Absolute Return letter for February 2015 titled, “The End Game.”
“Pessimism sells. For reasons I have never understood, people like to hear that the world is going to hell, and become huffy and scornful when some idiotic optimist intrudes on their pleasure.” – Professor Deirdre McCloskey
Absolute Return: The end of cheap oil
In large parts of the financial community there is a strongly held belief that the problems which caused the credit crisis back in 2008-09 have never been properly addressed, causing many to suspect that it is only a matter of time before the ‘end game’ is upon us – the credit crisis Mk. II so to speak. I will in the following pages look at various ways the end game might unfold but, before I do so, I shall return to one of the subjects I discussed in the January letter – the end of cheap oil – which caused a flurry of comments and questions.
So let’s begin with an update on oil. If you don’t really care to hear more about it, you can go straight to page 3, where my thoughts on a possible end game begin. Let me start with a quote from last month’s Absolute Return Letter, which you can find here. I wrote:
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“All I know is that the price of oil won’t stay below the production cost for a long period of time (as in years). Hence I think we will see the oil price at $100 again, and it won’t take many years, but it could be an extraordinarily bumpy ride.”
Based on the number of comments I received, that statement requires some explanation. First the number itself. I obviously don’t know if the price of oil will rise to $100, a little bit more or a little bit less, or over what time period. I am, however, a self-confessed numbers junkie, and want to put numbers on absolutely everything. Please do not take numbers like that too literally. Up it will go, though (I think).
Anatole Kaletsky, who is a brilliant thinker and writer, wrote an interesting piece in mid-January which you can find here. Anatole’s key argument is (and I agree) that, in a truly competitive market, the price should equal the marginal cost of production, which leads him to conclude that the current oil price of around $50 per barrel is a ceiling – not a floor. I happen to disagree with Anatole that the world is capable of delivering meaningful amounts of oil around $50.
Let me elaborate. When it comes to drilling, there are two types of costs. There is the cash cost, i.e. the cost it takes to extract oil from an already existing well, and there is the all-in production cost, which would include the cost of establishing the well, depreciations, etc. The difference can be significant to put it mildly, and longer-term strategic decisions, such as opening new wells, will, in the vast majority of cases, be a function of the oil price relative to the all-in marginal production cost. That is certainly higher than $50, but that’s a story for another day.
It is not the easiest thing to calculate the exact size of these costs, as oil producing countries are not the most informative I have come across; however, Morgan Stanley has recently made a valiant effort (chart 1). As you can see, none of the newer techniques, such as horizontal drilling, Arctic drilling, Canadian tar sands and shale are cheap. And, as far as shale is concerned, the all-in production cost is particularly important, because fracking will cause the well to deplete very quickly, often within a couple of years.
It is therefore relatively safe to assume that, at current oil prices, the shale boom will fizzle out fairly quickly. The other possible outcome, which I subscribe to, is that the price of oil will rise until the true all-in marginal cost of production has been reached. What is not safe to assume is anything at all to do with technological improvements – particularly under times of stress – which can be very unpredictable, as time has shown. Fracking itself is probably the greatest example of this.
If I am ultimately proven wrong on the oil price, it could very well be because fracking (or a new technology we haven’t even heard of yet) has effectively put a lid on the oil price, although I think the lid will prove to be a fair bit higher than the $50 suggested by Anatole Kaletsky. Should OPEC ‘misbehave’ and drive up prices to ridiculous levels, shale producers will simply increase production. This is likely to create a price range that is narrower, and less volatile, than the one we have experienced since the two oil crises in the 1970s, which again will be good for economic activity as it eliminates an important risk factor.
The one additional dynamic to consider is the large fiscal deficits in most oil producing countries which is only made worse the further the price of oil drops. Clearly the biggest risk factor in this context is Russia which needs an oil price of around $105 to balance its budget this year (chart 2). One can only guess if this will in any way add to geo-political instability, but it is a fact that virtually none of the world’s leading oil producing countries have as easy access to bond markets as we are used to in this part of the world.
Absolute Return: The end game
And now to the main topic of this month’s Absolute Return Letter – the end game.
Large parts of the financial community have been on tenterhooks ever since 2008. Somehow, many feel that we have never really left the crisis environment. Central banks have, with QE, managed to ‘lower the temperature’; however, the patient is still sick, or so the argument goes.
I can understand, and have some sympathy for, that view. Having said that, in my eyes, ‘crisis’ is a temporary condition but, after a period of time, if the condition persists, it is no longer a crisis but becomes the norm. What do I mean by that?
Since the outbreak of the credit crisis, it has been customary to blame pretty much every problem on central bankers who have become the bogeymen of modern times, at least in some people’s eyes. Having said that, the critics have conveniently ignored a very important question. Could it be that the low economic growth most western countries are suffering from is due to something entirely different and has little to do with the credit crisis and/or the policies currently being pursued?
My answer to that question is a qualified ‘yes’, and long term readers of the Absolute Return Letter will already know what I suspect is the main reason – demographics. They have really turned against us in the last few years and won’t turn favourable until the mid-2020s at the earliest, so we’d better accept that low growth is going to be with us for another 10 years or so.
Adding to that, today’s central bankers have inherited a system that is to a large degree unmanageable. Europe was nowhere near ready for a currency union (at least not with that many participants), as the difference between north and south was, and still is, too great. What is an entirely appropriate policy for one part of Europe may be destructive for another part, but the diehards, who continue to blame central bankers for all misfortunes, should point their canons in a different direction.
The slightly more positive conclusion to draw from this observation is that the crisis many investors are waiting for may actually never happen. We are possibly already over the vast majority of the hurdles. We just haven’t figured it out yet.
See full PDF below.