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The outlook for crude oil has a significant impact on many aspects of our economy and markets. We briefly mentioned the drop in crude oil prices in our summer newsletter, but the decline has become much more of a relevant theme going into the end of the year.
Brent crude now trades at a 5-year low of $61.85. That’s a massive decline of 46% from the June 19 high of $115.19. A confluence of factors have led to the significant reduction in price. The strong U.S. dollar has contributed to a broad decline in commodities overall. Total world rig count has been steadily increasing since 2009, totaling 3,659 rigs as of September. That’s approximately triple the amount from 2000, above the recent peak in 2008, and back to a level not seen since the mid 1980’s. Domestic demand has been trending lower, leading to a supply/demand imbalance.
The price of crude oil has a strong correlation with consumer price inflation in the short-term. This decline in energy expenditures increases discretionary spending by consumers and is a positive for the economy. Consumer sentiment is currently at the highest level seen since before the recession. This is a positive for the retail industry during this important holiday shopping season.
The S&P 500 dropped 3.5% this week, wiping out 5 weeks of market gains. The S&P ended near an important technical and psychological level at 2,002. Financial commentators mentioned many reasons for the large decline, including year-end tax trades, but the bulk of the discussion seemed to focus on the fall in crude prices. A 13% weekly decline in crude prices is certainly something that gets your attention.
Energy related companies are obviously negatively impacted by the continued and accelerated decline in crude. The most severely impacted are the drilling and exploration companies. Some of the stocks in this industry are down 70% from their recent peak. Many investors have unfortunately fallen for value traps in the industry with the argument that the stocks are cheap. Are they? There really is no way to tell until you can get a good idea of where oil will bottom and where it will stabilize over the next year and beyond. We do not believe anyone can do that with any certainty, but there will always be plenty of investors willing to speculate.
The energy sector comprises only 8% of the S&P 500. Most of the other 92% should actually benefit from decreased energy prices. Thus, we believe that the net impact of lower crude is positive. We’ve been actively looking for companies that will be the biggest beneficiaries of reduced energy prices. The consumer is one of the most obvious places, especially during the holiday shopping season. The positive effects of reduced energy prices is fairly pervasive though and should eventually show up in many areas of the economy.
Crude oil has potentially been technically oversold in the short-term and could be due for a bounce. We would caution anyone on trying to pick a bottom though, and we consider the fundamental drivers of cheaper crude to be likely in effect for a much longer period. We think investors that found themselves overly exposed to energy investments should form an exit strategy to lighten up their exposure on any bounce. They should also hedge their exposure risk by finding companies that benefit from the decline in crude.
Long-term investors may consider the decline in the market this week as a buying opportunity. We think that may make sense on an individual basis and certainly in consideration of the primary drivers of the market activity. As always, consult your investment advisor to determine the appropriateness of any change in your investments.
by Jason Self, CFA, CFP®
All investment decisions should be based on your specific situation. Please speak with your financial advisor before considering any changes to your investment portfolio. The information we have provided is for informational purposes only and is not intended to represent specific advice to anyone. We are not guaranteeing the accuracy of any information contained in this report and will not be held responsible for any errors or damages that result from acting on information in this document.