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When Oil Prices Influence Market Sectors, Diversification Can Save Your Portfolio

Oil prices have been making headlines for months now, and it’s no wonder. While it's easy to see the benefits of lower oil prices on consumers, not every market participant has been enjoying the decline. Some industries, particularly those in the energy-related sectors, suffer when oil prices are depressed. This sudden decline in oil prices—and its mixed effect on oil-price sensitive investments—serves as a great illustration of how diversification can work in a long-term portfolio.

What Causes Falling Oil Prices?

The change in price has been dramatic. After steadily rising and peaking at over $100 per barrel, oil prices were cut in half by the start of 2015, an unprecedented decline that took many industries and investors off guard.[1] The fall in oil was caused by a number of developments, according to The Economist:

  1. Reduced global economic activity and improved efficiency have led to lower demand.
  2. Geopolitical turmoil has not had much affect on output in Iraq and Libya.
  3. America is producing a lot of oil, raising supply even further.
  4. Saudi Arabia and other oil rich countries have not cut production to raise oil prices.

The Impact of Oil Prices on Industries

An interesting relationship exists between oil prices and different parts of the U.S. economy. Certain sectors, such as airlines, benefit strongly from a decline in oil prices. Charting out the recent price of major airline stocks against the decline in oil will demonstrate this point quite well. Meanwhile, stocks in the consumer discretionary sector are considered to be some of the larger beneficiaries of a sustained decline in oil prices. These would include cable TV services, theme parks, shoe stores, and premium coffee brands. Online retailers may get an extra boost from lower oil prices: not only might people order more goods, but the company’s costs to ship those goods are lower as well.

In contrast, if we view the stocks of U.S. companies that produce oil, or aid in the production process, lower oil prices can be quite painful, in some cases even jeopardizing a business model.  Examples of that would include U.S. shale producers and the firms that sell machinery to oil companies that have dramatically slowed their expansion process.

Less clear are the effects on sectors like alternative energy, especially solar power. Solar companies have suffered over the past few months, as there is an implied lower demand for solar products when oil is cheap. That said, the energy sector is volatile and recent studies show that alternative energy is a long-term play on the environment and sustainability and not strictly a function of current energy prices.

Diversification Is Key

As the effects of lower oil prices spread through the economy, they also spread through our portfolios. Some investors may attempt to avoid investing directly in commodity-linked securities, but that doesn’t mean they will fully escape the effects of oil price volatility. Because oil prices affect so many different market sectors, it’s particularly difficult for investors to avoid their overall impacts. But one way investors can partially hedge themselves from commodity volatility is by diversifying their portfolios across various industries and market sectors. That way, even if the energy stocks in a portfolio decline due to a correlation with oil prices, the consumer discretionary holdings may react well. Historically, stock market values increase over long periods of time, so a well-diversified portfolio should be able to withstand oil price volatility along with a host of other obstacles in the future.

[1] WTI crude last traded over $100 in July of 2014. As of May 6th, 2015, WTI crude is down 41.13% over the trailing 12 months.

Volatility Investors Diversification Economy Long-term investing

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