Oil prices, long steady at around $100 per barrel, have recently plunged to their lowest point since mid-2012.
Brent Crude Oil Spot Price data by YCharts
The cause is a combination of factors. U.S. production is growing like gangbusters thanks to our historic shale oil boom, while global economic growth is slowing, causing demand to decrease. In addition, certain OPEC nations, in an attempt to steal market share from U.S. oil producers, are lowering their prices.
While plunging oil prices are great when filling up with gas, they can play havoc on stocks linked to the price of the commodity, such as offshore oil drillers Seadrill (SDRL +0.00%), Transocean (RIG 2.01%), and Ensco (ESV +0.00%), and oil-producing MLPs such as Linn Energy (LINE +0.00%) and its non-MLP equivalent LinnCo (NASDAQ: LNCO), Breitburn Energy Partners (BBEP +0.00%), and Vanguard Natural Resources (NASDAQ: VNR).
As this chart shows, up until the recent recovery, each of these stocks and MLPs was down 20%-25% in recent weeks. Many investors in these companies and partnerships may be wondering whether low oil prices are here to stay, and if so, what it means for their high-yield dividend energy holdings such as these.
Let's take a closer look at how low the price of crude might fall, how long it may stay there, and whether now is a great buying opportunity for some companies and MLPs. The two ways falling oil prices can affect you come down to whether the decline is long-term. If it is, then your dividend or distribution will be cut, and future payout growth will be slowed or halted, and investors will potentially lose money on these investments. If it's not, then investors stand to profit by purchasing at these prices and locking in these attractive yields.
How low will oil go?
In an excellent recent article, my Motley Fool colleague Matt DiLallo explains the role of hedge fund speculators have had in driving the sudden drop in oil prices. According to OPEC, much of the decline in prices is due to this speculation, specifically an 8% increase in oil puts to the highest levels in 22 months. (A put is a bet on the decline in value of an asset.)
If speculators truly are the major cause of the price decline, then it increases the chance of a faster recovery in oil prices, once U.S. shale producers start decreasing production. According to analyst firm Sanford C. Bernstein & Co., 33% of U.S. oil production becomes uneconomical at $80 a barrel. In fact, according to analyst firm ITG, at $80 a barrel, oil production would rise only 5%, far less than the previous forecast of 12%. At $70 production growth would halt entirely.
What's the likely outcome for oil prices?
In the short term, oil prices may fall a bit further, with analysts at Bank of America expecting crude to hit $75 before stabilizing and averaging $85 a barrel in 2015.
However, there are several reasons to believe that this dip in oil prices won't last long.
First, OPEC's recent price reductions are a short-term move. According to the IMF, Saudi Arabia, which derives 80% of its government revenue from oil and dominates the cartel's actions, needs $91-per-barrel oil to remain solvent.
Second, though global economic growth is slowing, thanks to a possible recession in Europe and Japan's recent 6.8% economic contraction (caused by its raising its sales tax),the IMF is still expecting 2015 global economic growth of 4%.
The long-term outlook for oil prices is far stronger. According to a recent study by Morgan Stanley and Rystaad Energy, global demand for oil is expected to rise 15% to 26% by 2035, resulting in a likely oil price of $125 to $150 per barrel.
What does this mean for me?
In my opinion, the market's reaction to the recent sharp drop in oil prices is an overreaction. While it's true that a long-term decline in oil prices, such as one caused by a global recession or depression, could result in both dividend and distribution cuts for the companies or MLPs mentioned and slower payout growth in the future, I don't think that outcome is likely because of the combined megatrends of a growing global population and strong probability of growing global fossil fuel demand in years to come.
Takeaway
The quick decline in oil prices is likely to be a short-term event, to be reversed by continued (if temporarily slower) global economic growth and the long-term megatrend in rising global oil demand. Barring a long-lasting global recession or depression, companies and partnerships such as Seadrill, Ensco, Linn Energy, Breitburn Energy Partners, and Vanguard Natural Resources look to be excellent long-term high-yield income investments at these prices. I think investors would do well to consider them for a spot in their portfolio, because only in the unlikely event of a long-term decline in oil prices would the payouts from these companies and partnerships be threatened and the investment thesis invalidated.
