"Kee" Points with Jim Kee, Ph.D.

Without a doubt the story of the day is the breathtaking drop in crude oil prices that has occurred over the past month. Brent crude (priced in London) was $115 per barrel in June and now stands at $71 per barrel, while West Texas Intermediate declined from $107 to $67 per barrel during the same period. Stocks in the energy sector have declined almost 19% over the past three months and are down almost 10% year-to-date, even though the overall market is up nearly 14% for the same period. That is a great “real-time” illustration of the importance of sector diversification, which means owning stocks in all ten broad economic sectors (i.e. Healthcare, Technology, etc.) while limiting one’s exposure to any one sector. The downward movement in oil prices is consistent with the views expressed by speakers at our annual STMM Oil Symposium last May, and we have in fact been underweight in energy stocks in our portfolios since the beginning of the year.

 

What is driving oil prices? It starts with supply and demand. A decrease in oil demand will lead to lower oil prices and a lower volume of oil produced and sold. Likewise, an increase in supply will also lead to lower oil prices, but with a higher volume of oil produced and sold. If you are a consumer of oil, you benefit from lower oil prices regardless of whether they are predominately supply driven or demand driven. On the other hand, if you are a producer of oil – like Russia, or Texas – you are hurt by lower oil prices, but much more so if they are demand driven because the volume produced and sold also declines along with price

 

Demand: Globally, the economic data continue to show a slowing of growth outside of the United States, particularly in China, Europe, and Japan. I believe that China, at the margin, has the most impact on global oil demand growth, and China is slowing. But that’s been going on for years now, and so it does not seem to provide a good explanation for the timing of the sudden plunge in oil prices. Plus, airline stocks have rallied (increased) fairly dramatically as oil prices have fallen, and it seems unlikely that as economically sensitive an asset as airline stocks are, that they would do well if the oil price decline were primarily reflecting a decline in global growth.

 

Supply- the best explanation: Energy expert Daniel Yergin asserted Sunday in The Wall Street Journal that increases in oil production from the US and Canada over the last few years have balanced or offset production declines in the Middle East, resulting in $100 oil. More recently, slower global economic growth has been accompanied by large (and surprise) increases in supply from countries like Libya (who suddenly quadrupled output) and Saudi Arabia. And last week the Organization of Petroleum Exporting Countries (OPEC) decided not to cut output, that is, not to try to maintain higher prices by restricting oil output. These events seem to have triggered the price decline. The OPEC decision has been interpreted by some as an attempt by OPEC to drive the shale players out of business with lower oil prices that make hydraulic fracking uneconomical. But it can also be interpreted as a decline in OPEC cohesiveness, particularly since member countries like Venezuela and Iran (and Nigeria and Algeria) wanted a production cut and need higher oil prices in order to fund government spending (the countries that “matter” are Saudi Arabia, Kuwait, and the United Arab Emirates -Wells Fargo Securities). I think both are plausible, and it has led in recent weeks to conjecture that “$100 oil is over” and that $50 might be the new floor (Citi Research). That $50 per barrel figure also seems to be a widely cited break-even point for many US “tight oil” plays (WSJ).

 

Implications for the US: Lower energy prices are a positive for the US economy, but perhaps less so than they used to be. On the plus side, lower energy prices translate into lower gasoline prices (with a lag), a windfall for discretionary spending. They also lead to lower home heating costs and lower business/government fuel costs. But the energy sector also accounts for 24% of capital spending and R&D (research and development) spending in the US, so lower oil prices mean lower capital spending. Efforts that I have seen to quantify the overall impact off these two offsetting forces on US economic growth conclude that the net effect of lower oil prices on the US economy is positive (Federal Reserve; Goldman Sachs).

 

Oil and Texas: However, lower oil prices are unambiguously negative for Texas, the number one producer of oil and gas in the nation (Texas produces 36% of the nation’s oil, and 28% of its natural gas). Oil and gas comprise 13% of Texas output, but this has grown 68% since 2010, more than twice as fast as total state output. As a capital (rather than labor) intensive industry, energy makes up only 2.8% of total state employment, but job growth in the sector has been about five times that of the state since 2010 (Federal Reserve Bank of Dallas). Oil price impacts also vary by region, with energy comprising 25% of economic activity in areas like Midland; much smaller in areas like Dallas and Austin. There are spill-over effects as well, as energy production affects construction, professional and business services, trade, manufacturing, and banking. I think these spillover or “neighborhood effects” tend to be underestimated.

 

Our View: Texas job growth and general economic growth rates have been about double those of the country as a whole, largely due to oil and gas. For example, job growth in Texas is running at a 3.9% annualized rate, versus 1.9% for the US. That’s probably over. Jeanie Wyatt and I (and many of you I’m sure) can easily recall prior Texas busts, whether oil-related or other (like the Savings & Loan crisis of the 1980s). Then, as now, the story was that the Texas economy was more diversified than it used to be. But the subsequent downturns nevertheless exceeded everyone’s expectations. That’s probably the right frame of mind to have as we enter an era of lower oil prices.