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Cheap oil: good or bad?

Falling oil prices are making investors nervous. Global equity markets have trended down with energy prices lately to the point where the broader stock market is trading almost in lockstep with crude. According to a recent Wall Street Journal article, the correlation between the S&P 500 and the price of oil has risen to 90 per cent, the highest ratio in 26 years. Clearly, equity markets are tracking oil. But does this make sense?

Taking a big step back it really doesn't. Lower energy prices are actually a boon for almost all industries except those involved in oil and gas exploration and production (E&P). The world's largest economies including the US, China, Japan and Germany are net buyers of oil. When prices fall, the global economy receives the equivalent a major fiscal stimulus programme. What's more, consumers see the improvement almost immediately at the gas pump without having to wait on tax refunds or government spending programmes to begin.

On the other hand sudden, unanticipated changes — even positive ones — can be disruptive in the short run. For example, many capital equipment makers are now seeing substantially less demand for energy extraction and transportation equipment as the E&P companies are forced to cut back on unprofitable drilling. According to Standard and Poor's, approximately 30 per cent of capital spending, or about $890 billion had been dedicated to the oil patch, and a good portion of that amount was predicated upon at least $50 per barrel oil.

With oil now trading near $30 per barrel, one has to wonder about the current value of those projects. Moreover, many of these projects were financed with debt which is looking increasingly riskier as prices stay soft. The latest worry is over banks which may have lent too much to resource extraction companies. Some of the largest European banks are trading at levels not seen since the financial crisis due in large part to concerns about problem loans in the commodities sector.

Also weighing in on the oil/bear market argument is the notion that lower commodities prices are the proverbial “canary in the coal mine” for the global economy. Falling prices are thus assumed to be predicting an imminent downturn in the economy.

Indeed, the International Monetary Fund has been steadily lowering its forecasts for global growth. China, in particular, appears vulnerable. At the same time, cyclical stocks such as those in the consumer discretionary, industrial and financial sectors have taken a greater-than-average beating this year while investors bid up the prices of more defensive companies such as utilities.

The argument for cheaper oil predicting a slower economy, however, really considers just the demand side of the equation (slower growth mean less need for energy), without taking into account an abundance of new supply. Hydraulic fracturing has been a major source of disruption in the energy sector. Previously difficult-to-reach tight oil supplies in parts of America have now become economically accessible. With the US becoming steadily less dependent on imported foreign oil, the game has changed. And yet, tapping US shale through advanced drilling processes is merely another example of technology disrupting an established industry.

The bottom line is that oil prices should probably have less of an effect on the broader stock market then they currently do. In my opinion, investors have been increasingly leaning on oil for direction in response to general confusion about the course of the global economy. China's opacity with respect to its economic policies and unwinding of its credit-driven asset splurge, combined with America's leadership vacuum has created a stressful backdrop.

On the latter point, America's current president has just introduced legislation to tax oil by $10 a barrel — thereby potentially revoking a portion of the aforementioned energy price benefit — in order to fund some of his pet energy projects. Many similar projects have failed miserably and all could be covered much more efficiently by the venture capital industry. Certainly, the bill will be squashed in Congress — but therein lies the problem. Talk about wasted energy!

These are interesting times. Economies have been driven more and more by monetary policy to the point of unprecedented, negative interest rates and massive quantitative easing throughout much of the developed world while developing markets, largely joined at the hip with China, struggle to reinvent themselves.

The vicissitudes of the energy market have given short-term traders a focus. Market prices are either set by governments and cartels or determined by free market forces. In this case, the Opec cartel's unwillingness and perhaps inability to control its output is forcing the market to clear prices and this has not been a smooth process.

Cheaper oil should be considered within the context of the persistent evolution of technology which ultimately moves us forward. More efficient energy extraction has lowered the prices on a secular basis just as alternative energy sources including solar and wind power are slowly making us less reliant on fossil fuels. No one complains about the dramatic drop in semiconductor prices which now give us previously unimaginable access to computing power and information.

Investors can profit from these big swings. Many companies in the consumer discretionary sector are likely to benefit in the months and years ahead. In late 2014, I wrote here (“Playing the drop of oil”) that this sector was a good place to begin making investments as lower energy costs should eventually spur consumer spending. As it turned out, the consumer discretionary sector was the best performing group in 2015.

However, with markets swinging back in favour of defensive industries so far this year, consumer stocks have sold off more than the averages. The broad group includes many beaten down auto-related companies, media concerns and quality retailers where we are seeing bargains once again. When the dust settles, the market leaders will re-emerge as winners.

Bryan Dooley, CFA is a senior portfolio manager at LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information.

This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.

Supply boom: technology has disrupted the energy industry by giving access to previously inaccessible oil trapped in shale rock

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Published February 16, 2016 at 8:00 am (Updated February 16, 2016 at 12:25 am)

Cheap oil: good or bad?

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