GMO Q4 Letter To Investors:The Oil Shock
The International Active EAFE Strategy underperformed the MSCI EAFE index by 1.6 percentage points in the fourth quarter; the strategy fell 5.2% net of fees and the benchmark lost 3.6%. Country and stock selection were both negative. The strategy lagged its benchmark by 6.1 percentage points for 2014, returning -11.0%.
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GMO: Commentary On Oil
While the world hardly needs another opinion on the price of oil, we thought it important to address the situation with our clients. It is a commodity that is incomprehensibly complicated, with many market participants on both sides of supply and demand. The economic motives of these participants, while mostly rational, can often be influenced by geopolitics and national interest. And, the interaction of complex geology and the technology required for extraction make predicting the oil price an invariably futile exercise.
However, we do know that hydrocarbons have unique chemical and physical properties that make them very useful to human life and there is a limited supply stored in the earth’s geology. These two salient facts suggest that the price of oil should rise over the long term, unless or until new technologies are invented to provide the same chemical advantages of oil at similar cost.
The recent fall in the oil price has its roots in several factors, most of which have been understood by the markets for some time. First, recent technological developments in horizontal drilling and hydraulic fracturing techniques have allowed previously uneconomic shale oil accumulations to be produced, mostly in North America. Second, China’s economic expansion, which accounted for much of the demand growth in commodities over the last decade, has started to slow. Third, “operation taper” in the U.S. has slowed the supply growth of U.S. dollars, creating a deflationary effect on dollar based commodities. Increasing supply, decreasing demand, and fewer dollars relative to barrels should point to falling oil prices.
If the market understood the forces pulling oil prices down, it also had faith in OPEC to modulate the decline. For 15 years Saudi Arabia, and therefore OPEC, followed a price over volume strategy. They balanced the market when necessary by reducing supply in return for maintaining higher prices. As overall demand grew, largely as a result of China, the Saudis did not have to sacrifice much volume or market share to pursue this strategy. However, as China’s economy slowed, OPEC started to feel the competitive threat of shale oil. Also percolating was growing Saudi resentment toward the other members of OPEC who continued to finance opulent welfare states without having to bear much cost in balancing the market.
As a result, the Saudis have done a rational thing and pursued a strategy of maintaining market share. From the Saudi perspective, why should they cut production when they are the low-cost producer?
Our investment process tries to determine whether market expectations are exaggerated or biased relative to valuations. In the case of oil, our view is that the market is being reasonable. The price will eventually rise as investment in high-cost oil projects is cut. But, it will take time for the market to balance. The shale oil production in the United States has come from private companies, each of which will make independent decisions regarding which wells to drill and which to defer. It is hard to imagine that collectively they will be disciplined enough to cut production quickly. The lesson of natural gas in the U.S. is useful, since it went through the same supply growth, driven by shale wells, a few years before oil. At the time, natural gas prices plummeted, and despite significant reduction in gas well investment, overall production actually increased and prices remained low.
The one wild card in supply is, of course, OPEC. If a complete change in the Saudi’s policy leads them to target price over volume and announce production cuts, the oil price could rally with shocking speed and magnitude. In our view, this probability is low. Every communication from the Saudis suggests that they are taking the long view. They have clearly stated a willingness to suffer a few years of low prices if it makes the economics of the market balance, with them in their rightful place as the low-cost and high-market share producer.
We continue to see some value in energy stocks, particularly in Europe, but a lower-for-longer oil price has impaired the investment thesis for some of our holdings. As a result, we have sold our energy position down to neutral and have kept only the stocks with dividends that we believe are safe at current oil prices.
GMO: Country Selection And Market Update
Country selection was behind the benchmark by 1.3%. Our positioning in Europe subtracted from returns, particularly an overweight position in Italy, as the market underperformed MSCI EAFE in the quarter.
European markets continued to struggle in the fourth quarter. After the Russia/Ukraine crisis held investors back in the third quarter, the unexpected announcement of elections in Greece and the collapse in oil prices drove sentiment further down in the fourth. Greece will hold elections on January 25 with the anti-bailout Syriza party expected to win the majority. Unfortunately, the ECB’s much anticipated Asset Quality Review (AQR) for European banks didn’t inspire enough confidence to make up for a half-hearted recovery in Europe and continued macroeconomic upsets. For the first time in five years, Europe recorded falling prices, raising the possibility of Japanese-style deflation. On the positive side, ECB president Mario Draghi gave his clearest indication yet of his intention to undertake quantitative easing.
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