Oil's Big Slide - "Some Will Win, Some Will Lose"
If you recognized the tag line for this article as a lyric from a 1981 hit by American rock band Journey, go ahead and pat yourself on the back. Interestingly, the title of that ballad, “Don’t Stop Believin”, pretty well echoes our overall outlook regarding the long-term effect of falling oil prices on markets, and our portfolios.
What’s happening with oil? Basically, supply is outstripping demand; and demand has been softening. In addition, while media outlets have reacted to the decline with shock, the behavior of oil in the last few weeks shouldn’t have been entirely unexpected, given the fact that prices of commodities in general have been headed downward since June of this year.
Commodities are clearly out of their secular (long term) bull run. The peak of this cycle – which is easy to recognize once you’ve passed it – was probably in 2011. If the ensuing secular bear market in commodities lasts as long as the bull market did, we may have a while to go before it makes sense to be long in this arena.
The Onshore Wind
Given the fact that we could see low oil prices sustained for the next couple of years, the immediate bad news is for those currently holding energy-producing companies or stocks. Immediate pain aside, the right oil company, with a conservative balance sheet, built to survive in this environment – one that would continue to profit even at $35 or $40 a barrel – could end up becoming a very good purchase indeed. That said, dying secular bulls can be extremely risky, with investors who jump in early suffering significant losses as the specific market continues to head lower. This is one reason it’s not a good idea to use pessimism alone as a driver for buying.
Another real threat is the detrimental effect that low commodity prices can have on countries that are heavily reliant on oil for their exports and budgets. Of course this could actually be translated as good news for the United States as many of those countries are generally ill-disposed towards the U.S. If their revenues are lower, they’ll conceivably have less opportunity to engage in counter U.S. activities.
Also, although doomsday peddlers are claiming this tidal change will bring about a wave of defaults in the high yield bond market (playing on fears that past defaults in the housing market could repeat themselves in this market) we see this as not much more than an interesting way to get people agitated. While energy companies are indeed significant players in the high yield bond market, even if every one of them defaulted on their high yield bonds the effect would not be nearly as significant as the housing market defaults, simply due to scope. The potential exposure here is perhaps $100 billion, which is no small amount, but certainly nowhere near the exposure of the housing crisis.
The Beach Break
Bearish commodity cycles have typically been a tailwind for the U.S. economy, with a 10% drop in the real price of oil typically boosting economic growth by 0.20 percentage points one year later. So, a 40% decline in the real price of oil would potentially add 0.80 points to economic growth over the next 12 months. Also, unemployment rates tend to decline 18 months later.
Also, since we’re a consumer-driven economy, dollars saved at the gas pump often translate into greater retail spending. Falling oil prices generally provide real help to lower income households, as the cost represents a higher proportion of their total budget. They’re able to take that increase in cash flow and apply it to those areas where they previously had to cut back. It wouldn’t be a surprise to see holiday spending turn out a bit better than expected. While the numbers that came out regarding post-Thanksgiving shopping were lower than the year before, when all is said and done, a lot of gas pump savings may be directed back into discretionary spending, and end up wrapped as holiday packages.
In addition, airlines will benefit from lower oil costs, as jet fuel is one of the largest expenses for most airline companies. Take a look at the stock price of any of the major airlines since oil has started to decline and you’ll likely see an increase. If airlines only see a 10% drop in their fuel prices this year, their earnings will be significantly, positively impacted.
Usually, stocks do very well when commodities don’t do well. There’s very little overlap in secular bull markets, meaning that a secular commodity market usually goes strong when stocks aren’t the best place to be and vice versa. Looking back as far as 1900, secular stock bull markets occur at the same time that commodities were in secular bear markets, and although there have been periods where very large declines in commodities have been associated with recession, at present our information shows the odds of a U.S. recession are low.
Overall, we think the market is set up to rally strongly into the end of this year, with the current trend likely continuing into 2015. Of course that view can change, and there’s still a lot that can happen in December.
We’ll roll out our vision for the New Year in early January, but for now, we’re looking forward to a wonderful holiday season, and we wish you the same as we try to stay on the right side of momentum. Best wishes to all!
- Greg Stewart, CIO