by Robert G. Yetman, Jr.
In the wake of a sharp upheaval in the price of oil and a more recent, uneven recovery (of sorts), an increasing number of so-called average investors are getting hip to the fact that the price action of black gold exerts a direct influence over the value of their IRAs, 401(k)s, even as those accounts may not contain any investments that are direct representatives of the energy industry. Typically, the stability or instability in a given sector of the economy is not something that affects an entire portfolio, but oil, as we’ve witnessed, is an exception to that sort-of rule. From a colloquial perspective, it might be said that this is due simply to the fact that oil remains, quite literally, the lifeblood of so many machines that drive productivity, but while there is a broad truth in that, there is, of course, much more to the story.
In general, the average person tends to think of significant drops in the price of oil as a good thing, and why not? After all, most of us think of oil exclusively in terms of the gasoline we put in our cars, and surely we want the price of that to be as low as possible, yes? Additionally, although domestic production continues to rise, the U.S. remains in a position where it is importing more oil than it is sending away, suggesting that lower prices should be better for us. This is a position taken by Dr. James Hamilton, an economics professor at the University of California at San Diego, who says that the “bottom line is that it’s a net plus for the U.S. economy when oil prices go down because we’re a net oil importer.” Is that, however, really the case?
The problem with that idea lies in its narrowness and simplicity, particularly in an increasingly globalized economy, where one country’s commodity sneeze means that another nation is about to come down with economic flu. The reality is that…going back to the original idea that oil is the fuel, quite literally, of everything, and, therefore, so much else is connected to it (more about that shortly)…significant troubles nowadays in the oil market can make for tough sledding in the economy, and, in turn, the equities markets, down to your portfolio. Let’s first briefly account for why the price of oil has been down, and then why those sharply lower prices have been exerting such a macro effect on economies and equities.
The Reasons for Oil’s Price Dump
There are basically four reasons for the now-enormous inventory of crude. For starters, a stronger dollar has acted directly in lowering the price of oil. Oil, like other commodities, is denominated in dollars, and so when the dollar is stronger, when it is worth more, it necessarily means that the corresponding store of value becomes worth less, but worth less not in and of itself, but, rather, relative to that dollar. In other words, oil does not magically become intrinsically less valuable because the dollar is now stronger, but becomes so because the unit of value in this case, the dollar, is worth more.
Another significant bit of causation in the downward slope in oil prices is the particularly weak demand for crude, globally. This is due to one primary factor, and another that is more secondary. The primary factor is that many nations around the globe are suffering from hyper-stagnant economies, and the malaise is afflicting both nations that are fully modern as well as those that are emerging and developing. The International Monetary Fund (IMF) has predicted that none of the G7 countries will see growth as high as even 3 percent in 2016, and Germany, France, Italy, Japan, and Canada, in particular, are expected to miss reaching even the 2 percent mark this year. As for upstart economic powers of recent years, neither Brazil nor Russia are expected to emerge from their recessionary conditions anytime soon, and growth forecasts for China, the world’s largest importer of oil, remain tepid.
Then there is the matter of OPEC and its approach to controlling oil production, presently. That body has shown itself to be unwilling to cut production and keep prices elevated, in spite of the beating taken by member nations like Nigeria and Venezuela. It is believed that Saudi Arabia, the 800-pound gorilla in the OPEC room (it is the world’s largest oil exporter), is seeking to keep the pressure on America’s energetic shale oil and gas industry. The aforementioned Nigeria and Venezuela are examples of OPEC countries that do not have the deep pockets capable of withstanding the strategic approach taken by Saudi Arabia to maintain high production levels, and their own economies are suffering, as a result. Nevertheless, the less well-heeled member nations of OPEC are in no position to leave, because they cannot, on their own, enjoy the higher prices and better times that will resume once OPEC decides to move past its present strategic efforts.
Additional factors include America’s own significant uptick in domestic oil production, referenced in the preceding paragraph, as well as the effects of the much-maligned Iran nuclear deal. By agreeing to a reduction of its nuclear facilities, one of the benefits to Iran was the immediate lifting of U.S. and European Union sanctions against the Iranian oil industry. Ultimately, more oil is flooding the market.
Effects of the Price Drop
The precipitous drop in oil prices has resulted in wide-ranging economic fallout, and it is this fallout that serves as the bridge from the core reasons for oil’s price decline to its deleterious effects on the equities markets (and your portfolio).
For starters, the price drop has had its most direct and pronounced effect on the stability of those companies whose business is oil. To drill down at this (if you’ll pardon the pun) more specifically, oil operations can be broadly divided into two categories, upstream and downstream. Upstream operations refer to those activities that occur earlier on in the process of bringing oil to market, like exploration and production. Downstream operations are those that take place later on in the overall process, and have to do with refining and distribution. Because the costs of upstream operations are fixed, and generally more expensive because of the advanced drilling technologies utilized, companies that are oriented in the upstream part of the process have been hit hardest by the price drop; as with anything, once the cost of producing a good becomes greater than the price that can be received, losses ensue. Downstream operators don’t have as big a problem; as their role in the process is more of a middleman, in that they buy crude on one end and sell the refined on the other, fluctuations in the price of oil, per se, don’t necessarily affect their profit margins.
The end result is that those companies that are all upstream operations have been hit the hardest. However, as the largest oil companies are “integrated,” meaning that they participate in both upstream and downstream operations, their fortunes tumbled sharply, as well, when oil prices drop precipitously.
Additionally, of course, is the matter of layoffs. As oil companies fight to gain a handle on costs, job cuts remain a core tool of the effort. Over 23,000 workers were laid off in the first three months of this year, and a total of nearly 118,000 industry jobs have been lost since the beginning of 2015. Sharp layoffs mean trouble for local economies built around specific industries in distress, including in the form of homes foreclosures. Foreclosures in Texas jumped about 16 percent last year, while in Oklahoma they went up 36 percent. In North Dakota, filings in 2015 represented a near 400 percent increase.
There’s more to this part of it, and it shows how infectious these problems can be for other sectors, like banking and financial services. Oil companies engaged in upstream operations borrowed heavily to pay for the pricey drilling operations – that made particular sense at $100 a barrel, but the backslide in prices that began in the middle of 2014 largely changed all of that. In Q1 2016, nearly 90 percent of the operating profits derived from the energy sector were applied to just the interest payments on outstanding debt. All of the biggest banks have seen a recent jump in the number of non-performing loans in the energy sector, and, earlier this year, JPMorgan Chase declared it might have to set aside as much as $750 million in reserves this year, depending on how oil continues to move; during Q1, it increased reserves by $529 million, and while total loan loss reserves there are well over $1 billion, presently, it is unclear how effectively this sum can offset the potential troubles looming from energy-related loans overall. Both JPMorgan Chase and Wells Fargo presently have well over $40 billion in energy-related loans on its books. While it does appear that the largest banks have been very proactive in beating back the worst of the potential damage threatened by trouble in the energy sector, uncertainty over how things proceed from here remains. Relatedly, Standard & Poor’s warned at the beginning of 2016 that half of all oil junk bonds could default.
Also, while I noted weak global growth as a key reason for the drop in oil prices…and particularly throughout much of the emerging market…it is also, simultaneously, an effect of the price drop, as well. The economies of Brazil and Russia, for example, rely largely on energy exports.
Adding insult to injury is that it does not appear, on the consumer side, as though savings on energy products are translating into any benefit to the economy, at large. Gross domestic product (GDP) has been declining steadily in recent quarters, according to the Commerce Department: 2.0 percent growth in GDP in Q3 2015 was followed by 1.4 percent growth in Q4 2015, and just 0.5 percent growth in Q1 2016. Granted, there’s a lot more to this than just whatever singular benefit might be realized from a savings at the pump, and that is, really the point; the economic problems remain so vast, and the far-reaching effects of oil’s troubles so substantial, that they far outsize and potential benefit offered to the economy on the consumer side of the equation. Retail sales, specifically, remain sluggish.
The Link Between Oil Prices and the Equities Markets
Many analysts have marveled at the recent and historically-significant (they say) correlation between the movement in oil prices and broad equities market activities, but I remain unclear at what, precisely, makes this so momentous or noteworthy.
Analysts will tell you that the relationship between oil and stocks has been basically unprecedented, and many have gone to great lengths to explain the “unusual” relationship. However, in a piece published earlier this year at the Brookings Institution’s website, Ben Bernanke, the former Chairman of the Federal Reserve, articulates how what we are seeing is not as unusual as it might first appear to many. Using a sample that goes back roughly five years, to mid-2011, Bernanke illustrates the overall positive correlation between stocks and oil prices during that time; as he puts it, “The tendency of stocks and oil prices to move together is not a new development; it goes back nearly five years (the limits of our sample) and probably more.”
In the analysis published by Bernanke, he shows a positive correlation between stock prices, as represented by the S&P 500, and oil, as represented by the WTI crude price, of .39, as well as an even stronger positive correlation between stock prices and the demand component of oil, of .48.
In other words, while the volatility of the last year or so has evidenced a particularly noteworthy correlation between stock and oil prices, it is not accurate to suggest that a positive correlation has not existed previously. Bernanke speculates that the reason the relationship has been more pronounced lately is because, in a nutshell, sharply negative conditions in the oil market will tend to exacerbate the already-existing relationship.
We have seen signs lately that there has been a “decoupling” of oil prices from stock prices, but it is important to point out that this decoupling has come on the back of some stabilization in the price of oil, something Bernanke would find unsurprising. He would disagree, however, that we are seeing a true decoupling, but simply a lower correlative relationship – for much of 2016, the correlation between oil and stock prices has been close to 1.
The fact that energy is less than 3 percent of the U.S. economy, which is something to which many point when they express out loud their curiosity over the recent relationship between oil and stocks, is deceiving, for reasons we have discussed earlier; that is, while energy may be a small component of the overall economy in the most direct sense, its impact, particularly in climates of significantly negative price action, is substantial.
In other words, oil prices and stock prices are, generally, positively correlated, and become increasingly so the more the price of oil declines. No real shock there, given the factors.
So, what does this mean for you, as an equities investor?
Not as much as you might think, if your perspective is longer-term. Remember that we’re having this discussion entirely in the context of oil prices as an influencer of general stock market activity. Abnormally low oil prices are not sustainable for any appreciable length of time, which is what makes them abnormal. The strategic efforts by OPEC to pursue America’s markedly increased production by operating at its own high levels, in spite of the price volatility that ensues and the particular damage it is doing to the economies of its smallest member nations, cannot be engaged entirely in an infinite time and space vacuum, despite the significant reserves of the largest OPEC countries. Even if OPEC does remain intractable in its position for the foreseeable future, the determined efforts on the part of U.S. companies to lower the costs associated with shale production are now in the process of reaching a sort of critical mass, where the per-barrel breakeven point for oil well profitability has dropped below $50 at many sites. In other words, in the OPEC-U.S. oil duel, the U.S. is winning.
Let’s talk about the last part of the previous paragraph a little more, because it appears to contradict what was said earlier about the importance of higher-cost oil economically validating the expenses associated with drilling. As events unfold in real time, the high-cost technologies that are designed to ultimately improve efficiency are beginning to bear financial fruit. For example, as “super fracking,” a drilling technology designed to penetrate the rock formations more deeply, improves well production, breakeven costs drop. The U.S, has assumed the lead in so-called unconventional drilling techniques, while Saudi Arabia remains largely tied to more conventional…and higher cost…methods of oil extraction.
While oil (WTI, Cushing, OK) went from just over $105 per barrel in June 2014 (average daily price for the month) to 30.32 (average daily price) this past February, it has risen from there to 49.10 as of today. No one expects oil to move directly back to $100-plus per barrel, but neither is it expected to go crashing to the floor. Additionally, as U.S. production…at lower breakeven points…continues to increase, the influence of price, per se, on oil companies directly will be lessened.
So oil is in the midst of a recovery, of sorts, and as it makes its way back, the direct effect it exerts on market activity becomes less intense. Yes, the two are more closely correlated the further south oil prices travel, but acutely lower prices are not sustainable over the long term, and that is, really, the overriding point as you ponder just what sort of weight to attribute to oil, vis-à-vis your long-term investing outlook. The biggest issue in the near term is the trend in inventory, but as a shorter-term issue, it would be unwise to allow oneself to become too caught up in that from the standpoint of strategic equity investing. From a more active, more tactical standpoint, there are, even now, oil-centric moves to make, but that is a story for another time.