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Cheap oil, good for consumers, is slamming stocks. Why?

The Permian Basin oil field in Andrews, Texas.
The Permian Basin oil field in Andrews, Texas.
Published Jan. 23, 2016

Stocks are having their worst start to a year in history in part because of a rapid plunge in the price of oil. The price of crude is down 28 percent this year, which in turn has dragged down energy company shares in the Standard & Poor's 500 index by 13 percent.

This is happening even though low oil prices are wonderful for consumers and many companies.

"It seems ironic that in the runup to the global financial crisis we were worried about oil prices being too high in 2007 and 2008. Now we're worried about them being too low," said Julian Jessop, head of commodities research at Capital Economics Ltd. in London.

Here's what experts think is going on.

Why is oil so low?

Because there is so much of it.

A long run of high oil prices inspired drillers to develop new techniques and to go to new places to find more oil, and they succeeded. In the United States, oil drilling technology known as fracking has added more oil to the global market than the total production of any other nation in OPEC, other than Saudi Arabia.

Producers in the United States and abroad haven't cut back production very much, despite the low prices, and now the lifting of international sanctions against Iran could send more oil flowing into markets that are already awash in crude.

U.S. stockpiles are at their highest level in at least 80 years, and the International Energy Agency predicts that during the first half of this year global oil supply could outstrip demand by 1.5 million barrels per day.

Why do low oil prices hurt the stock market?

Oil company profits are plummeting, so oil company shares are plummeting, and that is dragging down the whole market.

Analysts estimate that profit for all S&P 500 companies in total is on track to be down a recessionlike 5.8 percent for 2015. But if energy companies were removed from that figure, S&P 500 profits would be up a very healthy 5.7 percent for the full year.

That profit drop directly leads to lower share prices that drag down entire indexes. Two of the biggest oil companies in the world, Exxon and Chevron, are part of the 30-member Dow Jones Industrial Average. Of the 20 biggest share price losers in the S&P 500 this year, 13 are energy companies.

Aren't lower oil prices a good thing for the economy?

It depends on why prices are lower.

If they fall because new supplies have been found, it usually helps the broader economy, and markets held up fairly well during oil's big slide from more than $100 a barrel in 2014 to less than $50 a barrel last year.

"In the long run, lower oil prices should be positive or at worst neutral for the world economy because all they're really doing is transferring income from oil producers to oil consumers," Jessop said.

But this latest plunge in prices to less than $30 a barrel has investors worried that oil prices are falling because global growth is slowing, as businesses and consumers in many developing countries, particularly China, cut back on spending. Bruce Kasman, chief economist at JPMorgan Chase, said steep drops in oil prices have historically been a sign of a weakening global economy.

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Could this lead to broader turmoil, the way the subprime mortgage crisis did?

It is already having some ripple effects, but the energy market isn't nearly as big or far-reaching as the housing market.

When oil prices were high, lots of banks, including some of the biggest on Wall Street, made loans to energy companies to finance drilling in North Dakota, Texas and elsewhere. Dealogic estimates that the oil and gas industry has roughly $500 billion in outstanding debt. According to the Federal Reserve, there is $11 trillion in outstanding residential mortgage debt.

Still, some are feeling it. Oil company cash flow is slowing, and companies are finding it harder to repay their loans. Oil and gas company bankruptcies are rising, and the entire market for so-called junk bonds has been shaken as a result of energy company defaults.

Is there an oil price that would be good for the market and consumers?

Jessop thinks that a price of about $60 a barrel would do the trick. "High enough to keep the main producers in business but low enough to provide a real boost to the incomes of consumers," he said. He expects prices to return to that level by the end of next year as oil companies pare back exploration and the glut is worked off.