The Oil Plunge

Last fall’s precipitous drop in oil caught many by surprise, although energy prices had been weakening since last summer. The plunge was a function of three developments: weakening global demand, a surge in U.S. production and surprisingly resilient supply out of the Middle East. A stronger dollar also contributed, since by definition that affects demand for dollar denominated commodities.

For 2015, expect oil to remain volatile, but with the potential for a two-way market should Middle Eastern production or exports falter. While lower prices will ultimately lead to some adjustment in U.S. production, current levels are unlikely to lead to an immediate cutback in U.S. shale production. However, they are likely to impact future exploration.

In terms of the implications of lower oil prices, while the collapse in oil helped produce a short-lived but still meaningful market correction, we believe lower oil prices are supportive of the global economy. Lower oil is a de facto tax cut for Western consumers and will also benefit several emerging markets, particularly those that subsidize energy prices.

We don’t believe that lower oil prices pose a fundamental threat to equities; energy accounts for a relatively small weight in most equity indices. In addition, consumer stocks, a larger portion of most equity benchmarks, are likely to be net beneficiaries of lower oil prices.

But falling oil prices are having a more mixed impact on bonds. Lower energy prices are helping to reduce inflation and dampen inflation volatility, particularly in the United States. However, lower energy prices are causing some distress in several smaller high yield issuers, putting some pressure on that segment of the market.