Impacts of the Declining Price of Crude Oil

The sharp and sudden drop in the price of crude oil over the last few months caught many market participants by surprise. This decline has broad impacts for the economy and, more specifically, the bond market. As measured by the price of WTI (West Texas Intermediate), the price of oil has fallen almost 28%, from $102.90 per barrel on June 25 th to $74.21 per barrel on November 14 th . The effects of the price decline are far-reaching:

U.S. Economy – Much has been made in recent years of the resurgence in U.S. oil production, which has been driven by large-scale discoveries and made more efficient by improved technology. A concern has emerged as to whether the price decline will slow production levels and hurt economic growth, particularly in the oil producing regions of Texas and the Upper Midwest. Lorenzo Simonelli, an executive from General Electric’s Oil and Gas division (which supplies drilling equipment), claims the price decline has yet to slow activity. “The projects so far are still viable,” he said, speaking last week at an event in Brazil. Even if production were to slow, however, investment in oil and gas represents less than 1% of U.S. GDP, according to Barclays. The larger impact of lower oil prices is a positive one and relates directly to U.S. consumers. Americans spend roughly $1 billion each day on gasoline, says Tom Kloza, global head of energy at the Oil Price Information Service, and the decline in costs will save Americans $8.4 billion in November and December compared to the same months in 2013. If prices were to stay at these levels, it would result in $400 in yearly savings per household. This extra cash would add nearly a half a percentage point to fourth-quarter GDP growth and generate $70 billion in additional consumer spending next year, says Barclays. On net, the positives far outweigh the negatives from a domestic economic perspective.

Bond Market – Lower crude prices have different impacts on different parts the bond market. Lower energy prices mean lower inflation, which gives the Fed more time to keep easy money policies in place. While the Fed would point to short-term drops in the price of oil as transitory, they pay close attention to inflation expectations, which are now moving lower. The University of Michigan forward-looking inflation expectations survey was released on Friday and showed a downtick in inflation expectations on a 1- and 5-year ahead basis. These metrics, combined with the current low levels of inflation, will likely be cited in the Fed’s next FOMC meeting statement as reasons to keep rates at the zero bound for the time being.

From a sector standpoint, two sectors of the investment-grade market are becoming interesting: TIPS and corporate bonds issued by energy producers. TIPS has been the worst performing sector in the investment grade market over the last 12 months, underperforming similar duration Treasurys by over 2%. Investors are currently pricing in 1.9% inflation over the life of a ten-year TIPS, down from 2.3% earlier this year. The time to buy TIPS is when inflation expectations have declined and are low, which is what we see today. Corporate bonds issues from energy producers have also gotten cheaper. Over the last three months, the energy sector of the corporate bond market has underperformed the broad corporate sector by 0.4%, a large move in such a short period. We are combing the universe for buying opportunities in names that have been unduly hit by the price decline, and will perform just fine operationally and financially even if this lower price environment persists.

Source: Barclays, Bloomberg, New York Times, Reuters, Oil Price Information Service