Notes on oil

The oil market has grabbed the headlines for the last month and this week I made a presentation at the request of a client so I thought I would share a few notes on the blog.

We are in an example of the classic commodity boom and bust cycle. This cycle holds for commodities who’s production requires a substantial amount of investment to produce. So I am thinking more of things like oil, where there is a great deal of capital required to explore, produce and transport oil.

The boom and bust cycle is cartoonishly illustrated below. Something increases the demand and hence the price, new, less effect producers step in, the extra supply reduces the price but the reduction in price does not stimulate enough addition demand to take up all the capacity of the new producers and some of them go out of business. I don’t think I need to tell you where I think we are in the cycle.

commodboom

While many of us learned in economics that energy demand does not respond very much to price changes in the short run (I need to heat my house in the winter no matter the price) but it is less well appreciated that the demand side is not that sensitive to short term price changes either. This interesting paper by Soren Anderson and his colleagues shows that existing wells continue to pump in Texas despite price drops, though exploration drops.

I also think that the debt financing of smaller, less efficient producers has a role to play too. A producer who borrowed to drill a well is stuck making interest payments and is better off drilling at a loss than leaving the oil in the ground. So we will likely see wells which come to the end of their lives go unreplaced rather than massive amounts of new wells scrapped. We are seeing modest declines in rig counts already.

All this is getting around to me saying oil will probably not stay at $50 a barrel for long. Though I’m afraid I will need to leave “long” undefined.

The industry is not dramatically out of balance. The chart below shows the difference between supply and demand, as calculated by the International Energy Agency. The oil market is murky and these numbers could be off, but they suggest that only a modest decrease in supply or increase in demand will move the market closer to balance, eliding over the issue of high inventories.

oil.bal

Where might the price of oil settle? Well, sadly, I don’t know that either. And in the short run markets can overreact. In fact, given the recent high levels of volatility there would have fairly high expected returns to induce buyers to brave the risk (that is, the price must be low enough compared to fair value, even higher if no one knows what “fair value” is). Suggesting that more declines are possible.

However the chart below, (from the IMF Direct blog via an excellent post by James Hamilton on the subject) while complicated, is worth the effort. On the X axis we see millions of barrels per day, on the Y axes the breakeven range in terms of dollars per barrel. So, one way to think about it would be to say: demand has been between 90 and 95 million barrels per day for the last several years, and the break-even to get that production is someplace in the $60 – $80 / barrel range. For what its worth, that is consistent with the prices of crude oil futures for delivery two years hence.

oil-4

While good news for most Americans, the oil price drop is not an unalloyed boon, even setting aside the possibility that it signals a decrease in global demand. According to NYU’s Aswath Damodaran The listed companies in the US spent about $900B on capital expenditures in 2013.  (Note that this $900B represents a bit under half of all private, nonresidential fixed investment).  That is a large number, even for a $17T economy.

oil.pie

Were that share to fall by half and the power and utility share to increase by half that would imply an investment drag on the economy of about 0.6%. This should be more than made up by increase in consumptive power by households, especially poorer households with a higher propensity to spend. Nevertheless, it is worth bearing in mind that there effects going in both directions.

Don’t Panic

The recent stock sell-off certainly has our attention. Yesterday, October 14th, the S&P 500 closed about 6.6% off its high, set only a month ago. And writing before the opening of October 15th, it looks like another bad day. As always, there is a chance of a further stock market decline, but we think the risk reward proposition of the stock market is still favorable. Accordingly. we have not reduced our exposure to stocks yet, though we are monitoring the situation closely. Why might investors want to cut their positions and why hasn’t Astor?

The fundamental argument for panicking

The strongest fundamental argument for reducing equity exposure is the possibility of a renewed recession in Europe, perhaps leading to deflationary fears in the developed markets. Recent news in Germany in particular has been disappointing, and any growth in the periphery is coming off of a very low base. We started noting weakness in the Eurozone in July, with our latest update last month here. In the last few months, the ECB has raised and disappointed expectations for a dramatic non-traditional easing. A renewed recession Europe would reduce growth prospects in the US somewhat and may have an outsized impact on large cap stocks which generate a good deal of their profits outside the US.

The “fear itself” argument for panicking

Roosevelt said, “The only thing we have to fear is fear itself.” Similarly, the sell-off in stocks itself (and the rise in the VIX, part of the same phenomena) is its own reason to cut positions. While we do understand the inclination, and we think a sober, quantitative risk control framework is important, we are not so sure that just cutting stocks because they are going down in price is always the best method. In fact, if you stayed out of the stock market every month which started with a 5% of greater drawdown you would cut your compounded annual growth rate by half over the period of 1970 – 2014. You would have to be a fearful investor indeed to be able to sacrifice half your returns.

Note that not all of the decline in the price of risky assets (such as stocks and commodities) is bad news. The decline in the price of oil, if translated into its typical relationship to retail gasoline prices could translate to a $600 per family bonus. A little stimulus at just the right time.

The stronger argument for staying the course

At Astor, the current state of the US economy is the primary input into determining the optimal mix of stocks and bonds. As far as we can see today, the state of the US economy is strong. We see it in the strength of the labor market and the strong pipeline for manufacturing. If the economy begins to slide, we will adjust positions. It is possible the current stock market weakness foretells a recession, but in general using the stock market to predict recessions is a losing bet.

In addition to the real economy, we closely monitor the level of a much broader collection of indicators which measure financial stress. The well-known VIX is included in this mix, but so are several other measures. We collect these indicators into a daily index of financial stress. So far, this measure has not risen to the levels where evidence has suggested reducing exposure.

Our conclusion: Don’t Panic

Because of its association with outsized declines, it is uncomfortable to write in October that we expect today’s stock declines to be transitory, as a gut reaction says to head for the hills. Our research counsels a steady hand, however, and as long as the fundamentals do nott change, we will not either.