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

MARKETS

 

Collapsing oil prices create destabilization concerns

 

Big sell-off in stocks last week as oil’s continued plunge caused concerns over global growth. These concerns were also driven by lower than expected industrial production numbers out of China. US oil closed below $60 per barrel on Friday, a dramatic decline from its June peak of over $110 per barrel. I’ve mentioned in prior Kee Points that whether or not a sustained fall in oil prices is bullish (good) or bearish (bad) depends upon whether it is being driven primarily by changes in supply or changes in demand. And lower oil prices amount to a wealth transfer from oil producers to oil consumers. If sustained, they also lower the price of energy relative to other inputs (labor, materials, etc) resulting in greater - and more energy intensive - production. But what about large, abrupt changes as has happened during the second half of this year? Can oil price spikes and oil price plunges both be bad? I think they can if investors view oil price declines as destabilizing. That seems to be the case right now. There is a pretty wide gap between the perceived price that energy producers need in order to cover costs (call it $40-$50 per barrel and up) and what many oil producing countries need in order to fund their governments (call it $70 and up). Lower oil revenues in countries dependent upon higher oil prices could definitely destabilize those regions, and I think that is why markets are down. That also seems to be the message from the bond markets: uncertainty tends to result in a flight to safety as investors buy safe US Treasuries, raising their prices and lowering their yields. This happened last week as 10-year Treasury yields dropped down to 2.09% on Friday.

 

A KEY TAKEWAY

Diversification is the key message here: your portfolio should be up even though oil prices have collapsed. The S&P 500 is still up over 8% while the energy sector including MLPs is down anywhere from -10% to -40% and more for many smaller exploration and production companies. In fact, oil is the only economic sector with negative returns for the year, while Healthcare, Utilities, and Consumer Staples have been the strongest. Those are the classic defensive sectors by the way, which corroborates the move away from risk reflected in the bond markets. But remember, if you go back to the 1920s, stocks average over three pullbacks (a decline greater than 5%) per year, and we’ve only had two this year (so far). I find that fairly surprising given the general lack of good news globally from Europe, Japan, and China, and given the great (30%+) run stocks had last year.

 

WHY OPTIMISM?

 

The case for it in the US

 

Virtually all of the economic models I see (La Jolla Economics, Wells Capital, Citi, UBS, etc.) forecast the global economy including the US to accelerate (slightly) through 2015. Raghuram Rajan, India’s Central Bank head and a leading light, in my opinion, describes the current global economy as “mediocre.” That’s probably the best way to see it, neither booming nor collapsing. Some of this relative optimism is no doubt due to confidence that policy makers will respond positively to negative data (particularly on the monetary side), providing kind of a backstop to the downside. But why should the US continue towards stronger growth in 2015? Here are some collective answers: (1) lower oil prices should support increased spending, (2) the good job growth we are seeing should support increased spending, (3) increased business confidence (reflected in business surveys) should lead to increased business cash spending, (3) consumer deleveraging is complete, (3) excess housing inventory is largely worked off (Citi), (4) new rules from the Federal Housing Finance Agency increasing mortgage availability and (5) lower constraints on local and federal government spending.

 

Note: Author Russell Gold, who spoke at our Energy Symposium in May, had an excellent piece on oil published in The Wall Street Journal over the weekend. Gold discusses the impact that increased US oil production has had on world oil markets. And he explains the dynamics that led to the Saudi’s decision not to cut output; namely, that prior cutbacks were met by “cheating” as other OPEC members secretly increased output. Policing cheaters is a classic problem in the economics of cartels. Gold’s piece is a great 5 minute read.