5 Investing Factors to Consider After a Plunge in Oil Prices

For consumers, the recent drop in oil prices is a relief. Lower prices at the pump means more cash to spend on discretionary items like clothes, electronics, dining out and more. Certain businesses, such as shipping and airlines, certainly benefit from lower fuel expenses. However, the factors behind the decline indicate a weaker global economy, and that could hurt growth in the U.S. Slowing growth around the world reduces the demand for oil, and more broadly reflects the fragility of the global economic recovery.

A strengthening U.S. dollar will also pose problems for any business that generates revenues abroad. Suddenly, U.S. goods become more expensive for the foreign consumer, which lowers demand. This may impact U.S. jobs, especially those in the energy industry. This has been one of the few bright spots of our economy, as the shale boom has created more than 2 million jobs, according to a 2012 study by IHS Inc., which provides industry data and consulting services. If unconventional drilling becomes unprofitable, the companies will halt production and lay off workers. Here are five factors to consider regarding the recent plunge in oil prices:

1. The stronger U.S. dollar negatively impacts the price of oil. The U.S. dollar has risen more than 7 percent over the past three months as the Federal Reserve ends quantitative easing, just as the European Central Bank contemplates increasing theirs. When the dollar strengthens, the buying power of other nations weakens. Since globally traded oil is denominated in U.S. dollars, foreign countries must pay more to purchase each barrel.

2. There has been a shift in supply and demand. Another factor driving down oil prices is simple supply and demand. Over the past decade, U.S. oil production has doubled to more than 14 million barrels of oil each day. Moreover, OPEC is pumping out nearly 31 million barrels daily and recently signaled intentions to increase production.

With geopolitical turmoil engulfing Middle East nations, many thought production out of Iraq and Libya would be tempered. Yet OPEC nations are producing more oil than ever before. This increased supply could not come at a worse time. With soft economic data from China and the EU, growth forecasts have been lower than expected. Lower growth implies lower demand for oil.

3. Political discord around the globe could be the last straw. If the fundamental shift in supply and demand coupled with a strong U.S. dollar were not bad enough, political motivations are fueling fears of a price war. Normally when oil is weak, OPEC throttles back production in order to stabilize prices. However, fighting in Iraq and Syria has created a divide in the OPEC nations.

Saudi Arabia, accounting for nearly a third of OPEC's production, is intent on taking market share from other Middle East nations and capping growth of U.S. production. The Saudis have one of the lowest costs to produce oil and can tolerate the lower oil prices much more than any other nation.

4. A price war will likely be resolved sooner rather than later. The White House is stuck between supporting healthy oil prices to foster U.S. oil production and lower prices to dealing a large enough blow to the oil-dependent economies of Russia and Iran that may bring them to the negotiating table. Saudi Arabia and the U.S. have significant influence over each other's interests.

The U.S. is currently intervening to halt the spread of Islamic State group, in which the Saudis have a vested interest. In return, a boost in Saudi production will cripple Iran and Russia. It is estimated that Iran needs oil prices to be near $140 per barrel to balance their budget and Russia needs them to be over $100. Though the U.S. would like to force Russia and Iran to respect its foreign policies, they would likely stop before destroying the domestic economy.

5. It is estimated that U.S. shale drilling remains profitable at $75 per barrel. The likely floor to oil prices will be somewhere around $75. The growth in the U.S. onshore market is expected to continue at current prices, but some oil drillers may begin to reduce spending if prices remain low. Fortunately, the $75 price is a blended average and includes companies drilling marginal wells on the outskirts of the shale basins.

Most of the national oil companies have focused on drilling premium wells in the heart of the shale plays, and many of those basins have break-even prices as low as $60. Should prices dip below $75, some production would almost certainly decline, quickly buoying oil. Oil is in the midst of a perfect storm and prices are reflective of this. While it could remain depressed for an extensive period of time, there is a limit. At a certain point, something has to give. It would be preferable if OPEC nations resolve their differences and cut production.

However, even in the face of persistent hubris shown by these nations, drillers will inevitably be forced to cut production if oil continues its slide in order to bring supply and demand back into balance. A final factor worth mentioning is domestic and foreign policy. The EU or China could increase economic stimulus, which would boost demand or the U.S. could incentivize the use of nationally produced oil.

Brett Carson , CFA, is the director of research for Carson Institutional Alliance where, as portfolio manager, he is directly responsible for managing several strategies, including perennial growth, long-term trend and write income. Additionally, the Omaha-based research department conducts thorough analyses of companies to identify undervalued stocks that carry attractive upside potential.

Investment advice offered through CWM, LLC, a Registered Investment Advisor. Securities offered through LPL Financial, Member FINRA/SIPC. LPL Financial is a separately owned entity from all other entities.