Oil prices hit new lows on Wednesday, dipping below $35 per barrel. The Wall Street Journal reports that the “global glut of crude” is to blame, explaining that production is high and companies in the sector are producing at full bore to maximize their revenues. To put that concept in perspective, the United States Energy Information Administration is reporting that domestic oil inventories went up by 4.8 million barrels of crude last week while analysts at the Wall Street Journal were expecting crude inventories to dip by 1.4 million and Bloomberg analysts were anticipating a decrease of 1.5 million. Moreover, the U.S. is importing more oil to make up for declining domestic production and to fill existing storage spaces with oil while the price is low. Current U.S. imports are up to 8.3 million barrels per day, its highest since September 2013, and crude is getting close to capacity.
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Crude Stockpiles and Exports
Expanding U.S. supplies could be seen as a bearish factor. After all, this time of year, stockpiles tend to shrink. According to Bloomberg for the Washington Post on Wednesday, “Limits on U.S. crude exports would be lifted immediately, according to a bill released early Wednesday by the House Appropriations Committee. The change would allow the president to impose restrictions on exports for national-security reasons and in case of a shortage.” The House is expected to vote today. “The U.S. restricted crude exports during the energy shortages of the 1970s,” continued Bloomberg in the Washington Post. ”Producers including Continental Resources Inc., Pioneer Natural Resources Co., and ConocoPhillips have been pressing for an end to rules that block overseas shipments of most raw, unprocessed oil while not curbing sales of refined products such as gasoline and diesel.”
However, in the short-term, any measures the government takes will have little effect. There is simply a ton of oil, and that is going to keep prices low for the time being. The bigger question for retail investors is how to respond to this situation.
Understanding the Implications
First, investors should keep in mind that low prices for oil today has consequences for tomorrow and, in fact, several years from now. “Companies making long-term investment decisions rely on the prices of futures contracts one or more years in advance,” explains the Wall Street Journal. “Producers trade futures and options contracts for coming years to lock in prices for the oil they plan to sell in those years.” However, right now oil prices are so low that no one wants to establish a bottom price by purchasing futures too early. In turn, oil producers are taking out fewer of these prices hedges. The downside is that as the price of a barrel inches lower, drilling may have to be curtailed until there is enough margin left after those companies fulfill their break-even costs. Also, remember that companies will sometimes use their oil and gas reserves as collateral for banking loans. If the price of oil continues to fall, these companies will have less value on their collateral and, in turn, be able to borrow less money.
At the same time, remember that oil could run lower. Money manager David Kotok, the founder of Cumberland Advisors, has said that prices could fall to $20 or even $15 a barrel. It might sound extreme, but keep in mind that some grades of oil are already in that range. Western Canadian Select (WCS), which is a thicker crude that is more difficult to refine, settled at $13.25 for July 2016 futures on Wednesday. Moreover, there are some pretty strong reasons why it could happen. For one, China’s economic slowdown left a large glut in the market. Also, “OPEC, led by Saudi Arabia, has been unwilling to balance the market by cutting production,” writes CNNMoney. “The oversupply problem may very well be amplified by the Iran nuclear deal. If the historic agreement goes forward, sanctions relief will allow Iran to drastically increase output.” Muhlenkamp and Company echoed this sentiment in its annual investment seminar held earlier this month, also noting that Russia’s oil production is also very high and likely to stay that way. In other words, lower oil prices are not just possible, they are probable.
Who Wins with Low Oil Prices?
Right now, lower prices have not trickled down to improved consumer spending. “I find it astonishing. Here we are, a principal cost cut in half, and it isn’t translating,” said Jim Cramer, noting that restaurant spending nor retail shopping has seen any measurable gains. Of course, that could be a matter of time.
Until then, lower fuel prices may benefit transportation companies like FedEx or UPS and different travel companies like airlines could see a bump in earnings because lower fuel prices keep their overhead expenses low. They may not pass those earnings on to consumers in the form of cost savings, but investors could see a boost in company share price. In addition, some auto sales may be attributable to lower gas prices. Farmers and food producers may benefit from lower oil prices as well in that the price that they can sell the crops and animals they raise are not changed but transporting those goods and fueling machinery is cheaper right now. Home heating costs may also be less for people who use gas or oil to heat their homes, but again, so far any cost savings has not translated into increased consumer spending.
Larger oil companies and producers like Chevron have had to cut payrolls to preserve cash while smaller outlets have had to sell off assets and reduce dividends. The effect of lower oil prices also affects the areas where the oil is mined and refined. Venezuela, Brazil, Iran, Nigeria, and Russia are each feeling the effect, as well as domestic oil outposts like North Dakota, Oklahoma, and Alaska. There is also a risk that with oil production capacity running so high, that there is no cushion if there would be a crisis in one of the affected areas.
For investors looking to get invest in oil as a commodity or balance their portfolios by adding oil producers, the consensus is to wait. According to Goldman Sachs, oil prices could remain this low for as long as 15 years. However, not everyone is as bearish on the subject. Barclay’s is estimating that oil will reach $85 per barrel by 2020. That’s not to say the price is low enough to buy in yet, but it is something for commodity investors to keep an eye on. Investors should also watch transportation company earnings and those associated with any company in the hospitality or travel industries. Retail and restaurants could also see a rise if oil prices remain low, but investors trying to play depressed oil prices should keep a careful eye on what happens in the global market as well as the domestic economy.