Oil Prices in Free-fall - Should I be Worried?

As I write this today, crude oil sits at around $5.50 per barrel! As we began the year at an already low $68 per barrel, we are seeing a collapse of the oil markets like never before. What does this mean to the world economy and all of us? Although gas prices at the pump continue to fall, is this something I should be worried about? Let;s dive in.

---

Never Forget that Oil is a Commodity

To better understand why the price of Brent crude has been so volatile, think about the definition of a commodity: "A basic good used in commerce that is interchangeable with other goods of the same type. Commodities are most often used as inputs in the production of other goods or services.”

Economics tells us, when the price of a commodity rises, supply usually rises as well. If oil rises to $100/barrel – shale oil development and hydraulic fracturing in North America become very profitable, for example. This is what led to much of the increase in the world’s oil supply over the past several years.

But when the price of a commodity rises, it will also place a damper on demand. As with all commodities, sustained high pricing drives supply increases and demand reductions. In the case of oil, global production has increased while global consumption is down – and the result is an oversupply.

With respect to oil, prices dropped recently because the supply of oil increased dramatically worldwide.  U.S. domestic oil production had nearly doubled and, as a result, foreign oil that would have been sold to U.S. consumers was sold in other countries.  In addition, since December 2015, U.S. producers were allowed to export crude oil for the first time in 40 years, so even more oil was on the worldwide market.

So, where is all this extra U.S. oil coming from?  Oil production in the U.S. surged in recent years due to shale oil.  Until recently, the oil trapped in layers of rock was largely inaccessible.  However, recent advances in hydraulic fracturing (fracking) and horizontal drilling have opened up the oil in this shale.  Producers have pumped this oil and continue to find new reservoirs of resource-rich shale. This increased production reduced both the cost of oil (more supply) and American dependence on foreign oil. 

At some point, low prices will eventually stimulate demand and curtail production. And with oil, as with all commodities, prices will find a new equilibrium.  With COVID-19 however, that demand is not currently needed, further exacerbating an already tenuous market condition.

Politics

How low is too low? As is often the case, politics and pure business sometimes is the driver, and it certainly was here. For a few years now, Saudi Arabia and Russia had an agreement.  They would create a floor in prices by managing and essentially limiting their production. That was going along swimmingly until the two disagreed on production levels; the Saudi's wanting even less in response to slowing demand, and the Russians oddly,  wanting to increase production.

Then like two children, they decided to settle their disagreement by seeing who could harm the other one more by driving the price even further down and flooding the world with more cheap oil. Hence, here we are! President Trump tried to send both kids to their room for a time out last week, but as is often the case with strong men, their pride will likely keep this going for months to come.

The Bad News from Falling Oil Prices

Economists and investors worry about the falling prices of oil for lots of reasons, including:

• Oil demand is considered a measure of economic strength.  Falling oil prices signal weak economic demand and slowing economic growth. Further, falling oil prices might indicate that we are entering a deflationary period, which harm asset values. 
• Collapsing oil prices can drive the U.S. dollar higher, making U.S. exports much less competitive in the world market. And this is important since some 50% of the Standard & Poor’s 500 companies’ revenues come from international markets.
• Falling oil prices hurt U.S. domestic oil production, which is an important economic growth sector. Faced with lower prices, oil drillers may shut down operations and lay off workers.
• Depressed oil prices could push 10-year Treasury rates to new all-times lows, as interest rates are closely tied to inflation/deflation rates. And the 10-year note fell below its historical low of less than 1% in early March, rallied a little, and has consistently remained below that threshold since the middle of March.
• Extremely low oil prices may disrupt certain financial markets including those for high-yield corporate bonds, fixed-income derivatives, and sovereign debt of some oil-producing countries.
• There could be increased geopolitical uncertainty due to the rapid loss of oil revenues in Russia and the Organization of Petroleum Exporting Countries.

These worries are legitimate, but a glass-half full investor might prefer to look at a more positive view, one that is bullish. Here is one such thought: it is true that generally speaking, when oil prices increased over a long period, stocks struggled, and when they declined long-term, stocks trended higher. But there are other reasons to be bullish too.

The Good News from Falling Oil Prices

In a more practical sense, how does the price of oil affect the cost of gasoline?  In a nutshell: a change in the price of a barrel of oil directly affects the price of a gallon of gas.

Here’s why: a barrel of crude oil holds 42 gallons. From this barrel will come about 12 gallons of diesel fuel, 4 gallons of jet fuel, and smaller amounts of propane, asphalt, motor oil, and various lubricants, along with about 19 gallons of gasoline.

So, it takes a barrel of oil, on average, to come up with about 1.5 tankfuls of gas in your average, non-diesel car.

Considering all the oil products, each person in the U.S. consumes an average of about 2.5 gallons of crude oil per day, according to the Department of Energy (that number is likely less at the current time, given COVID-19).

As of mid-April, according to the American Automobiles Association, the price of gas is trending down. In fact, AAA reports that the national average for a gallon of regular gasoline has decreased to $1.82.

And if you don’t live in Kentucky, you might not have noticed that it was the first state in the U.S. to see fuel prices drop under $1 per gallon. Then Ohio followed suit, with an advertised price of just 89 cents per gallon.

Will your state and the rest of the U.S. see gas prices drop under $1? Probably not, but the trend is certainly heading south, and some are predicting that the average national price will be under $1.50 by mid-summer.

Time to Invest in Energy Related Stocks and Funds?

Well, I love your thinking! Buy low. right? That said, it had better be a position that you plan to hold for a long time and stay committed to it. It is unlikely in the short term that oil will reverse up substantially and I'm not sure I would want to fight the downtrend (what's left of it) at this point.

Further, when a trend is changing, don’t expect to see a signal. Any forecasts you see about oil prices will almost surely be inaccurate.
Here are two themes that investors should remember:

• The price of oil has been a major economic factor for decades. The cost of energy affects virtually every aspect of the economy and the market, including our investments. 
• The price of oil will continue to fluctuate, producers and oil-producing countries will change their plans, and alternative energy sources will continue to develop. 

 
But the most important thing for investors to remember is this:

• Your Certified Financial Planner™ will monitor all of these developments and is your best source for information about their effect on your investments.