The Impact of Cheap Oil

The sharp decline in oil prices has quickly become one of the most powerful factors reshaping the global economy. The price of Brent crude oil has fallen from over $110 a barrel in June to $56 at the time of this writing.

It is difficult to discern whether supply or demand factors contributed more to the drop, and impossible to predict when prices will mean revert. However, understanding some of the forces driving this fall and the significant impact that cheap oil will have on the economy will help investors navigate current market conditions.

Despite some disagreement among economists about the root cause, supply and demand factors have arguably played a significant role in oil’s fall. Economic weakness around the world, particularly in Europe and China, has dampened global demand for oil. A strengthening  dollar, buoyed by expectations of rising U.S. interest rates and an expanding American economy while growth in Europe and Asia has slowed, places downward pressure on demand for dollar-priced commodities as they become more expensive to holders of other currencies. Downward pressure on commodities then imports lower prices to the U.S. However, this cannot tell the whole story, as demand for oil in the U.S. – the world’s largest consumer of oil – has been flat while its economic growth has not, suggesting that this is also a supply-side issue.

An increase in global production of oil has created a paradigm shift leaving OPEC to decide between maintaining pricing power or market share. Many non-OPEC oil producers have seen a dramatic rise in oil production fueled by technological advances in fracking. For example, the United States has nearly doubled its domestic production of oil since 2008. Historically, OPEC had set a floor on the price of oil, but now has created a floor on production levels, refusing to produce less than 30 million barrels a day. This decision has created global oversupply and forced the price of oil down. Most major oil producers are still marginally profitable at $40 a barrel based on current levels, so given the competition for market share there is no reason to expect them to cut production at current prices. Conversely, as oil companies pare back on marginal projects and production levels begin to fall in the future as a function of natural depletion, prices may edge higher to meet the costs to incentivize the reinvestment necessary to offset declining rates. Thus, even in a low demand growth environment the industry may re-price in a future need to reinvest. While nobody can be certain where the price of oil will be in a year, production is expected to run high for the foreseeable future and investors should prepare for and understand the positive and negative effects that cheap oil will have on the global economy.

The Positives

Falling oil prices typically benefit consumers, similar to a tax cut, as consumers have more discretionary income to spend on other goods and services. After all, the average U.S. family spends 4% of their income on gasoline. Cheap oil disproportionately benefits middle and lower-income groups since energy costs command a larger share of their total earnings. This demographic has missed out on most positive economic trends in recent memory – higher corporate profits, lower borrowing rates, and increased demand for workers with advanced degrees have mostly benefited businesses and wealthier individuals. A boost in demand from this demographic should bolster earnings for companies in the consumer discretionary sector such as the hospitality industry, apparel makers, and general retail. Consumer staples also tend to outperform when energy prices are low, benefiting producers of food, beverages, and tobacco. While falling oil prices will certainly increase demand in these industries, the transportation sector has the greatest potential benefit.

Airlines, railroads, and shipping companies have just seen a primary cost input reduced by over 50%. All else equal, this translates to higher profit margins and higher-than-expected earnings. According to its most recent projection, the International Air Transport Association (IATA) expects the global airline industry to profit an additional 10% in 2015 compared to previous estimates. The final effect may be even greater, as oil prices have continued to fall since the IATA’s December projection. However, despite the benefit to the transportation, consumer staples, and consumer discretionary industries, many industries will see cheap oil as a headwind to their earnings.

The Negatives

Aside from the direct impact on energy companies’ earnings, cheap oil will also have a major impact on capital spending. According to a November estimate from Deutsche Bank, energy producers accounted for a third of all capital spending in the S&P 500 last year. A drop in capital spending from energy companies will flow through to a number of industries, including but not limited to drillers, oil servicing companies, and industrial equipment and materials. Schlumberger, Halliburton, and U.S. Steel are just a few of the many companies in this market segment that have already announced layoffs because of the crash in oil prices.

Forecasts for first quarter profits in the S&P 500 have fallen 6.4% in the last three months according to over 6,000 analyst estimates compiled by Bloomberg, though they are still projecting growth. This number reflects the uncertainty involved in consumer spending; while energy companies are forced to cut back on their spending, there is no guarantee that money saved at the pump will circulate back into the corporate economy. A significant amount may instead be saved for retirement or used to pay down debt. Additionally, many analysts are concerned that the strengthening dollar will make U.S. exports less desirable, creating an additional headwind for domestic corporate earnings.

The significance of cheap oil will largely depend on how long prices stay at current levels before markets rebalance. Some of the factors contributing to cheaper oil may be offset by policy decisions around the world. Weakness in Europe and China has reduced demand for oil but has also led to accommodative monetary policy, which historically boosts commodity prices. The European Central Bank recently announced a new Quantitative Easing program that will involve €60 billion of bond purchases a month, and the People’s Bank of China began cutting interest rates at the end of November for the first time in over two years. Regardless of whether and to what extent these decisions will reflate the price of oil, cheap oil should ultimately be neutral for the global economy; money lost by its producers should be gained by its consumers, whether they are individuals, corporations, or countries. However, oil producing countries are much more concentrated than oil consuming countries, with Saudi Arabia and Russia providing almost 30% of global exports. Unfortunately, this means that the losses suffered by major exporters of oil will be far more dramatic than the gains experienced by net importers. Falling oil prices are a double-edged sword, creating winners and losers which may result in heightened volatility in financial markets in the short term, but should not concern investors focused on a long-term approach.

If you have any questions relating to this newsletter article or your investment portfolio, please contact an Andersen Tax investment consultant.