U.S. stock markets are hitting new highs again today. The S&P 500 has outperformed most Wall Street forecasts this year and is also widely outperforming stock market indices around the world. But not all sectors of the market are outperforming. Crude oil prices have fallen more than 30% from their highs and this is hurting the energy and materials sector of the markets. The chart below highlights the rapid drop in oil prices:
The fall in oil prices can be attributed to several factors in the U.S. and around the globe. Let’s examine these factors:
Global supply of oil has increased due to:
- Increased U.S. shale oil production unleashed by fracking technology
- Better-than-expected output in places like Russia, Iraq and Libya
The chart below illustrates the rapid growth of U.S. oil production the last 5 years:
Global demand for oil has decreased due to:
- Slowing economic growth in Europe
- China has entered a less oil-intensive stage of development
- Improved fuel economy standards have decreased gasoline demand
- Global use of renewable energy (solar, wind, thermal, etc) is increasing
- Increased use of natural gas, which is cleaner and cheaper than oil
On top of these supply and demand factors:
- The U.S. dollar continues to strengthen, with the currency recently hitting a two year high versus the euro. A stronger dollar tends to weaken oil prices
- OPEC, mainly Saudi Arabia, has yet to cut oil production to combat lower prices
Falling oil prices creates winners and losers in both the economy and the investment markets.
The winners in the economy:
- Consumers are the biggest beneficiary from lower prices at the gas pump (the average American buys 400 gallons of gas per year)
- Transportation companies (think airlines, rails, autos)
- Corporate profitability benefits from lower energy input prices
- Countries that import oil (China, Europe, Japan, India)
The losers:
- Oil producing nations (Russia, Iran, Venezuela, Nigeria, Saudi Arabia, Iraq)
- U.S. states levered to energy production (TX, AK, LA, NM, ND, OK)
- Energy producing companies and oil service equipment companies
- Employees in the oil sector whose jobs may be at risk if U.S. production is cut back
The investment markets reflect these winners and losers in the economy. Consumer driven sectors of the market have performed quite well. The energy and commodity sectors of the market have not. Between oil stocks, the materials sector, and industrial and utility names in commodity-related businesses, roughly 20 percent of the S&P 500 is a loser with falling oil prices.
The chart below highlights the inverse relationship between falling oil prices (red line) and consumer spending driven stocks (blue line)
A general rule of thumb:
- Oil prices above $100 per barrel tend to choke off the consumer and thus the economy
- Oil prices above $70 but below $100, the U.S. economy wins through cheaper gas prices, increased consumer spending and lower corporate input costs
- Oil prices below $70 tend to hurt the economy as oil production becomes unprofitable and energy sector output declines, along with the jobs and equipment used in this production
This Thursday most of us will be celebrating Thanksgiving, but there is also a very important OPEC (Organization of the Petroleum Exporting Countries) meeting happening in Austria. OPEC’s members include Saudi Arabia, Iran, Iraq, Kuwait, Venezuela, Qatar, Libya, the UAE, Algeria, Nigeria, Ecuador, and Angola. In the past, the Saudis have cut production to stabilize oil prices, but this time they are looking for the other members of OPEC to also cut production.
The future direction of oil prices will definitely be swayed by the magnitude of the production cut, if any. Any production cut over 1 million bpd should balance the market and send prices higher. A production cut less than that and oil prices will probably continue to slide. This Friday should prove interesting for global energy markets and oil sector stocks.
As of November 24th, 2014:
Dow Jones US Moderately Conservative Index is up 7.34% (TR) for the year
S&P 500 closed at 2,069.41 up 14.03% (TR) for the year
U.S. 10 year Treasury Futures are yielding 2.31% down 0.66% for the year
WTI Crude Oil futures closed at $75.71 down $22.99 for the year
Gold closed at $1,196 per ounce up $8 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.
