The Meaning of Oil

From July until December of last year, crude oil was in a steady decline, falling all the way from just under $100 a barrel, to $55.81 on the final trading day of the year. The steady drop has continued in 2015, hitting a six year low of $44.08 on January 27. It bounced to around $55 earlier this month and has oscillated between $49 and $55 per barrel since then. Increased supply, weaker demand, and a stronger dollar have driven oil prices lower over the past eight months and may continue to push prices downward. $40 per barrel is still very possible.

Oil companies are reacting to the decline in oil prices. The rig count has declined significantly. Per Baker Hughes, the number of oil rigs in use is now down to 1,019, the lowest since July 2011 and a 28% decline of 406 rigs from a year ago. The falling rig count has helped oil bounce, but production has not declined and will lag the rig count. Remember shale wells have strong initial output and decline 60-70% over the first year or so of production. Moreover, countless exploration and production companies have announced cuts to planned capital expenditures for 2015.

Prices at the pump are also rebounding. According to AAA, the average price for a gallon of regular unleaded gasoline has increased every day for the past 28 days, bringing the national average to $2.30 per gallon. This reverses a record 123-day decline from last fall that saw gas prices hit a five year low of $2.03 per gallon.

The increase in gas prices is indeed reflective of the recent increase in oil prices, but it’s also that time of year – the start of driving season. Demand increases every year beginning in February and generally peaks in August. Also in February, refineries begin maintenance for the changeover from winter blend to summer blend gasoline, which is more expensive to manufacture. The production process is longer and costlier, and the overall yield of summer blend gasoline per barrel of oil is lower. This brings some tightening to gasoline supply and has historically paved the way for seasonally higher fuel prices.

Over the past 15 years gas prices from the beginning of February to their summer peak (usually about May 9th) have increased on average $0.51 per gallon, or 23%. Oil prices for the same period (beginning of February to summer peak), have increased on average $8.32 per barrel or 14%. This suggests that while there may be some seasonality behind price increases in oil, increasing demand by summer drivers adds additional premium to the price per gallon of gasoline.

Many wonder if the decline in energy prices could be just the right medicine for the economy. Despite the recent jump in gas prices, US motorists are paying just over a dollar less per gallon than a year ago giving consumers more gas money at month’s end to spend on other things. Maybe that additional demand could spark job creation and the genesis of a more robust expansion that would ultimately drive energy prices higher. But, the consumer isn’t spending his savings. Economic data don’t evidence a correlation between gas savings to recent spending increases. A further look to history and economic behavior explains this disconnect.

History shows a roughly nine month lag between a drop in gas prices and increased consumer spending. Economists believe in rational consumers. When they feel secure, they spend and invest. Former Treasury Secretary Larry Summers uses the example of a refrigerator. Tell a consumer that the economy will be weak and energy prices will stay high, and the consumer will buy a less expensive, energy efficient refrigerator. Tell him that the economy will be good and that energy prices will be low, and he will spend more money on a fancier refrigerator with through the door ice, water, and a beer tap. If you tell the same consumer that the economy and energy prices will be volatile, and you’re not sure in which direction, the consumer will not buy a refrigerator. He will sit on his cash and wait until more certain times.

The current decline in energy prices is about nine months old. Consumers should be about ready to spend some of their windfall. Increased uncertainty will keep wallets in pockets, but if history is a good guide, investors would begin to see a pick-up in consumer spending almost any day now. If it starts, retailers should benefit. Pay attention to retailers like Wal-Mart, Target, and the dollar stores for early signs. For those considering investing in oil and energy companies, be careful and be nimble. Disciplined investors begin considering any asset that has endured a 50% price decline, but with history as a guide, this cycle may last a lot longer than many expect. If the rule is to buy low and sell high, these prices are not high relative to the past 10 years.
Peace,

Michael