With very good reason, crude oil prices seem to be on everyone’s mind these days. As a point of reference, West Texas Intermediate crude oil (WTI) recently fell below $90/barrel (bbl) for the first time in over 18 months after remaining steadily above $100/bbl. In addition, for reasons outlined below, we believe that price will continue to fall in the months to come. If that opinion holds true, the ramifications for considerably lower WTI prices are wide and profound as there is hardly anyone or any company that is not directly impacted by energy prices.
We believe there are two factors at work that seem to have converged to pressure oil prices lower. The first reason has been well covered in the financial press. That reason being the strengthening US economy and resulting stronger US dollar. Although a strengthening US economy has historically been very bullish for crude prices, we believe that a slowing China along with more efficient US consumption have acted to completely offset this normal pattern. As the US economy continues to strengthen and show resiliency, especially in relation to Europe, Japan, China, and our other trade partners, the US dollar will command higher exchange rates against those other currencies. Because crude oil is priced around the world in US dollars, a strong dollar (all else being equal) will necessarily continue to pressure crude oil prices lower.
Another related factor adding strength to the US dollar is that the Federal Reserve is slated to wind down its Quantitative Easing (QE) campaign this month (October). Once the Fed is done buying US Treasuries, the US money supply will revert back to a relatively fixed quantity (or supply) of money. Combined with the fact that Japan is currently aggressively fighting its deflationary problem with heavy doses of QE and Europe is just now starting up it’s own Euro-version of QE greatly suggest more strength yet to come for the US dollar. As the Japanese and EU QE campaigns flood more yen and Eurodollars into the global money supply, we would expect continued downward pressure on crude oil prices.
The above described monetary relationship between the price of crude oil and the US dollar is certainly a powerful reason behind the recent move lower in oil prices. However, the second reason that we believe WTI has fallen, and may continue to do so, is potentially even more powerful. There has been much discussion for several years now about US energy independence. As a nation, we have certainly moved in that direction with all of new oil production coming out of North Dakota, Texas, Oklahoma, and many other states from new technologies (“fracking” and horizontal drilling primarily). The truth is, these technologies have been around for decades, they just haven’t been economically viable until recently as crude prices have stayed consistently above $50-$70/bbl. Keep in mind, prior to 2006, WTI only sporadically traded much above even $40/bbl.
One specific area of macroeconomic theory that may be particularly useful in this respect is the theorem that Marginal Cost = Price (MC = P). It has always been my belief that that equation is generally true for most goods and services, but tends to be a pretty intangible measurement except when it comes to discussions about ubiquitous commodities, such as crude oil. Marginal Cost in this regard would be the cost, on average, to the oil industry of producing an additional barrel of oil, inclusive of exploration, drilling, transportation, and so on. It is also important to realize that this equation is meant to express the relationship between the cost of production and the market price over the long run, not on any given day.
So the application of the MC = P relationship to the current WTI market might look something like this. First, we assume that these new drilling technologies (fracking and horizontal drilling) only became profitable once WTI prices exceeded $50/bbl for sustained periods of time. That assumption would allow us to further assume that the Marginal Cost to the oil industry of all the new shale oil on the market (on average and in the long run) would be somewhere in the $50 range. The second part of the relationship assumes that producers will continue to produce oil as long as it’s profitable to do so, that is, the price exceeds $50 (in this assumption).
Even if we make a conservative estimate that MC is higher, say even as much as $70/bbl, that is still considerably lower than the current price ($87.70/bbl). We believe the WTI price is in the midst of reverting back to its Marginal Cost of production in the $50 - $70/bbl range. Obviously, even if we are correct in this fairly aggressive opinion, that decline won’t be straight or even consistent. What we are primarily anticipating is a general trend lower for WTI prices until MC = P.
The impact to the US economy, and indeed the global economy, of $50 - $70/bbl WTI would be profound. To the extent that everyone uses oil, everyone would benefit from lower WTI prices. In fact, it has been estimated that every $0.01/gallon drop in gasoline prices transfer as much as $1 billion of consumption from oil to other areas of the economy. Insofar as gas prices have already dropped $0.86/gallon since WTI prices started dropping, more than $86 billion has already transferred to other more consumer discretionary areas of the economy. If we are correct about a further drop from current levels ($87.70/bbl to $70.00/bbl), US consumers could realize an additional $45 billion windfall. Just for reference, $111 billion translates to approximately $500 per person in the US. In other words, everyone in the US will spend $500 less on gasoline and given our propensity to consume, we would likely spend most of that savings on other goods or services.
We have positioned the accounts we manage for this type of scenario. We have very little direct exposure to oil and gas producers at this time, nor have we for many months. Instead, we have opted to overweight those sectors and companies that should benefit not only from cheaper energy prices, but that also should benefit from the above described income transfer. To that end, we have been overweight industrials (which tend to use a lot of oil and gas) and consumer discretionary stocks. These sectors tend to do well during economic recovery and/or expansion as well. Consequently, if we are correct in our thesis that WTI prices should continue to moderate lower, you should realize a double benefit to your investment portfolio.
As always, please feel free to contact us if you have any questions or if you need to schedule an appointment to discuss your account or financial plan with us. This is particularly important if you have experienced a big change in your life recently (got married, retired, changed employment, bought/sold a business, etc.).
2013 Form ADV Notice and Offering – the firm’s 2013 Form ADV Part 1 & Part 2 filings with the State of Colorado Division of Securities and other regulatory bodies were filed timely on 3/31/2014. There were only minor modifications to the prior filing made in 2013. However, if you would like a copy of this important disclosure document, please contact us at (303) 442-3670 or email@example.com and we will be happy to deliver it to you at no charge.
Mark P. Culver
Culver Investment Company, LLC
360 Interlocken Blvd
Broomfield, CO 80021
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