Oil Continues Decline

Highlights of this Week’s Update:

1. S. stock indices drop, ending a seven week winning streak.
2. Stocks rebalanced in all three of our stock models, adding further diversification.
3. Interest rates move lower, gold prices higher.
4. Oil continued its skid, ending Friday at $57.52 per barrel.
5. Economic fundamentals continue to improve.
6. FED meets on Tuesday and Wednesday of this week.

READ ON FOR FURTHER DETAILS…………………………………………..

The Markets:

The major U.S. stock indices broke a seven week winning streak with the Dow Jones Industrial Average down by 3.78% last week and the S&P 500 dropping 3.52%.  The Dow is now up 4.25% for the year as of Friday’s close. (MarketWatch)  We recently rebalanced our three stock models, increasing the total number of positions for each risk level providing further diversification.

Gold continued to rise, gaining another $23.00 per ounce, closing Friday at $1,217.00.  Interest rates fell, with the 10 year U.S. Treasury rate dropping to 2.10% compared with 3.04% at the first of the year.  Mortgage also eased lower, with the average 30 year fixed rate mortgage right at 4% and the 15 year fixed rate ended last week at 3.09 (CNBC, U.S. Treasury,Bankrate.com)

Oil’s Slide Continues

Oil was the big story again last week, continuing its recent decline, with West Texas Intermediate Crude oil finishing Friday at $57.52 per barrel.  This compares with $98.42 per barrel at the beginning of 2014. (Energy Information Admin.)  As per GasBuddy.com, the average price for regular gasoline in the U.S. as of December 13 was $2.57 per gallon, which compares with $2.76 on December 1^st. That’s a 19 cent drop in less than two weeks!  Prices have even dropped under $2.00 per gallon in some areas. It’s extra cash in your pocket. With the exception of energy companies, falling prices have been viewed as a net plus for the broader national economy, and much of the market reacted accordingly throughout November.

What’s causing the swift decline in oil prices?

Most headlines talk of OPEC being to blame; however, we believe the data points more squarely at China for demand and non-OPEC nations for excess supply. China is the second largest consumer and the world’s biggest importer of energy. China’s imports as a whole have slowed since 2011 but have now almost flat lined since the end of 2013. This could be considered part of the “demand” for oil in the equation. On the supply side, non-OPEC nations have been exponentially growing the supply of oil, while OPEC has remained relatively stable. So, as you have weakening demand and excessively growing supply, economics teaches you that prices will indeed fall, at some point. This is an over simplification of the situation, but we believe them to be the two largest contributors.

America still remains a net-importer of energy, which means lower prices should benefit the country as a whole. It’s near impossible to predict the unseen factors, such as how much oil’s drop will indirectly impact other industries. Consequently, more energy focused locations, such as Oklahoma and Texas may see a larger negative impact if prices do not stabilize. In particular, companies with excessive debt levels have been slammed the hardest, along with those on the bottom of the energy food chain. This has caused high-yield spreads to quickly widen, adversely impacting the price of high-yield bonds. Off-shore drillers and other servicers have been the first to feel the hurt. On the contrary, if prices stabilize and begin moving higher, these firms will also see the most relief.  The following chart illustrates the dramatic increase on oil production for both the U.S. and Canada.

Due to the beautiful dynamics of the market, lower prices typically usher in higher demand. Lower prices could also set back the use of alternatives, since the payoffs are not as feasible with lower energy prices, though most were never feasible to begin with. While lower prices may hamper energy alternatives, it could also slow oil exploration due to the lower returns in areas which produce higher costs. With these scenarios, sustained lower energy prices should boost demand and decrease supply, which is the reverse situation that is currently being observed.

One caveat remains to be played out which is the countries with nationalized oil production. Certain countries use oil sales to fund their government and social budgets, which are now obviously seeing less revenue due to the lower prices. If these countries were to ramp up supply to try and offset this decline in price, these actions could have an adverse effect on oil prices and the decline could be exacerbated. This is only a small possibility but still needs to be addressed.  OPEC nations have such a low cost of production that they could easily continue producing oil, while most non-OPEC nations will have to slow and some even halt production. This will give OPEC greater “market share,” which most believe is OPEC’s goal when they announced no drop in production. The world will undoubtedly continue using oil, and OPEC would prefer to be one of few supplying it, even if it is at lower prices.

So, how much lower could the commodity fall in the interim? Well, we’d have to argue we believe not much. The current sell-off has now brought about sentiment readings not seen since late 2008, when oil fell from over $140 a barrel to $35. It may take months, but we can’t help but strongly feel stabilization for oil is in the near future. As the months pass, we will have better insight into if companies heed the warning and begin dropping capital expenditures, like Conoco recently revealed.

The dark side of lower oil prices

The Dow and the S&P 500 Index both ended their seven-week winning streak last week (MarketWatch) amid concerns the drop in oil prices may seep into the credit markets.  Stock prices and valuations had become stretched again since the sharp rise off October’s bottom, and were due for a pullback anyway.  The decline in oil provided a reason for many to take a more conservative stance and sell stocks last week.  We have remained underweight stocks for all risk levels, with all stock/equity exposure remaining in individual company stocks, not stock/equity mutual funds.

According to the Schwab Center for Financial Research, energy companies make up 15.4% of the Barclays U.S. Corporate High Yield Bond Index⁶, versus 10.3% in 2013. The energy sector is second only to communications.  Since 2010, energy firms have raised $550 billion through new loans and bonds (Bloomberg). It doesn’t come as much of a surprise that cash has flowed into energy companies.

But the recent fall in oil prices will likely make it more difficult for the highly-leveraged energy firms to meet their debt obligations. Research firm CreditSights, Inc. predicts the default rate for high-yield energy bonds will double to 8% in 2015.

Not surprisingly, some investors are selling out of high yield bonds, including those in the energy sector, which has pushed up yields (bond prices and yields move in opposite directions) and played a role in last week’s selloff in stocks. If oil prices rebound, we could see a reversal at some point, or if the economy continues to improve overall.

Economic Fundamentals Remain Stable to Improving

While stocks sold off last week, we received a strong retail sales report for November (U.S. Commerce Dept., Bloomberg) and spending trends are favorable. Additionally, the University of Michigan’s Consumer Sentiment Index hit its highest level since January 2007 (Bloomberg). It’s perfect timing in the midst of the Christmas shopping season. That comes on top of November’s strong 321,000 rise in nonfarm payrolls (U.S. Bureau of Labor Statistics). It’s still too soon to say the economy is firing on all cylinders, but growth appears to be accelerating from the decent pace we saw in the third quarter.

The Federal Open Market Committee holds a two day meeting this week on Tuesday and Wednesday.  With improving U.S. economic data, but global weakness and low inflation, it is expected they will keep the current course moving forward.

We appreciate the privilege of serving you and if you ever have any questions, or if we can be of further service, please don’t hesitate to call.  Have a great week!

God Bless,

Your TEAM at F.I.G. Financial Advisory Services, Inc.

 

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¹ The Dow Jones Industrials Average is an unmanaged index of 30 major companies which cannot be invested into directly.  Past performance does not guarantee future results.

³ The S&P 500 Index is an unmanaged index of 500 larger companies which cannot be invested into directly.  Past performance does not guarantee future results.

⁴ New York Mercantile Exchange front-month contract; Prices can and do vary; past performance does not guarantee future results.

⁵ London Bullion Market Association; gold fixing pricing at 3 p.m. London time; 2013 year-end price fixing at 10:30 a.m. London time; Prices can and do vary; past performance does not guarantee future results.

⁶ The Barclays U.S. Corporate High Yield Bond Index is an unmanaged index of high yield corporate bonds which cannot be invested into directly.  Past performance does not guarantee future results.