Running on fumes

Are declining gas prices bad for the Markets?

The past few weeks have seen an acceleration in the drop in the price of crude oil, with the expected contagion just beginning to work it’s way through the global financial system. At the closing bell last Friday, the S&P 500 Index had posted a weekly loss of -3.52%, the Dow had it’s worst week since 2011 with a weekly decline of -3.78%, the broad NASDAQ Composite Index lost 2.66% for the week, and the Russell 2000 Index posted a weekly decline of -2.54%, putting it back in the red year-to-date.

The carnage in Europe was even worse, with the EuroStoxx 50 Index declining by 6.41%. Around that same time, crude oil futures were declining by another 4%, S&P 500 futures were down over 1.5%, and Dow Jones futures were down over 1.7%; this did not bode well for the current week.

Many people wonder why declining oil prices are bad for the financial markets, as they translate into less expensive energy. The answer lies in how dependent upon oil prices we are in key sectors of both the equity and the bond markets. Energy is the largest sector of the High Yield – also known as Junk Bond – market, it is the second largest sector of the Investment Grade bond market, and it is the third largest sector in the S&P 500 Index. Thus, declining oil prices affect the overall financial markets more in the short and medium term than the positive effects of lower energy costs, and translates to less money available to small and medium energy companies as the cost of that money skyrockets.

As the price of crude oil falls, it makes extraction less profitable or unprofitable, especially for US and Canadian shale oil production, which must have a certain price to be feasible. Today, crude oil futures (NYMEX) were below $48 per barrel.

It is feared and expected that this is just the beginning, and it is already having negative effects not just on energy companies and bonds, but the High Yield Bond market overall, as the High Yield Bond Spread – that is the additional interest demanded over investment grade bonds to account for greater risk – increased dramatically this last week. As most folks reading this know, the High Yield Bond markets – before this oil shock – have been flashing warning signs about the stock markets for weeks, and recent events make those warning bells even louder.

This oil shock is the result of decreasing demand while crude oil production has been increasing – and only increased demand or reduced production will reverse it. Unfortunately, neither are likely; the Saudi’s have made it clear that they will not reduce production, and there is no reason to think that the Venezuelans or Russians are likely to do so. The global economy has been slowing for some time as has been often reported, so the only thing that seems able to “give” is US and Canadian shale production – because it is so expensive to produce, with the negative effects upon the US economy, jobs, banks, and therefore, ultimately the stock markets as well.

Hang on to your hats…