The Independent Market Observer

Low Oil Prices Hammer Markets

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Jan 20, 2016 12:56:57 PM

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oil prices hammer marketsOil prices continue to fall and are bringing markets down with them. We talked about why oil prices are dropping last week, so today, let’s take a look at why markets are getting hammered—and whether that is likely to last.

Markets reacting to costs, not benefits

The real reason for the market decline is the time lag between the costs and benefits of lower oil prices. When prices drop, the effect on oil-company revenues and profits is perceived immediately, and markets move to adjust. Recently, energy has been one of the worst-performing sectors for just this reason. Markets are efficient, forward looking, and excel at adjusting prices in response to this kind of event. The costs are now largely reflected in the market. As oil prices drop further, that damage is also being factored in, leading to the kind of drops we’ve seen this morning.

What about the benefits? Although the damage is focused and immediate, the benefits of lower oil prices are widespread and will only show up over time. Every person and every company uses energy in one way or another. But instead of a specific investment target, like the energy companies, there’s no poster child for the good side of lower oil prices. It’s harder to buy the upside than to sell the downside, and that's also moving markets.

What’s more, the benefits are slow to show up. For some companies, like airlines, the effect of lower oil prices does show up quickly. In other cases, as with the average consumer’s gas bill, it takes time. First, lower oil prices have to appear at the pump, then the consumer has to believe the price decrease will last for a while, and then his or her spending behavior actually has to change. Although the damage of lower oil prices is all too apparent, it can take a long time for the benefits to materialize.

We are starting to see some of the benefits, however. U.S. auto sales are at an all-time high, which makes sense. People tend to bucket their spending, so if they save on gas, they will tend to spend on cars, and that is just what has happened. Other parts of the world, such as China and Europe, which import significantly more energy as a proportion of their economies, have benefited even more than the U.S. You can make a good argument that, even as Chinese growth weakens and Europe is slow to recover, things would be significantly worse without the current low oil prices.

Lower prices likely to stick around

If the benefits are showing up slowly, will oil prices stay low enough long enough to be really meaningful? The answer is most likely yes.

Over time, oil prices have to be at or above the marginal cost of production. That is, if it costs $50 per barrel to drill a well and extract oil, oil will have to cost at least $50 per barrel. Here’s the problem: with wells that have already been drilled, any revenue might be preferable to no revenue, and suppliers can keep selling below the marginal cost of production price until the existing well is exhausted.

That’s where we are right now in many markets, including the U.S. Existing wells are producing even though it wouldn’t pay to drill new ones, and the price decline can last until those wells are exhausted.

This is also where geology comes in. Saudi Arabia has long dominated the oil markets because its cost of production is the lowest. At any given price, the Saudis can make more money (or feel less pain) than anyone else. As now, they are able to cut prices below other producers’ costs, in an effort to drive them out of the market.

With the U.S. fracking revolution and constant technological improvement, that advantage is eroding, but it’s still there. As a result, we can expect prices to remain low until the Saudis decide to reduce production. Even then, there will most likely be a cap on prices as U.S. producers move back into the game. Their marginal cost of production is around $50 per barrel and declining, which means relatively low oil prices should be with us for some time.

Short-term damage, long-term benefits

Long story short, markets are seeing the damage of lower oil prices but not fully pricing in the benefits. In other words, markets are overreacting. They tend to do this, and it can be painful.

Nevertheless, here in the U.S., we remain in a net-positive position with respect to low oil prices. Although the short-term damage is real, we stand to harvest the longer-term benefits, which should continue to boost our economy—and bring the markets back.

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