There is no doubt that oil’s rapid decline and the U.S. dollar’s ascension have been the two most important macroeconomic themes over the last 6 months. It is very fashionable right now for market pundits to pronounce that oil is heading to $30 or even $20 a barrel, due to excess supply and weak demand. I’d argue that this debate over short-term prices is not highly relevant and that oil will likely be significantly higher within a year to 18 months, barring a major economic meltdown in China or the United States. The best cure for low oil prices is low oil prices, because exploration and production companies aren’t going to explore and spend money to develop new wells at uneconomic prices for very long. Now to be clear, supply is likely to increase over the next 6-12 months because hundreds of billions of dollars have been spent on capital expenditures and holes that are drilled will certainly be produced, as the big money has already been spent so the marginal cost of production is quite low. CAPEX budgets are plummeting hard and fast even with companies assuming $70 oil prices, so at $50 the reductions will likely continue to escalate. Low oil prices will also likely spur increased oil demand due to price elasticity, which is already showing signs of bearing fruit in the increased amount of gas-guzzling trucks and SUVs being purchased after just one quarter of lower oil prices.
This morning I saw an interesting statistic on CNBC. Oil has sold off 50% within 6 months a total of 5 times since 1980. In 4 out of 5 times the S&P 500 was up over the next 6 months by an average of 3.7%. Far more importantly, in the 6 months following the previous declines oil was up 5 out of 5 times, and the average gain was a whopping 52%. Historical data is just that, historical, but it does paint a picture of market and investor psychology. Fear and panic can drive prices far lower than you’d expect in an instant, but over the long-term it is fundamentals that matter. If you were a bull on energy with prices at $90, how are you not a bull with prices at $50 if you have any reasonable time horizon? Lower energy prices are not going to be good for alternative fuels. Some of you might recall when ethanol stocks were the talk of the town going into 2008, but when energy prices collapsed, many ethanol companies went bankrupt and most investors lost a lot of money. The population continues to increase, particularly in emerging markets and demand for energy has been consistently strong.
Another interesting occurrence is the continuously declining rates of sovereign debt. The 10-year Treasury bond is now yielding less than 2%. Think about that for a minute. If inflation were to average 2% and if rates didn’t go up, your return would be 0. Rates are very likely to head higher at some point, so losses over the long-term are almost assured! Contrast that with an investment in one of the financials we own or on an energy stock such as BP or ESV. These two energy stocks have yields around 7% and 11%, respectively, and if oil prices rally to even $70 per barrel, I’d expect the stocks to be meaningfully higher. Now the price we pay for investing in stocks is volatility. Many market participants expect outperformance every month or quarter, which is absolutely toxic and unrealistic, because it breeds short-termism and market chasing habits.
I’d highly urge investors not to worry about their accounts every day or month, but look at it every 6-12 months as long as you trust your investment manager. Look at times of volatility and panic as a time to add money, as opposed to the time to get scared and watch how much your investment performance improves. The more talk of $30 oil, the more confident I am in the long-term investment thesis at current prices because when fundamentals do shine through, these same people will have to reverse course and buy the stocks. I’m not saying prices won’t continue to drop over the short-term, but I’ll go on record that prices will likely be substantially higher over the 3-5 year period that we target for our investments, so stock purchases at current prices seem quite desirable.