Goldilocks Visits the Oil Patch

June 2, 2016

Goldilocks Visits the Oil Patch Photo

Not too hot, not too cold. That’s been the state of the domestic economy for the better part of seven years. Moderate growth, low inflation, low interest rates and access to capital markets have been key ingredients to generating solid returns in the corporate and structured bond market for the bulk of the post-crisis period. The Federal Reserve (Fed) has been the primary engineer, dampening volatility and pushing investors out of cash and into income-generating assets. Every time we think the party is about to end, the central banks have managed to maintain order and reestablish equilibrium. Unintended consequences notwithstanding, the feat has been impressive, to say the least.

As I help craft our investment strategy, I continually ponder numerous catalysts and tail risks that would disrupt the delicate balance that exists. I wouldn’t have guessed that the one that looked like it was about to tip the balance to the downside was the cratering of energy prices. Oil prices hovered near $80 to $100 for the better part of four years before dropping 70% between the summer of 2014 and the beginning of 2016. Like many, I thought the decline in oil prices would be contained and be an overall net positive to global gross domestic product (GDP).

At the end of January, it was obvious that was not a good assumption. The market does not like disorder, but neither does the Fed. In a remarkable turnaround, dovish Fed comments, which led to a weakening of the dollar and rapid rebound in equity prices, coincided with the market discounting peak oil production and energy default rates. The timing was uncanny. Oil prices started to lift off and, like every market before it, seem to have discovered their version of Goldilocks – or in dollar terms, $50.

Key Takeaway:

$50 dollar oil now seems to be the new normal: The price which keeps debt and equity capital flowing, domestic oil production in check, OPEC at bay, and U.S. consumers happy. This would have been unthinkable a few years ago, much like 5% unemployment and sub 2% 10-year treasury rates. $50 oil will not produce great returns on capital nor will it prevent elevated defaults of highly levered and marginal energy companies. However, for the health of the broader bond market, it feels just right.

Tags: Chart of the Week | Oil | Federal Reserve | GDP

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The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.

This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.  This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.

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