Plunging Oil Prices: A Good News/Bad News Story

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 — which 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."

Generally, cheaper oil is good for the American economy. 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 December 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. Yet the immediate positive effects of lower oil prices in Europe need to be tempered by longer-term realities -- namely, weak economic fundamentals and the specter of deflation -- an extended period of falling prices.

The Deflation Factor

When prices fall across the board, consumers put off making major purchases on 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 product -- all of which can further stymie 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 extraordinary monetary policy established by the Federal Reserve.6
  • The revelation that the United States may be poised to eclipse Saudi Arabia as the world's leading oil producer may spell good news for U.S. equities in general -- and strengthen the dollar against other world currencies.

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.
  • Should oil prices remain depressed indefinitely, energy companies will likely slash research and development budgets, which could curtail innovation and stunt longer-term growth potential within the sector, particularly in the area of environmentally-friendly, alternative energy sources.

Contact your financial advisor 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," December 1, 2014.

2 The New York Times, "Free Fall in Oil Price Underscores Shift Away From OPEC," November 28, 2014.

3 MarketWatch, "U.S. households could save $1,100 from falling gas prices," December 2, 2014.

4 USA Today, "SUVs hot in best November auto sales since 2001," December 2, 2014.

5 Bloomberg, "U.S. Gains From Good Deflation as Europe Faces the Bad Kind," October 26, 2014.

6 Reuters, "Low oil prices boost stocks, deflation risk: James Saft," November 25, 2014.

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Post by Phil Ratcliff

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