“Then one day he was shootin at some food and up from the ground came a bubblin crude. Oil that is….black gold…..Texas tea” — from the theme to the “Beverly Hillbillies” television show.
Dear Clients and Friends,
Oil vey! We are all aware by now, that the velocity of the oil price decline has been fierce – down 48% from the July highs — and has been the source of the flu-like symptoms that nearly every investor has experienced over the last several months. Any and all oil related investments in a portfolio have been bottomless “black holes” and have contributed to damaged overall performance for 2014. How much of the problem is excess supply (from the U.S.) and how much of it is due to weaker global demand (mainly from Europe which is on the cusp of its third recession in six years), nobody really knows at this point but suffice it to say that the uncertainty over “why” is wreaking havoc with the global markets. Recently, it appears that Russia’s economy is finally beginning to suffer under the weight of lower oil prices and increased sanctions. The Ruble has cratered in value and short-term interest rates have risen to 17% as they try to prevent money from fleeing the country. This is not the same and dangerous problem as the 1998 Russian currency crisis that led to the collapse of Long Term Capital, but global capital markets nonetheless are worried that the Russian Bear’s troubles will spread default risk to other weaker oil dependent economies such as Brazil, Venezuela and Mexico. Although a bit hard to wrap your head around, this is the kind of thinking that flows from the panicked environment of declining oil prices.
As I alluded to above, there is a tremendous amount of negative sentiment towards oil right now and the resulting panic has created a perfect storm that has manifested itself in prices for energy stocks and MLP’s that we have not seen since the Great Recession of 2008. In 2009 the price of oil fell to $40 per barrel but at that time the U.S. and global economies were in a free fall and oil consumption was also falling. The factors that drove oil to collapse in 2009 like bank failures, financial system imploding, home prices collapsing, massive layoffs and other negatives, just don’t exist today. The global economy is not in a current state that would support on a prolonged basis, dramatically lower oil prices. Investors and newly created oil “experts” are making too much of the oil price decline by trying to connect the dots that are not there (i.e.: Saudi Arabia’s intention to drive marginal U.S. shale producers out of business or a rumored secret agreement between Saudi Arabia and U.S. to bankrupt Russia and ISIS with low oil prices). For legitimate reasons we (the U.S.) along with other OPEC nations are simply producing more oil than there is current demand. In addition a strong dollar, aggressive speculators and the ensuing panic has swiftly and disconcertingly driven the current price of oil to a level that has distorted and exaggerated the true supply/demand imbalance. I have included with permission, an article from our friend Brian Westbury at First Trust Economics and as Brian usually does, he clearly states that the fall in oil prices is due to macro-economic forces…..the same macro-economic forces that will lead to higher prices in 2015. It is worth the read.
Oil Price: Looks Reasonable
Brian S. Wesbury, Chief Economist
Robert Stein, Deputy Chief Economist
A former economic colleague, and mentor, used to say: “In the Bible, it says an ounce of gold will buy a fine suit of clothing.” We have read the Bible, and we haven’t found this, although there could be some high-powered math, using talents, cubits, frankincense and myrrh that make it true.
Nonetheless, the point stands – over long periods of time, relative value remains somewhat constant. Gold is trading at $1,210/oz. today and that’s about the cost of a fine suit. There are suits that cost more, and less, but, well, you get the point.
The reason we bring this up, is that the same “relative price relationship” should hold true for other commodities over time. The gold-oil ratio (using West Texas Intermediate crude prices) has averaged 15.8 over the past 30 years – meaning one ounce of gold would buy 15.8 barrels of oil.
In 2005, the ratio reached a low of 6.7; in 1986, it hit a high of 30.1. From 1990-1999 oil prices averaged $19.70/bbl and gold prices averaged $351/oz – a ratio of 17.8. Today, oil is $57/bbl and gold is $1,210/oz., meaning an ounce of gold will buy 21.2 barrels of oil.
In other words, relative to history, either oil is cheap or gold is expensive. Looking at other commodity price relationships, like silver, shows the same thing. One interesting fact is that in the past 30 years, the CPI is up 126%, while oil is up 116%, showing that, right now, with oil prices down almost $50 from their recent peak, oil has risen about the same as a broad basket of consumer goods.
This doesn’t mean that oil prices can’t fall further. After all, markets do what markets do. What it does mean is that the recent collapse in oil prices is not a sign of broad deflation. It is result of a shift in the “oil supply curve” to the right, due to new technologies in energy – horizontal drilling and hydraulic fracturing. Remember, the supply curve slopes upward from the lower left to the upper right. When a new technology increases supply at any price, like the invention of the tractor did with crops, the entire supply curve shifts. When this happens, output rises and prices fall, unless there is a shift in demand.
These days, two things are happening to keep a lid on demand. First, developing economies, like China and Russia are experiencing slower growth. Second, new technologies – like LED lighting, more efficient computer chips and less waste in office buildings, homes and manufacturing – are reducing energy consumption. For example, an iPad uses $1.36 of electricity every year, while a desktop computer uses $30 of electricity per year.
So, a right-ward shift in the supply curve is occurring at the same time demand is falling short of what was previously expected. In other words, the decline in oil prices is due to macro-economic forces, and those forces are mostly good, not bad. As a result, the drop in oil prices is a good sign, not one that indicates economic problems. The drop in stock prices last week, if it was based on the idea that falling oil prices are a negative thing, is temporary.
More importantly, most relative price indicators suggest the oil price decline has gone too far. Using the current price of gold, a barrel of oil is fairly valued near $77. Alternatively, comparing oil to multiple different prices, including a fine suit of clothing, oil is fairly valued somewhere between $55 and $70/bbl.
Bottom line: stocks and oil have fallen too much. Stocks should rebound soon and, barring a collapse in gold, we look for stability and then rising prices for oil in the years ahead.
Bringing it back to the U.S. economy, trends are improving and while lower oil prices could affect the job market to some degree (the oil industry has accounted for about 5,000 jobs per month, year to date), they are a net positive for the consumer and companies that use oil and gas as an input cost. The U.S. Energy Information Agency (EIA) estimates that U.S. households will spend $550 less on gasoline in 2015, the lowest amount in years which is a positive for the consumer, restaurants, retailers, airlines, trucking, rail, logistics, chemical, travel and hospitality. For the energy industry falling prices are the biggest problem for the exploration and production companies known as the “upstream” suppliers. However, as you go further from the source, there are energy companies that are not as adversely impacted. The “midstream” or pipeline companies and the “downstream” refiners are now “attractively” priced so at Cascade Investment Group, we have been reducing our upstream exposure and increasing our weighting in the mid and downstream companies where the dividends are safe and earnings growth is more visible. It goes without saying that the story for 2014 will be the “pretty much out of the blue” swift collapse of oil prices. Managing around this unforeseen event has made this year a bit of a challenge but we think we have portfolios positioned appropriately for 2015. Oil prices will rebound and the economy should continue to grow near 3% with cheaper energy acting as a tailwind both here and in Europe.
Since this will be our last posting before the end of the year, on behalf of all of us at Cascade Investment Group, we wish you a happy and robust holiday season with friends and family. Thank you for your continued trust and confidence in our work, we are truly grateful to you our clients.
P.S. — In 1985 (I was working in Denver at the time and I remember this), oil prices crashed by 70% as the Saudis, like today, continued producing oil while the price declined. The following year…..the S&P 500 rallied by 40%
P.S. – Toyota recently said that November sales of the 4Runner sport utility vehicle jumped by 53% and sales of the Prius fell by 14%
P.S. – According to Bloomberg, energy company insiders are buying shares at a pace not seen since 2012.
Sources: Real Money Pro, Seeking Alpha, First Trust and 361 Capital.