Lower oil – a blessing that feels like a curse

Posted by on Jan 20, 2015

I’d love to be able to take credit for this phrase but, no. It’s by Andrew Sheets, an analyst at Morgan Stanley. I use it because his phrase does a great job of helping to put the recent market gyrations in perspective. More on that in a bit.

This last week, we had more volatility as everyone seemed to be trying to out quote, out position and out guess which way the (your choice) stock, bond, gold, oil and, in a more recent development, commodity prices in general were going next. For the record, after this most recent run down – and back up a bit – by the major stock market indices, the Dow currently has the worst year-to-date result…down by a little over 3%. The S&P500 and NASDAQ are each off about 2% over the same time.

For those feeling a little uneasy, even though I’m not suggesting a complete repeat at this point, let’s look back to a year ago now. According to David Rosenberg, Chief Economist and Strategist at Gluskin Sheff, last January had the S&P500 lower by 4%. It then corrected by 6% by the middle of last February. Nonetheless, by year-end, as you may recall, the total return for the S&P was 14%. Short-term action is only important to traders – and perhaps the makers of Pepto-Bismol.

On the other hand, after two straight years of declines, global market uncertainty since year end has gold up more than 7% and silver higher by over 12% as this is written. However, as UBS said in a note in lowering its gold price forecast for the year to $1,190 from $1,200 – it settled at $1,276 per ounce on Friday – the outlook for the year “remains clouded.”

The Swiss bank said it had underestimated the downside risks earlier. They said that “Downside risks have slightly been increased by the decline in oil prices given the potential positive impact this would have on the US economy and the implied absence of an inflation threat.”

Bond market last week

Bond investors everywhere continue to have a two-handed situation to deal with. On one hand, the lower global oil prices have made inflation expectations keep coming down. That’s forcing the bond market to rally. This is good for existing bond fund holders as their net asset values are holding.

On the other hand, the lower rates continue to put pressure on those holding bonds for income as bonds coming due have to be invested at today’s rates. For example, Treasury yields fell last Thursday, with the 30-year yield hovering near record lows due to a surprise interest rate cut from the Swiss central bank. These rates are a great deal for borrowers, as the big jump in mortgage-refinances recently demonstrates.

One thing to think of with rates this low is how to prepare for the coming generational reversal in bond fund values. Just another case for reviewing your asset allocation to prevent over-exposure to any one sector. If you’d like personal help figuring that out for your investments, please be sure to contact me.

Why the shaky stock market?

The truth is – who knows? It’s not due to the economy. Let me throw out a couple considerations for you.

Here’s what Bob Doll, Chief Equity Strategist at Nuveen Asset Management, offered this week for a probable explanation for Mr. Sheets’ headline observation. Bob said, “Part of the market’s recent anxiety can be traced to oil’s 55% price decline since June 20. As mentioned, cheap oil is hugely positive for the broad economy, but the concerns of the negative what if crowd have spread that oil could harm fourth-quarter corporate earnings, the reporting of which will be taking place over the next couple weeks.” (Italics mine)

Here’s what Phil Orlando, chief equity market strategist at Federated Investors, offered by way of an answer to that earnings question.

Phil believes, as do I, that all the hand-wringing about the negative effect of crude’s drop on S&P 500 earnings comes from folks “forgetting about the positive consequences on consumer spending.” His calculations show that “Every 1 penny decline at the pumps adds a billion annually to consumer discretionary spending.” This translates to $157 billion in additional consumer discretionary spending just from last April. At that time, a gallon of unleaded sold for a national average of $3.70. (According to AAA, the average price at the national gas pump is now $2.10 per gallon…that’s the cheapest gas has been since May 2009.) Phil added that, in our $17 trillion economy, the extra cash in consumer pockets should boost GDP by another 1 percent. (That’s definitely not bad…)

The lower oil prices have helped our recovery by giving consumers more money to spend. As a result, the bank raised its US growth projection slightly to 3.2%. The prices haven’t helped growth in importers, such as Europe and Japan, and have worsened problems in major oil exporters.

Will low prices shut in our oil fields?

Inasmuch as I’m strictly a consumer, as opposed to being directly involved in the energy creation process, I can only offer the following opinion…no. Here’s some big picture reasons why.

Last week, the World Bank said it was reducing its outlook for global growth…but not by much. That institution expects the global economy to expand 3% this year, up from 2.6% in 2014…slower than its earlier 2015 forecast of 3.4%. The key is that there still is global growth – just not at the rates of recent years. Further, the demand for energy is likely to hold up for some time. The International Energy Agency predicts that, over the next 25 years, it will rise by 37%, mainly “thanks to rapid economic growth in emerging economies.”

Finally, according to a statement from the World Economic Forum, their research says that “the trading range in the brave new world of competitive oil should be roughly $20 to $50.” To reiterate, doesn’t that mean all our brave new oil sources will now be shut in? My response is likely not. Consider this.

Just where is the low for producers?

Let me call upon the fine folks at The Bakken Magazine who have a definite interest in where that price is for those fields in North Dakota. Smart folks that they are, they called upon some pros who ought to know – the North Dakota Department of Mineral Resources (DMR) – to do a review. At the time of the DMR’s review, the oil price was $48.83 per barrel of West Texas Intermediate (US crude) with an average price of $40.54 per barrel. It closed Friday at $48.69.

The DMR determined that the breakeven price points-the price at which new drilling would cease-vary across the Williston Basin. That makes sense. They said that for McKenzie County in the heart of the Bakken field, where the majority of the wells exist, new drilling wouldn’t cease until oil prices dropped to $30 per barrel. Counties that are on the outer-edge of the Bakken will be the first to discontinue drilling new wells with breakeven prices about $75 per barrel.

The price at which production from existing wells would be shut-in would occur when the oil prices drop to $15 per barrel. FYI, US conventional producers typically have costs at or below those of the shale drillers.

Oh, Canada!

I find it quite strange that all the oil price talk very rarely seems to mention our friends to the North and all they bring to this party…and it’s definitely more than chips and dip. Check this out.

According to the US Energy Information Administration, Canadian crude exports to our market exceeded 3 million barrels a day in 2014, a record volume that helped displace other import sources. Further, very few of Canada’s largest oil sands producers today are talking about scaling back production.

First, it takes a really long time and tens of billions of dollars just to set up a site. Then, since many of their costs are fixed, existing oil sands surface mines can make money at about $30 a barrel. The most efficient underground oil sands projects run by Cenovus Energy (CVE), a big Canadian operator, can stay in the black at $35 a barrel. That’s still above the break-even levels of many traditional oil wells, but below those of some other unconventional sources of crude.

Unlike shale oil properties, which require constant drilling of new wells to maintain output levels, once an oil sands site has been developed, it’s likely to steadily produce tens of thousands of barrels of product per day…for up to three decades. Oh, Canada, indeed.

The risks the Canadians face, assuming continued production growth, are that the oil sands producers may wind up being held back by a combination of high rail costs due to their being a captive market, as well as access to enough pipelines to handle their production.


This is not 2008, version 2.0. The stock market dropping was the primary reason for low price then. Today, the price drop is all about, in my opinion, a lot of supply, more than weak global demand. That’s one of those good things as the lower prices from increased supplies will go a long way to helping and supporting our growth.

There can likely be more bumps due to the oil price changes, to be sure. As those occur, please keep in mind that, for an investor, time in the market is way more important than trying to time it.



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