Is the drop in oil price good for investors?

oil well photoThe sharp drop in oil prices will benefit American consumers, many of the nation’s businesses and the economy as a whole. So why are stock market investors behaving as though oil under $50 a barrel and gasoline prices hovering around $2 a gallon are bad news?

The overall market’s recent decline reflects more than just the free fall in oil prices. Overseas economies are struggling; last week, the World Bank cut its forecast for global growth to 3 percent from 3.4 percent.

But fears about losses emanating from a devastated oil patch have weighed heavily on broad stock indexes. This response appears to be a case of investors seizing on the industry’s highly visible losers while ignoring the far larger number of winners.

The market’s first reaction to almost any shock is not to like it because it raises the uncertainty premium. Meanwhile, the beneficial effects happen over a longer period, when the change is perceived and anticipated to become more permanent. To some degree, investors are operating in an information vacuum: They don’t yet have clarity on the full effects of under $50 oil.

The value of money on the world market has more to do with the price of commodities, then the price of manufactured goods. With the moribund consumer economy in the US and the even worse consumer economy in Europe the income benefit of low oil prices simply isn't enough to jump start commercial activity quickly. This is aggravated in Europe where a larger portion of the cost of auto and truck fuel is made up by the fixed taxes rather than the variable cost of the commodity. A 50% drop in the cost of oil can be as little as a 10% drop in the cost of fuel in many countries.

Less conspicuous, however, are the winners in a world of cheaper oil, economists say. The good news is, they far outnumber the losers.

David R. Kotok, chief investment officer at Cumberland Advisors in Sarasota, Fla., estimates that the economic output among oil companies and related businesses could decline by as much as $150 billion this year because of the oil price collapse. But an increase of about $400 billion is expected in other areas of the economy, he said. The net effect is double the annual value of the two percentage point payroll tax cut in 2011 and 2012, which provided a big increase to consumer spending.

Investors also seem to be ignoring the benefits of lower-cost oil to small businesses. In December, as the oil price was dropping, the National Federation of Independent Business’s optimism index returned to its prerecession average and rose to the highest point since October 2006.

Owners of these businesses say they are increasing their capital expenditures this year. The N.F.I.B.’s most recent quarterly survey showed capital spending among these businesses rising to a seven-year high. This, too, will help offset the drop in oil and gas expenditures.

The overall economic benefits of the collapse in oil prices are significant, Mr. Shepherdson said. He predicted that it could add almost one percentage point to real gross domestic product growth in the United States this year. In an economy trending at 2.25 percent annual growth, that’s a sizable gain.

There is still some cause for concern. The growth for many consumer product companies doesn't come from the affluent countries, but instead comes from the emerging markets. Many of these markets are very tied to the price of commodities (their chief export) and especially the cost of petroleum. Unilever mentioned this in its latest report:

Consumer demand remained fragile and volume growth was barely positive in the markets in which we operate. Many emerging markets continued to be weak, particularly those dependent on oil and other commodity exports and those where currency devaluation is pushing up the cost of living for our consumers. Market growth in developed markets was negligible.

In general, I am optimistic. Eventually that spending savings will help the consumer spending in the developed world. Specifically, it will encourage the purchase of larger and less fuel efficient vehicles to be purchased which will drive higher paying manufacturing jobs.

This drop in the market also gives investors with cash reserves the opportunity to buy great companies at a discount. The general drop in the stock market is simply making the stocks of many great companies to be discounted too much to ignore. I teach this principle in more detail in my book, The Confident Investor. You can purchase my book wherever books are sold such as Amazon, Barnes and Noble, and Books A Million. It is available in e-book formats for Nook, Kindle, and iPad.

Photo by Tim Evanson

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