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.

 

Russia’s Entire Stock Market is Worth Less Than Apple Computers

Let's just call this what it is. Awkward.
Let’s just call this what it is. Awkward.

A few days ago a bizarre inversion took place. A single company was suddenly worth more than the entire investable market size of a major economy. While I like Apple a lot and applaud the incredible profitability of the company, this is more a story about how badly the Russian economy is doing.

Back when Russia was first inciting dissent inside the Ukraine following the ouster of the quasi-dictator running the country, it had banked on the idea that it’s continued escalation inside the borders of a sovereign nation would go unchallenged as few countries would wish to risk a military skirmish over a single, marginal country in Europe.

Vladimir Putin miscalculated however when he didn’t realize how precarious the Russian economy was. Sanctions were implemented and what followed was a largely hollow trade war that did more to identify Russia’s weakness than strength. But the most recent blow to Russia has been the change in the price of oil.

Screen Shot 2014-11-21 at 12.31.04 PMNow that the price of oil is under $80, Russia is suffering severely. Like many oil rich nations, oil exports substitute for taxes. This frees autocratic rulers to both pursue generous social programs while not having to answer to citizen complaints about high taxes. It’s how countries like Saudi Arabia  and Iran get by with little democratic input and a relatively passive population with little to no public disobedience about democratic rights (mostly).

This relationship though means that there are actually two prices for oil. First the breakeven price for extracting oil from the ground, and second break breakeven social price of oil. Those prices are different in every country. In Alberta for instance, tar sand oil is usually quoted at $70 a barrel for breakeven. But to cover the costs of running the government the price is much higher. For Russia the slide in price from $109 a barrel to $80 has meant wiping out it’s current account surplus.

Combined with the falling rouble (now 30% lower than the beginning of the year) and the growth of corporate debt sector, Russia is now in a very precarious situation. I’m of the opinion that energy, and energy companies have been oversold and a rise in price would not be unexpected. But whether the price of energy will bounce back up to its earlier highs from this year seems remote.

This is a stock photo of a guy thinking. Could he be thinking about where to invest his money? He could be. It's hard to tell because he was actually paid to stand there and look like this and we can't ask him.
This is a stock photo of a guy thinking. Could he be thinking about where to invest his money? He could be. It’s hard to tell because he was actually paid to stand there and look like this and we can’t ask him.

Over the last few months I’ve been moving away from the Emerging Markets, and while the reasons are not specifically for those listed above, Russia’s problems are a good example of the choices investors face as other markets continue to improve their health. If you had a dollar today that could be invested in the either the United States or Russia, who would you choose? The adventurous might say Russia, believing they could outlast the risk. But with more Canadians approaching retirement the more sensible option is in markets like the US, where corporate health is improved, debt levels are lower and markets are not subject to the same kind of political, economic and social instability that plagues many emerging economies.

 

How To Invest In Energy When You Hate Volatility

***This post will refer to both a mutual fund company and a particular fund. This post should not be construed as endorsing that fund. We always make sure that we cite our sources and in this instance our source is a fund company, and we are not suggesting in any way that you should invest in or purchase this fund. If you are interested in any fund, please consult with your financial advisor first for suitability, especially if that financial advisor is us!*** 

frackingSince the price of oil dropped there have been lots of reasons to be excited. First the price of gas at the pumps is so low that I don’t hate going there anymore. Second, investments in energy have suffered since oil lost close to $30 in value.

WTI price over the last 6 months. From NASDAQ.com
WTI price over the last 6 months. From NASDAQ.com

And while energy stocks have recovered somewhat from their low points, they are still way off where they were earlier in the year. I’m not going to get into the finer points about the nuances of energy producers and the various types of oil and  costs of production. It’s a worthwhile article, but will take up too much time here. Instead I wanted to focus on a different way that Canadians can participate in the energy sector.

Commodities can be volatile but also a valuable element of a portfolio. So how can Canadians play the energy sector while being mindful of the risks associated with it?

The answer may be by investing in what is called “Midstream MLPs”. Midstream MLPs (Master Limited Partnerships) are American operators that transport energy from the producers to the consumers. It’s a capital intensive business that is federally regulated but traded on the stock market. It therefore provides consistent cash flow while offering liquidity to investors. But Canadians already have opportunities for energy infrastructure, so why should they care about this in the United States?Midstream2The answer has everything to do with the rising levels of oil production in the United States combined with what federal regulators are willing to do to encourage new growth.

That brings us to the growth of the shale revolution in the United States. Newly discovered reserves (of significant size), improved technology and a dropping costs of production have set the US on a course to be the largest global energy provider in the coming years. This combination of efficiencies means that the United States is going to continue to increase its oil production over the next decade, while dropping the cost of extraction for each additional barrel. But each barrel produced has to go somewhere.

Projected Oil Growth in the United States
Projected Oil Growth in the United States

In the United States, Midstream MLPs are responsible for moving that oil. But it’s a sector that also must grow. Infrastructure to move oil efficiently from shale producers doesn’t exist yet, and regulators are eager to get MPLs in place with new development. New infrastructure is costly, and while the business model for an MLP doesn’t require a high price for energy to be profitable, it does need assurances about the consistency of the volume of oil to be moved. To encourage that growth regulators are allowing the price that MLPs charge to rise at a rate faster than inflation. Why are they doing that? Much of the shale oil is having to be shipped via rail to get to its right home. This causes price disparities that reduces producer margins and rankles federal governments.

 Pipelines in the US. Most of the pipelines direct energy to Texas, which isn't set up to handle the ultra light crude from shale projects. that energy, coming out of North Dakota, needs to get to New Jersey. The lack of pipelines means it is being shipped by rail to Chicago and then via pipeline.

Pipelines in the US. Most of the pipelines direct energy to Texas, which isn’t set up to handle the ultra light crude from shale projects. that energy, coming out of North Dakota, needs to get to New Jersey. The lack of pipelines means it is being shipped by rail to Chicago and then via pipeline.
The various prices of oil. Oil from Canada is sold at a discount while Brent crude is sold at a premium to WTI. Improving infrastructure would rectify this problem and equalize prices. (The WTI price is listed from the summer). Click on the image to see it larger.

 

Currently there is only one fund option in Canada that we are aware of for investing in MLPs. We had an opportunity earlier this week to meet the managers of this fund and were greatly impressed by what they had to show us. I am already a big believer in the growing Shale Revolution, and am particularly pleased by the arrival of new opportunities for investment. Growth in the Canadian and American energy sectors is good news for not just investors, but also citizens. Russia, Saudi Arabia, Venezuela and a host of other despotic and semi-despotic regimes have been able to get by on the high price of oil. Now they are feeling the pinch of a decreasing price that has the benefit of bringing jobs back to North America while weakening their influence. In all, this is a good story for everyone.

Want to talk oil? Send us a message!

 

 

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.