The average price of a gallon of gas fell to $2.27 from a $3.31 an year ago. The price of crude oil at $55 which ultimately drives the prices at your gas station is at a record five year low and has fallen over 40% in six months.
This sounds like good news for the average consumer in the United States and globally. As oil prices fall, consumers have an unexpected windfall of discretionary cash which they can use to buy other goods or save.
To understand the implications of low oil prices, an investor should examine the economic forces that are at work. Based on the data, it’s likely that supply forces are mostly at work here.
The price of crude oil is decided by the fluctuations and relative balance of supply and demand and is closely watched by economist who look at the price of oil as one of the leading indicators of changes in economic condition, such as economic slowdown or even recession (if oil prices fall) or inflation (if oil prices rise). The global economy is highly dependent on oil to function and to grow and the demand equation for oil is fueled by both the developed economies (US and Europe) as well as the emerging market giant such as China. The two largest consumers of oil by far being the United States and China. Thus in a worst case scenario, a rapidly falling oil price may indicate a recession in the United State or a slowing in growth in China. However, the good news in this particular case is that the demand for oil has softened but has not meaningfully dropped (See chart here.)
The softness can be attributed to a less than optimal recovery in Europe as well as a transitioning of the Chinese economy from an export driven industrial country to a services economy. And investors, also looking at other currently positive US and world economic data such as GDP growth, corporate profitability and improvement in unemployment rates among others, should not worry that falling oil prices are a sign of a major US and global recession just now and a decline in the US stock market.
Therefore, to understand why the price of oil has fallen so dramatically, investors need to look at the supply part of the equation. The supply for oil is more complicated because it is not driven by purely economic factors. Political incentives as well as technology innovation need to be taken into consideration. Currently, the largest suppliers of oil in the world is OPEC (40% of world oil production) followed by Russia and the United States.
- Political Drivers: Clearly there are significant political tensions amongst these oil producing giants and high incentive for the ruling governments to use the price of oil to manipulate each others economies. For example, a falling price in oil is a way to put economic pressure on Russia and its aggression in Ukraine, which the previous economic embargoes have done little to curb. The oil and gas sector account for roughly 16% of the GDP, 52% of federal budget revenues and over 70% of total exports. Falling oil prices were also directly related to the recent collapse of the Russian ruble. For the first time in a decade, the Russian autocratic government lead by Vladimir Putin is in the hot seat not only in the Western World but also at home. Second, the OPEC countries while divided on many issues, stand united about their views on oil price control. The OPEC oil producers also largely depend on revenues from oil to fuel their economies. As a result, when oil prices fall below a sustainable level (typically $70), OPEC agrees to decrease production and stabilize prices. However, on November 27th, 2014, the OPEC decided to not decrease oil production in an attempt to make shale oil production in the US unsustainably expensive and thus maintain control over oil production and prices over the long hall. With some $800 billion of foreign reserves, the Saudis can afford to wait-out lower prices, and they’ll do whatever it takes to stay competitive.Poorer OPEC countries such as Venezuela, Iran and Iraq suffer the most, when oil prices fall. Poorer OPEC countries such as Venezuela, Iran and Iraq suffer the most, when oil prices fall.
- Technology Innovation: The world of oil production has dramatically changed and it is unlikely that OPEC will have the historical ability to independently manipulate oil prices due to the changing role of US shale oil production. By far, the largest factor in the recent drop in oil prices has been the dramatic increase and anticipation of further increase in US shale oil production. The United States now produces close to 9 million barrels per day (bpd), which is about an 80% increase over what we produced in 2008. Next year the figure is expected to plow through 9 million bpd, netting the US the most output we’ve had in 40 years. Historically, OPEC is very aware that US producers become less profitable as prices drop below the $60 – $70 range and many US companies are just breaking even. So it’s clear that the Saudis have an incentive to keep prices low for as long as they can and change the economic incentives of the US oil boom. Therefore, it is not surprising that OPEC decided not to cut production this time around. In the near term that may marginally work, but over the longer term it doesn’t matter much to the US because of the significant steps the US has taken in the last five years to increase efficiency and build out capacity. The US has production capability, technology, and abundant supply, so many analysts believe that the US energy dependence is largely over: “Only five or six years ago, wells used to take 70, 80, 90 days to compete. Today they take two weeks. That in itself is a huge accomplishment. The same rig instead of drilling one well, can drill four. Companies now know how to drill faster than ever before. They learned it in trial and error. Companies don’t need as many rigs to drill as many holes in the ground and that in itself is a cost saving,” Fadel Gheit, senior energy analyst at Oppenheimer, said at an CNHBC interview. See growth of US oil production: Five Thirty Eight
Falling oil prices do not foreshadow a recession and a fall in stock prices. While I expect oil prices to remain low in 2015, this trend instead should have an overall positive impact on some stocks in the short and long run. Reversely, the currencies and economies of some net oil producing countries such as Russia and Venezuela are unlikely to recover quickly and may suffer long term losses as the oil supply picture changes structurally and the US emerges as a long term winner.
- US Energy Companies and Oil Producers – buy. Due to technology innovation and greater efficiency in oil production, stocks of US energy producers and companies should recover especially if oil prices rebound and stabilize in the $60 to $70 range which is likely in 2015. If strong economic data in the US and recovery in Europe continues, this would also be positive for US energy producers.
- Consumer Staples – buy Lower input costs and a continuously strong dollar make goods more affordable.
- Airline and Transportation Companies: buy Profitability of airline companies increases as oil prices fall. Continued economic growth in the US and a stronger European recover would also impact these stocks positively.
- Currencies of Net Oil Exporters – sell This applies to countries like Russia and Venezuela, where a huge portion of their economies is tied to the energy sector. Unlike the Saudis, these countries can’t afford to wait out a cyclical downturn in energy prices. As a result we would expect the currencies of these countries to remain low with unlikely recovery in 2015. I would not be surprised if 2015 bring political turmoil in such countries.