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.

Only Time Gives Clarity to Investors

The reality of the 21st century is that finding clarity in world events for investors is almost impossible. Take the recent price drop in oil, which has been hailed as both a good and bad thing. And as the new lower price of energy slowly becomes the norm, everyday news reports come in about its respective benefits and unintended negative consequences.

https://twitter.com/Walker_Report/status/540161044786589698

Those seeking to know what those events mean and what guidance headlines should give will only be frustrated by the almost endless supply of information that seeks to empower decisions but leaves many scratching their heads in wonder about the future.

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A big reason for this is the sheer volume of information that we can now rely on. Since the advent of computers and the more recent rise of high-speed communication and networking we have found that the core truth of an event still isn’t apparent until after something has happened. In other words it’s almost impossible to predict corrections before they happen despite an almost inconceivable amount of data and endless ability to process it.

This is true no matter where we look in the world of investing. Consider Black Friday, the end all and be all day in shopping in the United States. This year Black Friday seemed to fizzle. Sales were down 11% year-over-year and that got people nervous. Yet Cyber Monday, the electronic version of Black Friday, sales were up 17% and topped $2 billion for the first time. Combined with the longer sales period leading up to the weekend, many suspect that total sales were actually higher.

All of this data conflicts with each other, which for investors means sometimes you will be wrong. Small things sometimes prove to be big things, and what initially appears simple turns out to be surprisingly complex, and much of it you simply won’t predict. This points investors back to some dull but surprising truths about investing.

1. Not much has changed when it comes to determining what makes a company worthwhile to invest in. Corporate health, sound governance and healthy cash flow still tell us more than loud hype about potential new markets, new products and new trends.

2. Time is a better arbiter than you about investing. The old line is time in the market, not timing the market, and that still appears true. Many Canadians are likely wringing their hands about the sudden drop of oil and the impact it is having on their portfolios. But the best course of action maybe not to abandon their investments, but make sure they are still sensibly invested and well diversified. The market still tends to correct in the long run and immediate volatility (both up and down) are smoothed out over time.

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The S&P 500 over the last 50 years. From Yahoo Finance

Not every sensible investment will work out, but a portfolio of sensible investments over time will. For investors now wondering about the future and their investments in Canada, the best thing to do is understand the logic behind their investments before choosing a course of action.

 

The Media is Turning Market Panic up to 11 – Learn to Tune Them Out

The current market correction is about as fun as a toothache. Made up of a perfect storm of negative sentiment, a slowing global economy and concerns about the end of Quantitative Easing in the US have led to a broad sell-off of global markets, pretty much wiping out most of their gains year-to-date.

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This is what my screen looked like yesterday (October 15th, 2014). The little 52L that you see to the left of many stock symbols means that the price had hit a 52 week low. The broad nature of the sell off, and indiscriminate selling of every company, regardless of how sound their fundamentals tells us more about market panic than it does about the companies sold.

One of the focal points of this correction has been the price of oil, which is off nearly 25% from its high in June. Oil is central to the S&P/TSX, making up nearly 30% of the index. Along with commodities, energy prices are dependent on the expectation of future demand and assumed levels of supply. As investor sentiment have come to expect that the global demand will drop off in the coming year the price of oil has taken a tumble in the last few weeks. Combined with the rise of US energy output, also known as the Shale Energy Revolution, or fracking, the world is now awash in cheap (and getting cheaper oil).

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The price of Brent Crude oil – From NASDAQ

But as investors look to make sense out of what is going on in the markets they would be forgiven if all they learned from the papers, news and internet sites was a barrage of fear and negativity masquerading as insight and knowledge. The presumed benefit of having so much access to news would be useful and clear insight that could help direct investors on how to best manage the current correction. Instead the media has only thrown fuel on the fire, fanning the flames with panic and fear.

WTI & BrentContrast two similar articles about the winners and losers of a dropping price of oil. The lead article for the October 15th Globe and Mail’s Business section was “Forty Day Freefall”, which went to great lengths to highlight one big issue and then cloak it in doom. The article’s primary focus is the price war that is developing between OPEC nations and North American producers. Even as global demand is reportedly slowing Saudi Arabia is increasing production, with no other OPEC nations seemingly interested in slowing the price drop or unilaterally cutting production. The reason for this action is presumably to stem the growth of oil sand and shale projects, forcing them into an unprofitable position.

 

This naturally raises concerns for energy production in Canada, but it is not nearly the whole story. The Financial Times had a similar focus on what a changing oil price might mean to nations, and its take is decidedly different. For instance, while oil producing nations may not like the new modest price for oil, cheap oil translates into an enormous boon for the global economy, working out to over $600 billion a year in stimulus. In the United States an average household will spend $2900 on gas. Brent oil priced at $80 turns into a $600 a year tax rebate for households. Cheaper oil is also hugely beneficial to the manufacturing sector, helping redirect money that would have been part of the running costs and turning them into potential economic expansion. It’s useful as well to Emerging Economies, many of which will be find themselves more competitive as costs of production drop on the back of reduced energy prices.

A current map of shale projects, and expected shale opportunities within the United States and Canada.
A current map of shale projects, and expected shale opportunities within the United States and Canada.

Business Reporting isn’t about business, it’s about advertising revenues.

While Canada may have to take it on the chin for a while because of our market’s heavy reliance on the energy sector, weakening oil prices also tends to mean a weakening dollar, both of which are welcomed by Canadian manufacturers. Corrections and changing markets may expose weaknesses in economies, but it should also uncover new opportunities. How we report these events does much to help investors either take advantage of market corrections, or become victims of it. As we wrote back in 2013, business reporting isn’t about business, it’s about advertising revenues. Pushing bad news sells papers and grabs attention, but denies investors guidance they need.