Energy

The Black Gold Rush

     

With the price of WTI Crude Oil hovering at $49.90 a barrel, the market appears to be shaking off a tumultuous few years in the energy sector. Marked by substantially higher volatility and seemingly endless price declines, the oil markets monopolized the attention of investors as each tick was thought to signal recession one day and predict economic prosperity the next. While this cycle certainly resulted in a wild ride, it also serves as an excellent case study revealing the complexities involved in the seemingly simple concept of supply and demand within the oil markets.

To fully understand the origins of the recent oil supply glut, we must revisit the subprime mortgage crisis. By the end of December of 2008, WTI oil prices bottomed out at $31.41* a barrel as the world’s credit markets seized and stock prices plummeted. Sensing that a major intervention was necessary to salvage the U.S. economy, the Emergency Economic Stabilization Act of 2008 was signed into law by George W. Bush which infused $700 billion into the financial system. This stimulus package helped to stabilize the markets and started the slow but steady path to a recovery. As a result, by the middle of 2009 the stock market began to regain its footing and progressively started to reclaim losses.

 

A gradual recovery

As investor optimism increased, the price of oil proceeded to rise. By the end of 2010, oil prices had gradually see-sawed to $91 a barrel. In 2011, political unrest affecting Middle East countries including Egypt, Libya, and Yemen culminated in the “Arab Spring” which pushed prices even higher to $114.

From 2011 to 2014, geopolitical tensions continued to affect the energy sector. Especially influential were the conflicts in Iraq and Libya, as well as the tensions between Iran and the U.S. and its allies surrounding sanctions relating to their nuclear program. As a result, oil prices remained elevated and by January of 2014 the price for WTI crude was $98 a barrel. It was at this time, however, that oil production around the world exceeded demand. Consequently, inventories grew and word began to spread throughout the markets of a possible supply glut.

In response to this imbalance, major OPEC producers were expected to do as they had done in the past and reduce production to normalize prices. However, in a bid to force other producers out of business, Saudi Arabia instead opted for a price war. According to a Financial Times article published in July of 2015, “Riyadh self-reported crude oil production of 10.6m barrels a day in June, an increase of more than 200,000 b/d on the previous month and its highest level since records began.“

While this would appear to be an illogical economic misstep, the Saudis knew that they had to contend with a new factor in the energy market: U.S. shale oil.

 

American energy independence

In response to rising prices, American oil companies had begun to investigate more complex, expensive, and involved methods of oil extraction. Although these methods were once considered to be unprofitable, as prices rose they provided a viable means of production as improved technology allowed for more cost-effective and efficient oil extraction. Two of these methods were hydraulic fracturing and horizontal drilling.

Fracking and horizontal drilling contributed to a near doubling of U.S. oil production from 2010 to 2014. Likewise, an increase in Canadian oil sands production increased from 3.3 million barrels a day to 4.2 million in 2014, an increase of 27%. Furthermore, sanctions on Iran were lifted in an agreement that was reached on July 14, 2015, which allowed Iran to introduce its oil to new trading partners within the world markets and placed additional downward pressure on prices.

 

Battle of the oil giants

By the end of 2015, the oil market became a game of survival of the cheapest, where the producers with the lowest costs for oil extraction, particularly Middle Eastern countries, tried to force the higher cost producers out of the market. This move did not, however, result in the retreat that the Saudis had hoped for as non-OPEC countries proved to be more steadfast than they had anticipated. While U.S.-based oil companies faced immense pressure on earnings and balance sheets through write-downs, dividend cuts, layoffs, and rig closures, many of their more profitable rigs continued to pump in anticipation of higher prices down the road.

In January of 2016, however, there were finally signs of a possible turnaround. The Saudis released a statement indicating that the country was considering the sale of shares of Saudi Aramco, its state-owned oil company, in the largest proposed IPO in history. At a potential $2 trillion valuation, this was largely seen as a sign that the country was in dire need of additional funds. Additionally, it served as an indication that Saudi Arabia was ready to establish stability in the oil markets.

Furthermore, recent forest fires in Canada have reduced oil sands production by approximately 1 million barrels per day. In addition, weekly U.S. oil production fell from 9.6 million barrels in June of 2015 to 8.7 million as of the week starting May 20, 2016, a decline of 9.4%. Overall, U.S. inventories have fallen by 4.2 million barrels to 537.1 million barrels. Internationally, OPEC and Russia are said to be in talks to cooperate in reducing oil production, which has helped oil prices to recover to their current levels of approximately $49.

 

An intermission

We welcome the return to more normal oil price levels as it suggests that 1) the global economy is doing a bit better and 2) supply and demand are beginning to re-balance in the oil market. But the new found relative calm in the energy sector shouldn’t necessarily be taken as an all-clear signal. Volatility will likely continue. And the battle between US energy independence and Saudi market share isn’t over.

One of the main lessons of this saga is the importance of diversification in any investment portfolio. Spreading investment capital around different sectors of the stock market has allowed us to avoid a good deal of damage done by an energy sector that is down 24% over the last two years. Keeping energy investments to a relatively modest portion of our investment strategies helped control risk. And it allowed us to circle the wagons around a few high-quality energy stocks we believe will perform well over the long term.

Another lesson is that commodity price movements can be very difficult to predict. Yes, over the long-term, prices tend to move with fundamental factors like supply and demand. But even the largest, most successful oil companies and investors in the world were surprised by the recent price drop from $108/barrel to just $26/barrel. In the short run, predicting commodity prices is all the more fraught with rumors, speculators, headlines and day-to-day changes in market sentiment. Most of it is noise. So in the near-term we remain cautious and quality-oriented when it comes to energy investments. But longer-term, we are encouraged to see that oil supply & demand are finally in the process of re-balancing.   

 

Historical oil prices mentioned in this article reflect the WTI Cushing Crude Oil Spot Price obtained from Bloomberg for each respective valuation date.


*The foregoing content reflects the author's personal opinions which may not coincide with the opinions of the firm, and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that these statements, opinions, or forecasts provided herein will prove to be correct. Past performance is not a guarantee of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. All investing involves risk. Asset allocation and diversification does not ensure a profit or protect against a loss. Finally, please understand that–as with other social media–if you leave a comment, it will be made public.

Sailing Through November

 

Volatility has been the watchword for global markets this year. That goes whether you’re talking about emerging market’s economies or currencies, China’s or America’s stock markets, or global commodities prices. This year Canada slipped into a shallow recession and Brazil’s recession deepened. China’s Shanghai Composite Index surged 60% before crashing over 40%. Copper and oil have fallen over 20%. And our own stock market just completed its deepest correction since 2011. The VIX Index, which measures investor fear, temporarily spiked to four-year highs. Yes, volatility, which was mysteriously absent through 2012, 2013 and most of 2014, is back.

By now, we all know the list of risks & issues that caused the correction. Various signs of financial instability in China made us wonder if perhaps the world’s second-largest economy might be slowing more rapidly than expected. Certainly the government’s pathetic response to stock market chaos spoke of desperation. And falling commodities prices hinted at widespread global economic weakness.

Since the US has been in relatively better shape, the dollar has appreciated strongly against many foreign currencies. At the same time, our Federal Reserve is poised with its finger on the button to begin raising interest rates. And this expectation compounded the currency move and added to financial fragility in emerging markets.

Finally, Saudi Arabia’s strategy to limit US shale oil production growth has largely succeeded. Simply put, Saudi is one of the lowest cost producers in the world, and took advantage of the fact that supply was rising much faster than demand. As a result, corporate profits within the US energy production sector are more than 50% lower than year-ago levels. Many oil rigs have been idled and jobs eliminated.

Through the summer, the world looked like a more dangerous place for investors. And then at the beginning of October, everything turned around. And here we are, having just enjoyed the best month for US stocks in four years. What gives?

First, while global economic growth is clearly tepid, we’ve had some recent announcements regarding further monetary easing from central banks in both China and Europe, which are supportive of asset prices. This pattern of economic weakness followed by monetary stimulus is by now very familiar, with a strong positive impact on stocks. In addition, our Federal Reserve continues to be patient, preferring a stronger growth environment before raising rates.

Second, China’s financial markets have stabilized. That’s admittedly a small step toward normalization, but it’s worth pointing out that we are no longer reading headlines suggesting a full-blown financial crisis in China. And by the way, haven’t we known for some time that the Chinese economy is in secular decline as it transitions from export-led growth to consumer spending-driven growth? So it looks as though traders overreacted to China’s stock market correction.

Third, oil and the dollar have also stabilized, and this is critical to our stock market recovery. West Texas crude oil bottomed near the end of August at about $38/barrel but since then has kept a tight trading range of $44-50/barrel. To the extent oil remains over $40/barrel, it will be constructive for equities. At the same time, we’ve seen the dollar back off from its highs. Our currency appreciated at a very strong pace (about 25%) against a basket of foreign currencies from mid-2014 through March, but here again, it has fallen back into a trading range ever since.

One reason oil and the dollar are critical is that they have negatively impacted US corporate earnings. Corporate earnings grew about 8-9% last year, but have cratered due to lower oil prices and a stronger dollar. So second quarter earnings growth for S&P 500 companies came in at -2%, and third quarter growth is expected to be about -5%. The big picture for earnings isn’t all that encouraging.

But remember, it’s not red across the board. While energy and basic materials sectors are expected to post third quarter earnings growth of -20% to -60%, other sectors like consumer discretion, healthcare, telecom and utilities are expected to report positive growth. And even though the tech sector doesn’t look wonderful as a whole, look at the stellar earnings announcements by Intel, Alphabet (Google), Amazon, Facebook and Microsoft.

And there are some very positive factors here at home that could sustain the stock market rally. Household debt is down, the savings rate is up, and if you exclude gasoline stations, retail sales were up 4.9% year-over-year in September. Lower oil (and therefore lower gasoline) prices will benefit consumer spending as we move into the holiday shopping season. Also, the housing market is zipping along with 8% y/y growth in existing home sales, and 4-6% growth in home prices. Finally, the labor market—despite energy sector layoffs—is rather strong. Initial filings for unemployment insurance are down to 15 year lows and the unemployment rate is down to 5.1%. Anecdotally, we’re seeing more headlines about wage increases (like Wal-Mart), and we’re hearing CEOs complain about the difficulty of finding qualified employees. In our view, there’s not much slack left in the labor market.

Therefore, our view continues to be one of cautious optimism for the US economy and stock market. The positives continue to outweigh the negatives. We expect US GDP growth to remain in the 2.5% range next year, and that oil and interest rates will remain low for an extended period. We also believe this slow but steady environment opens up more opportunity at home than abroad. Of course volatility will remain the side-kick of investors as a by-product of slower economic growth. And investment success will depend on staying the course in spite of short term market fluctuations.  


*The foregoing content reflects the author's personal opinions which may not coincide with the opinions of the firm, and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that these statements, opinions, or forecasts provided herein will prove to be correct. Past performance is not a guarantee of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. All investing involves risk. Asset allocation and diversification does not ensure a profit or protect against a loss. Finally, please understand that–as with other social media–if you leave a comment, it will be made public.