Oil News: Saudis May Have Kickstarted Stocks' Volatility for 2015

By Markets Fool.com

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On Dec. 21, just as traders were gearing up for Christmas, Saudi oil minister Ali al-Naimi appeared to announce a seismic change in his country's -- and OPEC's -- policy regarding the price of oil, which has plummeted nearly 50% since June to multi-year lows (see the six-month chart for the Powershares DB Oil ETF , below). If accurate, the shift could have implications far beyond the oil market in 2015, including on the stock market. Considering that much of this year has been characterized by ultra-low volatility, with the CBOE Volatility Index averaging just 14.1 -- well below its long-term historical average of 20 -- equity investors could be in for a bumpier ride.

DBO Chart

DBO data by YCharts.

Here's what Mr. al-Naimi told the Middle East Economic Survey on Dec. 21:

As a policy for OPEC, and I convinced OPEC of this, even [OPEC Secretary General] Mr al-Badri is now convinced, it is not in the interest of OPEC producers to cut their production, whatever the price is... Whether it goes down to $20, $40, $50, $60, it is irrelevant.

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In other words, OPEC is now focused on protecting its market share rather than the price of oil per se -- as exemplified by last month's decision to maintain production at existing levels in the face of the price's decline. The expectation is that higher-cost producers -- including U.S. shale oil companies -- will be forced to scale back production, reducing the current oversupply and, ultimately, relieving some of the pressure on price (Saudi Arabia's marginal cost of production is just $10 per barrel).

Still, it's anyone's guess how long that process will take (although oil companies have begun to announce spending cuts); in the meantime, OPEC has just removed the floor on the price of oil. Traders and money managers are wrestling to understand all of the implications of this move.

In his latest memo, Howard Marks, who runs Oaktree Capital Management, quotes from his company's research comparing the current situation to an earlier episode in a different sector (take note -- Warren Buffett says Marks' memos are the first things he reads from his mail!):

An imperfect analogy might be instructive: capital market conditions for energy-related assets today are not unlike what we saw in the telecom sector in 2002. As in telecom, you've had the confluence of really cheap financing, innovative technology, and prices for the product that were quite stable for a good while. These conditions resulted in the creation of an oversupply of capacity in oil, leading to a downdraft. [To this list of contributing factors, I would add the not-uncommon myth of perpetually escalating demand for a product.]

We know how the ramp-up in telecom capacity ended (hint: not well!). As the Oaktree research concludes:

It's historically unprecedented for the energy sector to witness this type of market downturn while the rest of the economy is operating normally. Like in 2002, we could see a scenario where the effects of this sector dislocation spread wider in a general "contagion."

One means of contagion could be through the banks that have lent to oil companies (particularly smaller/ leveraged companies). Another potential area of concern: At around 15%, the energy sector represents the largest weighting in the junk bond market; oil's decline has already sent ripples through the market.

Finally, stock market volatility and oil price volatility are quite closely linked, as the following graph of the CBOE Volatility Index versus the CBOE Oil ETF Volatility Index shows (the correlation is 0.65):

Source: St. Louis Fed

[The VIX Index is a measure of the market's expectation for volatility of the S&P 500 Index over the coming 30 days.]

I've been writing for some time that investors need to avoid being lulled into complacency by the tranquil seas of ultra-low volatility, particularly as the Fed begins to phase out its accommodative, crisis-era measures. The unexpected drop in the price of oil combined with the shift in OPEC policy could be another factor that will fuel stock market volatility in 2015. Steeling oneself for that possibility will make it easier to endure instead of panic-selling during the first bout of excitement. In the meantime, genuine investors (as opposed to traders) can continue to focus on superior businesses with the aim of investing "through the cycle."

The article Oil News: Saudis May Have Kickstarted Stocks' Volatility for 2015 originally appeared on Fool.com.

Alex Dumortier, CFA, has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.