My colleague Jeffrey Rosenberg discussed the economic implications of a drop in oil prices last month, pointing to how it could affect supply, demand, and U.S. monetary policy. I wanted to revisit this topic, as oil prices hit a five year low last week. An increase in the supply of oil (particularly from shale oil in the US), and weaker worldwide demand, among other factors, have contributed to the significant price drop this year from over $107 a barrel in June down to its current level below $60. Recently, the market speculated about a potential production cut by OPEC to shore up the price, but failure to reach an agreement between the various member countries may mean that we should see low prices for some time.

Oil & the Energy Sector

Aside from paying less the next time you fill up your tank, the drop in oil has a powerful impact on oil and refining companies in the energy sector. At the very least, these entities will see their margins compressed. For example, say that it costs an oil drilling company $50 to extract each barrel of oil. When oil was trading at $100, their per-barrel margin was $50 ($100-$50). When prices fell to $60, that margin shrunk to $10. This has a significant impact on that firm’s profitability and their long term financial health. If we look at the investment grade corporate bond market, we see that the energy sector makes up about 11% of the universe. Since July, the prices of bonds in this sector have fallen, and their yields have risen. This has resulted in the additional yield spread over Treasuries that these bonds pay to increase from 0.92% to 1.62%. This increase in spread reflects the higher level of credit risk that these issuers now carry.

Ways to Consider Playing the Energy Game