Review & Outlook

Our take on the investing, financial, & economic themes of the day

Reaction to Falling Oil Prices

5 December, 2014 by Mark O'Brien in Commentary

The price of oil has collapsed from about $106 a barrel at the start of the third quarter to about $65.50 a barrel today.  That’s a big move.  Were prices to stay down, the consequences could be equally big.

Junk bond funds probably have the most exposure, at least in the short term.  As much as 17% of the junk bond market is energy related.  In 2006 the number was much lower, in the 6% range.  In  recent years there’s been a surge in issuance of bonds to pay for new drilling projects, especially those related to fracking. If the price of a barrel of oil  falls below the cost of producing it,  well, you know the rest.  It is not good for the marginal producers or their debt, much of which makes up the typical junk bond fund.

What’s the upside to the oil story?   The biggest beneficiaries would be companies that use oil.  One thinks of airlines, like Spirit (one of our small-cap stocks), railroads like Union Pacific, logistics/shippers like UPS and FEDEX, and food distributors like Sysco.  They just got a raise.

What about big oil companies like Chevron and Exxon?  Here the news is strangely mixed.  On balance, we would not do anything with big and established oil companies.  A periodic wringing out can be a very healthy development for an industry.  Indeed, the big problem with many economies, like those in Japan and Western Europe, is that marginal companies and industries are not allowed to fail.  Rather they linger on, depressing profitability for all companies.  If there is a wringing out, the survivors will be stronger than ever.

One last observation: any changes we make on the basis of falling oil prices would be gradual.  Big changes amount to big bets, and we tend to avoid them.