A perspective from E*TRADE Securities1
It hasn’t been a pretty couple of months for equity investors, who saw a year’s worth of gains go up in smoke before a rally in late November. But the news was especially bad for commodities and energy stocks, which took a collective nosedive over the past few weeks.
Low energy prices lower the cost of production, which can boost corporate earnings and benefit truck-dependent US auto manufacturers, but there is also a downside. While President Trump has cheered falling oil prices as a “big tax cut for America and the world,” weakness in the energy markets may be a harbinger of a larger economic slowdown.
The diminishing effect of Iran sanctions
Crude oil peaked in early October, six months after the Trump administration pulled out of the Iran nuclear accord and announced trade sanctions on Iran. Energy prices tend to trade on expectations and, at the time, traders feared sanctions would lead to crude oil shortages. These expectations were enough to push oil prices higher, with Brent crude—a benchmark for global oil prices—topping out at $85.60 on October 4, up from roughly $56 per barrel a year earlier.1
Given the potential implications of US sanctions on Iran, energy analysts remained bullish well into October, with some predicting that crude could hit $90 per barrel in 2019. Some analysts wouldn’t even rule out $100 oil next year.2
What a difference a couple of months make.
Since peaking on October 4, Brent crude prices are down nearly 30% in what some analysts predict could be a long bear market for energy commodities. Last week, JP Morgan cut its outlook for Brent crude from $83 per barrel to $73 in 2019 and $64 in 2020.3 In addition, a survey of 11 forecasters by S&P Global Platts predicted an average of around $75 per barrel next year.4
Source: FactSet Research Systems
Why the collapse in oil prices?
There are a number of reasons for oil’s recent weakness, but largely it boils down to excess supply.
• Rising inventories in the US: The Energy Information Administration expects US oil production to increase by 15% in 2018, swelling inventories and depressing prices.5 Much of the increase has come from shale producers that have helped the US become the world’s largest oil producer.6
• Increase in global supply: Inventories aren’t just rising in the US. Members of the Organization othe Petroleum Exporting Countries (OPEC) are famous for their lack of production discipline, and, true to form, some of the biggest producers have opened their taps despite an earlier agreement to limit output. Moreover, the International Energy Agency expects non-OPEC production to surpass 2.4 million barrels per day this year—well above earlier forecasts.7
• Glut in the refining sector: A lot of gasoline is sitting unsold at refineries around the world, which has led to a pullback in orders.
• Diminished expectations for economic growth: Energy prices and economic growth have a symbiotic relationship. While high energy prices can be an impediment to growth, rising economic fortunes can drive energy demand. Although many of the world’s economies are still expanding, economists have scaled back their outlook for global economic growth in the coming years, which has pressured energy prices. Demand has been especially weak in Asia and Europe, which have been hit hard by trade tensions.
Market participants are eagerly anticipating OPEC’s next meeting on December 6. Many analysts expect a plan to cut production in an attempt to shore up prices—although Iran is expected to be a dissenting voice. Even if member countries were to reach an agreement, a lot will hinge on participation. After all, cartel members can individually increase profits by cheating production agreements, even though this would collectively hurt the cartel if every member did the same thing.
What does this all mean for investors?
• Keep an eye on supply: An OPEC agreement to limit supply could stem the recent freefall in oil prices, although, as always, production discipline will be key. Falling energy prices could also put less-profitable US shale producers out of business—creating another wrinkle in the boom-bust cycle of energy-dependent regions like the Permian Basin in Texas and the Bakken Shale in the northern plains. Any cutback in US shale production could go a long way toward eventually stabilizing energy prices.
• Trade tensions loom large: An easing of trade tensions would likely bode well for global economic growth, which could support crude oil futures. Given the bellicose tenor of the Trump administration, this seems unlikely—although a revised North American trade agreement has been signed, and some progress reportedly has been made in trade talks between the US and China.
• Stay diversified: Limiting individual holdings may seem like a sensible means of reducing energy exposure, but keep in mind that energy represents only 6% of the S&P 500 Index.®1 For those invested in high-yield exchange-traded funds (ETFs), energy exposure is generally higher. Regardless, energy’s impact is greatly reduced as part of a broadly diversified portfolio.
For consumers, the news isn’t all bad. Lower oil prices should eventually make their way to the gas pump and could even reduce the cost of heating oil this winter. But in the larger scheme of things, the energy markets are simply doing what they always do—reacting to the forces of supply and demand—while providing another stomach-churning turn to the roller coaster ride of 2018.
1. FactSet Research Systems, November 27, 2018
2. “Brent oil could hit $100 by end of 2019, report says,” Houston Chronicle, October 23, 2018, https://www.chron.com/business/eagle-ford-energy/article/Raymond-James-Oil-could-hit-100-by-end-of-2019-13326507.php
3. CNBC, “JP Morgan gives its prediction for Brent crude in 2019,” November 22, 2018, https://www.cnbc.com/2018/11/22/oil-pricesjp-morgan-gives-its-prediction-for-brent-crude-in-2019.html
4. S&P Global, “Analysis -- Oil price outlook in 2019 little fazed by market jitters: Platts survey,” November 22, 2018, https://www.spglobal.com/platts/en/market-insights/latest-news/oil/112218-analysis-oil-price-outlook-in-2019-little-fazed-by-market-jitters-platts-survey
5. U.S. Energy Information Administration, “Short-Term Energy Outlook,” November 6, 2018, https://www.eia.gov/outlooks/steo/report/us_oil.php
6. U.S. Energy Information Administration, “Today In Energy,” September 12, 2018, https://www.eia.gov/todayinenergy/detail.php?id=37053
7. International Energy Agency, “Oil Market Report: 12 October 2018,” October 12, 2018 https://www.iea.org/oilmarketreport/omrpublic/currentreport/