Commentary on Recent Oil Price Decline
Prices for crude have collapsed below $70 per barrel in the second half of 2014, the lowest level in over four years, due to a dislocation between supply and demand. The suddenness of oil’s decline surprised most market observers who had predicted that oil would trade around $100 per barrel this year. While there are several factors contributing to the recent price decline, the largest factor is a global glut of oil supply that is not likely to be reduced anytime soon.
Supply and Demand Dynamics
Oil supplies have steadily risen in recent years. Part of the increase in supply is due to technological advancements in hydraulic fracking that have contributed to the shale oil boom in the United States. In fact, U.S. oil production has increased 80% since 2008 to about 9 million barrels of oil per day, thanks mostly to the shale oil boom. Additionally, war-torn nations like Libya and Iraq have seen an increase in oil supplies as production in those countries recovers from years of turmoil.
Compounding the problem, demand for oil has weakened in recent months due in part to economic stagnation in Europe and slowing growth in China. While the U.S. economy continues to grow at 2 – 4% annually, Europe is barely growing at all and is more likely to see deflation in the near term than an economic rebound. Thus, demand for crude has not kept up with the fast growing supply.
OPEC Fails to Support Markets
In the past, the Organization of Petroleum Exporting Countries (OPEC), led by Saudi Arabia, has acted to stabilize oil prices by manipulating production. When oil prices have dropped significantly in the past, OPEC has cut its production target to support prices, as many OPEC countries rely on high oil prices to support their economies and balance their budgets. However, OPEC oil ministers did not cut production levels at their most recent meeting last week. This is problematic because even if OPEC members more closely abide by their current ceiling target, such restraint will only have the effect of reducing oil supplies by approximately 300,000 barrels a day, which is not significant enough to bolster oil prices.
OPEC’s decision not to cut production is largely a function of geopolitics. Even though the U.S. does not export unrefined crude oil to the world market due to a ban on exports that was created during the 1970s oil crisis, U.S. shale production is a threat to Middle Eastern oil producers because it satisfies demand for oil by U.S. manufacturers that otherwise would be imported to the U.S. from the Middle East. OPEC is wary of cutting production to raise oil prices for fear that higher prices would incentivize more U.S. oil production, which would lead to lower market share for OPEC producers. By refusing to cut production, OPEC has signaled that U.S. producers will have to bear some responsibility for the glut of oil on the market.
Implications and Outlook
The recent slide in crude oil prices has important implications for the global economy and for equity markets. As oil prices drop, stocks of U.S. oil producers and service companies are hurt, while stocks in transportation companies benefit. The most vulnerable companies to a drop in oil prices are those producers with high debt and/or positions in high cost oil plays in the U.S., such as the Bakken play in North Dakota where the average cost of oil production is between $60 and $70 per barrel. While we typically favor energy companies for investment with low debt and low costs of production, the entire energy sector has declined due to the prolonged weakness of oil prices.
The energy sector is 9% of the S&P 500 and an integral part of investor stock portfolios in the expansionary phase of an economic cycle. While those portfolios will be hurt in the near term by the collapse of crude, this may also be viewed as an attractive time to begin positions in the energy sector for those portfolios that are under-exposed to the sector. Since the best bargains are often found in the times of greatest pessimism, we will search for stocks in those energy companies that we believe are best equipped to survive the decline in oil prices and will likely recover the most when oil prices stabilize at a higher, more rational price in line with historical trends. For those portfolios with a significant energy exposure, we will also look for stocks of manufacturing and transportation companies that use crude oil as an important input of production and will therefore profit the most from low oil prices.
A silver lining in the oil price collapse is that U.S. consumers will benefit from lower gasoline prices and lower home heating bills during the winter months. This may help retailers during the holiday season as shoppers will have more disposable income. Additionally, the Eurozone is a major oil importer, so the drop in oil prices may provide a much needed boost for the struggling European economy.
Lastly, we do not believe that $65 per barrel oil prices are here to stay for the long term. While Saudi Arabia can withstand low oil prices for an extended period of time, countries like Iran, Russia and Venezuela need significantly higher oil prices over $100 per barrel to balance their budgets. It is likely that these countries will apply pressure to other oil producing nations to raise prices if prices stay low for an extended period of time. Further, we expect U.S. producers to eventually begin reducing production, however it will take time for reduced spending on drilling to impact oil prices.