Oil Makes Stock Market Slippery

On this day in 1916* President Woodrow Wilson created two Naval Oil Shale Reserves, large sections of pristine oil shale (located in Colorado and Utah) which he kept from passing into private ownership. Back in those days drilling for oil in shale deposits was common practice. Of course the amount of oil they could pull out of those deposits was miniscule compared to what fracking has done for shale oil production today. This increased production from shale is what has caused the drop in oil prices and to some degree stock prices as well.

It is estimated that $2 to $3 trillion of capital is dedicated to the energy sector, commonly defined as not only the wells and oil structures, but also the pipelines, rail cars and other investments devoted to extracting and transporting this energy. This capital is targeted to an oil price of $60 or higher, and now the price is less than half that. Most of this capital, if prices do not improve dramatically, is substantially devalued, if not worthless. The U.S. as a whole certainly gains from lower energy prices, but the adjustment costs to the recent price collapse are huge and unprecedented. Although millions of workers are involved in energy production, every American is involved in energy consumption. And the lower prices of energy will eventually boost firm profits and workers’ income. We are in the process of experiencing the pain before the gain.

So what will stop oil prices and in conjunction stock prices from dropping? My friends it is entirely in the hands of our pals (tongue firmly implanted in cheek) in Saudi Arabia.

Saudi Arabia has an obvious interest in wiping out as much of this new energy production as they can.  Saudi costs of extracting crude are estimated to be $5 to $10 per barrel, so it knows that it can hold out longer than most others. By putting U.S. frackers’ and other marginal producers out of business, The Saudis will eventually achieve higher prices. Furthermore, the Saudis want to slow down the development of alternative energy sources and sharply lower crude prices will do just that. Many coal producers are at or close to bankruptcy and the development of solar energy and electric car production will inevitably slow.

This adjustment will cause much pain on the earnings front. We will get some significant write-downs from energy producers that will impact aggregate S&P earnings. But be aware of the “Aggregation Bias” The earnings from the energy sector will be negative this year. These negative earnings will be subtracted dollar for dollar from the earnings of the other nine positive earnings sectors when computing the overall P/E ratio. So the P/E ratio of the other nine sectors will be biased upward. One may feel that the valuation of energy stocks is too high or low, but outside the energy sector the P/E ratio of the market is about 16.3, right in line with post-war historical averages and far lower than the P/E based on aggregate earnings, which could move into the twenties.

I rarely make predictions about the direction of financial or commodity markets, but I will make one now. I believe the price of oil and many other commodities will bottom this year. It’s a safe prediction to make, after all how much lower can prices go?

*Ok, I really don’t know the exact day President Wilson established the reserves… But it sounds so cool when you say- “on this day”

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