What you need to know about falling oil prices


Writer James Buchan once said that oil is almost as vital to human existence as water -- despite it being an obscure commodity just a century ago

If that sounds hyperbolic, it isn't. As Buchan points out, oil clothes us. It heats us. It powers our machines and our economies. It gives us medicine. Life would be unrecognizable without it.

And that's why oil is the key to the world economy. It is interconnected with every human endeavor. Even minor blips in supply and demand have major repercussions.

So when prices plunge into near freefall, you'd better believe we're all going to feel it.

The positive side of cheap oil

Oil prices are at their lowest since 2009. Myriad factors are responsible, but oversupply is the chief culprit.

Weak economic growth across the globe has depressed demand. A surging U.S. oil industry has upped supply.

When oil prices began their precipitous drop this summer, many observers felt the stock market would experience a near-synchronized decline.

That didn't happen. The market soon rebounded to post some of its best numbers of 2014.

Counterintuitive? Perhaps. But a closer look at the situation reveals some promising trends. Declining oil prices are a major stimulus. Cheap gas creates a flurry of activity at the consumer level.

When we find ourselves with extra dollars in our pocket, we re-route those savings back into the economy. We buy extra food, drinks, clothes, cars.

Businesses also benefit. Airlines get cheaper fuel. It costs less to ship goods from one place to another. Low energy costs can turbocharge business growth.

The catch to cheap oil

While lower oil prices may be a net positive for the economy, they represent real trouble for energy companies. Because the drop in prices was so dramatic, many energy companies are simply unprepared to deal with the fallout.

The largest energy companies are major cogs in the world's economic machinery. While they can take a few punches, catastrophic setbacks will eventually affect the wider economy -- and investors. It's like nuclear waste -- without proper containment, everything gets polluted.

Some of the weaker members of the energy herd may get culled. An uptick in acquisitions is one possible outcome of sustained low oil prices.

Will oil prices rise in 2015?

Not if concerns about oversupply persist. Some analysts believe that oil prices will continue to fall next year as a result of an oil supply glut.

With oil prices so high in recent years, it has encouraged more players to enter the market.

Some of these oil producers came aboard with the expectation prices would remain stable. If prices fall, extracting oil in more difficult terrain becomes economically unfeasible. If it costs $75 to get a barrel out of the ground, you can't survive for long with market prices below $60.

That could lead some oil producers to exit the business. Such a decision is unlikely to be made rashly, however.

Most producers are likely to ride the turbulence out as long as possible. That means a drop in supply could be a year away, unless OPEC decides to cut production. But that's something they've declined to pursue.

Russia, too, may decide to cut production. The decline in oil prices has been disastrous for the Russian bear. That country's economy and budget are extremely oil dependent.

So far, however, Russia has declined to slow production. That may change if prices continue to fall.

How investors should react

If every crisis is an opportunity, then the energy sector is where any opportunistic investor should look, right?

Sure -- but you have to be cautious. The gravitational pull of tumbling oil prices has certainly snagged some oil stocks. More than a few prices seem absurdly low.

But some of these companies are staring into the abyss. A bad combination of debt and falling prices may spell the end for marginal industry players.

If you're going to invest, it's better to pick stable companies built to weather the storm. Companies with low debt and access to low cost oil are poised to survive, if not exactly thrive.

In a market with sub-$60 oil, that's as good as it's likely to get. Those willing to play the long game could see strong returns, however.

Because, in the case of oil, what goes down is surely going up.

Related Articles

Bubble, bubble, toil and trouble? Understanding the Different Types of Funds Selecting a Large Cap Stock in an Industry Under Siege
Your browser is out-of-date!

Update your browser to view this website correctly. Update my browser now