two years, global oil supply has increased by 1.5 million barrels per day more than demand. This imbalance has caused inventories of crude to rise by approximately 1 billion barrels with an expected additional growth of 285 million barrels in 2016.  Growing inventories are a sure sign of a supply/demand mismatch and almost always lead to falling prices.  OPEC producers, especially Saudi Arabia, have typically reined in production in these circumstances to restore the supply/demand balance and put a floor under prices.  However, in this cycle, OPEC production cuts haven’t occurred even in the face of plunging prices.  Furthermore, in the short run, the oversupply problem will likely get worse as Iran takes advantage of the lifting of sanctions to add several hundred thousand barrels of oil daily to world supply.

Even though low oil prices create winners and losers among businesses, on balance, they’re a positive for the U.S. economy.  Despite our growing shale oil production, we are still a net importer of oil and lower prices help us.  So, what then could explain the recent stock market habit of falling on days when the oil price drops and rising when the oil price goes up?  One possibility is that the stock market is using the price of oil as an indicator of the strength of the global economy in general and China in particular.  After all, a surplus of oil can arise from too little demand as well as too much production.  China has been the shining star of growth among global economies for many years but has recently been faltering at the same time that the developed world has been growing at a very slow pace.  Given the widespread suspicion of China’s official economic statistics, the stock market may view the price of oil as an important indicator of Chinese growth and, by extension, an ominous indicator today for global economic activity.  If that construct is accurate, what’s bad for oil prices may indeed be bad for U.S. business.

In any case, it’s important to remember that the best cure for low prices is low prices, no matter what commodity we’re studying.  High oil prices sparked the shale oil boom in the U.S., which brought additional supplies to the market and ultimately pushed prices down.  Low prices remove the incentive for drilling by making it unprofitable.  Oil supply is particularly responsive to drilling reductions (rig numbers are down 60%), because oil wells have a natural production decline curve meaning the peak production from a well occurs in the first year and declines every year thereafter.  So drilling new wells is required just to maintain existing production levels!  Low prices also lead to increased demand as can be seen in the recent lift in SUV and light truck purchases (up 13% in 2015) while gas squeezing economy car sales have lagged (e.g. Prius sales down 12%).  We don’t pretend to be able to predict the timing of the oil price cycle, but we do know that market forces drive that cycle, and we can capitalize on opportunities that are created by it.