Will+Low+Oil+Prices+Persist+-+Strategy+Monthly+-+Feb+2015

BBH STRATEGY MONTHLY / Will Low Oil Prices Persist? For a While...

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Strategy Monthly

Will Low Oil Prices Persist? For a While… February 13, 2015

The U.S. economy remains on solid footing and recent data show cause for optimism despite potential threats from vola‐

tile energy markets, a strong dollar, lackluster international growth and the resurgent financial crisis in the euro zone. In

financial markets, a sharp decline in Treasury yields in January gave rise to gains in most rate‐sensitive fixed income sec‐

tors while the S&P began the year with a monthly decline of %. In the early days of February though, most of this

early performance has reversed. Outside of the U.S., solid local currency performance in both international developed

and emerging markets only translated into USD gains of roughly . % after accounting for the strong dollar.

Energy

The recent drop in energy prices continues to dominate headlines and for good reason. With no obvious shock to the

system, how exactly did the price of oil drop by over half in the span of six months? As we have written in past Strategy

Monthly commentaries, the best explanation is still that this is a supply driven phenomenon. Although increasing U.S.

shale oil production has been staring us in the face for several years, it wasn’t until OPEC met on November , and

declined to cut its production that oil clearly turned downward from its trading range of the past four years. In both

and , U.S. West Texas Intermediate Crude (WTI) briefly traded below per barrel, only to bounce back in fairly

rapid fashion. On November , , however, WTI declined by over % from its previous close of . and pro‐

ceeded to fall for the next two months to less than . It is clear now that the market expected OPEC to cut production

and keep a floor under oil prices, and that substantial high‐cost drilling activity was taking place (much of it in the U.S.)

assuming this environment of relatively high oil prices would continue.

While predicting the future path of commodity prices is an imprecise science, studying the microeconomics of U.S. shale

oil production can still yield a few clues as to what kind of supply response we may see. The first important point is that

shale oil wells have substantially higher decline rates than traditional oil wells. While rates vary by region (even within

the same shale formation) and by operator, various publications estimate that it is not uncommon for % of the oil from

a new shale well to be produced within the first year. Accordingly, Energy Information Administration (EIA) data from the

Bakken shale show monthly depletion rates of roughly % for legacy wells. Because of these steep decline rates, U.S.

shale production has the potential to meaningfully taper off in a short period of time (perhaps six months to a year) once

producers stop drilling new wells. EIA data show that roughly half of U.S. oil production is from shale. As far as existing

wells though, the substantially lower costs of operating an already producing well mean that unless oil prices fall further,

most existing wells are likely to stay online, and thus we will have to wait for the naturally steep decline rates of shale

Will Low Oil Prices Persist? For a While... February 13, 2015


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wells to curtail production. Once a well is drilled, the ongoing costs of operating the pumps and other related equipment,

plus transportation, are only a fraction of the overall cost. Various estimates of “shut‐in prices,” or the minimum price

needed to continue operating a producing well, seem to show that a substantial level of U.S. production can keep wells

running with prices in the to range per barrel. In comparison, Rystad Energy, an oil and gas consulting firm, esti‐

mates that the average breakeven price for new shale development is per barrel. However, this figure is a nation‐

wide average and ranges from to across different shale plays. There is further variation between the high and

low quality acreage within the same shale. Additionally, the fact that some producers have hedged their production out

into the future means that there are firms that have no incentive to adjust production in response to short‐term move‐

ments in price.

While there is no shortage of speculation about oil

prices, most analysis seems to show that the world is

currently oversupplied by about million barrels of

oil per day. With OPEC declining to cut production,

U.S. shale is one of the most substantial sources of

supply that can adjust production over a short time

horizon. Thus, focusing on rig count data can yield

early clues as to when the market may come back

into balance. As of February th, the oil rig count

from Baker Hughes, which shows how many rigs are

actively exploring for oil or drilling new wells, has de‐

clined almost % since peaking in September. This

is a tangible sign that producers do not view current

prices as high enough to justify the costs of new ex‐

ploration and production. While rig counts have begun to decline, counts of producing wells and, most importantly, pro‐

duction, have yet to decrease. There is an expected lag between a trail off in rig counts and production declines, but the

high depletion rates of shale wells ensure that the lag time will be less than for conventional oil supply.

Changing gears and focusing on the long‐term outlook for oil prices, we believe the most important determinant of oil

prices in the long term is the total marginal costs of production in the industry. Oil producers ultimately make production

decisions based on whether the spread between expected prices and their own costs of production will be wide enough

to justify drilling new wells, and thus the marginal cost of production has a powerful influence on prices, especially in a

more competitive market where some of OPEC’s cartel power has been eroded. In the short term, however, oil prices in

an oversupply environment can fall precipitously, and in theory are bounded only by the short‐term costs of operating a

well, while also being heavily influenced by the levels of oil inventory. Importantly, though, because the U.S. produces

such a large volume of shale oil with costs in the to range, and because those wells have shorter lives than tradi‐

tional sources of oil, it is likely that U.S. shale production will be an important marginal producer of oil for as long as our

shale reserves hold up, and both Saudi Arabia and OPEC decide not to prop up prices with production cuts.

Oil’s Effect on the Economy

Beyond the absolute level of oil prices, the more pressing question for the U.S. economy is to what extent any weakness

in the energy sector might hurt overall U.S. growth or employment. To that end, evidence of the turmoil in the energy

industry is slowly starting to appear in economic data. While the BLS’s January Employment Situation Summary shows

that all sectors of the private economy added jobs versus the prior month, mining & logging showed a small decline of

Baker Hughes: U.S. Crude Oil Rig Count

As of January 31, 2015Source: Bloomberg, Baker Hughes, BBH Analysis

0

200

400

600

800

1000

1200

1400

1600

1800

2007 2008 2009 2010 2011 2012 2013 2014 2015



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, employees, with oil & gas extraction accounting for , of those lost jobs. Average weekly hours worked in min‐

ing and logging also declined by % versus December, the most of any other economic sector. At the moment these

numbers are somewhat trivial, but as the months go on, they will reveal just what the negative impacts of a decline in oil

prices might be. On the positive side, though, reduced energy costs helped push real disposable personal income to grow

by an annualized . % in December — its highest level in two years — and this in turn helped drive annualized personal

consumption gains of . % in the th quarter of . Despite the fact that lower energy costs are already present in the

income numbers, a slowdown in energy investment by businesses was not present in the data. Investment in both min‐

ing structures and equipment was still positive, and thus we expect that a pullback in these areas will manifest itself over

the first half of the year, or possibly in subsequent revisions to th quarter numbers. Ultimately we believe that the ben‐

efits of lower energy expenses will outweigh the costs of a pullback in energy investment, though this depends greatly on

what consumers and businesses do with their newfound savings. To the extent that this money is spent or reinvested, it

increases the odds that the economy will weather this temporary weakness in the energy sector. Only time will reveal

the true magnitude of any dislocations, as the second and third order effects from changes in business investment (ener‐

gy is a highly capital intensive industry) and possible employment declines (energy jobs are relatively high paying) are

impossible to calculate. We would note, though, that because the benefits of lower energy costs are widely dispersed

among consumers and businesses, while the costs will be absorbed disproportionately by a select group of oil producers,

the downside of the drop in oil prices will be more tangible.

Economic Update

Looking beyond just the energy sector at the broader set of employment data, it is clear that the U.S. labor market start‐

ed with a bang. With an above consensus print of , new jobs in January coupled with net revisions of

+ , to the prior two months, this was one of the strongest months of job creation in the past years. Only a hand‐

ful of times since has net job growth (current month payroll gains plus revisions) topped the , mark. The

recent strength of the labor market is further apparent in the six‐month trailing average of job gains in the following non‐

farm payroll chart. After a brief period of weakness in early , payroll growth has marched steadily upward, and the

Employment Breakdown

As of January 31, 2015Source: Bureau of labor Statistics, Non-Farm Payroll Data Table B-1, BBH Analysis

(Jobs figures in 000s)

Economic Sector Total Jobs % of Total Month-over-Month Year-over-Year

Goods Producing SectorsManufacturing 12,330 9% 22 228Construction 6,314 4% 39 308Mining & logging 912 1% -3 36

Total Goods Producing Sectors 19,556 14% 58 572

Service Providing SectorsTrade, transportation & utilities 26,720 19% 51 565Government 21,891 16% -10 80Education & health services 21,758 15% 46 509Professional & business services 19,486 14% 39 715Leisure & hospitality 14,976 11% 37 482Financial activities 8,077 6% 26 159Other services 5,614 4% 4 78Information 2,771 2% 6 47

Total Service Providing Sectors 121,293 86% 199 2,635

Total Economy 140,849 100% 257 3,207

January 2015 Employment Data Change in Employment



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six‐month average now stands at over , . Though the unemployment rate ticked up slightly from . % to . %,

this merely reflects the BLS’s annual updates of its population controls. While both the size of the labor force and the

employment tally increased, the labor force estimate increased more (+ , , versus + , ), and thus the unem‐

ployment rate was nudged higher.

Furthermore, January showed a sharp reversal of

the worrying slowdown in wage growth witnessed

in December. Last month hourly wages on nonfarm

private payrolls declined by . % per month, but in

January we saw a bounce back of . % for produc‐

tion and nonsupervisory workers and . % for all

workers. With this move, December’s numbers

now appear to be an anomaly, and year‐over‐year

wage growth is now at or above % for both series.

While wage growth overall still remains surprisingly

slow this far into our economic recovery, the situa‐

tion now seems to be stable and not worsening.

Federal Reserve

With the Federal Reserve’s upgraded view of job

gains and the pace of economic activity, and the

blockbuster January jobs report that was released

just over a week after the recent FOMC meeting,

the Fed will likely experience more pressure to

begin laying the groundwork for a normalization of

short‐term interest rates. The Federal Reserve will

have time to digest another report on both em‐

ployment and inflation before the next committee

meeting (and press conference) in mid‐March

though. Regardless, all eyes will be on the Fed to

see if they start to telegraph any potential rate

changes for their June meeting, the next meeting

after March at which there will be an ensuing press

conference.

So far, inflation is the part of the Fed’s dual mandate that has allowed the FOMC to stand pat on raising rates. While

headline inflation has waned to a . % annual increase due to declines in energy costs, core inflation has remained more

consistent at . %, though that, too, is meaningfully lower than the Fed’s long term target of %. And while core inflation

supposedly removes the volatile energy component from the calculation, it will also be indirectly affected by energy. To

the extent that low energy costs decrease the cost of services such as transportation, core inflation will eventually de‐

cline as the affected businesses compete with each other via lower prices. As the Fed has acknowledged on numerous

occasions, however, monetary policy works with substantial lags, and thus, while inflation is not currently forcing the Fed

to act, if the labor market continues to show robust progress back to normal levels, that will likely cause the Fed to err on

the side of caution by raising rates sooner than it otherwise would. The Great Recession clearly created substantial slack

Average Hourly Earnings –Year-Over-Year Growth

As of January 31, 2015Source: Bureau of Labor Statistics, BBH Analysis

Production &

Nonsupervisory

All Employees

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

2008 2010 2012 2014

%

Monthly Change in Nonfarm Payrolls

As of January 31, 2015Source: Bureau of Labor Statistics, BBH Analysis

Six Month

Average

0

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100

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in labor markets, but it is hard for us to see how the

economy can absorb greater than , new jobs

per month for a substantial period of time without

that creating inflationary pressures, and we believe

the Fed is thinking about this very issue as well.

Corporate Earnings

Corporate earnings are another important compo‐

nent of our country’s economic health, and th

quarter earnings season is well underway.

With roughly three‐quarters of the S&P ’s mar‐

ket cap having announced results, per share operat‐

ing earnings are set to decline . % year‐over‐year,

the first decline since . Buried in these results,

however, are charges related to pension expenses

that have the effect of reducing earnings growth by

roughly %. Focusing on a narrower definition of

operating earnings would instead yield an earnings

growth number closer to %: much lower than in

past quarters, but still positive. Because the S&P

earnings numbers represent per share figures, it is

important to note that they can be influenced by

share buybacks. Revenue growth, which is also im‐

pacted by share counts, but not by the idiosyncra‐

sies of different definitions of net income, is esti‐

mated to have increased by . % in the fourth

quarter. To put some numbers behind the share

buyback phenomenon, according to data tabulated

by Standard & Poors, since the second quarter of

the “buyback yield” of the S&P has outpaced the dividend yield by a full percentage point ( % versus %). That

% buyback yield thus accounts for a non‐trivial portion of the roughly % annual growth in operating earnings over the

same time frame. While a prudently executed buyback program can add to shareholder returns, the market’s record as a

whole on buybacks is abysmal, and when using the pace of S&P earnings growth as a gauge of the general operating

environment for businesses, it can be misleading.

Another factor influencing earnings growth this quarter is currency translation. Because S&P companies derive

roughly half of their revenues from overseas, their earnings are subject to the volatility of currency markets. We believe

currency effects tend to cancel out in the long run, but in the short run they can have a marked impact on earnings.

Though it is difficult to estimate the exact impact for the market as a whole, we note that the value of the trade‐

weighted dollar1 increased almost % in the fourth quarter, and many companies have acknowledged currency head‐

winds on their earnings calls.

1 The Nominal Broad Dollar Index is a weighted average of the foreign exchange values of the U.S. dollar against the currencies of a broad group of major U.S. trading

partners.

U.S.TreasuryYield Curves

As of December 31, 2014Source: Bloomberg, BBH Analysis

0.01% 0.00% 0.05%

0.45%

1.16%

1.64%

2.22%

0.02% 0.04% 0.12%

0.67%

1.65%

2.17%

2.75%

-1%

0%

1%

2%

3%

4%

1 Month 3 Month 6 Month 2 Year 5 Year 10 Year 30Year

December 31, 2014

January 30, 2015

S&P 500 Earnings Growth

As of February 5, 2015Source: Standard and Poor’s, BBH Analysis

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

% Change Year-Over-Year

na na

ConsensusExpectations



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Financial Markets

Turning to the markets, January was a strong month for

rate‐sensitive fixed income strategies, while the S&P

fell by . % to start the year. As we go to press on this

Strategy Monthly, however, early February data show that

Treasuries have given up most of their gains, while equity

markets have bounced back from their end of January

lows. The movement in medium‐ to longer‐term Treasury

yields in January was quite remarkable and sent govern‐

ment bond markets off to their strongest start since .

Yields in the ‐ to ‐year range all declined by over

basis points (bps) during the month, sending the Bank of

America/Merrill Lynch U.S. Treasury Index up . %. In the

credit sector, investment grade credit spreads widened by

bps in January, while high yield spreads widened by

bps. When coupled with changes in the yield curve, this

led to gains of . % in corporate bonds and . % in high

yield.

In equity markets, the S&P declined by . %, and the

smaller capitalization Russell declined by . %. In‐

ternational equity markets fared better, though gains in

U.S. dollar terms were hurt by the strong dollar. Interna‐

tional developed equity markets rose . % in local curren‐

cy terms, but only . % in USD. Similarly, emerging mar‐

kets rose . % in local currency, but only . % in USD.

Perhaps the most unexpected development in the past

year has been the strong rally in U.S. Treasuries. Since

the ‐year yield peaked at over % at the end of ,

it has fallen by almost half through the end of January

. There is likely a confluence of factors responsible

for this drop, but one notable reason is the even lower

yields available on government bonds outside the U.S.

In the ‐ to ‐year maturity band, Bank of America/Merrill Lynch data show that while U.S. Treasuries currently yield

. %, an average of other government bonds around the world is yielding less than . %. Data on U.S. Treasury pur‐

chases confirm that investment into U.S. Treasuries picked up in from , and in addition to helping push U.S.

Treasury yields lower, this has created upward pressure on the foreign exchange value of the U.S. dollar. These trends

bear watching in because of their broad effects on both fixed income and currency markets.

Thomas Martin, CFA Investment Strategy Analyst

G. Scott Clemons, CFA

Chief Investment Strategist

Fixed Income Returns

*Annualized return figuresThrough January 31, 2015Source: Bloomberg, BBH Analysis

Fixed IncomeAsset Classes:

Investment grade taxable bonds: Barclay’s Aggregate; Investment grade tax-exempt bonds: S&PMunicipal Bond Index; Inflation protected: Barclay’s U.S. TIPS; High-yield: BofA Merrill Lynch High-Yield(Cash Pay Only).

2.1%

3.1%

4.6%

1.7%

4.3%

5.6%

0.7%

7.5%

8.7%

3.3%

0.9%

4.6%

0

1

2

3

4

5

6

7

8

9

10

YTD 2015 Trailing 3 Years* Trailing 5 Years*

Investment Grade Taxable BondsInvestment Grade Tax Exempt BondsHigh Yield BondsInflation Protected Bonds

%

Equity Returns

*Annualized return figuresThrough January 31, 2015Source: Bloomberg, BBH Analysis

Equity Asset Classes

Large cap U.S.: S&P 500; Small/mid cap U.S.: Russell 2500; Non-U.S. developed: MSCI EAFE; •Non-U.S. emerging: MSCI Emerging Markets.

YTD 2015 Trailing 3Years* Trailing 5Years*

US Large Cap EquityUS Small/Mid Cap EquityNon-US Developed Equity ($)Emerging Markets Equity ($)

%

-3.0%

17.5%

15.6%

-2.0%

16.7% 16.7%

0.5%

10.1%

7.1%

0.6% 0.9%

3.4%

-5

0

5

10

15

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