Vicissitudes and viscosity
Stocks ended last week up despite a down Friday as positive sentiment dissipated on possible production controls coming out of the meeting of 16 major oil producing nations in Doha, Qatar on Sunday. Investor hopes for production cuts coming out of the meeting were high earlier in the week, helping to fuel stocks higher. But sentiment changed and by the end of the week concerns that the meeting would be a bust sent stocks downward.
Interestingly, oil has had an important - but changing - relationship with the American economy and stock market over time. As one of the first nations to industrialize - and in particular the first country to mass produce automobiles - oil was an extremely important commodity to the US. Oil has had the power to advance the nation - and alternatively to choke it.
I am old enough to remember the oil crises of the 1970s, when my parents had to wait in line for hours to fill up their gas tanks - and only when their license plate allowed them to, as odd-even rationing only allowed those whose license plate ended in an odd number to purchase gas on odd days and vice versa. It could take hours to fill up one's car with gas in those days; long lines wrapped around the block as US consumers waited for the privilege to purchase relatively expensive gas. This was a result of the changing relationship between US oil companies and their Arab host countries.
Oil fuels political power
For several decades, US oil companies could essentially dictate (with a small amount of negotiation) the amount they would pay per barrel for the oil they extracted: from 1948 to 1971, the price of oil was incredibly stable, hovering around $2 per barrel. But change was on the horizon as documented in David Halberstam's "The Reckoning." In 1954, a new leader came to power in Egypt, Gamal Abdel Nasser, who had a vision for pan-Arab nationalism with oil as the source of its power.
This idea began to take hold among oil-producing Middle Eastern nations, with OPEC (Organization of Petroleum Exporting Countries) being created in 1960. OPEC countries cooperated more closely as the decade progressed, fueled by anti-Western sentiment. This came about just as the US and other developed countries became more reliant on the Mid-East for oil.
In 1970, US oil production began to decline for the first time, adding to American vulnerability. And by then OPEC was flexing its muscle. OPEC failed to agree with major Western oil companies on a price for oil in the fall of 1973; OPEC wanted $5 per barrel while the oil companies refused to go above $3.75, doubting that OPEC could execute an effective boycott. OPEC, however, did just that and dramatically cut oil production.
The US oil embargo was underway. While it ended just five months later, the US experienced another oil price shock later in the decade. In 1978, civil unrest in Iran resulted in reduced production; while other OPEC nations increased their output in response, resulting in only a 4% drop in oil supply overall.
Panic ensued in the US where the oil crisis of 1973 was still fresh in people's memories. The price of oil was driven up and long lines again appeared at gas stations. The effects of these oil crises would be felt for decades to come. Back in the 1970s, my father traded in his giant, gas-guzzling American car for a Volkswagen Rabbit that ran on diesel while President Carter exhorted the nation to keep the thermostat down in their houses and wear more layers. The balance of power had shifted and American consumers saw firsthand that oil - its price and control over its production - could wreak havoc on an economy.
Consumers faring better than investors
Not surprisingly during this period, there was a very high negative correlation between the price of oil and GDP growth in the US. But then came the 2000s and the hope of one day reaching oil independence, and with it greater control over the production and price of oil. Geological technology had evolved, creating a cheaper way to extract oil from US soil via hydraulic fracturing (hydrofracking). While controversial because of its environmental impact, this technology enabled the US to produce more of its own oil and gas.
In addition, an emphasis on alternative energy sources also marginally helped lessen reliance on foreign oil in the past few years. This, combined with a less cohesive group of oil producers and reduced demand due to a slowdown in China and elsewhere, caused the price of oil to fall significantly, beginning in 2014. The scenario was the exact opposite of the 1970s - not only were there no lines at the pump, but Americans began trading in their smaller cars for SUVs. Toyota Priuses found few takers and sat on lots. But then something unusual began to happen. Surprisingly - and somewhat counter-intuitively - the stock market began reacting negatively to low oil prices. Now it is investors, rather than consumers, who are being held hostage by the price of oil.
And it makes sense, given that the low price of oil negatively impacts one of the fastest-growing industries in the US. In recent years, a very significant portion of capital spending has come from the energy sector. Similarly, the energy sector has weighed down on earnings and revenue in recent quarters. According to FactSet, if the energy sector is excluded from first quarter earnings, the estimated earnings decline for the S&P 500 Index improves dramatically from -9.3% to -4.2%. Similarly, if the energy sector is excluded from first quarter revenue estimates, the estimated revenue growth rate for the S&P 500 increases from -1.3% to a positive 1.6%.
Water: the new oil?
The high correlation between oil prices and stock prices that we have seen in recent months continues to this day. Yesterday's meeting in Doha has been labeled a failure, with major oil-producing nations such as Saudi Arabia and Russia unable to reach a production cap agreement because Iran refused to participate. The cohesion that made major oil-producing countries so powerful in the 1970s is nowhere to be found now. Quite the opposite: Saudi Arabia has reportedly threatened to flood the market with oil. The balance of power has shifted again.
Our short-term view is that oil production will continue to rise, keeping prices low. More importantly, we believe relatively low oil prices should be a net positive for the US economy over the longer term because it benefits consumers, saving them money that they can spend elsewhere. While consumers have not yet spent that savings in a significant way, behavioral economics suggests the longer oil prices remain relatively low, the more likely consumers are to spend that money.
We will need to monitor the situation closely because of the major impact oil is having on the US stock market and economy, as well as numerous emerging economies. For investors wondering what the implications are, they can expect more overall volatility in the stock market - and may want to consider diversifying their portfolio with a "water theme" given that in the future water could usurp oil as a critical commodity. Think blue gold…