TSP

By: Lyn Alden

Over the past 12 months, during the second half of 2017 and into the first half of 2018, oil prices have been in an almost non-stop bull market, going ever-upward.

Crude Oil Brent Prices Over 5 Years:

Source: Nasdaq

From 2010 to 2015, oil prices were in a high plateau, spending most of that time over $100/barrel. However, as new shale technologies allowed for dramatically increased output of U.S. oil, the global supply and demand balance of oil became imbalanced towards the supply side.

As this chart shows, the supply (blue line) became considerably higher than consumption (brown line), resulting in increased inventories:

Source: US Energy Information Administration

Both supply and consumption keep increasing over time, but after oil prices fell due to oversupply, many less efficient oil suppliers turned off production and several oil-producing countries agreed to trim their production to restore higher prices, so global supply stayed relatively flat for a few years which allowed for global consumption to catch up.

Recently, Venezuela’s oil output expectations declined due to political instability in the country. And Iran’s oil output expectations declined due to President Trump’s decision to withdraw from the Iran Deal. This pushes the balance more towards consumption and higher prices.

How Oil Prices Affect the Economy and Stock Market

Oil producers strongly benefit from higher oil prices, because their costs remain the same but their revenue from selling oil goes up, resulting in much higher profit margins. Oil and gas stocks represent approximately 6% of the C Fund, 6% of the I Fund, and 5% of the S Fund.

While the correlation is far from perfect, higher oil prices can lead to higher inflation, because oil is a major input into the economy. The cost to produce food, plastic, commodities, manufactured goods, and just about everything goes up, and the cost to transport everything to the end-user goes up as well. Inflation is good for certain asset classes like real estate with existing fixed mortgages. But it also means interest rates will rise, resulting in higher borrowing costs for consumers and companies across the board.

For the average consumer, their gasoline prices go up along with oil prices, which impacts their budgets. For example, the average U.S. household spends almost as much money as they earn each year (resulting in an approximate 5% average annual savings rate), and the percentage of gross income spent on gasoline varies from 2-4% depending on prices, or about $1,000 per year. And their interest rates on debt will increase if inflationary pressure remains, including all variable-rate loans they currently have.

Some analysts have argued that the major decline in oil prices from 2014-2017 helped prolong the current economic expansion and bull market, because the decline in oil prices was beneficial for consumer spending on other areas of the economy and allowed inflation and interest rates to remain historically low. The second stage of the argument is that as oil prices go back up, consumers will be hurt and have to trim spending elsewhere, which could be recessionary. Indeed, higher commodity prices and higher inflation are historically hallmarks of late-stage periods of economic expansions.

It remains to be seen how far up oil prices will go, and what major political events could result in changes to supply or consumption. And over the very long-term, the steadily declining prices of solar energy and the adoption of electric vehicles both threaten to substantially reduce the need for oil.