Making Sense of Lower Oil Prices

The slide in such an important commodity isn't the crisis it may seem, once you understand the forces at work and how they might influence your investing.

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U.S. equity markets have had a volatile time in 2016, due in part to worries about the fall in oil prices to notable lows. But does oil's prolonged trough signal a looming domestic and global economic crisis, or the start of a virtuous cycle that will propel the U.S. into a new era of expansion?

As is so often the case, the answer lies between the two extremes. "We view the drop in oil prices as a mostly positive dynamic," says PNC Chief Investment Strategist Bill Stone. "And it is likely to play out over the long term, not immediately — but it's still on balance a beneficial factor."

How Oil's Prices Flow Through the Economy

To understand why, it helps to grasp exactly what we mean when we say "oil prices are falling," and why the price of oil means so much to the markets.

"We watch WTI, West Texas Intermediate, to understand U.S. prices, and use the price of Brent crude as an indicator of global oil price activity," Stone notes. "They generally move in the same direction — and at the moment, the story they tell is the same: pretty negative, at least for people who own significant oil holdings, and net positive for the consumer side."

The first half of that statement seems intuitive, but how could the consumer benefit from this market dynamic? Consider that lower oil prices make it cheaper to produce plastic — a major input for the goods that go into many shopping carts, in stores and online. The price of gasoline also slides when oil falls, which drives down a major expense for not only the American household, but also for shipping those consumer goods around the country. Cheaper gas and lower-priced goods tend to boost consumer spending, which in turn improves corporate earnings — or so the theory goes.

Limiting Factors

Why are the equity markets so rocky if this virtuous cycle is in place? To start, outsized expectations about the American consumer. "It’s fair to say that people expected the consumer to be even stronger, but that’s not to say the consumer isn’t strong," Stone offers. He points out that the national gross domestic product for 2015 rose 2.4%,[1] and personal consumption contributed heavily to that — new auto sales in Q4 2015 were the strongest in years.[2] "It’s not the consumer that’s the problem in the U.S. economy," Stone continues.

Now that the U.S. has become the world's swing producer of oil, we have more negative offsets than we did in the past because more parts of the economy are sensitive to a downturn in oil. "The U.S. has more exposure to energy because we have become a bigger producer, thanks to the advance of the oil shale industry," Stone says. "The net positive effect of lower oil prices isn’t as big as it used to be because of the production we’ve added."

The global economy is also at a weak point: Japan and the eurozone nations are still struggling to grow, and China has slowed. That's not to say it's collapsing, Stone is careful to point out: "We have expected China to slow for some time, so it shouldn’t be a surprise. It's just the law of large numbers; even a small shift matters when it's in the second-largest economy in the world." Together, these factors limit the positive effects of lower oil prices — but don't cancel them out.

Investing With Oil in Mind

"We believe that overall, lower oil is a net positive. That said, you have to be mindful of the negative part of that net," Stone cautions. Specifically: Energy-related investments, which are likely to see the greatest effect of lower oil, will require the most vetting. "Because our view on oil is lower for longer, you have to explore whether a given company is positioned to survive. Examine how much its business is levered to oil." High-yield bonds warrant the same degree of scrutiny, because so much of that portion of the credit market consists of energy companies.

Sectors that are likely to benefit from lower oil prices include consumer goods, entertainment and even airlines. "Look for companies that are likely to find their margins expanding because this major cost of business is decreasing," Stone suggests. "Or those that are likely to attract the dollars that consumers aren't spending at the pump."

Most importantly: Don’t get too distracted by daily movements in the price of oil. "Low oil prices are a net positive so even just having oil stabilize will be enough to make things look a lot brighter pretty quickly," Stone asserts.

    Bill Stone Bill Stone PNC Chief Investment Strategist
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  • Important Legal Disclosures and Information

    1. U.S. Department of Commerce Bureau of Economic Analysis. National Income and Product Accounts Gross Domestic Product: Fourth Quarter and Annual 2015 (Second Estimate). Feb. 26, 2016.

    2. U.S. Department of Commerce Bureau of Economic Analysis. Table 2.4.5U. Personal Consumption Expenditures by Type of Product. Last Revised on: Feb. 26, 2016.

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