February 1, 2016

Oil – The Three

Biggest Worries

By Mitch Zacks \ Senior Portfolio Manager

We think it’s high time someone put their foot

down and called the collapse in oil prices what it

really is: a net positive! I find it interesting that,

when oil prices are high, the narrative is negative.

But, when prices fall precipitously and energy

becomes cheaper that’s also a bad thing! You can’t

have it both ways but, in my opinion, it’s not

inherently good or bad. There are pros and cons to

both situations – some industries suffer and others

benefit – but, I think in the current environment

that lower oil prices will be a net positive for the

global economy. It should ultimately help more

industries, companies, and consumers than it hurts.

The Broader Context

The collateral damage to lower oil prices falls

almost squarely on the sector which, as we all

know, has taken an absolute beating in earnings. It

spills over to the broader economy in pockets:

lower capital spending on oil exploration, about

200,000 industry jobs lost and counting, bank

losses (at the margin) which can slow economic

activity if banks become risk averse.

A closer look at the numbers provides clearer

context for the potential impact of Energy’s

decline for the broader economy:

Capital expenditures from the energy-

producing industry are only around 5% of

the nation’s total spending on equipment;

Employment in oil and gas extraction is

about one-eighth of 1% of total nonfarm

employment;

U.S. energy companies only account for

about 6% of the S&P 500.

The Energy sector is important, but it’s not the be-

all and end-all for the economy. The consumer is.

And, lower oil and gas prices should inspire more

spending and increased saving (which includes

reducing debt), and provide a boost to consumer

confidence – making bigger purchases of homes

and autos more feasible.

There’s a prevailing argument today that there is

‘more to the oil story’ in terms of risk, and it

focuses on three lines of thinking as far as I’ve

seen. Let’s take a look.

(Zacks Investment Management is not affiliated with LPL Financial)

Mitch on the Markets

February 1, 2016

The Three Biggest Worries

1) Bank Exposure – the fear here is that banks

have too much energy exposure in their loan

portfolios. With a lot of capital intensive oil and

production companies being forced to go offline,

due to loss of profitability, losses are accumulating

and, at worst, some companies are defaulting. If

this becomes systemic, banks would arguably be in

trouble and the credit issues of 2008 could come

right back.

But, the scale of the matter is much smaller than

most seem to think it is. The biggest banks

typically have less than 5% of their total loan

portfolio in Energy, and they are well-capitalized

in the aftermath of the credit crisis. Nevertheless,

they’ve been adding to reserves just in case:

Citibank by $250 million in the latest quarter,

J.P.Morgan by $124 million, Bank of America by

$2 billion. Smaller regional banks in drilling areas

are more of a concern, but they can be avoided and

should not drag down the overall financial sector.

Another factor to remember is that loans within the

oil sector are typically asset-backed loans,

meaning that banks can make a claim on property

if it comes down to it.

2) Slowdown in China Blamed for Falling Oil

Prices – it’s tempting to blame falling oil prices on

sinking global demand. And, with China’s

slowdown, it’s also a logical argument. But, how

do you explain the fact that China imported almost

10% more barrels of oil (335 million) last year

than in 2014! Sure, some of that was strategic

inventory building while prices were right, but this

is rising demand any way you spin it. Falling

prices are more heavily weighted in supply

pressures with the global glut building as Saudi

Arabia and OPEC produce some 30 million barrels

per day and the U.S. continues record production.

Demand has leveled off as the economic cycle

matures, but it hasn’t dropped off.

3) Oil Prices Correlated to Stocks – the

seemingly lockstep movements of falling oil with

falling stock prices has many rushing to call

‘correlation.’ If you buy that story, then the future

of stock prices could look in jeopardy – oil prices

are still searching for a floor and it’s difficult to

know what the price recovery will look like and

how long it will take. But, the notion that stock

and oil prices are tightly correlated is head-

scratching when you look past the last six months.

The chart below tells the story – more often than

not when one zigs the other zags:

Bottom Line for Investors

Give the adjustment period some time. The

immediate impact of steep declines in oil prices is

mostly negative: depressed earnings in the Energy

sector that drag down aggregate S&P 500

earnings, lost industry jobs, young companies

going out of business, loan losses for banks at the

margin. The medium to longer-term impact of

lower energy prices outweighs the short-term

adverse effects, in my opinion: lower input costs

for resource-sensitive products and companies,

higher discretionary income, better prices for

travel and tourism. The net effect, I think, will be

to help more industries and companies than it hurts

and to give consumers a monetary and confidence

boost to go out and spend more.

- Mitch

About Mitch Zacks

Mitch is a Senior Portfolio Manager at Zacks Investment

Management. Mitch has been featured in various business

media including the Chicago Tribune and CNBC. He

wrote a weekly column for the Chicago Sun-Times and

has published two books on quantitative investment

strategies. He has a B.A. in Economics from Yale

University and an M.B.A in Analytic Finance from the

University of Chicago.

(Zacks Investment Management is not affiliated with LPL Financial)

Mitch on the Markets

February 1, 2016

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(Zacks Investment Management is not affiliated with LPL Financial)