Thoughts on the Oil Market

With the market in its current state, especially oil prices, we continually scour other “experts” opinions on where we might be headed.  Professor Jeremy J. Siegel, a regular commentator on CNBC and contributor to Yahoo! Finance and Kiplinger’s Personal Finance, has an interesting opinion.  He recently stated, “I estimate that anywhere from $2 to $3 trillion of capital is committed to the energy sector, broadly defined, including not only the wells and oil structures, but the pipelines, rail cars and other investments devoted to extracting and transporting the energy. This capital is designed for an oil price of $60 or higher, and now the price is less than half this level. Much of this capital, if prices do not improve, is substantially devalued, if not worthless. The U.S. as a whole certainly gains from lower energy prices, but the adjustment costs to the recent price collapse are huge and unprecedented. Although millions of workers are involved in energy production, every American is involved in energy consumption. And the lower prices of energy will eventually boost firm profits and workers’ income. We are in the process of experiencing the pain before the gain.”
 
“It is in Saudi Arabia’s interest to wipe out as much of this new energy production as it can. Saudi costs of extracting crude are estimated to be $5 to $10 per barrel, so it knows that it can hold out longer than most others. By putting U.S. frackers and other marginal producers out of business, Saudi will eventually achieve higher prices. Furthermore, the Saudis want to slow down the development of alternative energy sources and sharply lower crude prices will do just that…This adjustment will cause much pain on the earnings front. We will get some significant write-downs from the energy producers that will impact aggregate S&P earnings. But be aware of the “Aggregation Bias.” The earnings from the energy sector will be negative this year. These negative earnings will be subtracted dollar for dollar from the earnings of the other nine positive earnings sectors when computing the overall P/E ratio. So the P/E ratio of the other nine sectors will be biased upward. One may feel that the valuation of energy stocks is too high or low, but outside the energy sector the P/E ratio of the market is about 16.3, right in line with post-war historical averages and far lower than the P/E based on aggregate earnings, which could move into the twenties.“
 
We will continue to monitor the market and earnings but will “stay the course” for now.  When or if we feel it is necessary to make portfolio changes, we will let you know. As always, please call us with questions or concerns.