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Stepan Lavrouk
Stepan Lavrouk
Articles (634) 

The Value Investor's Handbook: The Broader Impact of Oil Prices

The price of black gold can affect far more than just the energy sector

October 22, 2020

In what has been a pretty turbulent year, one sector has gone through even more unrest than the overall market - the energy sector. Even before lockdowns came into effect, oversupply was exerting downward pressure on global oil prices, as producers were unable to reach a consensus on output cuts.

Earlier this year, the price of oil (or, more precisely, the price of some oil futures contracts) actually went negative. This pricing anomaly is now being investigated by the Commodity Futures Trading Commission - the regulatory body that oversees the U.S. financial derivatives markets - and there is some evidence that it might have been the result of market manipulation by a few well-positioned insiders.

Oil prices have still not recovered to anywhere near their five-year averages since then. The amount of attention that this incident received demonstrates an important fact - the price of oil affects more than just the bottom lines of energy companies. Here's how fluctuations in this variable can affect other types of businesses.

When cheaper is worse

On the face of it, you might think that lower oil prices are a good thing for the broader economy - after all, no one likes to pay more at the gas pump - and obviously this would be better for businesses that need oil, such as airlines. The U.S. used to be a net importer of oil, but this all changed with the shale revolution. In 2019, the U.S. became a net exporter of crude and refined petroleum products for the first time in many decades. This occurred because of the development of cost-effective methods of oil extraction like fracking, which allowed shale companies to tap previously unavailable resources.

However, fracking may have unlocked new resources, but it still costs far more to produce a barrel of shale than it does for more conventional methods. It costs U.S. shale companies around $35 to produce a barrel of oil - and that's not even factoring in other expenses: the breakeven price for U.S. shale is estimated to be between $50 and $55. For comparison, it costs Saudi Arabia just $2.8 to produce the same amount.

So if the U.S. is a net oil exporter, you can begin to see why falling prices would translate to bad effects for the wider economy. Energy companies employ a lot of people, these people then spend their wages buying products and services from other companies. The benefit of cheaper energy is more than offset by the dependence that the U.S. economy has on the second-order spending generated by the sector.

By some estimates, the U.S. energy sector supports 6.4% of the overall labor force. And this doesn't even take into account the exposure that the financial sector has to energy companies. So the next time that you see a news story about big developments in the oil industry, take heed - it could affect more than you know.

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About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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