While most people were recovering from a gluttonous Thanksgiving, the energy markets were extremely active last Friday. The price of U.S. crude oil fell 10.2% in the day, while energy stocks were massacred. The primary reason for the decline was OPEC’s decision to keep production steady, despite calls from many of its constituents to cut production to boost prices. Saudi Arabia is by far and away the dominant force in OPEC and the decision to keep production steady in spite of a 45% decline in oil prices over the last several months is strategic for a lot of reasons.
First of all, Saudi Arabia’s costs to produce a barrel of oil are about $10, compared to between $40-60 for U.S. shale oil producers. The reduction in price should weed out weaker participants and protect Saudi market share. Secondly, a decline in oil and natural gas prices reduces the economic viability of renewable energy such as solar, wind etc. This is a huge long-term issue for the Middle East and Saudi Arabia is in a strong enough financial position where it can play the “long-game,” unlike the weaker OPEC members such as Iran and Venezuela. Saudi Arabia’s government is closely aligned with the United States and its biggest perceived threat is and always has been Iran, whose state religion is a different form of Islam. Iran’s financial condition is not nearly as strong as Saudi Arabia as its oil production costs are higher and sanctions have riddled the economy from its nuclear program. Saudi Arabia is highly against having a nuclear Iran, so the idea of further pressuring the government to comply with the international community in regards to its nuclear intentions through financial pressure, clearly doesn’t hurt the Saudis’ cause.
Russia is another world power that derives the majority of its revenue through oil and natural gas sales. Putin has been making aggressive moves in Ukraine and seems set on maintaining control over parts of the former Iron Curtain. With sanctions already impacting Russia, lower energy prices will further pressure the economy, likely putting Russia into a recession in 2015.
This is just some of the geopolitical background. Investing is primarily about buying individual businesses at large discount to intrinsic value, as macro-economic forecasting is generally a loser’s game. At T&T Capital Management (TTCM), we have been fairly agnostic in relation to energy prices. The global economy’s growth is anemic so demand is fairly weak, while supply is up. This sell-off makes sense and can certainly continue. Over time, production will inevitably slow down, reducing supply and creating more balance. This should bolster pricing. In general, we have been underweight the energy sector and have previously taken profits on a lot of the positions that we did have. Most of our exposure is through cash-secured puts and covered calls, on companies that we believe are trading at discounts to their liquidation values if they were to be auctioned off. These companies are hedged to various degrees and have been extending their debt maturities by taking advantage of attractive credit markets. Of course, if energy prices stay this low there will be considerable risk for the industry and no company in the sector will be immune from being impacted. A few clients have asked if it is time to aggressively build positions in the sector. I don’t believe we are at the stage yet where it makes sense as there could still be more blood in the water to come. I don’t pretend to be able to pick the bottom, but it will take time for supply growth to slow down and for demand to pick up.
Most aspects of the economy will benefit from lower energy prices. Our large financial investments should benefit as consumers have more money to spend and maintain strong credit. This could also bolster mortgage demand, as rates seem likely to stay quite low with inflation expectations being so moderate. At some point, energy stocks and bonds will likely be incredible buys. Our strategy of selling cash-secured puts will ensure us a much cheaper entry-price than what would have been available had we just bought the stocks outright, but the key is letting the options expire to get the full benefit. In the short-term, high volatility and mark to market trading will cause price distortion and our hope is to use that to our benefit when we find attractive opportunities. Below is a link to an article discussing Friday’s action. This type of volatility is just part of what financial markets do. It’s not something to be scared of, but instead through prudent analysis and research, provides ample room for opportunity.
Thank you very much and let me know if you need anything at all!
http://blogs.wsj.com/moneybeat/2014/11/30/lessons-from-oils-black-friday/