Beyond Cheap Gas…
The dramatic plunge in oil prices has transformed the global economic outlook and is having wide-ranging effects on consumer wallets. Bottom Line/Personal asked top energy consultant Robert McNally to explain what’s behind the changes and to forecast where energy prices are headed…and we asked energy investment expert Elliott Gue how investors can profit.
OIL PRICE OUTLOOK
• How low are oil and gasoline prices going to get?
Oil prices, which have plummeted by more than 50%, could sink to as low as $30 per barrel from a high of $108 per barrel in June 2014. That could push gasoline prices to a national average as low as $1.80 per gallon, less than half the level reached in 2011.
• Why such a drastic drop?
It seems complicated why this is happening, but it’s really a simple story of supply and demand. Despite weakening global demand and continued growth in global oil supplies, Saudi Arabia and some other OPEC producers have made clear that they will not cut their production levels to bring supply and demand back into balance. That means the world is facing a huge oil glut in 2015.
• How long will prices stay low?
We could see lower prices for the next year or more, but there will be wild swings until supply and demand come back into balance. Producers already are cutting way back on new drilling, but that won’t show up as a slowdown in the growth of production for several months. Down the road, when global economic growth returns to healthy levels, prices are likely to rise sharply.
• Isn’t that the strategy of Saudi Arabia and its OPEC allies—to force cuts in US production growth and eventually drive up prices as a result?
That’s true, in part. Fracking has increased US production by 70% since 2008 and is releasing three million barrels a day of oil trapped in underground shale rock. But fracking costs more than traditional oil drilling and isn’t very profitable below $50 per barrel, so lower prices are forcing some producers to cut back on their investments. Other high-cost producers, such as those engaged in offshore drilling, also are slowing investment.
The OPEC strategy is already beginning to work, at least in its effect on US producers. New oil well permits have tumbled in the US. ConocoPhillips, BP and other producers said that they will slash capital spending and drilling in shale basins, which is expected to slow US output growth from an added 900,000 barrels a day to 700,000 a day by the second half of 2015.
But behind the scenes, OPEC is not unified. Another big part of Saudi strategy is to force Russia and OPEC members Iran and Iraq to cut back their output. That has yet to take place.
Meanwhile, demand for oil has been dropping in the face of weak economic growth in places such as Japan and Europe and a slowdown in economic growth in China, the world’s second-biggest oil importer. That won’t turn around for a while, partly because oil prices are based on the US dollar, which has soared in relation to foreign currencies and kept gas prices relatively high outside the US. That impedes growth in demand.
• How much will oil prices rebound eventually?
When global economic growth starts to pick up in the future, demand for oil will quickly overwhelm supply. Fracking is a technically complicated operation, and US producers can’t simply flip a switch and ramp up production after slowing it down.
If global economic growth picks up enough speed, oil prices may at least temporarily top the 2008 peak of levels around $140 per barrel. That’s because OPEC is already pumping oil near its capacity, so it cannot raise production much further when demand rises sharply.
• How much of an impact will the lower oil prices have on the economy?
Lower prices at the pump are expected to save the average American household $750 in 2015. That is contributing to a rise in consumer confidence. In addition, lower oil prices reduce our trade deficit and borrowing costs…and provide a big restraint on inflation.
However, if the price drop is temporary and followed by a sharp rise, the positive effects will disappear. Also, cutbacks in US shale oil production could hurt the US economy because fracking supports more than 1.7 million direct and indirect jobs, according to research firm IHS Global Insight, and it has boosted tax revenue in several states.
Various companies that benefit from the drilling boom already are cutting payrolls. For instance, US Steel is laying off 600 workers at an Ohio plant that makes steel pipe for oil exploration and drilling…and oil-services giant Halliburton is cutting 1,000 jobs.
In addition, cheap oil has rocked some economies that are heavily dependent on oil exports, including Russia and Venezuela. Venezuela’s risk for default on its debt is soaring, and Russia may not be too far behind. Such defaults would have far-reaching ripple effects for regional financial markets and economies. Finally, imploding oil prices could even drive a country like Iran to foment unrest in other oil-producing countries, such as Saudi Arabia, in order to disrupt oil supplies and drive up prices.
THE INVESTMENT OUTLOOK
The plunge in oil prices boosted stock prices of some companies while crushing energy company stocks, some of which fell 40% or more in the second half of 2014. There are some strategic moves you still can make now to profit…
• Invest in companies that benefit from lower oil prices. Airlines are an obvious example because fuel costs constitute up to one-third of their overall expenses. While airline stocks already have had big run-ups, American Airlines Group (AAL)—the result of a merger between US Airways and American Airlines—can keep climbing as long as oil remains under $75 per barrel. It is the only major carrier that does not use hedging strategies to modulate swings in oil and jet fuel prices, which means that it benefits greatly from falling prices.
I’m also buying stocks of companies that see their profit margins improve because of cheap oil. These include plastics and chemical manufacturers that use crude oil as a raw material to make most of their products and gas stations that buy gasoline at falling wholesale prices but don’t reduce the prices they charge at the pump as quickly.
My favorites now…
LyondellBasell Industries (LYB), a leading global chemical manufacturer, makes products used in items ranging from mattress cushioning to food packaging. Recent share price: $78.98.
CrossAmerica Partners LP (CAPL) has been buying up gas station/convenience stores around the US and operates more than 1,000. Recent share price: $38.77.
• Look for oil-related companies that are not affected by lower oil prices. This seems counterintuitive, but several pipeline providers have long-term contracts to transport oil from one region of the country to another. The companies earn the same guaranteed fees whether oil prices rise or fall. Pipeline companies typically are structured as publicly traded master limited partnerships (MLPs). They pay no tax and pass through most of their earnings to investors.
My favorites now…
Shell Midstream Partners (SHLX), an MLP created by Royal Dutch Shell that went public in late 2014. Recent share price: $40.69.
Enterprise Products Partners (EPD), one of the largest pipeline MLPs, with 50,000 miles of onshore and offshore pipelines. Recent share price: $34.32.
• Avoid big oil producers—but create a watch list. They are too risky to bet on now because their share prices could continue to sink. However, once oil prices stabilize, big producers with strong balance sheets will be able to buy up smaller competitors at cheap prices. Stocks to watch and buy when oil prices stop falling: EOG Resources (EOG), which is very active in shale basins in Texas and North Dakota…and Occidental Petroleum (OXY), the fourth-largest oil company in the US based on market value.