Last week, OPEC failed to cut production quotas – though it didreveal its own irrelevance.
Now, for the first time since 1972, oil prices are being set by the free market, not by a producer cartel. That means much lower oil prices, along with some surprising winners and losers.
On top of that, we're seeing a bit of market turmoil, which is always dangerous for long-term-oriented income investors.
Luckily, there are ways to profit from the turbulence…
Traditionally, lower oil prices were thought to be an unalloyed good thing for the u.s. economy, as they reduced imports and put more money in consumers' pockets. But that's no longer the case.
You see, the fracking revolution made the United States more self-sufficient in oil… but the country is now a generally high-cost producer. And fracked oil, along with oil from tar sands in Canada and deep offshore oil, becomes unprofitable if oil prices drop to the $60 to $65 level and stay there.
While the United States is mostly neutral on oil prices between about $75 and $100 (above $100, the damage to consumers exceeds the benefit to oil producers), the U.S. economy is damaged by prices below $75.
Low prices mean lots of bankruptcies. Marginal oil producers go bankrupt, and their debt weighs down the bond markets and the financial system. At the moment, about 15% of the outstanding junk bond debt (rated BB or below) is derived from the energy sector, a percentage that has doubled in recent years.
As Austrian economists put it, a prolonged period of low oil prices makes energy sector investments into “malinvestments” that must be liquidated, causing destruction in the overall economy.
Where in the World to Invest
For income investors, the implications are clear: We must pull our money out of investments such as energy production master limited partnerships (MLPs) that require high oil prices to do well.
“Midstream” MLPs involving pipelines should be closer to neutral on the oil price decline, since their profits are simply a “flow-through” from energy production. On the other hand, as I mentioned a few weeks ago, refinery MLPs benefit from lower oil prices and should be seriously considered – although their cash flows and incomes fluctuate wildly.
