Why are falling oil prices dragging the market down?

Oil is pretty special.  After air and water, it’s probably the most important substance for mankind.  Different from air and water, oil is not free (or nearly free).  Oil touches every part of our life, even the lives of “green” people who drive electric cars and have solar panels on their roofs.  Oil takes us from point A to point B in our cars and airplanes.  It gets every single product from its producer to its consumer—food, clothes, cars, phones, everything.  In many communities it powers the plants that literally keep our lights on.

Historically, going all the way back to its discovery in Pennsylvania in the 1859, the price of oil has been prone to booms and busts.  Early on, the discovery of a single well could send prices plummeting, driven by fears of over-supply.  More recently, supply restrictions like OPEC or geopolitical conflict can send the price soaring; while signs of weakness in demand like a global economic recession can send prices diving.

The past couple years have been no different.  Oil has fallen from over $100 per barrel to where it stands today, less than $35.  That’s quite a fall in prices, but why is that such a big deal?  Interestingly, as the market has been struggling the past few months, many market pundits cite the fall in oil is hurting the stock market.  But does that really make sense?  Let’s take a look.

 

Market pundits, as usual, are full of crap

As we all know, the market has been extremely volatile lately.  That coupled with the price of oil falling has led a lot of talking heads on channels like CNBC to correlate the fall in the market to the fall in oil.  However, if you look closely, you’ll see that there isn’t much of a correlation.

Since 2014, the price of oil has fallen 65 weeks and risen 47 weeks, while the S&P 500 has fallen 49 weeks and risen 63 weeks.  So there different but the real nail in the coffin is that of the 112 weeks, oil and the S&P 500 have moved in the same direction . . . (wait for it) 53% of the time.  So they have both risen or both fallen a little more than half the time.  They have gone in opposite directions, one goes up and the other goes down, 47% of the time.  That seems like a flip of the coin to me.  So the data totally refutes the idea that oil is driving the market in a major way.

The markets are incredibly complex, and it’s naïve to believe that the price of a single commodity, even the most important commodity there is, would drive the market.  Those talking heads need their sound bytes and need to appear as though they’re explaining what’s going on, but we know better.

So first, and foremost, don’t believe everything you hear from CNBC.  They have a lot of airtime to fill, and they say a lot of stuff that under the slight of Stocky’s analytic scrutiny is total crap.

 

Case for the fall in oil hurting the stock market

Obviously if the price of oil falls 70% over the course of a couple years that is going to have a devastating impact on the oil industry.  And remember that the oil industry is incredibly big (probably about the third largest industry in the US) and incredibly complex.  There are geologists looking for new oil deposits, drillers, truckers and pipeline people taking oil to/from refineries, refiners, all the way down to gas station attendants.  So let’s look at how the price of oil impacts them.

The people who run gas stations aren’t going to be affected at all.  Drivers are still filling up their cars (probably even more than before because gas is so cheap), and the gas stations are still making their couple cents markup on each gallon of gas.  No Impact.

Refiners are probably impacted a little bit, not because their business is going down (similar to the gas station people, it’s probably going up), but because their customers, the oil producers are getting squeezed by price, so that is probably trickling down to them.  My neighbor owns a couple oil refineries and he has mentioned that they normally charge something like 15% of the cost of the oil they refine, so obviously if prices go down they get impacted.  But people are still using plenty of oil so the refiners are still going to be plenty busy, and if they have to raise prices to make it work, basic economics say they should be able to.  Small impact.

Geologists and drillers in the US are feeling the pain.  When oil was at $100 there was a huge incentive to try to find extra supply so that kept a lot of these people employed looking for and then drilling new oil wells.  However, as you can easily imagine, when oil is trading at $30 there’s no where near that incentive to find new wells.  Plus you have all the industry that goes with helping set up wells and keeping them running.  Think of cranes and enormous drills, wiring and tubing; all sorts of crap (Halliburton is a big player here).  When you aren’t looking for new wells, you don’t need all that other stuff.  A lot of those people are out of work.  Major impact.

That even flows through (pun intended) to the people running the wells that are online.  Even after you factor in the huge start-up costs to find a well and get it going (more on that in a minute), there are significant costs in keeping a well up and running.  If a well is profitable at $100 but not at $30, then those wells might get shut down, and those people might lose their jobs.  Medium-major impact.

Finally you have the truckers who transport the oil around.  They are probably getting less business taking crude oil from US fields to the refineries, but they should have just as much business as ever from taking refined gasoline to the gas stations.  Plus, truckers are pretty flexible; if they aren’t driving oil they can easily drive something else.  Small-medium impact.

There are a lot of players in the oil industry, and some of them, especially those involved in the discovery of oil are really hurting.  And of course this has a compounding effect where they lose their job, can’t buy things other people product, and on with the downward spiral.  But let’s not lose sight of the bigger picture.  There are probably 150 million working Americans.  Only a very, very small fraction of those are in the energy industry, and only some of them are losing their jobs.  So this impacts a relatively small number of people, but it impacts them in a large way.

 

Case against the fall in oil hurting the stock market

How about the rest of us?  Oil’s price falling is unambiguously a good thing.  Something we all need is getting less expensive.  Obviously we feel that at the pump where it used to cost $60 to fill up our car and now it only costs $25.  We can all use that $35 to spend on other things which keep other people employed, or we could (gasp!!!) save it.

And as I said above, oil permeates through every part of the economy.  So if you don’t drive a gasoline car, you’re still getting the positive benefit because it cost less to get your food to the grocery store, to fly your FedEx package across the country, and nearly every other thing you use in your daily life.  This is what the press has called the “oil dividend,” the extra money that we’re all getting because things aren’t as expensive.  It won’t add up to millions, but it’s not unreasonable to imagine a family saving $1000 a year because of the lower oil prices.

If you compare two scenarios though, it seems lopsided.  An oil worker is losing his job while a family is saving $1000.  But remember it’s a numbers game.  Maybe there are a tens of thousands of people (and that seems high to me) in the oil industry who lost their jobs.  But there are a hundred million people who are getting a small benefit.  It’s a numbers game and the masses, with their small benefit, clearly make up for the relatively small amount of people who get crushed.

 

Final verdict

So if you look at all that, clearly the fall in oil prices should be a good thing for the economy.  And largely it is.  The nation is pulling out of a recession and there is broad-based economic growth.

But there’s still a nagging voice that is saying “not so fast”.  The problem with oil prices isn’t that it’s low now and a while ago it was high.  We have an amazingly adaptive economy that can thrive with low oil prices just as easily as it can with high oil prices.

What screws things up is when oil price change so quickly.  As I briefly mentioned earlier, starting up a new oil well is a major undertaking, and “major undertaking” is French for “expensive”.  Before a single drop of oil comes to the surface, companies are investing tens and hundreds of millions of dollars.

Of course, they would only do this if they thought they could generate a profit.  If oil was at $100 then they would look at all the places that can profitably produce oil at $100 and start getting to business.  Now they aren’t dummies and they know oil prices can move, so there’s a risk involved but that gets factored in too.  But when the bottom falls out of the price of oil and those wells become unprofitable, at some point they have to shut down the well and much of that initial investment gets lost.

And it’s not just oil producers.  Look at a company like Tesla.  They make electric cars, and as you can easily imagine, electric cars are really attractive when oil prices (and thus gas prices) are high.  You can see it in their numbers: sales have slowed down considerably as oil prices as fallen.  Just like the oil producers, the fine people at Tesla need to figure out if they should expand, make a new factory, all that stuff.  If they did that when oil prices were high (which in fact they did) then a lot of that investment might be in trouble now that oil prices are low.

Making it even more local, imagine your neighbor was looking to buy a new car.  When gas prices were high she was considering a Nissan Leaf (about $30,000) instead of a Honda Civic ($18,000), in large part to take advantage of savings on gas.  She buys her Leaf figuring she’ll save $2000 per year on gas, but then gas plummets and her savings are only $1000.  Her “investment” of the extra $12,000 she spent on the Leaf is in bad shape.

 

To bring this home, I think it’s unquestionable that lower oil prices are a good thing.  Yeah, a few people might get hurt, but that’s pretty small compared to the masses that are helped.  But the real problem isn’t high or low oil prices, but it’s unpredictable oil prices.  That’s when people or communities or companies make large investments which might turn out to be really bad decisions.

What about you?  How is the low cost of oil impacting you?