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Why is the rapid decline in oil prices causing market volatility?

Over the past several weeks the price of a barrel of oil has dropped from approximately $100 per barrel to closer to $50 per barrel. On the surface this seems like a tremendous economic benefit. Gas prices have been cut significantly from $3.50 or so to around $1.90 per gallon. Less money spent on gas means more money to spend elsewhere. Restaurants, retailers and so forth should be thrilled. So why aren’t the markets feeling the joy?

Deflation concerns are the answer. What is deflation and why is it bad for investments? First, let me say that it is a complex issue, but I am going to try and take a surface level approach here. Naturally, there are numerous factors in a worldwide economy that can occur that would have an impact. It is impossible to address all of those possibilities. In short, however, deflation indicates a significant change in economic conditions and if it persists can spiral out of control and have long-lasting repercussions.

Deflation is a decrease in the general price level of goods and services and it occurs when the inflation rate falls below 0% (a negative inflation rate). The fall in oil prices is a good example. Although we may like it when we are standing at the pump, the reason oil prices have fallen can be of concern. First let me say that oil and food prices are volatile. That is why they are excluded from government inflation measurements (CPI). That being said, in this case there is an increasing glut of oil and subsequently oil reserves have increased. The cause of this lies predominantly with the US drilling and fracking techniques that have allowed more domestic production. This has reduced our dependency on OPEC nations as we now consume a greater amount of our own oil; rather than from foreign sources. China is another major oil consumer. Though their economy continues to expand at about 7% per year, it is far below the double digit growth rates of the recent past. The slower growth combined with lingering poor economic conditions across the European Union and sanction based slowness in Russia we have seen an economic slowdown that has caused a shift in the demand curve. Producers of oil need to sell their products and to do so with current inventory levels prices must fall.

The simple answer seems to be to stop producing as much product. Although reducing supply would gradually have the desired impact of increasing demand, it is getting to that point that is an issue. OPEC has chosen to try and smoke out the US fracking companies. By maintaining production levels and driving prices down many of these new US companies find it unprofitable to drill. Their cost structure is high as they are highly levered and payments on equipment and manpower start to strain these startup companies cash flow. OPEC’s hope is that eventually these companies will go bankrupt and the production declines will be from fewer non-OPEC participants. Think of it in this way, OPEC has long enjoyed the swimming pool greatly to itself. Over time, however, more and more people have been jumping in and now the space is overcrowded. The pool may be uncomfortable right now, but the members of OPEC want to return to the days where they were the primary users of the pool. Rather than to climb out themselves or come to the pool less frequently they have decided to jump in and stay. Over time they want to drive the new members out.

Deflation can impact several areas of the economy. Initially, the prices of goods and services in other areas may start to fall. Lower prices in oil mean cheaper manufacturing costs, lower delivery costs and so forth. This can further reduce prices at the grocery store or retail outlets as oil based products such as plastics cost less to make. Near term this can be good for companies and profitability. Lower costs and firm retail pricing seems like an option. But gradually everyone wants price adjustments. The retailer knows the manufacturer is making a greater profit so they want to share in the bounty. Demanding lower costs they purchase the products for less. The manufacturers typically will do that particularly if the retailer buys at higher volumes. The retailer is willing to do so because they know that they can lower their prices to move the merchandise since they paid less initially. However, competitors follow suit and the price decline spreads across the economy. Now margins start to get squeezed and profits actually decline. When profits decline companies look for more efficiencies and start reducing labor forces. Reduced labor or higher unemployment means less demand for goods and services. Less demand in a higher inventory environment means even lower prices and lower profits, more layoffs and the spiral continues.

Now, this scenario is not playing out as we sit here today, but it is the reason that investors are a bit nervous. The FED has a long history of monetary intervention to try and stem inflation and control interest rates. Deflation although it rarely happens is also a major concern and would be fought vigorously by the FED. To do so there are two primary tools. The first is lower interest rates. This generally spurs economic activity. However, worldwide interest rates are already so low that there is little room here at this time. More likely, the contraction of the monetary supply or some level of stimulus such as tax relief would need to be used to increase demand.

I don’t think we have reached this point yet. In fact, I believe the FED will increase rates starting this year and will try to do so at a steady measured pace. This may cause some slow down economically, but likely it would be offset by the increased consumer discretionary money. It may also stem production expansion. Finally, if rates are increased and at some point rates need to be decreased to offset deflation the FED would have room to do so.

In the end, the effects of the financial meltdown in 2008 are still having an impact. The FED artificially stimulated the economy with lower interest rates and government spending. Now they are trying to maintain the balance of avoiding runaway inflation while not sending the economy into deflation. I expect periods of volatility to arise periodically in our long trek back toward normal rates and economic conditions. Central bank intervention between the US and European countries should allow us to avoid any major long-lasting or catastrophic occurrences. We continue to monitor conditions and act accordingly. One final comment is that any economy is like a large ship. It doesn’t turn quickly rather it is gradual and adjustments take time. Choppy waters and storms arise, but a steady course and investing strategy allows for growth in various stages of the economic cycle.
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