An unexpected and largely unpredicted fall in commodity prices has hit energy stocks, causing at least one hedge fund to close its energy fund completely. Allocations to the industry did not lighten before oil began falling this summer, and the futures market showed no signs of distress. Now, however, headlines are calling for even $40 oil to come.
Whether that happens or not, it’s important to understand how oil’s price impacts other asset classes and industries.
This issue is becoming more pressing, as oil has lost a substantial portion of its value and broken several resistance points that many technical analysts bet on—and lost a lot of money as a result:
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The $80 resistance did not last long, and $70 was quickly broken when OPEC announced that it would keep output unchanged. While it’s recovered from the initial shock, speculators disagree on whether we’re looking at a dead cat bounce or a recovery.
The fall in oil prices benefits net importers and harms net exporters, meaning that U.S. stocks (SPY) have benefitted from the fall. Even U.S. utility stocks (XLU) have risen, as strong growth and rising demand expectations as a result from falling prices. However, energy stocks (XLE) are suffering, with a 15% decline for the sector in the last 3 months.
That’s still better than Russia (RSX), which is in a bear market. Additionally, it has weakened the ruble and threatened other emerging markets that either depend on energy outputs (like Venezuela) or that depend on commodity consumption (like Brazil, Chile, or Turkey).
Additionally, the impact of falling oil on Europe is complex and unclear. On the one hand, falling energy costs could encourage more Europeans to spend, as is expected for the U.S. On the other hand, falling oil prices could cause prices to fall, which would lead to a deflationary trap that would stop growth. The ECB could stem this trend by expanding the monetary base, and Mario Draghi today hinted that the ECB will do exactly that. Still, the Euro Stoxx 50 (FEZ) is down over 5% for the past three months.
Back in the U.S., consumer discretionary (XLY) and retail (XLR) stocks have had solid gains, as the market is much more confident on American consumers’ benefit from cheaper oil. A similar trend can be seen in Japan, which has escaped deflation thanks to an expansion of the monetary base. While that action has caused the yen to weaken (it reached 120 to the dollar for the first time in years on Thursday), it has also caused Japanese stocks to rise, similar to U.S. stocks’ movement in 2013. American investors have bet on this trend by buying Japanese stocks and hedging with a currency short, which is easily done with an ETF (DXJ). That asset class is by far the winner for the last three months, with an 11% rise.
At the moment, the debate on oil’s price trend has gotten fiercer. The question of whether a price war between Saudi Arabia and U.S. oil producers will hurt the entire sector, or yield winners and losers, is a question that investors need to answer. If they can, they can create a long/short strategy in energy that will have massive risk-adjusted returns. If they can’t, however, their fund might face the same fate as the hedge fund that recently decided to stay away from energy altogether.