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February 1, 2016
Oil – The Three
Biggest Worries
By Mitch Zacks \ Senior Portfolio Manager
We think it’s high time someone put their foot
down and called the collapse in oil prices what it
really is: a net positive! I find it interesting that,
when oil prices are high, the narrative is negative.
But, when prices fall precipitously and energy
becomes cheaper that’s also a bad thing! You can’t
have it both ways but, in my opinion, it’s not
inherently good or bad. There are pros and cons to
both situations – some industries suffer and others
benefit – but, I think in the current environment
that lower oil prices will be a net positive for the
global economy. It should ultimately help more
industries, companies, and consumers than it hurts.
The Broader Context
The collateral damage to lower oil prices falls
almost squarely on the sector which, as we all
know, has taken an absolute beating in earnings. It
spills over to the broader economy in pockets:
lower capital spending on oil exploration, about
200,000 industry jobs lost and counting, bank
losses (at the margin) which can slow economic
activity if banks become risk averse.
A closer look at the numbers provides clearer
context for the potential impact of Energy’s
decline for the broader economy:
Capital expenditures from the energy-
producing industry are only around 5% of
the nation’s total spending on equipment;
Employment in oil and gas extraction is
about one-eighth of 1% of total nonfarm
employment;
U.S. energy companies only account for
about 6% of the S&P 500.
The Energy sector is important, but it’s not the be-
all and end-all for the economy. The consumer is.
And, lower oil and gas prices should inspire more
spending and increased saving (which includes
reducing debt), and provide a boost to consumer
confidence – making bigger purchases of homes
and autos more feasible.
There’s a prevailing argument today that there is
‘more to the oil story’ in terms of risk, and it
focuses on three lines of thinking as far as I’ve
seen. Let’s take a look.
(Zacks Investment Management is not affiliated with LPL Financial)
Mitch on the Markets
February 1, 2016
The Three Biggest Worries
1) Bank Exposure – the fear here is that banks
have too much energy exposure in their loan
portfolios. With a lot of capital intensive oil and
production companies being forced to go offline,
due to loss of profitability, losses are accumulating
and, at worst, some companies are defaulting. If
this becomes systemic, banks would arguably be in
trouble and the credit issues of 2008 could come
right back.
But, the scale of the matter is much smaller than
most seem to think it is. The biggest banks
typically have less than 5% of their total loan
portfolio in Energy, and they are well-capitalized
in the aftermath of the credit crisis. Nevertheless,
they’ve been adding to reserves just in case:
Citibank by $250 million in the latest quarter,
J.P.Morgan by $124 million, Bank of America by
$2 billion. Smaller regional banks in drilling areas
are more of a concern, but they can be avoided and
should not drag down the overall financial sector.
Another factor to remember is that loans within the
oil sector are typically asset-backed loans,
meaning that banks can make a claim on property
if it comes down to it.
2) Slowdown in China Blamed for Falling Oil
Prices – it’s tempting to blame falling oil prices on
sinking global demand. And, with China’s
slowdown, it’s also a logical argument. But, how
do you explain the fact that China imported almost
10% more barrels of oil (335 million) last year
than in 2014! Sure, some of that was strategic
inventory building while prices were right, but this
is rising demand any way you spin it. Falling
prices are more heavily weighted in supply
pressures with the global glut building as Saudi
Arabia and OPEC produce some 30 million barrels
per day and the U.S. continues record production.
Demand has leveled off as the economic cycle
matures, but it hasn’t dropped off.
3) Oil Prices Correlated to Stocks – the
seemingly lockstep movements of falling oil with
falling stock prices has many rushing to call
‘correlation.’ If you buy that story, then the future
of stock prices could look in jeopardy – oil prices
are still searching for a floor and it’s difficult to
know what the price recovery will look like and
how long it will take. But, the notion that stock
and oil prices are tightly correlated is head-
scratching when you look past the last six months.
The chart below tells the story – more often than
not when one zigs the other zags:
Bottom Line for Investors
Give the adjustment period some time. The
immediate impact of steep declines in oil prices is
mostly negative: depressed earnings in the Energy
sector that drag down aggregate S&P 500
earnings, lost industry jobs, young companies
going out of business, loan losses for banks at the
margin. The medium to longer-term impact of
lower energy prices outweighs the short-term
adverse effects, in my opinion: lower input costs
for resource-sensitive products and companies,
higher discretionary income, better prices for
travel and tourism. The net effect, I think, will be
to help more industries and companies than it hurts
and to give consumers a monetary and confidence
boost to go out and spend more.
- Mitch
About Mitch Zacks
Mitch is a Senior Portfolio Manager at Zacks Investment
Management. Mitch has been featured in various business
media including the Chicago Tribune and CNBC. He
wrote a weekly column for the Chicago Sun-Times and
has published two books on quantitative investment
strategies. He has a B.A. in Economics from Yale
University and an M.B.A in Analytic Finance from the
University of Chicago.
(Zacks Investment Management is not affiliated with LPL Financial)
Mitch on the Markets
February 1, 2016
ZACKS INVESTMENT MANAGEMENT, INC.
www.zacksim.com Disclosure: Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. No recommendation or advice is being given as to whether any investment or strategy is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of herein and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. Third-party economic or market estimates discussed herein may or may not be realized and no opinion or representation is being given regarding such estimates. This material has been prepared by Zacks Investment Research (ZIR) an affiliate of Zacks Investment Management,
Inc. (ZIM) on the basis of publicly available information, internally developed data and other third party sources believed to be reliable. Neither ZIR nor ZIM has sought to independently verify information taken from public and third party sources and does not make any representation or warranty as to the accuracy, completeness or reliability of the information contained herein. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Indexes: The S&P 500 Index is a well-known, unmanaged index of the prices of 500 large company stocks, mainly blue-chip stocks, selected by Standard & Poor’s. The S&P 500 Index assumes reinvestment of dividends but does not reflect advisory fees or other expenses. The volatility of the index is materially different from the individual performance obtained by a specific investor. An investor cannot invest directly in this Index.
(Zacks Investment Management is not affiliated with LPL Financial)