Thoughts on the Market

March 9, 2020

In addition to more negative coronavirus headlines (ex-China which continues to improve), the big financial news over the weekend was the enormous decline in crude oil prices throughout the globe, with prices tumbling over 20% in one day. Oil prices are now close to $30/barrel vs. over $60/barrel for much of 2019. The reason was the inability of OPEC/Saudi Arabia and Russia to strike a deal to limit output, and instead their decision to actually raise output. The oil market, like any other, finds its price through supply and demand. The roughly 30% decline in crude oil prices year-to-date through Friday was mostly caused by shrinking demand, primarily due to the coronavirus impact on the Chinese economy and travel. The extreme drop today is due to expanding global supply in the face of that weak demand.

As of Friday, the Energy sector made up roughly 3.3% of the S&P 500, so on the surface it may seem like an oil price collapse would not be too bad for US stocks, especially when you factor in the positive economic impact of lower gasoline prices. However, this misses the broader picture:

  • Since 2018, the United States has been the world’s largest crude oil producer, with Texas/Gulf of Mexico accounting for over half of US production.1
  • The Energy sector makes up roughly 7 million US jobs and a large portion of US capital exepnditures.2 3
  • Perhaps most importantly for the financial markets, the Energy sector makes up over 10% of high yield debt outstanding.4 A spike in defaults can raise the cost of debt for all companies and lead to trouble for banks that have issued loans to these firms. Falling crude prices also lowers the outlook for inflation, which can also hurt banks by driving down long-term interest rates.

Recall that we had large oil oversupply issues as recently as 2015, with oil prices briefly dropping into the $30s. Defaults did rise in 2015/2016, but they were kept in check by oil quickly rallying back to $50+. The key to how much this truly impacts the economy and financial markets will be how long oil prices stay at their current depressed level. If coronavirus-related demand weakness improves this summer and OPEC/Saudi Arabia and Russia are able to strike a deal soon (which is in both of their best interest), this could be short-lived once again. In the meantime, it is another issue to worry about for financial markets and the global economy.

What does this mean for your portfolio?

We may sound like a broken record here, but the short answer is again nothing. We are not in the business of forecasting oil prices relative to what is priced into the markets. Therefore, we strive not take directional bets on this either way relative to client benchmarks. We use estimated mid-cycle earnings to value cyclical companies like oil & gas firms and rank them on a relative basis vs. each other. We have set risk limits on what percentage of a client’s portfolio can be allocated to oil & gas companies. While these companies have been very weak this year and especially today, we see no reason to change our process going forward.


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