As crude oil prices hit their lowest point in more than four years, consumers around the globe are asking, “What are the potential benefits and downside of lower oil prices?”
Oil prices, which are down nearly one-third since last summer’s peak, have come under pressure due in large part to new energy supplies — notably from the United States — that are tipping the balance of supply and demand.1
Over the past several years, U.S. oil production has increased more than 70% and, according to The New York Times, “the United States is poised to surpass Saudi Arabia as the world’s top producer, possibly in a matter of months.”2
Cheap Oil: Good Medicine or Economic Malaise?
Do lower oil prices have a positive or negative effect on the global economy? The answer is “yes.”
In the short term, we have seen the share prices of oil stocks plummet —particularly U.S. oil companies, where gas and oil is extracted from shale formations using hydraulic fracturing or fracking. Many U.S. shale oil producers have far higher costs than conventional rivals, and thus the drop in oil prices more significantly affects their net profit or loss margins.
However, many U.S. oil companies need to carry on pumping to generate at least some revenue stream to pay off debts and other costs, so fracking will continue.
Furthermore, industry affected companies, like Caterpillar, also fell in value. Caterpillar supplies much of the machinery and engines used for fracking. When oil prices dropped, the demand for new equipment came to a halt.
However, cheaper oil is good for the American economy in the long run. It is estimated that savings from tumbling gas prices represent the equivalent of a $75 billion tax cut for U.S. consumers — or roughly $1,100 per family on an annual basis if prices remain at current levels (as of Dec. 2, 2014).3
More disposable income in the hands of consumers is likely to boost consumer spending, which, in turn, feeds economic growth. Case in point: Automakers reported total sales for the month of November were up 4.6% to 1.3 million, the best monthly finish since 2001.4
In a broader economic context, lower oil prices reduce the cost to manufacturers of producing and transporting their goods, and to airlines of operating their aircraft, thereby improving profit margins and investor sentiment.
On a global scale, lower oil prices should boost consumption and lower manufacturing costs in oil-importing economies, particularly in Europe, where sluggish economic growth has much of the continent teetering on the brink of recession.
The Deflation Factor
When prices fall across the board, consumers put off making major purchases in the hopes that prices will fall even farther. When spending stalls, companies’ revenues suffer and pressure mounts to cut costs by laying off workers, freezing or reducing wages, or raising the price of the goods they produce — all of which can further hinder consumer spending and deepen the deflationary cycle.
The good news/bad news nature of deflation has everything to do with what is driving the drop in prices of goods and services. For instance, if it is a lack of demand — as many economists say is currently the case in the Eurozone — deflation could be damaging. If, however, it is due to a boost in supply — such as the oil and gas boom in the United States — it can prove beneficial to economic growth.5
Takeaways for Investors
Similarly, from an investment perspective, lower oil prices present a double-edged sword. On the positive side:
• Low-priced oil should help to buoy U.S. stocks by strengthening the economy and by extending the period of low interest rates established by the Federal Reserve.6
On the downside:
• In the short term, investors in the energy sector — and commodities markets in general — should prepare to see the plunge in oil prices reflected in the price of the securities they own.
Contact your Certified Financial Planner™ or certified public accountant to learn more about oil price trends and the affect they may have on your financial situation.
1 The New York Times, "Morning Agenda: Oil Prices in Free Fall," Dec. 1, 2014.
2 The New York Times, "Free Fall in Oil Price Underscores Shift Away From OPEC," Nov. 28, 2014.
3 MarketWatch, "U.S. households could save $1,100 from falling gas prices," Dec. 2, 2014.
4 USA Today, "SUVs hot in best November auto sales since 2001," Dec. 2, 2014.
5 Bloomberg, "U.S. Gains From Good Deflation as Europe Faces the Bad Kind," Oct. 26, 2014.
6 Reuters, "Low oil prices boost stocks, deflation risk: James Saft," Nov. 25, 2014.
The opinions expressed above are solely those of Kondo Wealth Advisors, Inc. (626-449-7783, [email protected]), a Registered Investment Advisor in the state of California. Neither Kondo Wealth Advisors, Inc. nor its representatives provide legal, tax or accounting advice.