Danger! The Oil Price Ripple Effect that’s Threatening All Investments
Safe Sector that’s Benefiting from Low Oil Prices
High Dividend Utility Stocks
Even if you don’t own a single energy stock, the oil price crash of the past six months could harm your portfolio in much the same way the 2008 housing crash brought down the whole stock market. After falling over 50% since June, oil prices fell again this week, triggered by news of weak economic growth across the globe. In particular, slowing growth in China and Europe has investors worried that lower energy consumption in those countries will further reduce already weak global demand for oil.
To be clear, China’s economy is still growing, but at the slowest pace in 25 years. And since China is the world’s second-largest consumer of oil and its top importer, falling demand there would have ripple effects across the globe.
And oil prices are already very, very low: at about $48 per barrel today, oil prices are now less than half what they were at their peak in June. The decline has meant a huge adjustment for energy companies, financiers and everyone else whose business plan was based on oil prices staying around or above $100 a barrel. And most weren’t prepared: since 2010, oil prices have dipped below $100 per barrel on only a few occasions, and have usually rebounded within weeks.
The sudden 50% slide of the past six months blindsided many, and has already contributed to the dissolution of several hedge funds.
Now investors are worried that small energy companies, particularly North American shale oil producers, will start to default on their debt and go under. While shale drilling has become much more economical in recent years-contributing to the current global supply glut of oil-it is still one of the most expensive ways of producing oil. BHP Billiton has already idled 40% of its U.S. oil rigs operating in shale deposits. However, most smaller, less-diversified shale oil producers don’t have that option, and some that are unprofitable at these oil prices may be forced to default.
While the market could probably absorb a handful of defaults, market watchers are afraid that a wave of defaults will cause repercussions throughout financial markets. Many small energy producers have high levels of debt, used to fund expensive drilling and fracking activities. If enough of them default on this debt, it could cause contagion in the non-investment-grade bond market (where most of these companies borrow), just as the sub-prime mortgage crisis of 2007-2008 spread throughout the financial industry.
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Energy companies only account for about 15% of the high-yield debt market, but investors fear that a wave of defaults would also swamp the companies and funds that make, trade and own these loans, just as the mortgage crisis almost brought down AIG. If a few of those companies fail, it could have repercussions far beyond the energy industry, making borrowing more difficult for all non-investment-grade borrowers, just as the liquidity crisis at AIG and the failure of Lehman Brothers left thousands of borrowers in the lurch.
As a result, non-investment-grade or junk bonds-and stocks and funds that have anything to do with the junk bond market-have become much less attractive to many investors. That’s causing yields in the junk market to rise, and widening the spread between the yields on U.S. Treasuries and the yields on junk bonds. According to some technical analysts, this is often a harbinger of a major downturn in the stock market, as it was in 2007.
If the worst-case scenario plays out, it’s easy to see how these analysts could be right, and the crisis could spread well beyond the energy industry to cause a more generalized market downturn.
It could also spell doom for investors with a lot of money in non-investment-grade debt, whether through individual bonds, ETFs or their financial advisors. And while “junk bonds” sound like something all but the most speculative investors would stay away from, conservative investors have actually flocked to the non-investment-grade market in recent years, seeking yields they couldn’t get in safer fixed income investments. You may even have exposure in your own portfolio that you’re unaware of. In addition, many financials, including business development companies (popular with retirees for their high yields), do a lot of lending in the junk bond market.
However, only time will tell how bad energy sector defaults will be. Ratings Agency Moody’s recently said that it expects few corporate defaults in 2015, citing the strong U.S. economy, strong corporate earnings and relatively few debt maturities this year. Analysts at Deutsche Bank agreed in a note issued Friday, arguing that only a small percentage of U.S. jobs are in the energy sector, and that losses there will be offset by the benefits of cheap gas elsewhere, especially in the transportation and construction sectors.
I wouldn’t buy a bunch of stressed high yield bonds here, but I do recommend that instead of focusing on what could go wrong, investors should try to find the silver lining-and even the opportunity-here, as the Deutsche Bank analysts did. There are many stocks benefiting from low oil prices, including some with high yields that are much safer-and have much more growth potential-than junk bonds.
For example, the impending crisis in the energy industry has created multiple tailwinds for utility stocks, which are some of the best, most reliable dividend paying stocks out there.
The most obvious benefit to utilities is low energy prices, which reduce their costs, since they’re major energy buyers (especially electric utilities). But they’re also benefiting from fears of non-investment-grade defaults, since most utilities are investment-grade borrowers and are considered very safe investments.
Lastly, even though investors are fleeing the high-yield bond market, many still need regular income, and utilities pay great, high dividends.
Many utility stocks have already had great advances over the last few months-in the Cabot Dividend Investor portfolio, we’re sitting on 23% and 34% total returns in our two utility positions-but there’s still plenty of room to run. Over the next several months, I’ll be highlighting some of the best, highest-yielding opportunities in this space, in an ongoing series I’m calling High Dividend Utility Stocks. Stay tuned for my best picks in the space in coming weeks.
Chloe Lutts Jensen
Chief Analyst, Cabot Dividend Investor