One of the major stories in 2015 and 2016 has been the volatility in crude oil prices. Oversupply in the market has driven prices down to levels not seen in over a decade.
Just 5 years ago, in April of 2011, West Texas Intermediate (WTI) crude oil prices hit $115/barrel. Talk of “peak oil” reigned, with analysts calling for the price per barrel to move as high as $150. Unrest in the Middle East and other potential disruptions from the supply side had companies scrambling to hedge prices and saw consumers being forced to dispose more of their income at the gas pump. Fast forward to today and, as of this writing, the price per barrel of WTI has collapsed 75% to approximately $29! So what has happened and what does this mean for the economy, the markets, and for your portfolio?
To start, oil is a commodity. Commodity prices are dictated by the underlying economic fundamentals that affect supply and demand. If demand increases, and supply stays constant, prices go up, and vice versa. By way of example, when Florida oranges get a winter frost and there are less available, orange prices, and every product which uses oranges, rise. Prices will rise and fall until the supply and demand of the commodity are placed back into equilibrium. The math is actually fairly straightforward…..the cause of supply and demand changes – well that is where this topic becomes complicated.
For years the world has been subject to the oil price manipulations of the Oil and Petroleum Exporting Countries (OPEC). OPEC controlled the lion’s share of the world’s oil supply, so they in affect controlled the oil market and pricing. They were the swing producer meaning that If OPEC decided to slow production the price of oil across the globe rose. Being the swing producer certainly had its benefits as OPEC members used their status to build massive reserves of wealth. One look at the opulence in Dubai or the wealth of the Saudi royal family showed OPEC’s power and influence. Controlling supply meant controlling price and as a result, oil price movements had predominately been dictated by supply. Historically, global economic growth (recessionary pressures or expansion periods) has been the primary driver of demand side moves impacting price. OPEC enjoyed this influential supply side status for decades…..until now.
The U.S. Shale Revolution
In Western PA we are very familiar with the shale revolution and how technological advancements allowed Exploration and Production (E&P) companies to drill down further than ever to extract previously unreachable deposits of natural gas. That same technology is now used to extract previously unreachable deposits of oil. When the price of oil hovered between $90 and $100 from June of 2011 through June of 2014, the “Black Gold Rush” began and E&P companies could profit handsomely despite the higher costs of extracting difficult to reach oil. Companies borrowed high levels of debt to fund projects and small cities began sprout up in areas like North Dakota and Western Canada. As a result U.S. oil production flourished and the motto “Drill, Baby Drill” came to life. Job growth boomed as the U.S. became one of the largest global oil producers, ultimately becoming the new “swing producer”. The chart below from JP Morgan reflects the massive growth in rig counts and production experienced from 2013 through 2015. This boom in U.S. oil production leads us to our current situation…..
You know what they say about too much of a good thing? The massive oil production in the U.S. ultimately took power away from OPEC. OPEC was faced with a choice: Decrease production to let prices rise or increase production in an effort to maintain market share through the lowering of prices which would ultimately put high cost producers, like U.S. shale drillers out of business. OPEC chose the second option and on Thanksgiving of 2014 voted to maintain oil production levels which unleashed a torrent of downward pressure on prices. The subsequent collapse in oil prices has wreaked havoc on high cost producers as well as countries heavily reliant on oil exports – see Russia, Nigeria, and Venezuala as examples. We’ll refer you again to the JP Morgan chart that shows the collapse in U.S. rig counts. Oil production has essentially become a standoff to see who blinks first.
Will Saudi Arabia flinch as their income, which relies on oil exports for 90% of their revenue, rapidly shrinks? Or will low oil prices force a wave of bankruptcies in U.S. shale companies, with highly debt laden companies unable to break even at such low prices? We don’t know the answer to that yet, but we do know that the standoff has driven prices to what 5 years ago seemed to be unthinkable levels.
But isn’t low oil a good thing? At its core, for net -importers of oil, low prices are a good thing. Current gasoline prices in the U.S. are the equivalent of a $1,500-$2,000 per year tax credit to the income of the average American family. Less money at the pump means more money to spend elsewhere. Let’s not fail to mention the savings on input costs for everything from industrial production to airline costs (it would be nice if the airlines would pass those on to us). Even truck sales from Ford and General Motors have reached their highest levels ever due to the lower costs of running these vehicles! With 2/3 of U.S. GDP coming from consumer spending/consumption, the economic benefits have the potential to be big.
However, in the short-term, at least in the U.S., concerns remain regarding the potential defaults of shale companies and the contagion of that debt in the high-yield debt markets. Job losses in the oil patch have increased and negative earnings from energy companies have had a profound impact on the S&P 500 index. Additionally, the market still struggles to embrace the idea of oil prices as a supply issue and not a demand problem. Again, demand problems tend to foreshadow recessionary environments and markets are very sensitive to the possibility of economic recessions.
Overlay the fear of a slowing China, and the market has become intertwined with the price of oil. Take this past Friday for example. Rumors of collaboration between Russia and Saudi Arabia to limit oil production increases sent WTI soaring over 8%. The Dow Jones Industrial Average followed suit by jumping 313 points or over 2%.
Uncertainty over the short-term price movements of oil will continue to fuel fearful stock market investors. This uncertainty leads to volatility, and volatility is front and center in today’s markets. Institutional investors, due to their infinite time horizon, are using this opportunity to buy great companies at significant discounts to what they were trading at just a few months ago. For many individual investors the memories of 2008 still linger, when the anxiety of a 50% market decline was too much for many to stomach. However, we do not believe we are in that type of environment.
When will the stock volatility subside? When will the markets return to a healthier state of growth? What are the catalysts that will turn the momentum and mood?
We will address each of those in future communications.