The price decline in oil affects various entities around the world in different ways. The list below highlights some of the impacts
- Oil producing country’s budgets are dramatically impaired (think Russia, Iran, Venezuela, Nigeria, Saudi Arabia, etc)
- Consumers around the world benefit from lower gasoline and heating oil prices (including the middle class in the U.S.)
- Companies and their stock prices are damaged in the energy complex around the world
- Workers in the energy industry are at risk of losing their jobs (workers in states such as Texas, Louisiana, North Dakota, Alaska, etc)
Net/net I believe the U.S. economy is a marginal winner with oil prices this low. Lower gasoline prices are offset with less production of shale oil (which is often too expensive to extract from the ground at $50 a barrel) and the people it employs and capital it consumes.
The bigger question is when should investors step in and buy the correction? I’m asked this question all the time and here’s how I’d answer.
Oil supply and demand is usually closely balanced around the globe. Recently, slower demand from places like China and Europe along with increased production from places like Russia, Iraq, Libya and particularly the U.S. has caused an oversupply of oil. Look at the chart below to see how much the U.S. alone has increased crude oil production the past few years. Production is at 25 year highs:
In fact, the U.S. now produces more oil than Saudi Arabia! To produce all this oil energy companies use more and more drilling rigs. Look at the 15 year chart of U.S. drilling rigs below:
This chart highlights the boom in drilling activity that’s taken place in US shale oil fields. What this also shows is that the rig count is starting to decline. Overproduction has rocked the price of oil. To bring supply and demand back in line either:
- Global demand has to increase (not happening right now) or
- Production growth needs to decline
In the past OPEC countries have cut production to bring global supply and demand in balance. This time they’ve decided not to cut production in favor of holding market share (or to force higher cost US shale producers out of business). Low oil prices will force energy companies with higher lifting costs (the cost to pull oil out of the ground) to pare back production targets for 2015. The result is falling rig counts, lost jobs in the energy sector, less capital equipment used and lower production levels. This is the process for bringing oil supply and demand back into balance.
The question is how long does this process take and when does the price of oil (and the stocks of energy companies) start to go up again. The short answer is I don’t know and I won’t be able to pick the exact bottom in oil and stock prices. I do believe that
- Oil prices are more of a buy than a sell at $45 a barrel and prices will be higher 1-2 years from now
- Stocks of higher quality energy companies will survive this down cycle and continue to thrive in the future
In the near term oil prices could certainly dip lower (they were below $40 as recently as 2009). In fact, Goldman Sachs just predicted $39 oil in the next 6 months (keep in mind just a couple of years ago they predicted oil was going to $200). The point is forecasts are all over the board and tend to be more reactionary than forward looking.
Last year I made the error of recommending a domestic oil stock named Energy XXI (EXXI). They just did a large acquisition that doubled the size of the company. The problem is they used debt to finance the acquisition and their cost of producing a barrel of oil (along with their debt service) is probably in the $50-$60 range. The acquisition made a ton of sense when oil was over a $100, but not so much when its $50 a barrel (imagine if Ford was suddenly forced to sell cars at half price, their profits would also evaporate). The fact is not every energy company will survive if oil stays at $50 for some time.
If you want to bargain hunt oil prices or energy stocks I’d recommend sticking to higher quality (lower debt, lower lifting cost, and large cap) companies. Examples of large high quality companies in the energy complex are:
- Integrated oil producers like Exxon and Chevron
- Oil service companies like Schlumberger and Halliburton
- International producers like Royal Dutch, Total or CNOOC
Investors could start to dip their toes into these type of names, but I’d hold off on buying anything more speculative until the back half of 2015. This will give us time to see the fallout of lower oil prices on some of the weaker sisters in the energy stock universe.
It’s more difficult to invest directly in the price of crude oil. Crude oil ETF’s gain exposure to the oil markets through futures contracts. There is this effect in the futures markets called “contango” where spot prices are lower than monthly future prices. This causes tracking error and can cost investors dearly. Oil price ETF’s should ideally be used only for short term trades of less than a month if you want to replicate the price of oil.
I believe oil prices and energy stocks are trying to bottom. The bottoming process can take time and short term traders could continue to press prices lower. If your time horizon is long enough buy quality first, and speculate when you’re more certain a bottom has been set. Remember, markets can remain irrational often times longer than investors can stay solvent.
As of January 15th, 2015:
Dow Jones US Moderately Conservative Index is down 0.21% (TR) for the year
S&P 500 closed at 1,992.67 down 3.15% (TR) for the year
U.S. 10 year Treasury Futures are yielding 1.71% down 0.46% for the year
WTI Crude Oil futures closed at $46.74 down $6.97 for the year
Gold closed at $1,265 per ounce up $82 for the year
To expand on these market reflections or discuss other portfolio strategies please don’t hesitate to reach out to the Gradient Investment team.
