What Plunging Oil Prices Mean

Over the past months, oil prices have steadily declined, dropping below $60 per barrel on Thursday for the first time in over 5 years. This has resulted in a gasoline prices declining from nearly $4 per gallon in mid-summer to approximately $2.60 per gallon. What does this mean? What are the implications of this sudden change?

How much has the price of oil declined?

Oil prices have declined over 45% in nearly six months.

  • During the summer of 2014, oil traded in a range of $90-110 per barrel.
  • In early October, the price per barrel was $90.
  • On November 5th, oil traded around $80 per barrel.
  • On December 5th, oil traded around $66 per barrel.
  • On Thursday, December 11th, oil closed at $59.95 per barrel.

What has caused this decline in oil prices and how long will it last?

Oil prices, as a commodity, fluctuate based on supply and demand, as well as political and economic factors. Financial traders also can significantly affect prices, and may even exacerbate the price swings.

The recent price decline has most likely been caused by a huge rise in US oil production over the past few years, as well as a decrease in worldwide demand for oil. The US has been steadily producing more oil in recent years, due to shale and fracking innovations. While supply has increased, OPEC nations have not reduced their production.

In the past week, the further price declines were caused by new information. US data released on Wednesday showed that US oil supplies rose far above predicted amounts (oil inventory levels), while US production increased to its highest level in decades.

The future direction of the price of oil is very difficult to predict, as is any commodity or stock. There would have been few, if any, economists or oil analysts who would have predicted oil prices at these levels at the beginning of 2014. We doubt that few would have predicted prices below $60 per barrel of oil even a month or two ago. The pace and extent of the price decline is an unexpected event which could not have been anticipated or accurately predicted.

We cannot predict the future price of oil. However, we do know that we can learn from the past, which teaches us that oil prices tend to move dramatically, both up and down, and often quickly and unpredictably.

According to some reports, the current global production of oil is greater than demand by as much as a million barrels of oil per day. Saudi Arabia and other OPEC nations have not indicated that they will cut their production, as they need the revenue. In the short term, US oil production will likely remain the same or increase over the next year. If oil prices remain low, it appears that oil companies will eventually cut back on new project investments, which could reduce future production. This may take time to occur and impact future supply levels, and then, future oil and gasoline prices.

What are the investment lessons?

The sudden decline in the price of oil and gasoline confirms our belief that relying on predictions to make investment decisions is not a valid strategy. Unexpected events can and will occur.

The market impact of the sudden decline in oil prices confirms our philosophy of being well diversified across many companies, industries and countries throughout the world. By being very broadly diversified, our clients will not be dramatically affected by companies, industry sectors or countries which may be adversely impacted by these events.

Yes, our clients will feel the impact of the decline in oil stocks which are held in portfolios, but these may be offset by other companies which benefit from the price decline. More importantly, we do not make huge bets on specific stocks or sectors like energy, so while an oil company stock may have declined 20-40%, the impact of this on our client portfolios will be muted.

Beyond stock prices, there is now growing concern in the junk bond market about the ability of many energy production companies to repay debt which they have issued in recent years, under the assumption of much higher production prices. We have a policy of only buying very high quality debt on behalf of our clients. This risk-reward tradeoff is the proper philosophy.

Another major lesson:

During the depths of the financial crisis of 2008-09 and in subsequent years, I have stressed the resiliency of companies and countries to innovate and develop new technologies. This is a major influence on our long term positive view of the world and financial markets. While cognizant of problems throughout the world, the impact of the new innovations, like fracking, will now benefit many individuals and companies in the form of much lower gas prices, which will positively impact the economy.

Sources:

“U.S. Oil Prices Drop Below $60,” 12/11/2014, online, WSJ.com

“Capital Journal,” WSJ, 12/9/14

“Plunging Oil Prices Won’t Dent Supply in Short Term”, WSJ, 12/12/14

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