Oil Moving Higher: Market Implications
Following a surprise announcement by OPEC (Organization of Petroleum Exporting Countries) earlier this month, Brent crude oil rose above $55 per barrel—a 16 month high. OPEC announced their intention to limit daily oil production by approximately 1.2 million barrels. The immediate result of the OPEC announcement was to send oil prices higher by more than 15%.
Much has been written about the oil price decline of the past two years. Just as consumers and investors were beginning to get used to $100 oil, the price of a barrel plummeted to below $30 by early in 2016. Even with a substantial rebound into the $50 per barrel range, oil remains drastically below its recent highs of the past five years.
Without diving too deep into the geopolitical explanations behind the decline in oil, the primary culprit is Saudi Arabia. Threatened by the emergence of fracking and shale oil from the United States, as the world’s largest oil producer Saudi Arabia drove down the price of oil in order to bankrupt the shale producers.
Saudi Arabia’s strategy has had mixed results at best, with most U.S. energy firms surviving even in spite of low oil prices. In the interim, the Saudis have run massive government budget deficits due to lower crude oil prices. The pain that the Saudis have endured has arguably not produced the shale bankruptcies that they had hoped. Accordingly, the recent OPEC announcement reflects a shift in Saudi strategy to a higher average price per barrel.
The decline in oil prices has brought both good and bad. On the one hand, the average price of a gallon of gasoline in the United States is now below $2 for regular unleaded, resulting in a significant cost savings for consumers. JP Morgan estimated in 2015 that the reduction in gasoline prices saves the average U.S. family approximately $750 per year. On the other hand, lower oil prices have had a hugely negative effect on the profitability of energy companies in the U.S. Collectively, these energy companies comprise 7-8% of the S&P 500. Indeed, the recent suffering of energy companies has impacted the overall profitability and earnings growth of the broader U.S. stock market.
Looking forward, there appears to be a happy medium for oil prices in the $50-$70 per barrel range. At these prices, consumer prices remain modest and keep headline inflation in check. At the same time, energy companies are (mostly) no longer losing money at these oil price levels, and could actually be additive to corporate earnings growth in the U.S. stock market. While this range isn’t a prediction for the future of crude oil prices, it would be a welcome return to normalcy.
Whatever happens to energy prices in 2017, a more gradual move in either direction would be preferred by investors and consumers alike. The volatility of energy prices in recent years has had a much larger impact on the economy and the stock market than is generally warranted.
Based upon supply and demand dynamics, the global oil markets look to return to balance in 2017. With the prospect of flat, or even potentially higher oil prices as a result of this balancing, energy companies earnings could become a tailwind for the U.S. stock market next year. This would be an improved outcome, after two years of high volatility and uncertainty for the energy industry.