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The Impact of Low Oil Prices

By Niklas K. Oskarsson

Following the sharp, almost 50%, decline in West Texas Intermediate (WTI) prices in the back half of last year, prices have stabilized and mostly fluctuated around $50/barrel year to date. The lower price level is positive both for global economic growth and for domestic growth. Stateside, the net benefit to GDP growth is estimated to be 0.2% for each $10 oil price decline, thus, translating into an almost 1% boost to GDP growth assuming prices stay at the current level. Globally, most developed countries and emerging Asia stand to benefit while the Middle East, Greater Russia, and parts of South America will face headwinds.

More specifically, the Eurozone with its low production level is well positioned to take advantage of the price decline as long as the Euro does not collapse. Since mid-2014, the Euro has depreciated by about 20% versus the US Dollar dampening the positive oil price effect since US Dollar denominated imports become more expensive. China and India are other major beneficiaries of the oil price decline. Recent studies indicate that several of the major oil net exporting countries, including Saudi Arabia, Russia, Norway, and Venezuela, may enter recession this year if oil prices stay low.

Historically, the stock market has performed well following a sharp oil price decline. According to Strategas Research Partners, over the last 30-years the S&P 500 has on average returned 23% in the 12-months following a 30% or greater decline in oil prices, with the cyclical (Materials and Consumer Discretionary) sectors leading the way and the defensive (Utilities and Telecommunication) sectors lagging. Since the 2014 oil price decline episode was not associated with a US recession but instead started in the sixth year of the economic cycle and with equity valuations already in fair value territory, we suspect the stock market move will be more muted this time around.

In the second half of this year we expect oil prices to push higher as stronger global growth boost demand and as production, especially on the unconventional side, come offline. Over the last four years US shale oil production has increased by around 4 million barrels/day and at the current price level capital investment is being cut back. With a one year depletion rate of 75% for many of the shale wells, the lack of new investments could quickly translate into reduced production. A wild card to this outlook is the June 5, 2015, OPEC meeting. In the two months following the last meeting, on November 27, 2014, oil prices declined by 37%. Now that OPEC has made it clear that their primary focus is to defend their market share rather than to support prices, we don’t foresee any sharp price reactions if they again decide to keep their production level unchanged at the June meeting.

The information based here represents the judgments and opinions of the management of Virginia Global Asset Management and not intended as financial advice.