PMC Weekly Review - August 21, 2015

A Macro View – Oil Declines

Since June 2014, oil prices have declined by almost 70%, with WTI Crude trading as low as $40.40 over the last week. The fast and sharp decline in the commodity occurred as five forces collided: increase in U.S. oil production, persistence of production in Libya, discord between OPEC members, and slow in growth in oil demand from Europe and China. To expand, while the U.S. does not export oil, it has become the world’s largest oil producer, which has caused the country to cut oil imports by half, and caused excess supply internationally. As two rival governments continue to struggle for control over Libya, many economists expected oil production to slow. However, production normalized fairly quickly, creating an even larger global surplus. OPEC struggled to exert control over price and production, with Saudis and Kuwaitis reportedly having been in a price battle. Lastly, supply continued to further increase as growth in Europe slowed, and as Asian countries cut energy subsidies. While these forces collided in June 2014, we continue to observe elevated crude inventory levels, with the U.S. Energy Information Administration (EIA) reporting Wednesday morning that U.S. commercial crude inventories increased by 2.6 million barrels last week to 456.2 million barrels - levels not seen at this time of year in at least the past 80 years. Additionally, there are concerns that Iran could open their pipeline and further exacerbate the situation. As oil is a commodity in which price is determined by supply, demand and expectations, Citigroup has stated they predict a drop to $30 a barrel is not out of the question.

What’s wrong with $30 a barrel oil you ask? As a consumer, it seems like money that would have been spent at the pump could be allocated elsewhere, such as consumer discretionary items paying down liabilities, or boosting savings. In fact, Federal Reserve Chair Janet Yellen has compared the cheaper gas to a tax cut for the American people. Unfortunately, there are broader consequences, such as oil producer nations feeling stretched financially, as well as corporate balance sheets and valuations being negatively reshaped. According to a 2012 EIA survey, the top oil producer in the world is Russia, producing 14.0% of the world’s oil, as well as Venezuela and Mexico producing 3.56% each of the world’s oil. As crude is dollar denominated, it puts pressure on these producer nations, with the Russian ruble steeply declining and the stock market consequently falling. Furthermore, many credit rating agencies have downgraded the countries bonds to junk status. Venezuela was already in trouble when oil was $120 a barrel, but combined with the decline in oil prices, the world’s highest inflation rate, and a currency that is declining there are concerns the country could default on its debt next year. While the country has the largest oil reserves in the world, The President, Nicolás Maduro, has resorted to calling the oil decline a conspiracy led by the U.S. Our neighbor to the south, Mexico, is not in such dire straits, but the country’s growth has been harmed by falling oil prices and on Thursday the Mexican Treasury Department lowered expected GDP growth for 2015 from 2.0% to 2.8%. While low oil prices have hurt the aforementioned sovereign nations, as previously mentioned, there are causes for concern domestically as according to CNBC, “the pullback in energy prices is likely to drive overall S&P 500 profit growth into negative territory for full-year 2015.” This is caused as decreased oil prices pressure revenues and margins of oil and gas companies. Additionally energy companies are forced to devalue reserves, hurting balance sheets, which in turn decreases the market value of the corporation. Changes in corporate valuations could lead to increased M&A activity, which can ultimately change the structure of the Energy Sector.

Certainly, the increased oil supply, and the decreased demand for oil in emerging markets contributed to the 70% decline in oil prices over the last fourteen months. While this decrease in oil prices might be good for the average consumer’s pocket book, we cannot overlook the fact that investors are concerned that downward pressure on the U.S. Energy Sector, as well as sovereign oil producers, could result in a falter in the stock market.

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