“My formula for success is rise early, work late, and strike oil.” – J. Paul Getty
Less than a year ago, the cost of a barrel of crude oil in the United States was over $100, where it had been hovering for more than two years. Now that same barrel can be bought for approximately $50. The implications of this collapse are enormous. As a consumer of 20 million barrels of oil per day, the U.S. now spends $1 billion less each day on that commodity, $365 billion over the course of a year. Some of those savings will help corporate profits, but much of it will allow individual consumers to spend more on their other needs and wants, such as food, clothing, or an iPhone 6.
What caused this precipitous drop in oil prices? More importantly, what will happen to oil prices going forward? As we wrote in our June 2012 Investment Strategy Update, Energy Independence – More Than Just a Pipe Dream?, energy producers in the U.S. have in fact “struck oil” with the development of technologies in horizontal drilling and hydro-fracking to coax oil out of heretofore unproducible shale formations. We believed that this increased production, along with successful ongoing conservation efforts, would ultimately lead to lower oil prices. However, we did not expect prices to move so far, so quickly. The resultant disruptions have impacted the stock market, and our goal with this update is to assess the reasons for the oil price collapse in order to understand the opportunities that may arise therefrom.
As with any product or service, prices drop when the quantity supplied exceeds the quantity demanded. In the current case, oversupply has been a function of excessive production rather than insufficient demand. In fact, worldwide demand for oil has continued to increase at a remarkably steady rate that has averaged approximately 1.2 million barrels per day each year. Looking back to 1995, daily global oil consumption was 68 million barrels. In 2014, it was more along the lines of 93 million barrels, and the only major variation in this nearly straight-line growth occurred as a result of the 2008/2009 financial crisis and global recession. Not surprisingly, most estimates peg 2015 demand at between 94 and 95 million barrels per day. Over the last three years, the U.S. (with a little help from Canada) has provided almost all of the worldwide production growth of more than three million barrels per day. This increase alone has absorbed almost all of the world’s incremental demand over that period.
However, last summer global demand began to wane, primarily due to economic softness in Europe and China. At the same time, the world’s producers continued to take advantage of $100 oil to drill aggressively. In many similar situations in the past, OPEC – or more particularly Saudi Arabia – cut its production to balance global supply with demand, thereby keeping prices high. This time the Saudis decided not to serve as the marginal, or swing, producer, which would have meant ceding market share to North American producers. So when the Kingdom announced in late November that it would not cut production, prices dropped still further and have yet to recover.
How Long Will This Go On?
The U.S. production renaissance has been so successful that it has threatened the long-term oil price, which Saudi Arabia’s government relies on to be high to continue funding its social spending. So part of the rationale for their stance not to cut production was to force shale producers to cut. In this they will be quite successful, but it won’t be until late 2015 or early 2016 when we will start to see an actual reduction in supply. That reduction is inevitable because there has been a quick and massive response by U.S. energy companies to low prices. Capital budgets for the major producers have been cut by 30 to 50% so far, with some of the weaker players slashing budgets by as much as 70%. The number of active drilling rigs in the U.S. has dropped from approximately 1900 to 1100 currently, with the expectation of a further drop to 900. Because one of the main characteristics of a fracked well is that the resulting production falls off very rapidly, even wells completed in 2014 will see major declines this year. Coupled with less new drilling, overall production will drop soon enough. Of course, decline curves differ around the world, but the same principle applies everywhere.
So if you are a producer, the situation looks pretty bleak at the moment. If you are a consumer, however, enjoy this magnificent gift while it lasts. But it won’t last, because one thing we know for certain is that the best cure for low oil prices is…low oil prices. Inevitably, lower oil prices will cause an increase in demand. Economists can argue how elastic that response will be, but we see some of the signs already. Consumers are buying more pickups and SUVs, to the obvious market-share detriment of smaller, more efficient vehicles. We would expect more driving vacations this summer as people take advantage of the low prices at the pump. These trends, along with the aforementioned decline in supply, will bring the market back into balance and prices will rise once again.
We also see headlines touting pundits’ predictions of $30 or even $20 oil, a surefire clue that we are closer to the low in oil prices than the high. However, real pricing is available from the collective wisdom of the market. Known as the “futures strip,” these are the prices at which one can actually go out today and buy or sell oil to be delivered in the future. As such, it matters much more than a single analyst’s opinion of what prices might do. The current price for a barrel of West Texas Intermediate crude oil is approximately $50, but if one wanted to buy that same barrel today to be delivered 12 months from now, the price is $58, and two years out it is $62 a barrel. So fill up early and often. Our longer term outlook is that we will not see $100 oil again for quite some time, but by next year we expect to see oil prices trade up into a new normal range of $60 to $80 a barrel
The investment implications of recovering oil prices are fairly straightforward, though the timing is not so clear. Energy stocks, of course, have significantly underperformed the overall market since last summer. Although there is a range of performance, with deepwater drillers and small, highly-levered exploration and production companies having the toughest time, no sub-sector has been spared. Even the pipelines and storage facilities, whose stock prices held up the longest, are meaningfully off their highs. As energy prices recover, the stocks of the various players will have a cyclical rebound, but we will need to be careful about maintaining reasonable oil price expectations. Even if we see $60 again this year, it will not be enough to return some companies to profitability.
There is another group of companies that have suffered since the decline in oil prices: those that sell products and services to the oil and gas extraction industries, whether engineering and construction companies or broadly diversified industrials that have one or more divisions exposed to energy. A recovery in oil prices should at the least improve sentiment on these stocks. Also, stocks tied to alternative sources of energy naturally move in accord with traditional energy stocks, so opportunities in this area could surface, as well.
So when, or more importantly, at what equity prices should one increase investment exposure to the energy and related sectors? While we believe that it makes sense to own some of these securities currently, it is also our belief that we will see the low in oil prices during the second quarter of 2015. Oil inventories in the United States are currently at 80-year highs, and the seasonal high point of inventories during the year is still in front of us, from late April to early May. Oil storage in the U.S. is getting tighter, and it wouldn’t surprise us to see localized situations in the next couple of months where there is no place for more oil to go economically, with the only reasonable option being to curtail production. It would be during such a transitional period that we would look for opportunities to increase our investment exposure.
Of course, lest we forget the broader economy in our focus on energy companies, energy consumers (i.e. practically every individual and business out there) have effectively been given a tax cut. Even if oil recovers to $70 or $80 longer term, the savings over where we were a few months ago would still be quite meaningful. Although the lost profits and lost jobs within the energy and related sectors are negative factors, the net effect of lower energy prices should be an overall positive for consumer spending, GDP, and ultimately, corporate profits.
The stock market continues to exhibit the increased volatility that seems to have defined it since the Federal Reserve ended the Quantitative Easing program in October. After a weak January, a very strong February, and a weak March, we haven’t seen much net progress since late last year. This see-saw behavior reflects uncertainty about our economic future. Stock market investors can’t get a clear read on the future operating environment and profit growth opportunities for U.S. companies. Yes, our economy is growing, but recent economic data releases have not made the case for a stronger expansion to replace the low-growth, low-inflation environment we’ve known for the past six years.
The Fed has been giving clear signals that it would like to raise short-term interest rates, if only to have the room to lower them again later, if circumstances dictate. The problem is with the global economy. The Europeans have only recently recognized the depth of their economic dysfunction and decided to go all-in on Quantitative Easing themselves, thereby triggering negative interest rates there for the first time. And now China has begun to ease more aggressively, as well. With the Fed clearly looking to move in the opposite direction, the U.S. dollar has soared. As a result, the most recent corporate earnings season was not up to expectations. However, many companies missed their targets or altered their outlooks only because of the strength in the dollar, and so far have been given a pass by the market. And when at its latest meeting the Fed governors reduced their year-end 2015 expectations for short-term rates, it became clear that their ability to raise rates does not match their desire. The aftermath of this announcement was a quick drop in interest rates and a resultant jump in stocks.
Our continuing belief is that bonds remain less attractive than stocks, though they are still valid investments serving two purposes. First, they do generate current cash flow, modest though it may be. Second, and perhaps more important, bonds should offset the risk of negative stock movements in a portfolio.
As for the stock market, we believe that we remain in the secular bull market that began in March of 2009. Stocks are no longer as cheap as they were then, but neither are they unreasonably expensive. With the uncertain global economic environment, the Fed may raise rates somewhat, but will likely default to staying accommodative for longer than many assume. And with few attractive alternatives, we expect investors to continue bidding up stocks over the next several years, perhaps eventually to the point of significant overvaluation. Short-term corrections, which can come at any time for any number of reasons, wouldn’t necessarily de-rail this. In fact, interim corrections tend to prolong the process as bullishness subsides and perceived value is temporarily restored. Our task is to walk the line between maintaining meaningful exposure to a stock market we expect to continue rising, while at the same time looking to reduce risk by trimming holdings with more expensive valuations.