Cheap Oil and Market Jitters

Oil has fallen by over 56% since last June, something most analysts had not predicted. This has resulted in periods of stock market volatility — particularly for energy companies and those that supply them.

Why Is Oil Falling?

First, it’s due to oversupply driven primarily by US production and our current shale and natural gas boom. The US is now the largest energy producer in the world. That’s right - as of last year, we’re bigger than Saudi Arabia in the energy business. Second, Saudi Arabia and the Organization of Petroleum Exporting Countries (OPEC) is battling this US boom by resisting production cuts, signaling it’s prepared to let oil fall to a level that may ultimately drive the US to reduce its drilling and overproduction. In short: it’s competitive strategy. So, with the US pumping and exporting oil at lower prices, and OPEC no longer constraining supply as a way to keep prices higher — this game of “price per barrel” chicken could go on for some time.

As a positive, cheaper oil means lower prices for consumers, which usually translates into higher consumer spending — good for the economy, good for stocks — although this takes some time to work its way into the system. The downside of cheap oil is that it reduces capital spending among oil explorers and drillers — which affects overall economic output, and puts downward pressure on other commodities, such as copper and steel because they feature so prominently in energy production. The stock market is trying to figure out how to digest the potential reduction in economic activity due to cheaper oil — where the cost of getting it out of the ground might be higher than the current price — and weigh it against how much and how quickly that increased cash in consumers’ pockets will make it back into the economy. That’s largely why we are seeing current market anxiety.

Why We Believe Cheaper Oil Is Good

The US economy is 68% driven by consumer spending. Consumers win in a cheap oil world. Oil/gas capital spending represents only about 1% of US gross domestic product (GDP) and less than 10% of US total capital spending (which in turn represents about 12% of US GDP). Therefore, the benefit of lower energy prices to the consumer, and many businesses, greatly outweighs the hit to energy companies and/or energy-oriented spending; even if the hit is not inconsequential, especially to energy-oriented states. This establishes the case for consumer spending outpacing income growth, given that consumer free cash flow is rising rapidly. Lower gas prices, just in 2014, saved American consumers an estimated $14 Billion according to AAA. The forecast is that every American family will save $550 due to cheaper gas in 2015. That’s cash that can go somewhere other than the tank.

Furthermore, lower energy prices put downward pressure on overall inflation; a plus for both the US economy and stock market. It reinforces the “Goldilocks” economic environment (not too hot, not too cold) which is a plus for stocks. Lower inflation has historically meant higher stock valuations. In fact, there is a direct inverse correlation between the energy sector’s weight in the S&P 500: a lower weight, typically courtesy of lower energy prices, has led to higher overall S&P 500 P/E ratios, and vice versa.

In other words, though the stock market will gyrate along the way — having energy companies be a smaller component of the overall stock market is good for the stock market.

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