Oil Prices Headed in the Right Direction!
Since late June 2014, the price of a barrel of oil has declined from $107 down to a low in December of $52 (West Texas Intermediate), representing a 48% decline. Such a large move in a short period of time presents both positive and negative effects for consumers, investors, companies and governments. Price swings like we have seen in oil this year can create big winners and big losers. As investors, that’s why we always want to be diversified and own a variety of different types of assets.
Reasons for Decline in Oil Prices
There are two primary reasons for the decline in oil prices. Simply put, it’s all related to supply and demand. The global supply of oil has increased. Since 2008, the U.S. has increased oil production by 3.5 million barrels per day, which alone is more than the production of any OPEC member except Saudi Arabia. Libya has also come online much quicker than many anticipated. In 2015, it is estimated that Libya will produce 1.5 million barrels per day. Meanwhile, normal demand from China, Europe and Japan has been anemic due to their stagnant economies. The result of increased supply and decreased demand is surplus, which drives prices down over time.
The Winners
U.S. Energy Independence – The U.S. is now the largest energy producer in the world when you factor both oil and gas. This is a large step toward energy independence. In 2005, the U.S. was 60% dependent on imported oil, but today only 21% dependent. U.S. production increases have come from abundant oil shale reserves, the ability to extract oil, and fracking and horizontal drilling. Fracking is a controversial method that involves blasting a mixture of sand, water and chemicals into shale rock to release the oil and gas inside. The shale boom allows producers to access the oil at a lower cost than traditional drilling. Many geopolitical experts believe energy independence will allow the U.S. to eventually untangle itself from challenging relationships with unstable governments like Venezuela, Iran, Russia, etc.
The U.S. Consumer and Consumer Stocks – 
In September 2008, the all-time high for average price of regular gas in the U.S. was $4.10 per gallon, today it is $2.30. Lower gasoline prices help consumers spend more money which benefits consumer discretionary companies like McDonald’s, Walt Disney, Amazon and Ford. The estimated windfall to consumers is approximately $125 billion.
Manufacturers – Manufacturing is a huge beneficiary of lower oil prices. U.S. Steel saves $100 million a year when the price of 1000 cubic feet of natural gas declines by a dollar. Agriculture is a heavy user of energy in fertilizer and transportation costs. The U.S. economy and work force are beneficiaries of global companies that are looking for new plant locations. The ready-access to natural gas is extremely attractive to European and Japanese companies because they can access it for 50% to 70% less than in their home countries.
The Losers
Energy Stocks – The energy sector is the only sector in the U.S. with negative returns for 2014, down over 7%. Meanwhile the rest of the U.S. market is positive with double digit returns. Energy stocks benefit from high oil prices and suffer when the prices drop. Eventually when the oil supply tightens, prices will rise, allowing stocks to recover; however the timeline cannot be predicted.
Oil Producing Countries – Oil producing countries, whose governmental budgets are heavily dependent on oil are suffering in export revenues. Countries like Iran, Venezuela, Russia and Saudi Arabia have government budgets dependent on oil at break-even oil prices of $137, $120, $100, and $93, respectively. With oil trading in the $50’s, they are running huge deficits. Significant portions of their budgets are used to subsidize the cost of energy and social programs. As an example, the costs of Venezuela’s subsidies are $27 billion or 8.6% of their GDP. This allows Venezuelan citizens to buy gas at seven cents per gallon versus their Columbian neighbors who pay $4.70 gallon. Subsidies are not easily taken away.
What it All Means for You
Market forces are hard to predict and they can have varied effects on investments. Therefore we continually advise staying diversified and taking a long-term approach. By allowing you the benefit of the winners and cushioning the blow of the losers, a diversified portfolio keeps you comfortable throughout the market’s fluctuations and has proven to be best over time.
Quarter-to-date Returns as of 12/31/2014:
S&P 500 13.69 | Russell 2000 4.89 | MSCI EAFE <4.90> | MSCI ACWI (global stocks) 4.16 |Barclays Aggregate 5.97