Forecasting Energy Prices and the Impact on Stocks

Crude oil is a manipulated market, subject to the policies set by OPEC, although we underestimated its importance more recently. During the 1980s OPEC set the OGSP (Official Government Selling Price) at $18-$20/bbl (see left chart below). Some of the OPEC members cheated, loading ships with more crude than “contracted,” essentially discounting the price. This constant undermining of the price, combined with the U.S. increased production, led to an attitude that OPEC is no longer relevant. That has proved to be a hasty judgment.

1 Cash

Energy prices are filled with a history of extreme moves. The table below shows five key events that moved prices 50% to 100%, including the recent drop of 57%. Note that the 47% drop in 1985-1986 was the result of Saudi Arabia dumping oil on the market to bankrupt Iran in their fight with Iraq. So, the Saudis have done this before and don’t easy capitulate.

2 Events Table

Just a note about natural gas as it relates to this. It doesn’t. Even though natgas is traditionally a domestic product, it tracked crude prices through 2008, much in the same way any energy source, including firewood, would adjust to the change in fuel prices. But the recent methods of fracking and the surplus of natgas has caused prices to be mostly independent of crude oil.

How Do Crude Prices Affect Stocks?

Not surprising, crude prices affect stocks differently. Below are two examples of companies dependent on energy, Exxon-Mobil (XOM) and United Airlines (UAL). We naturally expect XOM shares to decline when crude decline because lower prices mean lower margins. For the airlines we expect a benefit from lower oil prices. In both cases that’s correct. But there are other factors to consider.

3 Stock

XOM is a vertically integrated company and the effect of crude oil is muted. It is also lagged. We can see that the price drop in 2008 was not quite in phase and stock prices continued to decline after crude prices bottomed and started to rebound. We expect the same lag now.

UAL is a different story. Stock prices declined as crude rallied in 2007 but did not recover after the decline. Much of that could be due to the way the company hedges oil. If it protected the price at a high level then they locked in higher costs. From 2009 through 2014 we see a steady rise due to new pricing policies, in particular baggage costs, something that annoys travelers each time they check in, but has produced large profits for the airlines. Unlike 2008 (perhaps they learned something), stock prices now reflected lower costs for fuel.

The Forecast

Where can we expect crude prices by the end of the year? That depends mostly on Saudi Arabia. If it decides to cut production then prices can easily go back to $80. History shows that some rally is likely, perhaps to $60, which will put continued pressure on U.S. high-cost producers. The one thing we can be sure of is that there is less opportunity being short than being long, but there is always risk.

As for stocks, it again depends on the company and their level of diversification and hedging policy. Southwest Airlines has always been in the forefront of hedging, but it’s difficult to be right all the time. We can still expect the airlines to have some residual benefit from lower oil prices, which are only slightly above their lows, before prices stabilize. We expect XOM to continue to decline, following its historic pattern, even if prices rally soon. That decline could continue for another two months.

© 2015 February 16 KaufmanSignals.com – Energy Forecast – All rights reserved

 

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