What Oil Is Telling You

Since its recent peak at the end of June, the price of oil has dropped more than 20 percent. As a consequence, the S&P 500 Energy index has suffered a decline of about 15 percent over the same time frame (compared to a small increase for the overall index). The drop in oil (and corresponding drop in energy stocks) is causing much consternation throughout the investment world because it is inconsistent with the narrative articulated by most economists. Large decreases in the price of oil are normally a sign that economic growth is slowing. But most economists continue to forecast a steadily improving domestic economy, with minor headwinds caused by a stagnant Europe and a slowing China. Rather than economic weakness, economists have blamed oil's drop on the recent strength in the US dollar as well as a large outward shift in the supply curve owing to the boom in US shale production.

The dramatic increase in domestic production is undoubtedly part of the story. According to an article in the Wall Street Journal this week, ("Wall Street Reins in Bullish Calls on Oil," by Nicole Friedman), "In September, domestic crude-oil production averaged 8.7 million barrels a day, a 28-year high." The surge in domestic production has moved the US closer to the day of complete energy independence. Optimists hope that energy independence will allow us to disengage from ongoing conflicts in the Middle East and elsewhere, potentially saving the taxpayer trillions of dollars.

Likewise, the rise in the US dollar is responsible for some of the drop in oil. Because oil (and many other commodities) is traded in dollars, a strengthening US dollar is usually accompanied by a drop in the price of oil. We need to be careful to acknowledge, however, that the strength in the US dollar is a response to economic deterioration in other parts of the world. Investment dollars generally flow to countries offering relative high growth and economic opportunity. But just because the US appears relatively strong does not necessarily mean that domestic growth expectations have improved. The strength in the dollar could simply reflect the fact that conditions are that much worse overseas.

For my part, I believe that the drop in oil is (also) a harbinger of a wider economic slowdown. The drop in oil goes beyond the spike in domestic supply and the strength in the dollar. I believe this because the magnitude of the decline is more consistent with what we would see in periods of economic weakness. This is especially true if one considers the many geopolitical risk factors that, in normal times, would support higher oil prices. And while increased domestic supply could potentially make up for lost production in Russia and the Middle East, the transition would take time. There is simply no premium in oil right now for potential near-term supply disruptions. And finally, the action in the bond markets supports the slowdown thesis. Bond investors appear more concerned with the threat of global deflation than with some sudden growth-induced spike in inflation.

The good news is that oil's drop, in and of itself, is a stabilizing mechanism for the global economy. The lowest US gas prices in four years will result in hundreds of dollars in annual savings for the American consumer. Importantly, these savings disproportionately affect those in most need -- the middle class, who will be more inclined to spend the savings elsewhere. Given our view that the middle class has really not participated in this economic recovery nearly to the extent that wealthier folks have, lower energy prices could be the spark for an accelerated economic recovery.

But there is also a downside to the drop in oil as it relates to the domestic economy. A study by The Perryman Group (as reported on Rigzone.com) says that the energy renaissance in the US is now contributing about $1.2 trillion annually to GDP (about 7 percent of the current run rate in annual GDP). The same study says that the US energy industry is creating US jobs in droves. "Since the start of the economic recovery, the energy industry has contributed about 30 percent of the total job growth for the nation," said Dr. Ray Perryman, president & CEO of The Perryman Group. By the end of the year, if not already, the US is expected to be the world's largest crude oil producer. Given the energy sector's large contribution to growth and jobs, there is a point at which the drop in oil prices is no longer constructive. At some level of oil prices, it becomes uneconomical for high-cost shale producers to continue pumping. Indeed, some have speculated that the Saudis are maintaining their pace of production as prices fall in order to force higher-cost producers, such as the shale producers in North America, to cancel projects. And as projects get cancelled, so will the jobs and ancillary economic benefits associated with those projects.

In summary, the drop in oil is likely attributable to a number of factors. In our view, at least some of the drop should be viewed as a canary in the coal mine with regards to future economic growth. And while lower gas prices should act as an economic stabilizer, a continued drop in energy prices could imperil the US energy renaissance, which has created new jobs and added greatly to economic activity. With regard to investments in energy stocks, it may make sense to add to positions following such poor relative performance. However, doing so will require an ability to withstand significant volatility as the aforementioned trends play out. But before getting too gloomy on the sector, be sure to remember that future global economic growth will undoubtedly lead to increased energy consumption over the long run.