Thursday, January 22, 2015

The Crude Collapse

Investors,

   The last 6 months have seen a collapse in commodity prices (particularly crude oil), a strengthening dollar (and collapsing Yen), and generally flat equity prices with rising volatility.  In this commentary I'll focus on crude and then discuss the big picture.

Crude Oil   
  Oil's price has been falling primarily because US crude production has been skyrocketing, for fundamental and sustainable reasons.  New technologies developed over the last 15 years have increased US crude oil production from 5 million barrels per day in 2008 to 9 million barrels per day currently, and likely over 10 million per day within a year.  The US is now the world's largest energy producer, and that appears unlikely to change any time soon.  There has been a huge amount of new well drilling in the US over the last few years; while many of these projects will be unprofitable at current low prices, much of the cost is sunk and unrecoverable, so the companies will recover as much cash as they can by drilling.
  But none of that is new, so why did the price crash in the last 5 months?  There were a few timely triggers.  First is the abatement of geopolitical risk.  Turmoil in Iraq and Libya, as well as tensions with Russia and Iran have not substantially affected production.  The market was pricing in a substantial geopolitical risk premium to the price of crude, and much of this has now been removed.
  Second is global recessionary fears.  The global rate of growth has slowed and investors are pessimistic.  Weaker global growth means less demand for crude.
   Third is OPEC.  The market expected OPEC to cut production at their meeting at the end of November, and instead they held steady.  There is speculation that this was due to internal politics - that Saudi Arabia wanted to put pressure on Venezuela and Russia who more desperately need the higher oil revenues that come with higher prices.  Another hypothesis is that Saudi Arabia wanted prices to fall far enough to completely shut down research into alternatives and new exploration.  However, it may be that Saudi Arabia simply felt that cutting production wouldn't raise the price enough to justify the drop in their sales volume.
   Crude prices today are unsustainably low unless the world falls into a global depression.  The marginal cost of developing a barrel of crude at today's production levels is about $70 per barrel.  But...the glut of recently finished and nearly finished wells means that the price could stay depressed for at least a couple years while we work off the excess supply.  I think buying crude oil futures out 3 to 5 years forward is an attractive bet, but it's not a crazy mispricing by the market. 
   The market is still trying to decipher how oil related equities should be affected.  Many oil companies will go out of business, while others are probably trading at excessive discounts.  I don't have a sense if the sector as a whole is cheap or rich, and I lack the expertise in the sector to try to identify the winners and the losers.  Some smart stock pickers will make a lot of money in this sector over the next couple years though.  There are also lots of interesting and hard to calculate second order effects.  For example, the Canadian banking sector will be hit hard by the drop in investment banking activity that was previously supported by tar sands projects.  
   While cheaper energy is unambiguously a major boon to GDP growth, its effect on markets is more subtle.  Energy is over-represented in US equity and debt markets relative to its role in the economy, because the energy sector is mostly composed of large and publicly listed companies.  So while the economy as a whole will benefit from cheaper energy, specific equity and debt markets may not because the companies in that particular index will see their profits fall.  Below is a graph that shows the relative weight of energy in various indexes.  Those indexes with the largest percentage of energy have been hit the hardest by the crude price decline.  
  Thinking globally, countries that are large net importers of oil (like China, Japan, South Korea, and Germany), stand to benefit the most from the price drop.



Big Picture:
 Global interest rates remain near all-time historic lows and artificially suppressed.  Additionally, credit markets are pricing in almost no default risk.  Between these two factors, bonds are very unattractive investments today.  
  US equities are substantially overpriced, to the point that their expected real returns over the next 7 years are near zero.  Global developed market equity (Europe and Japan) are a little overpriced, and emerging market equity is about fair (which is very cheap in relation to the US).   
  The US unemployment rate is now at 5.6%.  While there's no magical number, 5% is often referred to as "full employment."  This suggests there is very little slack left in the labor market.  However, wage growth has been slow and we have not yet seen evidence of inflationary pressure.


Mea Culpa and Positioning: 
  In my last commentary 6 months ago, I suggested positioning for inflation and highlighted the rampant global money printing.  Instead of inflationary pressure, we've seen strong disinflationary or even deflationary pressures globally that may continue for the next 6 to 12 months.  My basic perspective is unchanged - the massive money printing will eventually create inflationary pressure, and we continue to see slack in the labor market shrinking. The market is pricing in very little risk of inflation, and very few people are worried about it.  That doesn't tell us whether it will happen or not, but it does suggest that at the first hint of inflation, we'll see an exaggerated response by the market since many participants will be caught out of position.  I continue to favor gold, silver, bitcoin, emerging market equity, short Yen, and commodity related exposure.  If crude oil falls any further, I will likely buy futures settling in 2020.  
  Wealth inequality is a hot button political topic, but it's also of critical interest to investors today.  One reason the Federal Reserve has been able to quadruple the money supply without triggering rampant inflation is because the newly printed money has ended up in the pockets of the very wealthy.  The very wealthy aren't spending the extra cash, rather they're investing it and bidding up equity, bond, and real estate prices.  If more of the newly minted cash finds its way to lower and middle class households, a much larger percentage will be spent on consummables and services, which will create upward pressure on prices and then wages.

Cheers,
Ari

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