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HOT TOPIC: Is Cheap Oil Causing Trouble for the U.S. Economy?

HOT TOPIC: Is Cheap Oil Causing Trouble for the U.S. Economy?

HOT TOPIC: Is Cheap Oil Causing Trouble for the U.S. Economy?

Published: March 18, 2016

Oil prices began a downward slide in June 2014. Brent crude, the benchmark for global oil prices, plunged roughly 70% — from highs above $100 per barrel to less than $33 in mid-February 2016.1

Crude oil plays a part in the manufacturing and worldwide distribution of everything from food to electronics. The earnings of oil companies large and small tend to take a hit when oil prices drop, but many other businesses see their costs fall, which typically boosts profits. Cheaper fuel is helping American consumers save billions of dollars that they can spend on other goods and services.2

Low prices are often a welcome development for oil consumers and the broader U.S. economy, primarily because consumer spending powers about two-thirds of U.S. gross domestic product (GDP). So you may wonder why falling oil prices have made investors jittery and sparked so much volatility in the stock market.

The short answer is that a longer-than-expected period of global oil price instability has stoked investor fears about potential negative consequences for corporate profits and economic growth, especially after U.S. GDP growth weakened to 1.0% in the fourth quarter of 2015.3

Enough Isn’t Enough
Surging oil production in the United States, the Middle East, and elsewhere has resulted in a global oil glut. Iran has also boosted production following the recent removal of international sanctions.4

In the past, the Organization of the Petroleum Exporting Countries (OPEC) — a cartel of 12 oil-producing nations — collaborated to control global supplies and prop up prices. This time around, many nations have ramped up output in a bid to capture market share and presumably to let low prices drive some high-cost producers out of business.5

In mid-February, Russia, Saudi Arabia, Venezuela, and Qatar discussed freezing production at January’s high levels. The proposal seemed to represent the start of a collective effort to stem production, but neither Iran nor Iraq would commit to an agreement.6

The persistent drop in oil prices might indicate that the global economy is slowing more than people think. A February report from the International Energy Agency predicted that global demand will grow at a slower pace in 2016. The closely watched agency also estimated that supply may exceed demand by an estimated 1.75 million barrels a day in the first half of the year, given the assumption that coordinated production cuts are unlikely to occur.7

A Heavy Anchor
Low oil prices are undoubtedly bad news for the energy sector. Energy stocks saw steep losses in 2015 (–21.12%), compared with a slight gain (1.38%) for the S&P 500 index total return.8

Energy accounts for only about 7% of the S&P 500 index, but the industry’s slump could continue to drag down the performance of the overall market. For example, S&P Capital IQ expects total earnings for companies listed in the S&P 500 index to drop 5% in the fourth quarter, in large part because energy profits are expected to fall 70%.9

Will Oil Spill Over?
Beyond the energy sector, industrial companies that supply equipment — and banks that lend money to struggling energy companies — may also be vulnerable. Weak oil prices contributed to the bankruptcy of dozens of U.S. oil and natural gas companies in 2015, and a large number of debt defaults could be waiting in the wings.10

Energy firms are normally big spenders, but U.S. producers have already started cutting back. Industry outlays on mining, shafts, and wells dropped 35% in 2015, and more spending is being cancelled. Nationwide, fourth-quarter 2015 GDP growth was hampered by a 1.8% decline in business investment.11

Solid U.S. Prospects
Despite global headwinds, the domestic economy seems to be holding up, posting moderate 2.4% annual GDP growth in 2015.12 U.S. oil firms have shed thousands of jobs, but the sector accounts for just 1.5% of U.S. employment.13 In January 2016, the nation’s unemployment rate dropped to 4.9%, which the Federal Reserve considers close to full employment.14 And in December 2015, the Federal Reserve projected another year of 2.4% GDP growth in 2016.15

Eventually, accelerating demand and/or slower production should help stabilize prices. But changes in the global oil market are difficult to predict. A sustained period of low oil prices might have broader implications, presenting opportunities and challenges for investors. Still, it’s important to stay focused on your long-term strategy and avoid overreacting to market volatility.

The return and principal value of stocks fluctuate with changes in market conditions. Shares, when sold, may be worth more or less than their original cost. The S&P 500 is an unmanaged group of securities that is considered to be representative of the U.S. stock market in general. The performance of an unmanaged index is not indicative of the performance of any specific investment. Individuals cannot invest directly in an index. Past performance is not a guarantee of future results. Actual results will vary.

1, 6) Reuters, February 19, 2016
2) CNNMoney, December 16, 2015
3, 12) U.S. Bureau of Economic Analysis, 2016
4, 7), February 9, 2016
5), February 9, 2016
8) S&P Dow Jones Indices, 2016
9) USA Today, February 9, 2016
10) CNNMoney, February 11, 2016
11, 13) The Wall Street Journal, January 28–29, 2016
14) Bloomberg Businessweek, Feb. 15, 2016
15) Federal Reserve, 2015

The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. Copyright 2016 Emerald Connect, LLC.