Oil has made a lot of headlines lately, and it’s no wonder. After steadily rising and peaking over $100 per barrel, oil fell 55% in half a year, an unprecedented decline that almost no one expected:
The fall in oil was caused by a number of developments, which The Economist summarizes as follows:
1. Low demand from lower economic activity and greater efficiency
2. Geopolitical turmoil is relatively low, causing output to stay strong
3. America is producing a lot of oil, rising supply further
4. Saudi Arabia and their allies have not cut production to cause prices to rise
These developments have had a huge impact not only on the oil market, but for related industries as well. What many investors don’t realize is that changes in oil prices have an impact on virtually every industry and market sector, meaning that every portfolio is exposed in one way or another to oil. Let’s take a look at how some sectors are impacted by changes in oil, and how investors can harness these trends to their advantage.
The relationship between oil and other sectors of the U.S. economy depends upon whether oil is supportive or not supportive to that industry. In other words, sectors that profit from rising oil will benefit from a rise in oil, and sectors that profit from falling oil will benefit from a fall in oil. The most obvious example are energy producers like Chevron (CVX), Exxon (XOM), and ConocoPhillips (COP), which tend to see higher earnings for some of their operations as oil prices rise, since they are oil producers.
Less clear are sectors like alternative energy, especially solar power. Solar is considered a more expensive energy sector that will eventually replace oil when it becomes too expensive or simply when oil runs out. Therefore demand for solar is likely to rise with oil prices; falling oil prices will be negative for solar.
Then there is the demand part of the equation. Higher oil prices mean more money spent on energy and less money spent on things like clothes, gadgets, vacations, and so on. Travel, technology, retail, and consumer discretionary can see some relationship to oil prices, especially in one way: when oil gets cheaper, people will likely have more money to spend on alternatives, so these companies will see higher revenues on falling oil prices. Additionally, these companies depend on oil to transport goods, so falling oil prices will lower their costs, too.
Some of this theory has played out very clearly in the last six months. First, we see that falling oil has been seen as broadly a good thing for the economy, with large-cap stocks (DIA) and small-cap stocks (IWM) rising when oil began to fall. The broader group of U.S. companies (SPY) was also seen to benefit:
Source: Google Finance
However, the inverse relationship between oil prices and company stocks was much more acute in some industries, as we see here:
Source: Google Finance
The biggest beneficiary from the fall in oil was the utilities sector (XLU), a usually conservative and low-volatility sector. The idea here is twofold: utilities companies pay for energy, so lower costs equal greater margins. Additionally, utilities companies will see more demand for energy, as lower prices encourage more energy consumption.
Close on the industry’s heels is the retail sector (XRT), where the higher consumer spending theory played out. With gas prices falling by over half and going below $2 per gallon in many states, it’s easy to see why investors would get giddy about people spending less at the pump and more in stores. Also, retailers will need to spend less on transport to get goods into stores. Both ideas were great for the retail sector, helping it post 12.8% gains in half a year.
Shortly behind were both consumer discretionary (XLY) and transport (IYT) stocks. Both are theoretically likely to benefit from more money in consumers’ pockets, just like retail will—so the gains are to be expected. Additionally, the transport sector, which includes airlines, package delivery companies, and trains, spends more on energy than almost anything else, so a fall in oil prices is a bonanza for them.
Finally, technology (XLK) saw a modest gain, but much less so than other sectors. While some tech companies use oil to produce and distribute goods, it is a far lower concern than in other sectors, so oil’s impact on the sector is likely to be more muted. Thus it gained only 4.2%, less than half the gains of any of the other sectors.
Diversification is Key
No one can time when oil is going to rise or fall—or even if it will. Investors cannot avoid the volatility of oil prices altogether, since it has a direct impact on so many asset classes. At the same time, investors will not always profit from a rise or fall in oil. The key is to diversify across industries, so that your portfolio will be protected from a steep rise or fall in oil prices.