$33 to Fill ‘er up – We Should be Happy, Right?

Gas prices in our part of Vermont remain stubbornly above the national average, but we figure that we’re still on track to spend $1,000 less on gasoline per car than we did last year. That’ll buy us each something on the order of 175 pints of Ben and Jerry’s ice cream, 10 days of skiing at Stowe or 2,000 K-cups to brew in our Keurig machines – darn nice whatever your preference!

Gasoline prices move with oil prices, which have dropped from $100 a barrel to $50 in the last six months. Consumers clearly benefit when the price of one of the things we need, like gasoline, falls. However, cheaper oil that is good for the consumer has been a monkey wrench for the markets, as recent volatility has demonstrated. Our research suggests there has been little correlation between oil and equities over long periods of time. However, we did find some evidence that stock prices tend to follow oil when investors are nervous about the economy. This is especially relevant  after a multi-year bull run. A number of prominent market observers are warning that the plunge in oil prices is a harbinger of a weakening global economy and more pervasive deflationary pressures, a frightening combination.

Our take on oil’s drop:

  • Oil’s precipitous price decline is primarily due to a supply shock as the rapid increase in US energy production has eclipsed demand from a sluggish global economy.
  • The supply/demand imbalance is likely to be with us for some time given producers’ long lead times and sunk costs together with divergent geopolitical agendas.
  • For the US economy in particular, the next six months should reveal that the beneficial effects for the consumer considerably outweigh the negative impact of the decline in energy investment.
  • In the absence of a more sinister explanation for oil’s drop and given some promising indicators of economic strength, we see the US as relatively well insulated from the more systemic deflation that persists in Japan and may now threaten Europe.
  • Given the uncertainty about the trajectory of oil prices, it is sensible to seek out investment opportunities where success factors are not dependent on the future pricing of oil.

Let’s dig a little deeper:

Slowing demand growth has contributed to oil’s collapse – European and Asian economies are in pause mode. But larger supplies are the main story. New US production accounts for the majority of worldwide supply growth over the past four years – with perhaps more on the way. Saudi Arabia has reacted by abandoning its historical support role as the global energy balancer and is instead keeping its pedal to the metal to maintain market share. As learned in Economics 101, greater supply must be met with increased demand, or price will fall until the two are again in equilibrium. In today’s world, the price had to fall quite a bit to restore that balance. Short-term demand is inelastic; we’re not going to double our drive to work or heat our houses to 90 degrees just because it got less expensive to do so.

Truck and SUV sales are accelerating as we enter 2015. Taking a longer-term view, we think adoption of cleaner and more efficient vehicles, homes and lifestyles will continue unabated. Years from now, today’s developments may be regarded as part of a permanent downward shift in the demand curve for oil. Demographics (i.e. the preference of the Millennial generation for urban living), and a pervasive drive to cut costs via greater efficiencies are factors behind this trend. With it will come fresh opportunities for investors.

In the meantime, cheaper gasoline and heating fuel mean that consumers can buy more of everything else, even with stagnant wages. In the US, this probably means more restaurant meals, iPhones, vacations, and excursions to T.J. Maxx. Indeed, lower oil prices are expected to add 5% to US retail sales in the coming quarters and a rise in industrial production should follow. Benefits will be muted elsewhere in the world as higher taxes dampen the effect (Europe) or because gasoline consumes a smaller share of the family budget (developing world).

All else equal, oil’s fall is a positive. However, were it to be accompanied by negative changes in overall price levels, we’d have real cause for concern. Deflation is a negative feedback loop. If prices are expected to be lower tomorrow, people rationally defer purchases until tomorrow. The economy shrinks, wages fall and jobs are lost. Those with debt become ever more indebted. Fortunately, there is little evidence of broad-based deflation in the US. The costs of food, housing, education and healthcare continue to rise. Vigilance is nonetheless required – a stronger dollar could enable our trading partners to export deflation to America.

Oil producers are now slashing budgets and marginal wells are being shuttered. Yet over the next six months, supplies from new, more productive oil wells in Texas and North Dakota are likely to keep flowing. We foresee a bumpy ride before a long-term equilibrium comes into view. There is always a chance that the Saudis and OPEC could change course while geopolitical developments in Russia, Nigeria, Venezuela, or the Arab World are wild cards beyond our ability to fathom.

Some parallels from history:

  • 1986 – oil fell from $30 to $10 in less than six months, as OPEC “shocked” oil prices lower to restore market share it had lost to North Sea and other producers. Although oil prices gained 80% within a year, it was four years before oil made new highs.
  • 1998 – prices fell almost 50% as SE Asian “Tiger” economies stumbled from late 1997 to late 1998. Within a year the loss was erased.