Why oil prices dropped and why they won’t stay down long

By Krishna Memani, Chief Investment Officer at OppenheimerFunds

Key Points

  • Consumers have enjoyed a material drop in gas prices in recent months.
  • This occurred largely due to a confluence of changes in the economic environment.
  • Look for oil prices to bounce back along with the economy in the months to come.

The recent sharp decline in oil and gasoline prices may feel like a pleasant surprise to consumers, but it is a symptom of what was unsustainable monetary policy and ongoing slowing global economic activity. Not surprisingly, it took a toll in 2018 on stock performance for energy-related stocks.

The immediate benefits for consumers

First, the good news: For the average American consumer who drives 13,000 miles a year1 in a vehicle averaging 24.7 miles per gallon,2 the recent $0.65 decline in the cost of a gallon of gas across the United States, if sustained, amounts to roughly $350 per year in savings. Extrapolated across 222 million licensed U.S. drivers,3 that’s, with all else being equal, a $77.7 billion stimulus for the U.S. consumer.

 


What pushed down oil prices?

To some extent, the decline in energy prices is the result of impressive U.S. oil production. The U.S. is a large contributor to the current world surplus (supply outstripping demand) of 1.2 million barrels of oil per day. That said, in large part, the recent downward move in oil prices was a direct consequence of significantly tighter financial conditions in the U.S.

The tighter conditions that helped drive down the cost of oil in 2018 were driven by four primary and interrelated components:

  1. Interest rates across bonds of different maturities
  2. The strength of the U.S. dollar
  3. Credit spreads between high-quality and lower-quality bonds
  4. Equity valuations


In short, an interesting confluence of events contributed to the oil price drop. Fiscal stimulus — in the form of the tax-cut package that took effect in 2018 — and the brief spurt of above-trend U.S. growth that followed led to higher U.S. interest rates. This prompted the U.S. Federal Reserve (the Fed) to continue raising short-term interest rates to temper economic growth and thwart a potential surge in inflation. Above-trend U.S. growth coupled with the Fed’s tightening stance attracted global capital to U.S. dollar-denominated assets, strengthening the dollar. This combination of factors contributed to slowing U.S. economic activity and reduced energy demand.

Further compounding the problem was that energy companies tend to be more reliant on below-investment grade U.S. credit markets to finance their operations. Credit spreads had widened as investors exhibited a tendency to favor higher-grade bonds given the slower rate of economic growth. Some investors are concerned about energy companies’ ability to service their existing debt given today’s lower energy prices. True to form, equity prices followed credit markets lower. 

Look for conditions to change

We have seen circumstances like this before. The last time, in mid-2015, U.S. economic growth had also largely decoupled from most of the rest of the world. The Fed raised the fed funds rate 25 basis points to 0.25 percent and signaled four additional interest rate hikes in the coming year. The U.S. dollar rallied meaningfully, economic growth stalled, oil prices collapsed, and corporate bonds and U.S. equities corrected. A recession was averted only when the Fed backed off its tightening stance and the U.S. dollar stabilized. By the end of 2016, gasoline prices had rallied by 40 percent off the bottom and oil prices doubled. Energy stocks climbed 27.4 percent, outperforming other sectors of the broader stock market. The elongated bull market for both credit and equities resumed.  

Where do we go from here?

Now, as in early 2016, we believe the Fed will have to postpone future interest rate hikes indefinitely to avoid further deterioration in economic activity and declining inflation rates. It appears the Fed is coming around to that decision, and the markets are anticipating the fed funds rate in 2019 to be effectively unchanged. If that’s the case, then the current business and market cycle may extend for several years. What’s more, equity valuations globally are as attractive now as they were in early 2016. If all these factors align, we could see a continuation of strength for both the business sector and the capital markets.

Be prepared for change

Our expectation is that the recent collapse in oil prices and the subsequent slide in performance for energy companies will be short-lived. If the economic developments described above come to fruition, we should see a dramatic shift in the market. This may mean paying more for gas at the pump, but it also could represent investment opportunity in the energy sector and across the broader markets.

 

Discuss this with your financial advisor as you determine how to position your portfolio, considering recent changes and what may lie in the future. 

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