Special Report on Oil by Ben Strubel, Strubel Investment Management
The stock market has recently gone on its fourth sizable downturn this year (and before we had a chance to publish this article subsequently recovered most of the lost ground). This time the culprit seems to be some combination of falling oil prices and a collapse of the ruble and Russia’s economy.
We can safely ignore Russia as a source for global economic concern because the Russian economy is simply not large enough to take the world economy down with it. Using 2013 World Bank GDP figures Russia is only 2.8% of the world’s economy (by contrast the EU is 23%, the US 22%, and China 12%). Additionally Russia exports more than it imports so the Russian market is not a very large end source of demand for the rest of the world. In the event of a collapsing Russian economy the rest of the world would remain unscathed.
That basically leaves us with the title of this report, oil, as the source of the current market turmoil. The current thinking is that oil prices provide useful information about the health of the global economy. Demand for oil is viewed as a proxy for economic growth. High oil prices, in the view of many, mean that demand for oil is strong. Conversely falling prices must mean demand is weak and economic growth might be slowing.
Gates Capital Management's ECF Value Funds have a fantastic track record. The funds (full-name Excess Cash Flow Value Funds), which invest in an event-driven equity and credit strategy Read More
Unfortunately the price of oil is worthless as an economic indicator. Since 2000 when the Commodities Futures Modernization Act legalized essentially unlimited speculation in commodities markets using the prices of commodities as economic indicators ceased to be useful. (This is especially true for oil in which real world transactions are priced based on futures prices).
The following shows a chart of the NYMEX WTI Crude futures market for the five years prior to deregulation and for a five year period six years after deregulation.
Prior to deregulation the crude oil market was dominated by hedgers, that is people who were either selling physical crude oil or buying physical crude oil. Speculators made up 15% of the market at most (every market needs some amount of speculators to help facilitate transactions). The oil market, and thus oil prices, actually reflected the real world supply and demand for oil. The price meant something. If oil prices were rising, demand for oil was rising (or the Saudis were raising prices).
Now look at the current structure of the oil market (above graph, right side), the amount of the market controlled by speculators has steadily increased and is about 70% of the market. Today the oil market is controlled by speculators, the only thing the price of oil tells us is what price the speculators have bid it up to. It is impossible to look at oil prices and discern anything about the health of the real economy.
In fact, the rise in oil prices over the past decade and a half has mainly been due to the ever increasing amount of speculative money flowing in to commodity markets, mainly in the form of commodity index funds being sold by Wall St. to unsuspecting retail investors.
For instance the chart below shows the amount of assets pegged to the S&P GSCI, a popular commodities index. As of several years ago the total was $200B.
Including other commodity index products, actively managed commodities funds, and private accounts by 2008 over $300B in speculative money had flowed in to the commodity markets and the total is likely higher today.
What’s the true price of oil? It’s difficult to assess. A study by Goldman Sachs (I have no idea why Goldman Sachs, a financial firm that benefits from speculation in the oil market, actually admitted speculation in the oil market is causing problems) pegged the true price of oil around $85/bbl in 2012, oil executives seems to think $70 to $80/bbl is the true price, while I’ve read $60/bbl as the true price from various reform groups and think tanks pushing for increased regulatory oversight of Wall St. and commodities markets. There is probably an incentive for Goldman Sachs to downplay the result of speculation, oil executives probably want to believe the price is a bit higher than it is, and reform groups would want to over exaggerate the effects of speculation so I’d say $70 sounds right about in the middle but those prices were before the shale oil boom really took hold so perhaps something in the $60 to $70 range is correct.
Unfortunately economists cling to the belief (and continually peddle that nonsense to the public) that completely unregulated markets are magically stable with prices that are always correct and participants that are always rational. The result of this belief is a trend towards deregulating markets and the accompanied increase in volatility. The less regulated the market the less stable it will be.
With so much speculative money currently in the oil market it’s difficult to say when prices will bottom out and how long it will take. My guess is that once we have a few months of positive global economic data oil prices will begin to rebound towards their true price. This is similar to how markets panicked over the end of the various quantitative easing programs despite the fact that the programs did basically nothing.
For oil companies and companies whose business depends on oil and gas exploration things are mixed. Stronger, financially sound companies who used reasonable oil prices estimates in their breakeven analysis for projects should be just fine. Those who undertook difficult projects with high extraction costs and gambled on higher oil prices will have problems. The financially stronger players may have an opportunity to pick up good assets from cash strapped drillers if the downturn in oil prices continues.
If oil prices continue to slide and approach the $40 to $50/bbl range (which should be well below the actual price range of oil) you may see us begin to rebalance the portfolios to average down on our two oil holdings (Royal Dutch Shell and BP) and perhaps look to add another company related to the oil and gas industry.
In summary, enjoy the low prices at the gas pump for the next few months courtesy of the speculators on Wall St.
Happy Holidays from Strubel Investment Management