‘Tis the Season to be Merry

Have you filled up your car with sub-$2 per gallon gas?  If you haven’t had the privilege yet, you shouldn’t have to wait very long.  The national average price for a gallon of regular unleaded gasoline sits just above the $2 level and is trending downward.  In fact, there are 29 states offering gasoline for under $2 per gallon.  For some perspective, prices are down 24% from last December and 38% below December 2013 levels.  These lower prices will have a meaningful impact on the average US household, which can expect to spend about $750 less on gasoline this year.  Think of it as an unexpected year-end bonus courtesy of the oil and gas industry.  I’m pretty sure Clark Griswold would agree that it’s better than the jelly of the month club.

What’s behind this pleasant surprise?  While there are several factors, the most significant reason is the huge increase in US oil production, which has reduced the amount of oil we import each year.  Since 2008, domestic output has grown 80% to 9 million barrels a day.  Over that same time period, domestic demand has barely budged.  As a result, we are now importing about 2 million fewer barrels of oil per day.  Members of OPEC aren’t happy.  They still produce the same amount of oil, but this shift in supply and demand has driven the price of oil down sharply.  OPEC’s plan seems to be to keep pumping oil until they drive the price of oil down to the point where US producers can’t make a profit.  Prices are very close to that level, but continuous improvements in US oil production efficiency have lowered extraction costs substantially.  Energy companies now spend $36.20 to produce a barrel of oil in the US.   The spot price of oil sits just above that level at $36.31.

That’s not to say the US energy sector hasn’t suffered. Jobs have been axed, rig counts have dropped and revenue is down. Capital spending among energy companies has been reduced by $250 billion in 2015 and $320 billion more will be slashed for 2016.

While the news may not be great for the energy sector, other industries have greatly benefited from lower energy prices.  Excluding the energy sector, capital spending at S&P 500 companies is up almost 16% over 2014. The transportation, chemical and utility industries have gotten a surprise lift to profit margins this year.  Auto sales are within striking distance of eclipsing the 14-year-old record of 17.4 million vehicles sold.  Inflation has been kept in check in part because of the decline in energy prices.

Where do we go from here? It will take some time to reach equilibrium of supply and demand, then work off the excess global energy inventory that’s been building for the past year and a half.  The energy market also has to absorb an estimated 1 million additional barrels a day of production once economic sanctions are lifted against Iran in 2016.  It’s estimated equilibrium won’t be reached until the second half of 2016 and the excess inventory won’t be worked off for another year or two after that.  During this period, energy and gas prices should stay relatively low as many expect the price of oil to remain below $60 per barrel for at least the next few years.  The benefits of lower energy costs should continue for many companies outside the energy sector, boosting their profit margins.  Energy companies with too much debt or that are too dependent on high oil and gas prices will struggle. There will be industry consolidation as companies with deep pockets and lower cost structures use this period to purchase attractive assets at discount prices.

The events afflicting the energy sector illustrate why we believe in investing in high quality, dividend-paying companies.  During times like these, owning high-quality companies with strong balance sheets helps us sleep better at night.  These companies have the financial wherewithal to make it through tough times and emerge stronger once the storm has passed.  Our Dividend Growth Portfolio consists of high quality companies that have a track record of increasing their dividends in good times and bad.  Contact your FIA to learn more about the Dividend Growth Portfolio.