Market Comments for the period ending December 13, 2014.
Given the sudden spike in financial market volatility caused by the 44% drop in the price of crude oil over the past six months, we wanted to offer some perspective on the topic.
The chart below depicts the spot price of West Texas Intermediate Crude Oil (“WTI”) over the past decade. In the summer of 2008, the spot price closed near $150 per barrel. Then, as is now true, the story was based on conventional beliefs about the global macro-economic environment and the fundamentals of supply and demand for oil.
In the spring and summer of 2008, speculators were extrapolating the seemingly insatiable demand for crude oil coming from emerging markets (primarily China) with the belief the world had reached its peak oil production capacity, thus concluding the price of oil could only head higher.
Today, the story has come full circle. On Friday, the spot price of WTI crude closed at $63.13. Now the story is that demand from emerging markets (particularly China) is very weak and not likely to recover anytime soon, while the world is awash in crude supply thanks to the U.S. energy revival driven by the technology advancements of fracking and horizontal drilling.
As we learned in 2008, we should be careful to not extrapolate a trend infinitely into the future. That is an essential lesson of long-term investment success. But we do keep in mind that oil, as with many other commodities, is an inefficient market that tends to overshoot on the upside as well as the downside.
Remarkably, however, for this commodity the story remains the same – $80 is the clearing price of crude oil that makes the industry work and offers the petroleum necessary to keep the global economy moving. Indeed, looking at the chart above, the red line shows the $80 level as a center price point. In the early 2000s, it provided resistance while in the most recent past it has provided support.
Investors in recent weeks have extended what was largely an oil industry issue to the broader economic backdrop. In the short run, the drop in the price of oil has provided a direct stimulus to U.S. consumers. Over the past two months, data have clearly indicated an uptick in discretionary spending with the added disposable income.
However, the concern has now shifted to what the soft demand is indicating. While it is hard to identify a particular catalyst that would raise demand, the forces of economics will eventually provide the correction. The only question is when.
History has taught us it is a common mistake to look at current conditions and assume they will continue indefinitely, but not everyone heeds the lesson. As such, there are opportunities presented to the long-term investor in times like this to benefit from others’ mistakes.
Based on our review of expert commentary and research into the global supply-demand dynamics of the oil and gas industry, we believe the real issue is not demand that is too soft but rather over-abundant supply conditions. Indeed, the dramatic decline in oil prices can stimulate global demand. Yes, the near-term might be painful for marginal and highly leveraged producers in the energy industry but the motivation to merge or rationalize production will once again lead to price equilibrium.
Will the recovery in the price of oil and the energy sector in general happen quickly? Probably not. But many countries and industries outside of those heavily dependent on the price of oil will benefit, which may lead to lower inflationary pressures, stronger economic growth and rising household income in many parts of the world similar to what occurred when oil prices fell in 1986 and 1998. This could turn out to be the upside surprise many are presently ignoring heading into 2015.
We have always been contrarian investors looking for the out-of-favor opportunities. At times we can be early, but our patience has proven to pay off over time more often than not. We are looking at consolidating into the holdings we have the strongest belief in while also looking to add other positions that are now attractively priced due to the volatility.
Although we acknowledge that a continued drop in oil prices can lead to short-term global economic disruptions (recall the 1998 Russian ruble default and the subsequent global implications) and lead other regions into recession, we do not accept this as the inevitable ending. Outside of the energy sector, the benefits of lower-priced oil outweigh the costs and that gives us reason for hope.
Jack E. Payne, CFA, CFP
Partner & Chief Investment Officer