When an asset class with the influence of oil falls 56% in a span of 6 months, it grabs attention. Few people (if any) anticipated recent developments and the topic has been widely debated, raising many questions from clients. To help provide clients some clarity on the situation, we outline some of our views below regarding the decline of oil and potential implications.
Oils decline is positive for consumers of oil, not producers. Because consumption comprises a larger percentage of the U.S. economy, falling oil prices are generally viewed as a net positive. The oil decline essentially serves as a tax cut for low and middle income consumers. However, the shale boom has been a clear positive for the U.S. economy in recent years, benefitting overall growth conditions, employment, trade deficits, and capital spending so there is sure to be fallout.
Oils decline has been driven by classic supply/demand dynamics. Weaker global demand combined with a surge in U.S. production has created a global supply glut. OPECs recent production decision to maintain output in the face of falling prices has exacerbated weakness.
Oil has likely entered a new price environment. Prior periods of supply surges left oil prices low for an extended period (i.e. 1980s 1990s). We believe such an outcome could play-out again with prices establishing a new trading range well below the $80 110 range that has existed for much of the past decade.
A rapid build-out of U.S. energy production left companies with weaker, more leveraged balance sheets, which may be vulnerable in oils new price landscape. Companies with weak balance sheets are most vulnerable to oils decline as most hedges roll-off by third quarter of 2015. Those companies with stronger balance sheets will likely capture market share and grow stronger, while the weak will likely get weaker or disappear altogether.
Active managers are selectively exploiting opportunities, lessening the need for clients to try picking a bottom. Oil prices have tended to overshoot in both directions, making it hard to predict exactly where prices will bottom.
Lower oil prices and a stronger U.S. dollar are helping to suppress inflation. While the Federal Reserve wants to move interest rates off the zero bound to provide policy flexibility in the future, a lack of inflation pressure furthers the likelihood they will be very deliberate in raising interest rates.
Falling oil prices increases geopolitical risk in oil-producing countries. We believe the stage is set for geopolitical events to drive higher volatility in 2015 and oil may be a key driver.