A Question of Time By: Gabriel PotterMBA, AIFA® 2015.01.07

It’s getting harder and harder to write articles with any expectation of price accuracy for oil.  I finished an article on the Energy sector when oil was at $63 – already a significant drop.  It ended 2014 in the mid $50s.  At the time of writing this blog post, the price per barrel of oil has skidded below $50.

As we implied in our previous blog post, the long term price range for oil may be dependent on the lead time and breakeven points on drilling new wells.  Since the long term break even prices – including sunk costs and marginal costs - for new wells range from $40 to $80, that implies a reasonable range target.  However, since the marginal cost of drilling is significantly lower, there isn’t really a $40 short term floor on prices.  There are other factors at play, making the calculation of supply and demand even harder to figure out.  There are significant price “hedges” that won’t expire until the middle of this year.  In other words, drillers have already signed contracts to deliver oil for a pre-specified price; the natural bottoming out of supply can’t occur until prices that drillers receive reflect the new reality of the oil glut.    To counteract this future oversupply pressure,  the US is making a concerted efforts to open up our excess oil and natural gas for European export, opening up more demand.  Similarly, Reuters reports that US shale producers are racing to build up more hedges to extend their protection from low prices, perhaps as long as the second half of 2015.

The stock market is also absorbing the incongruity in timing.  In the long term, cheap energy is good for the economy, reducing the costs for nearly every good and service.  It will take some time for these savings to work through the economy and for the full impact to be calculable, and appreciated by consumers and businesses.  In the short term, the significant amount of energy producers represented in the equity indices are taking a tremendous, direct hit to their revenues.  Paradoxically, this means that the equity markets are getting clobbered today… because energy is cheap.

In the long term, we’ll figure this all out.  It’s just a question of time.

Gabriel Potter

Gabriel is a Senior Investment Research Associate at Westminster Consulting, where he is responsible for designing strategic asset allocations and conducts proprietary market research.

An avid writer, Gabriel manages the firm’s blog and has been published in the Journal of Compensation and Benefits,...

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