Asset Management News or Noise: A Closer Look at the Oil Market Meltdown By Russ Cearley, Partner, Director of Portfolio Strategy In late November, the Organization of the Petroleum Exporting Countries (OPEC) decided to hold its oil production output steady at 30 million barrels per day. Heading into the meeting, some people believed that OPEC would cut production in light of the increase in U.S. domestic energy production and generally softening prices. When this did not happen, oil prices fell precipitously due to concerns about global oversupply. As of the writing of this post, oil prices have fallen back to 2009 levels, with both West Texas Intermediate and Brent Crude trading at $65 to $70 per barrel, down from $110 in June. As we mentioned last week, we believe this is a newsworthy development; it has the potential to be the biggest news story as we head into next year. Today, we will dive deeper into what the drop in oil prices means for the market. We will also try to identify areas of opportunity and associated risks that come from this shift. Lower-Priced Oil Is Broadly Positive for Most Economies When studying the implications of falling oil prices, the most important factor to consider is how much of the drop was driven by supply factors and how much by weaker demand factors. This shock appears to be mostly supply-driven, unlike 2009 s oil price shock, which was largely the result of slowing overall demand stemming from the global financial crisis. Why is this important? Consumers can react much more quickly to falling oil prices than producers. The net effect is that price drops should broadly benefit global growth. Using estimates by the International Monetary Fund, the current fall in prices of roughly 40% could result in as much as 1% to 2.6% in additional GDP growth by the end of 2016. According Should prices stay near current levels, the U.S. could spend approximately $180 billion less on oil in 2015 than it did in 2014. 1
to Strategas Research Partners, the benefits of lower energy prices are just now starting to be felt. Because the drop in prices was so quick, the weighted average cost of oil so far for 2014 is still flat, indicating that the benefit has not really yet begun to kick in. Should prices stay near current levels, the U.S. could spend approximately $180 billion less on oil in 2015 than it did in 2014. The benefit of lower oil prices will vary drastically by geographical region. The benefit would be felt, as expected, in traditional consumer, net energy importing regions (such as the U.S., Europe and Japan), but the economic benefit would be relatively broad based, with benefits extending to China and other broad-based emerging markets. Countries that rely heavily on oil exports for revenues (for example, Russia and Saudi Arabia) would feel the biggest negative economic impact. Commodity Bull Market in Late Stages While the drop in energy prices undoubtedly has positive implications economically and for end consumers, the impact on direct commodity and energy-related investments will be more uncertain. From 1998 to 2014, commodity prices broadly appreciated at approximately 10% per year, as measured by Ned Davis Research. There are a number of factors that seem to point to this current cycle reaching the later stages. The chart below from Ned Davis Research shows a slowing trend of price gains across commodities. 2
The implication is that commodity-related investments, which have been very profitable for investors over the last decade and a half, are unlikely to produce similar types of returns over the next cycle. This does not necessarily mean that there won t be opportunity to make money in these types of investments in the future. But it does mean that we will need to be more selective and likely underweight this portion of our portfolios all else equal. 3
Long-Term Pricing Rebound Much work has been done to determine the marginal cost of producing a barrel of oil. However, determining the marginal cost of oil is difficult because it varies so widely between geological areas. In theory, the prevailing market price should not sustain below that of the marginal cost, as eventually unprofitable ventures will cease, constricting supply and supporting prices. While both current and future expectations for oil prices have fallen, they have fallen much more precipitously in the spot market than in the futures market. BCA Research published the chart below, which shows that while the price of oil in the spot market has fallen from around $110 to $70, the price in the futures market (June 2017) has fallen only from $100 to $85. This market pricing indicates that the market is currently pricing in at least a partial rebound toward mid-$80s oil. 4
Implications for Countries, Companies and Consumers On balance, lower energy prices will benefit most countries, companies and consumers. The biggest headwinds will be felt by traditional oil producing countries and companies. Longer term, we would expect oil prices to stabilize, as indicated by futures market pricing. However, the U.S. energy revolution may have permanently lowered the cost of energy, indicating a potential lasting tail wind for many global consumers. What Is News or Noise? Like most of you, we are inundated with information on our phones, in our email inboxes and on the Internet. Clearly, the world doesn t need another investing blog to reprocess stale information or reformat the day s useless headlines. Thus, in our investment blog, News or Noise, we ve taken up the challenge of sorting through the infinite bits of background noise and seeking the few truly newsworthy nuggets of information. What are the stories today that are likely to be meaningful for investors in the future? A very small number of headlines are important, and of those, many are immediately processed by investors. Only a tiny fraction of all the new data is truly relevant and underappreciated. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by SignatureFD, LLC), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from SignatureFD, LLC. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. SignatureFD, LLC is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of the SignatureFD, LLC s current written disclosure statement discussing our advisory services and fees is available upon request. 5