Oil Patch Revolution

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Despite rising volatility and widespread anxiety, U.S. stocks finished the year with a strong quarter. Real estate investment trusts (REITs) were the strongest performers rising 12.3 percent, while small cap stocks gained 9.7 percent and large cap stocks added 4.9 percent. International and emerging market stocks lost ground for the quarter and the year. In fact, this year’s loss reduces the 10-year annualized return on international stocks to only 4.5 percent—well below the 7.9 percent return for U.S. stocks.

The big news in the quarter was the continu­ing collapse of commodity prices. The Goldman Sachs Commodity index suffered its largest quarterly decline since Q4 2008, falling 27.7 percent. The price of oil was the main culprit, plummeting 41.6 percent in the quarter and nearly 50 percent in the second half of the year.

A word about diversification and asset allocation

The collapse of oil and the underperformance of international equities highlight the importance of asset allocation and diversification in individual portfolios. Strong returns in one asset class may make us wish we had everything invested there. However, that kind of thinking is a dangerous trap. As the following chart illustrates, an asset class’s strong performance one year is often followed by weaker performance the next. Diversification leads to a smoother ride and more sustainable performance over time.

This was highlighted by a conversation I had with a client a few years ago. He wondered why my performance wasn’t keeping up with his self-managed account. I said, “That’s a good question. Tell me what you’re doing.” He replied, “It’s simple. I own the Vanguard Energy Fund and it just keeps going up.” Mystery solved. Oil was the best performing asset that year, so of course he was doing better than my diversified portfolio. Unfortunately, he was also taking on more portfolio risk—risk that has become a lot more apparent in the last six months.

The importance of this principle cannot be overstated. Diversification is vital to your long-term financial health. If you at times wonder why your portfolio isn’t keeping up with a particular market index, it probably has something to do with diversification and asset allocation. If you have questions about your asset allocation, please let us know. We would love the chance to discuss it with you.

A funny thing happened on our way to “peak oil”…

Not long ago, it looked like high oil prices were here to stay. Arjun Murti, Goldman Sachs’ oil analyst, warned of an oil “super spike” that would drive the price of crude to $200 a barrel. Other analysts had similarly dire predictions. Few predicted the radical shift fracking technology brought to the global oil market.

Over the last few years, America has revolutionized the glo­bal oil market. Since 2013, U.S. output has grown over 20 percent and accounts for almost all of the increase in global oil production. The drop in oil prices prompt­ed an even faster expansion of produc­tion as firms and nations scram­bled to cover revenue short­falls. According to a report by Stratfor, global oil produc­tion between July and Novem­ber 2014 increased by about 1.4 million barrels per day—about twice the rate at which global demand was expected to increase in 2014.

The steep decline in oil prices raises some very interesting questions about what comes next. Oil-dependent countries such as Russia, Venezuela, Nigeria, Iran and Libya will find their economic troubles magnified as budget deficits balloon dramatically. The threat of social unrest will keep these countries pumping oil in an attempt to maintain vital social programs.

In the developed world, the banking sector is vulnerable, though the magnitude of their exposure remains to be seen. Already some of the largest banks, including Citigroup and Bank of America, have reported lower earnings caused at least in part by lower commodity trading revenue. As oil-producing countries and companies come under fiscal pressure, we can expect an increase in defaults on bank loans. Remember the 1980s and the implosion of Texas banks? Hopefully, it won’t be that bad.

As we see it, the winners from lower oil far outweigh the losers. Though we should be careful to not take the analogy too far, we can think of the drop in oil as a massively progres­sive tax break with the largest proportional benefit going to the lowest income groups. The dollars that would have been spent on gasoline can now be used to purchase a much broader array of consumer goods. Manufacturers also benefit from lower transportation costs, lower energy input costs and, in some cases, lower raw material costs.

Overall, the drop in oil prices should provide a boost to economic activity in developed economies—especially the U.S.. A stronger economy should lead to higher corporate earnings and higher prices for stocks and bonds. Though we try to avoid making forecasts, we feel recent developments should prolong the bull market and benefit our investors.