Why do falling oil prices rattle investors?

So why in the world did stock prices fall faster and further on Monday than they have in months on what most would call good news that oil prices were now below $50 per barrel? It is an interesting question, and the answers become more interesting the deeper we drill (sorry).

On the surface, rapidly falling oil prices mean that the earnings of oil companies and those closely affiliated with them will suffer. The earnings for most are directly tied to the price of oil at the well-head. “Operating earnings from the energy sector in the Standard and Poor’s 500 stock index fell 26.6% in December 2014 vs. a year earlier, according to Howard Silverblatt, senior index analyst at S&P Dow Jones Indices. That drop, in turn, helped push the S&P 500’s operating earnings down 5.6% during the same period” as reported in USA Today.

The new technology oil producers including the tar sands in Canada and shale (hydraulic fracturing or fracking) throughout the US will become money-losing propositions if oil prices dip below certain levels. While pinpointing exactly what those prices are is difficult, rapid drops such as the ones we have seen in the last several weeks make investors nervous.

As new-technology oil companies become questionable, a host of additional questions crop up. What has been an economic boon to many states and regions could reverse if oil prices fall too far. Banks that have committed large portions of their lending to the new-technology companies could become suspect. The economic boon many states have enjoyed from investment and employment growth could reverse, significantly impacting retailers, consumer services, and even housing.

Economist Jed Kolko has looked at the historical relationship between oil and home prices to see how the latter react during times when energy comes cheap. He writes “Oil prices have plunged from over $100/barrel in July 2014 to around $50/barrel in early January 2015, threatening oil-producing economies around the world. Within the U.S., big oil price drops have historically been associated with job losses and falling home prices in energy-producing regions. In particular, plummeting oil prices in the 1980s were followed by declines in employment and home prices in Houston, Oklahoma City, Tulsa, New Orleans, and other nearby markets.”

The big question investors have been wrestling with for weeks is; what’s driving oil prices down? The answers on the demand side for oil do not bode well for stock prices. According to the NY Times, “the last time oil and gasoline prices fell this low was in the wake of the 2008-9 financial collapse, when crude oil fell from well over $100 to below $40 a barrel in a matter of months.”

The economies of Europe and developing nations, including China, are slowing with some already in recession. Slowing gasoline demand is being compounded by a huge wave of increasingly efficient vehicles.

At the heart of the demand or global economic weakness answer is the threat of deflation. Some may fear that policy makers (the Federal Reserve and their global counterparts) have not adequately dealt with the threat of deflation, or falling prices. Jim Vogel, a debt markets strategist for FTN Financial says “There is certainly a deflationary mind-set in the market…and as we enter 2015, it’s beginning to nag some people that there could be a deflationary component to the economy.”

Why are falling prices a bad thing? “The simple explanation: In a deflationary environment, consumers resist making large purchases of just about everything in anticipation that prices will continue dropping and lead to better deals are ahead. The result is a broad slowdown of economic activity. Further, deflation makes it more difficult to pay off debt, something American consumers and many U.S. employers have a great deal of.”

The other side of the answer to falling oil prices, the supply side, is interesting if not daunting because of its unprecedented  scale and potential duration and economic impact. According to experts, there is a glut of oil being produced in the US, Canada, Iraq, and a handful of other countries that will not soon abate. In the past OPEC has often moved to cut back production to support prices, but this time is different. Saudi Arabia, by far the largest member of OPEC, is not cutting its production back. In a recent interview Saudi oil minister, Ali al-Naimi, indicated his country would remain steadfast rather than cut production anytime soon. “If I reduce, what happens to my market share?” Mr. Naimi said. “The price will go up and the Russians, the Brazilians, U.S. shale oil producers will take my share.” But, it is more likely that their true motive is to slow or stop the production of shale in the US, so they can once again have control over supplies. What we have is an old fashioned price war for market share – US vs. OPEC.

The oversupply is expected to continue at least through the first half of 2015 if not beyond. According to the NY times article, “the ramping up of several refineries in Saudi Arabia and the United Arab Emirates is likely to increase exports of products like gasoline and diesel by 500,000 barrels a day in the coming months. Even without the Keystone XL pipeline, other Canadian pipelines coming online will bring as much as 350,000 more barrels onto the market.” Experts are now predicting that oil could go as low as $40 or even $30 a barrel.

At the center of our question of why erratic markets lies the fundamental truth of our human nature. No matter how strongly we claim to prefer coloring outside the lines, we secretly like order, even boundaries, all the more. When events or prices in this case, break out of accepted ranges we begin to question our confidence in our expectations for the future.

Markets represent the collective thinking/reacting of the people who participate in them. When surprises enter into market, reactions take the driver’s seat. Defensive reacting takes over to protect net worth, at any cost if necessary. But when normalcy returns investors return to their offensive game-plan, taking a more pro-active, strategic focus on what could/should be and what profits might be made if correct.

While professional investors must to some extent play the game with offense and defense on the field at opposing times, life-purpose investors should employ both at the same time, avoiding the expensive drags (taxes, expenses, and opportunity costs) that arise from whipsawing into and out of markets based on surprises and guesses.

The best approach for life-purpose investors, we believe, is to focus your energies on what you can control, i.e. your goals and how you want to reach them; to craft a financial plan that fully describes your goals and priorities, which is continually and rigorously tested to meet or exceed your goals through all kinds of market conditions; and finally to invest as efficiently as possible to avoid unnecessary risk, expenses, and opportunity loss.

Falling oil prices and all the potential economic impacts they bring are interesting, but what’s infinitely more interesting is discovering the hopes and dreams of our clients and designing plans to get them there as quickly, efficiently, and confidently as we possibly can.