Oil: Lower for Longer

We’ve done a little video to try and explain why analysts now expect the price of oil to stay much lower for much longer. It’s a different format than our previous videos, but we think it offers an opportunity to be more informative with a greater impact than some of our other videos.

We’ll be playing around with this idea for a while, experimenting with ways to make it interesting and quick, so please send us your thoughts and any topics you’d like us to cover.

In other news, the Canadian and global markets have been taking a beating over the last couple of weeks. Much of this is tied to an expected Federal Reserve rate hike for the end of December. The rate hike will be unbelievably small, but markets have been selling off in anticipation of it’s arrival.

The “normalising” of interest rates is a hot topic for many. Some American manufacturers worry that rising rates will inflate the USD further than it already has this year. In Emerging Markets the rising USD has meant a collapse in investment while funds flow back to American shores. Proponents of the rise have argued (persuasively I believe) that seven years after a major financial crisis it makes no sense to have interest rates at emergency levels. Long term cheap credit can’t be allowed to continue.

Canada is also getting badly beaten by the continuing falling price of oil and the end of the commodity super cycle. The slowing down of China has meant that there is simply less need for the huge amount of raw materials we have been selling. Prices on iron ore and copper have all been falling with the price of oil.

Canada is also saddled with other problems. Debt to income just hit a new high, while government debt is expected to grow substantially over the coming years while the economy looks to be doing worse.

We’ve been extremely busy in the second half of this year, which has kept us from writing as much as we have in the past. But we will try and be back later in the week with some more analysis on the markets and economy.

 

 

A BRIC You Can’t Build With, A Ship That Won’t Sink

The month of August has so far been a repeated drumming for global markets. Falling oil prices, the devalued yuan and a collapsing Chinese stock market have people running scared, and if we’re totally honest it’s probably too soon to know what it really happening as easily panicked sellers jump the gun.

bricInstead I’d like to take a moment to reflect on the fall of the BRICs, the supposed new economies of the developing world. Back  in 2003, two Goldman Sachs analysts wrote a paper called “Dreaming With BRICs: The Path to 2050” which made a convincing case that Brazil, Russia, India and China would grow substantially over the next half century. For a while that seemed true, and the few BRIC mutual funds available returned solid results to investors who bought the BRIC story.

Today much of that story sits in tatters. Russia is more regional gangster than growing economic power, a victim of its own pointless efforts to reestablish hegemonic influence and maybe even undo NATO. Brazil is a longer story, but financial mismanagement has largely undermined Brazil’s early 21st century economic kick start, leaving interest rates too high and an economy on a path to recession. India is perhaps the only country that sits separate from this mess, but as a democracy (one mired in corruption no less) it’s own worst enemy is often protectionist populism that threatens to undo it’s own promise.

Yes, I have managed to shoehorn this image into my article. Have you watched this movie recently? Me neither. I haven't missed it either.
Yes, I have managed to shoehorn this image into my article. Have you watched this movie recently? Me neither. I haven’t missed it either.

But with the Chinese economy heading for what looks to be a potentially prolonged slow down (or worse) it seems safe to say that we’ve lost the path to 2050 and aren’t in danger of finding it anytime soon. This is a useful reminder that predictions about the futures of markets, no matter how grounded in math they may be, are in fact almost always misguided. That may seem obvious with much of the recent history a testament to predictions gone wrong, but it is surprisingly easy to be sold on investment ideas that seem to be an inevitable certainty.

There are a multitude of reasons for this, not the least of which is the human defect to see patterns in randomness. Attempts to control and manage huge events; to understand, tame and control random elements of nature is the underpinning of almost every story of hubristic arrogance that leads to tragedy, both literary and literal. Whether we are watching a history of the Titanic, or Alan Greenspan testifying to the benefits of derivative markets, there is always an iceberg somewhere threatening to make a mockery of our certainty.

This is what travelling the ocean was frequently like in history. Had we waited until we had an unsinkable boat we would never have sailed anywhere.
This is what travelling the ocean was frequently like in history. Had we waited until we had an unsinkable boat we would never have sailed anywhere.

I’m of the opinion that there may be somethings simply to complex to be fully understood. That shouldn’t mean we shy away from complicated markets, rather we should be mindful about the risks of participating. After all, the Titanic sunk largely as a result of the assumption it could not. But people had been sailing across the ocean for centuries with considerably greater danger. That’s a useful reminder about investing. Good investment strategies don’t seek out perfect investments, ones that cannot be undone by bad markets, instead they assume that markets are filled with risks and aim to navigate the dangers.

Will We All Be Victims of Cheap Oil?

OILEarlier this year we wrote that Russia’s economy was fundamentally weaker than Europe’s and that their decision to start a trade war in retaliation for economic sanctions over the Ukraine would hurt Russia far more than Europe. As it happened Russia has suffered that fate and had a helping more. The collapsing price of oil was a mortal wound to the soft underbelly of the Russian economy, leading to a spectacular collapse in the value of the Ruble and an estimated 4.5% contraction in their economy for 2015.

The Ruble’s earlier decline this year had already made the entire Russian stock market less valuable than Apple Computers, but as the price of Brent oil continued to slide below $60 (for the first time since 2008) investors began to loose confidence that Russia could do much to prop up the currency, prompting an even greater sell-off. That led to an unprecedented hike in the Russian key interest rate by its central bank, moving it from 10.5% to 17% yesterday. Moves like that are designed to reassure investors, but typically they only serve to ensure a full market panic. The Ruble, which had started the year at about 30 RUB per dollar briefly dropped to 80 before recovering at around 68 to the dollar by the end of trading yesterday.

The Russian Ruble over the last year. The spike at the end represents the last few weeks.
The Russian Ruble over the last year. The spike at the end represents the last few weeks.

Cheap oil seems to be recasting the economic story for many countries and millions of people. The Financial Times observes that oil importing emerging markets stand to be big winners in this. Dropping the cost of manufacturing and putting more money in the pockets of the growing middle class should continue to help those markets. The same can be said of the American consumer, who will be benefiting from the sudden drop in gas and energy prices.

The Financial Times always has the best infographics.
The Financial Times always has the best infographics.

Losers on the other hand seem easy to spot and piling up everywhere. Venezuela is in serious trouble, so is Iran and the aforementioned Russia. Saudi Arabia should be okay for a while, as it has significant foreign currency reserves, but as the price drops other member states of OPEC will likely howl for a change in tactic. But along with the obvious oil producing nations, both the United States and Canada will likely also be victims, just not uniformly.

Carbon Tracker Initiative
Carbon Tracker Initiative

Manufacturers may be breathing a sigh of relief in Ontario, but Canadian oil producers are sweating it big. Tar sand oil requires lots of refining and considerable cost to extract. Alberta oil sands development constitute some of the most expensive projects around for energy development and a significant drop in the price of energy, especially if it is protracted, could stall or erase some future investments. This is especially true of the Keystone Pipeline which many now fear isn’t economically viable, in addition to being environmentally contentious.

This chart was produced by Scotiabank
This chart was produced by Scotiabank

Saudi Arabia has continued to allow the price of oil to fall with the intention of hurting the shale producers in the United States. This price war will certainly claim some producers in the US, but it will difficult to know at which point that market will be effectively throttled. Certainly new projects will likely slow down but the continued improving efficiency of the fracking technology may make those producers more resilient to cheap energy.

But there is one more potential victim of the falling price of oil. That could be all of us. I, like many in the financial field, believe that cheap energy will enormously benefit the economy. But our biggest mistakes come from the casual confidence of things we assume to be true but prove not to be. A drop in energy should help the economy, but it doesn’t have to. If people choose not to spend their new energy windfall and save it instead, deflationary pressure will continue to grow. As I’ve previously said, deflation is a real threat that is often overlooked. But even perceived positive forms of deflation, like a significant reduction in the price of oil, can have nasty side effects. The loss to the global economy in terms of the price of oil is only beneficial if that money is spent elsewhere and not saved! For now confidence is that markets will ultimately find the dropping price of oil helpful to global growth, regardless of the early losers in the global price war for oil.