Oily effects on investments
Joel Dresang: Brian, since the middle of 2014, oil prices have collapsed. It really has affected the financial markets. Why do we care so much about oil?
Brian Kilb: You know, Joel, I think the best way to determine the impact of these big macroeconomic issues is to figure out how it affects interest rates, earnings or valuations. In the case of oil, what we’re really focused on is the impact on earnings. Last year, the S&P 500, the energy sector was 6.6% on a market cap basis of the S&P 500. Those earnings were down 78% last year. That’s a big number and a big negative impact on earnings.
Joel: What about consumers? We’re a consumer-driven economy. Consumers have been saving at the gas pump.
Brian: Well, Joel, thanks for reminding me there is another side to the trade here, right? That’s the benefit to the consumer of lower gas prices.
Two years ago, 2014, average gas price was $3.58. That’s dropped below $1.50 this year. That saved the consumer $140 billion last year, but the consumer hasn’t put it to work yet as much as we hoped they would. So, we haven’t seen the benefit on the consumption side – just yet.
Joel: Why not?
Brian: So many issues that have caused an uncertainty where we just we really haven’t regained our footing yet. And there’s just a general sense of uneasiness that goes back many years now, where the consumer hasn’t regained his or her confidence enough to spend on those discretionary items. Those things that maybe they don’t need, but they want. But that will come.
Joel: Let’s back up a little. Why are oil prices so low, anyway?
Brian: Well, kind of classic economics, really, when you relate pricing to commodities, we use a term called elasticity. Commodities are really sensitive to changes in supply and demand.
This is an issue of supply. Production for oil over the last five years has risen dramatically, especially in the U.S. where we produced roughly 5 million barrels a day in 2010. Now, close to 10 million barrels a day, due in part to the explosion of the fracking industry contributing to that.
Meanwhile, the rest of the world, the normal big producers throughout the world are still pumping as much as they can. And that’s creating overall a situation where we have a glut in oil to the point where we have oil sitting in ships unable to be delivered anywhere, because there’s nowhere to store it. There’s a lot of oil out there, Joel.
Joel: You mentioned uncertainty. I imagine if oil prices were at an equilibrium, that that would help. What’s it going to take to get there?
Brian: Joel, the markets will find a balance. If producers make money somewhere between $40 and $70 a barrel, enough supply has to be chased out of the industry to find that balance again. The producers that produce at the higher costs, those marginal producers, are going to be shaken out of the industry.
The second part of that is the producers that will survive in the long run will probably need to reduce their production to levels where prices will rise, where they find that equilibrium, where enough companies will remain profitable in the long run to sustain the oil industry.
Joel: So what, if anything, should investors be doing about all this?
Brian: Well, first of all, Joel, know that a balanced portfolio will have exposure to the energy sector, and you’re going to participate in the recovery when it occurs.
But, if you have a greater appetite for risk, you want to take a little bit deeper dive, you could invest in specific energy company stocks. You could use ETFs or mutual funds that focus on the energy sector.
Joel, one of the ways that you can also add is to focus on those countries that are commodity-driven economies and re-balance your portfolio more from a regional standpoint than an energy-specific standpoint.
Joel: But for a balanced long term investor, it’s just patience?
Brian: Patience. This thing’s going to take care of itself. You’re going to participate in the recovery. Stay the course.
Brian Kilb is executive vice president and chief operating officer of Landaas & Company.
Joel Dresang is vice president-communications at Landaas & Company.
(initially posted Feb. 22, 2016)