Crude oil’s cascade beginning in the summer of 2014 shocked the markets and sent the energy sector into disarray. Wells were idled, capital spending plans were shelved, companies went bankrupt and unwanted supply went anywhere it could—including into tankers held in harbor. While the per-barrel price has bounced off these lows, settling near $50 in recent weeks, it is still volatile due to geopolitical situations impacting supply and low inflation compromising the traditionally beneficial effect of lower prices.
Taken in full, the environment has arguably created such a different dynamic: we can no longer look to the price of oil as the primary indicator of the condition of the global economy and the valuation of risk assets. A new view of oil’s role must take into account the greater context, with attention especially paid to inflation. We believe investors should consider the following three key points to get a more complete grasp of the bigger picture:
- A traditional view is that the lower cost of energy is good for the economy. When the price of crude falls, the cost to manufacture goods does as well, benefiting industry and energy-importing countries such as the U.S. and China. That in turn puts more cash in consumer pockets and revs up GDP, stimulating these economies. But this progression assumes a typical inflationary environment, and the world is far from that at present. The U.S. recovery from the global financial crisis has been the slowest of the post-war era, and countries elsewhere are even more growth-challenged. Disinflation worries continue to be front-and-center, prompting some central banks to keep rates near zero and others even to move into negative territory, including much of Europe and in Japan. In this context, a decline in energy prices is unwanted because it tends to put downward pressure on inflation. Simply put: in periods of high inflation, lower oil prices help; in times of low inflation (the current environment), they hurt.
- The second crucial observation to make is that the supply-demand dynamic has changed—but not in the way some think. One popular explanation is that aggregate global demand has not yet recovered from its precipitous plunge during the Great Recession. But the reality is that demand for oil has been, and continues to grow, if at a sluggish pace. Corporate and household balance sheets are solid, and the growth rate, as measured by the number of barrels bought per day, has been steady and somewhat predictable. We feel instead that it’s a supply issue. With OPEC no longer the de facto regulator of crude pricing through the manipulation of supply, effective coordination is mostly off the table. OPEC has yet to curtail production; the U.S. shale industry has nearly doubled production over the past 10 years until a recent pullback; and oil-rich countries such as Iran, Iraq and Libya have returned to the market but with plenty of questions. Production, therefore, is unpredictable and volatile, abetted by conflicts in the Middle East, Venezuela, Libya, Nigeria and Russia. It all makes oil a poor—if not broken—gauge of macro trends.
- Finally, the sheer size of the global oil enterprise means viewing it as an industry is useful. The energy sector is a sizeable portion of the stock market that represents global energy exploration, production, oil-field service and refining conglomerates, and more. When profits fall, capital expenditures tend to go first, affecting more than just energy companies. As the plunge in crude stretched into 2015, even the major corporations were postponing or outright canceling drilling projects from offshore rigs to shale gas wells. Slowly but surely, however, the industry has adapted to the new scenario, especially in the U.S. Whether through bankruptcies or cutbacks, the sector has essentially right-sized. The private sector can adjust relatively quickly to severe challenges like this. But sovereign nations can’t do so nearly as fast or as efficiently. The dive in prices has ravaged the economies of energy oil-rich countries such as Nigeria and Venezuela and disrupted others, such as Australia and Canada. While governments can sell bonds, print money and tap reserves for immediate needs, expansive programs such as social services or military build-up can’t be ramped down quickly.
The swing of supply and demand for oil will always play a role, but the paradigm has shifted, perhaps permanently. We can no longer can look at oil prices and energy through the prism of the past, but must examine it in context and from different angles to best gauge its meaning and effect on the world economy.