Posted on January 9, 2015 by David Laidlaw
Two financial trends dominated the last half of the year just passed. The first was the dramatic decrease in the price of crude oil. The second involved the continued increase in the prices of US-based common stocks.
For most of the last five years, oil has traded in a range between $90 to $110 per barrel. As recently as July of 2014, a barrel of West Texas Intermediate Grade crude oil traded for over $100. Oil prices began to decline gradually in August reaching $75 per barrel by November. Since the beginning of December, oil has fallen another 33% to about $50. Oil prices collapsed further during the financial crisis; however, that movement was in response to a global recession.
We believe the price decline has resulted from a new equilibrium point between supply and demand. Hydraulic fracturing (fracking) has uncovered vast supplies that have flooded the domestic market. Oil production in the United States has increased from about 7 million to 13 million barrels per day over the past 10 years according to statistics published by the United States Energy Information Administration. Similarly, Canadian supply has also jumped. While Mexican production has declined, the country has loosened governmental capital controls allowing for expanded technology transfer from the US that will in turn lead to additional exploration and production.
On the other side of the equation, demand for oil has stagnated. Most of the incremental demand for petroleum products was a result of China’s unprecedented industrialization. While economic statistics from China’s government are notoriously unreliable, the country’s domestic economy has slowed significantly. Official figures suggest growth has decelerated from 10% to 7% per year since 2010; however, commodity price declines suggest the damage is worse than reported. Economic growth in Europe is non-existent and Japan entered a recession in mid-2014. The United States has also become far more efficient and is not dependent on increased petroleum supplies to grow its economy. US oil consumption peaked at 20.20 million barrels of oil per day in 2005 and has subsequently decreased to 18.96 in 2013 even though the economy has grown substantially.
The combination of greater supplies and lower demand has increased oil inventories. Oil stocks increased during December for the first time since the recession (see Chart for comparison of 2014 to prior years).
Lower oil prices are a boon for every company and economic sector of the economy throughout the world except oil producers, servicers, and dictatorial governments dependent on oil revenues. Expenses for manufacturers and transportation companies will be much lower given oil’s 50% decline over the past six months. Consumers will also have more money in their budgets to increase their spending (and potentially saving) given that gasoline is now selling for a national average of $2.19 per gallon compared to $3.32 a year ago according to AAA.
Two International Monetary Fund Economists estimated recently that global growth will increase by an additional 0.7% in 2015 due to lower fuel prices. This development is further good news after 3rd Quarter GDP figures in the US were just revised upward to an annual rate of 5%, well above the rates experienced over recent years.
The only downside to this lower energy price paradigm is that it could reflect lower long-term economic growth rates throughout the world. Under this scenario, a global slowdown eventually rebounds back to the United States since there would be little appetite for US goods and services abroad. However, we believe this scenario is less likely.
On the other hand, we are less sanguine concerning continued stock market expansion. The S&P 500 advanced over 13% during 2014. This increase represents the sixth straight year of positive market gains and the third during which the major domestic averages expanded by over 10% (note: the market increased 16% in 2012 and 32% in 2013). Earnings have been increasing steadily, but again, the rate of increase is slower than the rate of appreciation in price. Stocks are fundamentally more expensive than the market averages suggest. The two largest companies by market capitalization, Apple and Exxon, sell for a reasonable 16 and 11 times their respective earnings over the past year. However, smaller companies are much more expensive fundamentally with the smallest companies, represented by the Russell 2000, selling at an exorbitant 66x earnings.
The final issue to consider is the Federal Reserve’s monetary policy. Low bond yields have persisted since 2008 and the 10-year US Treasury Note yields below 2%. The Fed is expected to increase short-term interest rates during the Spring of this year. Higher short-term rates may in turn lead to higher rates across the yield curve. If this occurs, bonds may provide better competition to stocks for investors’ savings in the future. However, if low rates prevail, stocks will still be the only alternative for investors to achieve returns above the rate of inflation.