Oil plunged to below $50 a barrel recently, down from $115 six months ago. What caused this? What are the economic implications? How does this affect my portfolio?
Let’s take a look...
What Caused This?
In short an imbalance in supply and demand. Supply has been increased in the US from 5 million barrels a day to 9 million over the past three years or so. When prices have fallen in the past, OPEC has cut production in an attempt to maintain higher prices. This time around Saudi Arabia, OPEC’s largest producer of Oil by a significant margin, appears to be taking a long term approach to this market. They believe that $50 oil may force some “frackers'' out of business.
They may be right. Fracking is profitable at $100 a barrel, but according to most experts, not at $50. At the same time that the supply of oil has increased, the demand for oil has declined as Europe, China and all of Asia are suffering from slower economies. Exacerbating the decline are hedge funds. These non-regulated pools of money have traditionally used leveraged oil future bets as a tool to help boost overall returns. These oil contracts must be sold to meet margin calls when prices decline. This selling forces prices lower, leading to more margin calls and more selling.
What are the economic implications?
Lower gasoline prices and lower costs to transport goods may lead to a boon for consumers. The increased consumer spending should continue to lead to greater economic growth. However, on the negative side, oil producers are suffering. Although many have likely hedged the short term movement in oil prices, a prolonged period of lower prices can cause real problems to these producers.
Slower growth, layoffs and even bankruptcies are likely should the price oil remain at depressed levels or even decline from here. According to the Wall Street Journal Schlumberger “the world’s biggest oil-field services provider… announced 9,000 job cuts.”
How does this affect my portfolio?
According to CNBC, Oil producers make up roughly 17% of the high yield bond market. The concern that some oil producers may not be able to pay back their loans has led to a decline in this asset class. This negative consequence of lower oil prices is balanced by the likely stronger economy we should experience as a result of the lower gasoline prices.
The need to be a diversified investor has never been clearer to us. Although the S&P 500 was up about 12% in 2014, many oil producers were down 40%, 50% and even 60% in share price! Should oil stabilize at this level, or even increase a bit, the overall economic effect should be positive. Because the stock market, in the long run, reflects the strength of the economy we believe these lower oil prices are ultimately a positive for the US economy and the US stock market.
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