The Lessons Of Oil

Not many outside the investing business have heard of Howard Marks. He is a very successful money manager at Oaktree Capital with a reputation built mostly around distressed debt investing.  

He also writes very well and publishes Memos that I eagerly read.

His latest is on the fall in the price of oil and what lessons we can learn from it.

I highly recommend it to anyone who wants clear thinking on the subject.

If you don’t want to read it, here are some quick highlights:

“…what ‘everyone knows’ is usually unhelpful at best and wrong at worst.”

“Not only did the investing herd have the outlook for rates all wrong, but was uniformly inquiring about the wrong thing.”

“Asset prices are often set to allow for the risks people are aware of.  It’s the ones they haven’t thought of that can knock the market for a loop.”

“Forecasters usually stick too close to the current level, and on those rare occasions when they call for change, they often underestimate the potential magnitude.”

 “This is an example of how hard it can be to appropriately factor all of the relevant considerations into complex real-world analysis.”

“Most people easily grasp the immediate impact of developments, but few understand the ‘second-order’ consequences…as well as the third and fourth.”

“…it’s hard for most people to understand the self-correcting aspects of economic events.”

“If you think markets are logical and investors are objective and unemotional, you’re in for a lot of surprises.”

“A well-known quote from economist Rudiger Dornbusch goes as follows: ‘In economics things take longer to happen than you think they will, and then they happen faster than you thought they could.'”

“The key lesson here may be that cartels and other anti-market mechanisms can’t hold forever.”

“…it’s hard to analytically put a price on an asset that doesn’t produce income.” 


Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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The Lessons Of Oil

Plunging oil prices

The recent plunge in oil prices raises lots of questions.

If you haven’t noticed, the U.S. and world price for oil per barrel have plunged 35.2% and 38.2%, respectively, since June. If stock or bond markets were down by this amount, people would be freaking out.

Of course, plunging oil prices sounds like a good thing, right? That means lower costs for fuel at the pump, lower transportation costs with airlines, lower costs to ship goods by rail or truck, lower prices generally, etc.

But, a question should be raised in your mind: why are oil prices plunging? Trying to answer that question is what has many market observers scratching their heads.

Are oil price plunging because demand is dramatically lower? Oil prices frequently plunge going into recessions as demand dries up relative to supply that remains stable. China is certainly slowing down, and large economies like Europe and Brazil are clearly struggling. Slowing growth is, without doubt, part of the issue. Demand has also declined because high oil prices over the last decade have led to reduced consumption and greater use of alternative sources of energy, like solar and wind. That, too, may be playing a part.

Are oil prices plunging because supply is outstripping demand? Shale oil in the U.S. (predominantly) is bringing huge new supplies of oil into the market. High oil prices over the last decade have made it very profitable to find and produce oil. This has made once unprofitable oil in places like the Canadian oil sands and deep sea drilling profitable. Additional supply is definitely playing a part in oil’s recent plunge.

But, why has the plunge occurred over the last 5 1/2 months and not before. Declining demand from China, Europe and Brazil did not become hot news over the last 6 months, nor did the increasing supply coming from shale oil, oil sands or deep sea drilling. What, then, has changed?

And this brings us to geopolitics. The price of oil is not set in a truly free market. The OPEC cartel has long been the marginal producer of oil, and Saudi Arabia in particular can usually produce oil to set prices where they want. For the last decade or so, Saudi Arabia and OPEC have been happy with oil prices of around $90 a barrel, and they have been quite open in stating that fact.

Recently, however, the Saudis have said they think oil could stabilize at $60 a barrel. Now, we have the real culprit. Why do the Saudis want oil prices to be 33% lower than previously? And, here comes the speculative part of my article. 

Some observers think that the Saudis have all of a sudden decided to make shale oil and other high cost competition unprofitable. This explanation scores high on the international conspiracy front, but would seem strange given the fact that such high cost competition has been quite obvious for some time. Perhaps it took that long for consensus to build within Saudi Arabia?

Other observers have noted that Russia’s move into the Ukraine might be the cause. In this interpretation, the Saudis are doing the west’s bidding by increasing supply to put the screws to Russia. It has been said that Russia needs $110 a barrel oil to pay for all its government programs. With that, such an interpretation makes sense although it strains credulity to think that Saudi Arabia would do the west’s bidding, especially considering that it is also said that Saudi Arabia needs $90 a barrel oil to fund its own government programs. Also, the crisis in the Ukraine and Crimea with Russia started right after the Sochi Olympics ended–last February. Why would the Saudis wait four months to put Russia under pressure. Consensus building and political wrangling from the west?

Something that did happen last summer as opposed to over the last decade or last February is the rise of the rise of the Islamic State of Iraq and the Levant (ISIL). In fact, in late June, ISIL proclaimed a worldwide caliphate. Around the same time, ISIL took Mosul and threatened to march on Baghdad. The Saudi government lives in fear of an uprising close to or inside their borders because they are themselves a religious totalitarian state. Perhaps the Saudi fear of ISIL or organizations similar to ISIL is what is leading the Saudis to suddenly be comfortable with $60 per barrel oil. Keep in mind that ISIL is funding its uprising with oil it is grabbing and selling on the black market. Making that oil less profitable or unprofitable would clearly put the screws to ISIL and similar followers.

What has caused oil prices to plunge over the last 5 1/2 months? It’s probably a combination of the things I raised above: lower demand, higher supply and geopolitics (shale oil boom competition with OPEC, Russia, ISIL). The question now becomes: what happens going forward? How long will the Saudis keep oil prices low? Will that dampen supply and lead to a price spike when the Saudis do let up? How will the rest of the economy or world governments react to lower oil prices? How will that impact the economy as things eventually return to normal?

I don’t have answers to those questions, but they will definitely impact world markets and economies over the next several months and years.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Plunging oil prices

Two areas of concern for markets…

When everyone is bullish about the economy and markets (including yours truly), it’s time to look at page 16 news. 

Page 16 news is important, but doesn’t seem important enough–yet–to make it to the front page of the newspaper.  By the time a piece of news hits the front page, it’s already priced into markets.  One should look at page 16 news to know what hasn’t been priced into markets (hat tip to Donald Coxe).

What important news is on page 16 and should be on page 1?  1) Long term bond prices have been dropping hard and 2) oil prices are steadily rising to high levels.

Despite the Fed’s efforts to drive short and intermediate term interest rates lower, long term rates have been rising (yields rise when bond prices fall).  This is important because long rates reflect the market’s assessment of inflation, and because long rates impact meaningful borrowing rates, like mortgages.

The yield on 10 year Treasury bonds have gone from 2.4% to 3.5% over the last 4 months.  That’s a roughly 9% decline in the price of a 10 year bond.  During this same time, the stock market has rallied almost 20%.  As I’ve said in this space before, bond and stock prices should not be moving in opposite directions over the long run.

(Geek’s note: stock prices reflect cash flows discounted over time.  I’m willing to pay $0.91 for $1 of earnings a year from now if I want a 10% return.  That 10% desired return is the discount rate and the $1 I get a year from now is the cash flow.)

Stock prices should reflect long term bond yields.  All things being equal, when long term bond yields rise from 2.4% to 3.5%, this higher discount rate should drive down the price of stocks by over 30%!  Now, as you may have guessed, all things are never equal.

Some believe stock prices are rising and bond prices are tanking because investors are more optimistic about the economy.  I disagree with this position.  Long bond yields rise because of inflation, and inflation is bad for stocks.  Bonds and stocks tanked in the 1970’s as inflation fears rose, and rallied strongly in the 1980’s and 1990’s as inflation fears shrank to nothingness. 

Bond prices do rise and stocks tank when deflation is the fear, as has been the case during the last decade.  But, bond prices tanking and stocks flying because investors are optimistic about the economy?  I can’t think of any historical examples to support that.

Keep in mind, too, that long bond yields also impact mortgage rates.  If long bond yields are going up, so are 30 year mortgage rates.  How exactly is giving an already disastrous housing market an additional headwind of higher priced mortgages supposed to be good for stocks and the economy?  I can’t think of a good reason.

The spike in bond yields may be a temporary phenomenon, and that is my guess about what’s happening.  If bond yields come back down below 3%, that would seem to give the all-clear signal for stocks (at least, for a while).

The other page 16 news is oil prices hovering around $90 a barrel.  The last time this happened, in late 2007 and early 2008, the U.S. economy was entering recession. 

Higher oil prices lead people to consume less.  It tends to act as a natural governor on the economy–when energy prices spike, it tends to slow the economy.  Oil prices impact heating costs, travel costs, grocery costs, pretty much everything.  And, if you have to pay more for those things, you don’t have money left over to buy that new electronic gadget you’ve had your eye on.

Just as long bond yields declining would give the all-clear signal for stocks, so would be declining oil prices (below $80 a barrel). 

But, as long as long bond yields spike and oil prices keep rising, bad news is brewing for the stock market and economy. 

I don’t have any illusions that I can predict such events, but I will be watching with great interest to see what happens.  If long bond yields and oil prices hit the front page, it’ll be too late to do anything but cry in your beer.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Two areas of concern for markets…

Who has oil and natural gas?

A fascinating editorial in Forbes magazine recently (April 16, 2007, Steve Forbes) pointed out an amazing fact: 95% of oil and natural gas reserves are controlled by government owned oil companies versus only 5% for international oil companies.

I find this interesting for a couple of reasons.

First, I think it points out how ridiculous it is to blame big oil companies for oil and gas prices. If international oil companies like ExxonMobil, BP and Chevron only control 5% of oil and gas reserves, it’s simply not possible for them to control energy prices. All they can really control is their costs of production, and they should be judged by that criteria.

Second, I think it brings up an interesting question about where oil and gas prices will go over the long term.

If you believe that government owned oil companies will do an efficient job of finding, producing and bringing to market oil and natural gas, then such energy prices should be headed down.

If you believe the government controlled oil companies of Saudi Arabia, Iran, Qatar, the United Arab Emirates (UAE), Iraq, Russia, Kuwait, Venezuela, Nigeria, Libya, Algeria, Malaysia, Mexico, China, Brazil, and India will do an inefficient job of keeping supplies up with demand, then you should expect oil and natural gas prices to head up over time.

Please keep in mind that not every country has an equal vote. Saudi Arabia and Iran have close to twice the reserves as #3, Qatar. And, Quatar, UAE, Iraq, Russia, Kuwait and Venezuela have about twice as much as #9, Nigeria. (ExxonMobil, #14, has only about 1/3 as much as Nigeria)

I’m over-simplifying things a bit, but in general, the performance of investments in oil and gas companies will hinge on the market price of the commodities they produce. If exploration and production can stay ahead of demand, prices will go down. If it can’t, then prices will go up. And, judging by the low price to earnings multiples of many oil and natural gas companies, I’d say the market is guessing the government oil companies will keep up. I’m not so sure.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.