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Oil Prices and Equity Returns

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No doubt one of the biggest stories over the last 18 months has been oil. Currently, oil prices (as measured by the WTI Crude Index) are at levels we haven’t seen for almost 13 years. While many see falling oil prices acting as a tailwind for the overall economy, there are also dramatic employment consequences for those currently working in the energy sector. Places like Houston, TX are feeling the overwhelming effects of these recent lows. Most importantly, the question we want to ask is, “what does this all mean for the investor?” We cannot predict with a high degree of accuracy what the future holds for equity investors, but we can utilize historical data to provide insight.[i]

Historical Relationship Between Oil Prices and Equity Returns

The table below shows the historical correlation between monthly oil spot prices and both domestic (CRSP 1-10 Index) and international (MSCI World ex USA) equity returns. 

As you can see, there has been little to no correlation between spot oil prices and equity returns around the world. From 1986-2015, the actual correlation with CRSP 1-10 has been 0.02 and 0.05 for the MSCI World ex USA Index. When returns from oil are negative equity returns have been positive. Similarly, when oil price returns are positive, equity returns have still been positive. Extreme negative oil price returns (below 10% and 20%) for the trailing 12-month period have also been environments for positive equity returns.

Some advisors believe that this is a good reason to have oil be part of a well-diversified portfolio, but we will get to that later on.

Are We Seeing a Decrease in Aggregate Demand for Oil?

In short, no! Aggregate demand around the world has been relatively stable over the last 18 months. Aggregate supply has increased sharply over the same time period and subsequently driving prices down. The chart below shows the overall inventory in US Crude Oil since 1991 (data provided by the US Energy Information Administration).

Inventory levels have remained relatively stable from 1991 until 2010, when inventory started to rise and then sharply near the end of 2014.

Implications for Investors

While low oil prices can provide a tailwind for the economy, there are very dire consequences to those who find themselves employed in the energy sector. In Houston, TX, companies like Southwestern Energy (NYSE: SWN) have laid off 40% of their workforce.[ii] Investments that are heavily reliant on the energy sector like Mastered Limited Partnerships (MLPs) are facing heavy losses, but a well-diversified portfolio hasn’t seen as dramatic declines. The table below provides the energy sector weights across multiple equity and fixed income indexes as of December 31, 2015.

For the well-diversified investor, the energy sector makes up approximately 6% of global equity markets and approximately 2% of global bond markets. Since we cannot predict with a high degree of accuracy which sector in the economy is going to be the next winner, it is prudent to hold all of them. For those who recently made an active bet on the energy sector have felt the effects of being concentrated.

Commodities as a Good Portfolio Diversifier

As we mentioned before, there has been very close to zero correlation between oil prices and equity returns. This usually implies the potential for adding oil or other commodities to a portfolio of equities and bonds to further diversify and possibly hedge inflation. Our recommendation for investors is to avoid commodities for one main reason: they are speculative in nature.

The benefit of investing in public companies is that we expect a positive return on our investment. Companies make products; consumers buy those products, thus generating profits. As an equity investor, you have a future claim on those profits. Commodities do not produce anything. It is based purely on supply and demand. You can imagine that as we move away from fossil fuels and towards alternative energy sources, oil may become obsolete. There is no way of calculating what this may look like, but the most recent period is an important reminder of how volatile commodities can be.

Academic evidence on the role of commodities in a portfolio is generally mixed.[iii] From 1986 to 2015, the annualized return for the WTI Crude Index has been 1.25%. In real terms (inflation adjusted), returns have been negative.

Conclusion

The recent fall in oil prices has been dramatic. For most consumers, there has been a net positive given less money spent at the pump and directed towards other areas of our economy. The story has not been quite as positive for those employed in the energy sector. From an investment standpoint, there is no substantial information embedded in oil prices that we can use. Historically, there has been virtually a non-existent relationship between oil prices and subsequent equity returns. US inventory data points to an increase in aggregate supply as the culprit for falling prices versus a decrease in aggregate demand. For those investors who are heavily concentrated in the energy sector, times have definitely been rough. Investors holding a well-diversified portfolio have not experienced as dramatic of results. In general, investing in commodities hasn’t provided a net positive portfolio benefit, although the historical correlation has indicated a possible diversifier. In the end, it is just an interesting story and not much else.


[i] Dimensional Fund Advisors, LP. Crude Oil and Financial Markets. February 2016

[ii] Brantley, Max. “Southwestern Energy Layoff Include 600 in Arkansas.” Arkansas Times, January 21, 2016: http://www.arktimes.com/ArkansasBlog/archives/2016/01/21/southwestern-energy-layoffs-include-600-in-arkansas

[iii] Lee, Inmoo & Marlena Lee. Coping With Inflation Uncertainty. Dimesional Fund Advisors, LP. August 2009.