Benefits of lower oil prices outweigh any negatives
GDP-driving consumers have the most to gainJanuary 29th, 2015
Reasonable people can disagree.
I’ve learned that this truism is what, ultimately, drives markets. Otherwise, why would we have sellers and buyers? If they all thought one price was good for everything, I’d say my job would be right up there with watching paint dry. Lucky for me and capitalism, that’s not the case.
The current disagreement that has the markets all jumpy is that of the effect of dramatically low oil prices … on everything. This has caused a lot of market “givens” and assumptions of past years to be questioned, and markets don’t like uncertainty.
I believe that the oil price drop, together with its economic ripple effect, is a major positive for the economy. My goal with this piece is to help provide you some facts, without headline emphasis, to help you understand why I believe that, as well as to provide you information to help structure your personal investments.
As this is written, the U.S. crude oil price is down about 55 percent since its high last June and about 20 percent since the start of the year. Goldman Sachs issued a research report stating that it sees West Texas Intermediate (WTI, aka, U.S. crude) falling to $40.50 in the second quarter with North Sea Brent crude — the international reference prices — falling as low as $42, before each recovers somewhat in the second half of the year.
It doesn’t look as if it’s going to jump back higher soon, especially after the oil minister from the United Arab Emirates said in mid-January that, “The Organization of Petroleum Exporting Countries (OPEC) cannot continue protecting a certain price.” Adding to that was Saudi billionaire businessman Prince Alwaleed bin Talal, who is a member of the Saudi royal family, who said about the same time that, “We won’t see $100-a-barrel oil again.”
Then there’s the two-handed view of the current prices. As in, on one hand, compared with a year ago, they are definitely, absolutely cheaper. However, on the other, as economist Dr. Scott Grannis points out, when we adjust for inflation, the price of crude today “is almost exactly equal to its average since 1970.” Put another way, the supply of crude we enjoy has enabled us to overcome the real, as well as politically created, shortages we’ve had since the turn of the century. Today’s price should be considered reasonable, rather than cheap.
Another thing that may provide OPEC incentive to keep prices low is that it’s not the daily cash price — but rather the price over about a year — that is important to most producers. Most shale producers have typically hedged their price risks out nine to 12 months. That same UAE energy minister, representing one of the countries hoping to retake market share and squeeze out domestic U.S. oil, actually has suggested that prices will have to be held low while the companies are still hedged.
Another challenge for OPEC is that most non-OPEC producers are still cost effective at a much lower price than current levels. Those non-OPEC oil sources have an operating cost of less than $20 a barrel.
Nonetheless, many are concerned or even convinced that there could be negative repercussions throughout the economy due to this same price drop. Seems to me that cheap oil is hugely positive for the majority of the economy, but fears have spread that oil could harm fourth-quarter corporate earnings.
Is there bad news?
There seems to be a perception that global oil usage is down. While it’s true that the growth of new usage is off, the world is still using lots of crude and its by-products. For example, the U.S. Energy Information Administration raised its world oil demand growth forecast for this year and has projected 2016 world oil demand to be up another 1.03 million barrels per day from 2015. And that’s mostly just to maintain status quo usage.
Here’s another little talked-about positive point. The Energy Information Agency said recently that, due to the abundance of shale-produced natural gas, the price of that gas, adjusted for inflation, is now 81 percent below its 2005 high price; about the same as what it cost in the late 1990s. It’s a tremendous competitive advantage globally for our industrial users.
How about the immediate benefit to consumers? Tom Kloza, chief oil analyst at Oil Price Information Service, said the average price for regular unleaded gas for all of 2015 will be $2.49 per gallon, about $1.10 per gallon less than in 2014.
“Based on likely consumption patterns, we believe this will result in an annual savings of more than $120 billion.” And that’s just from gas purchases.
The bigger picture
Liz Ann Sonders, the should-be world-famous chief market strategist at C. Schwab, offered this explanation that seems to me to do an outstanding job of explaining the wide effect of this oil price change.
And I quote, “Close to 70 percent of the U.S. economy (GDP) is consumer spending, which will gain nicely from cheaper crude. Only about 10 percent is capital spending, of which 10 percent to 15 percent is the energy sector. That comes to roughly 1 percent of U.S. GDP output, which might decline this year, making it a relative drop in the economic bucket.”
She added, “The well-publicized challenges for energy producers are small compared with the gains by American consumers and businesses that are paying less for gasoline, diesel, jet fuel, petrochemicals, and the like.”
The short answer is that falling oil prices hurt (many – not all) oil producers, but they benefit oil users across the board. Since there are far more users of oil than there are producers, the net effect of lower prices on the global economy should be positive.
Lower energy prices also put downward pressure on overall inflation, a plus for both our economy and stock market as lower inflation historically has meant higher stock market valuations. That combination of economic growth and lower inflation is one reason stock prices have been rising while bond yields have been falling during the past several months.
Earnings decline at oil exploration and production companies but rise for companies in the air, rail, trucking, and shipping business whose fuel costs decline a lot.
Consumers — 70 percent of our economy, as Sonders said — have more money to spend on things other than energy, benefitting consumer goods companies and retailers. According to David Kotok, at Cumberland Advisors, rough estimates are that depressed energy prices will add $300 billion to our economy annually. That’s a pretty big windfall all across the economy, especially when you consider how much that money will likely turn over.
Cheaper gasoline causes driving to increase, bringing gains to the lodging and restaurant industries. And, with the cost of that driving lower, people buy bigger cars, benefitting the car and truck makers. Likewise, increased travel stimulates airlines to order more planes — a plus for the entire aerospace sector.
The cheap oil isn’t good news for alternate energy companies — they become even less competitive, government subsidies notwithstanding.
A decline in the price of gasoline motivates people to drive more, increasing the demand for oil and gasoline. Lower prices either increase the demand for oil or reduce the supply. Each of these can cause the price of oil to rise at some point, all else being equal. In other words, lower oil prices have within them the seeds of higher oil prices.
Until the crude price finds its own level, it’s going to be pretty hard to make firm choices as to when to invest in the sector. Dollar-cost averaging is a great way to step in during fluctuating markets.
Don’t focus on the “what-if” negatives. Instead, look at the certainty of the wide-ranging benefits to many sectors, industries, and consumers from these low oil prices. I think you’ll agree that it’s a good thing for our economy and, ultimately, the earnings of most of these beneficiaries.
Michael Maehl is an independent financial adviser and Spokane-based senior vice president of Opus 111 Group LLC. He can be reached at 509.747.3323 or firstname.lastname@example.org.