Oil-Part 1

Oil-Part 1
David R. Kotok
December 1, 2014

Every so often we get a shock from the oil patch. Sometimes the price spikes (1973-4 saw a quadrupling) and sometimes plummets (a drop from $115 to under $70 in this year of 2014). This downward price shock is large enough to force change. Bullets follow.

1.    Someone’s income is someone else’s expense. Losers are those who were dependent on rising or steady oil prices. Winners are those who benefit from lower oil prices and lower prices for all the things whose cost is driven in part by the cost of oil.

2.    High-yield bonds dependent on higher energy prices are now at greater risk. Therefore bond analysis must separate energy-dependent flows supporting bonds from those that are not tied to the Energy sector.

3.    The composition of the US economic recovery since 2009 has a large growth component sourced in the Energy sector renaissance in our country. Some part of that component is now going to stop growing. Other parts will defer capital expenditures. The falling price of oil in the US has now reached levels where many properties and activities function below the marginal cost of production. Facilities lose money while they try to stay in business. This will assuredly trigger retrenchment in the Energy sector.

4.    Company by company, entity by entity, and trust by trust – all need to be analyzed separately. Their capital structures require examination to determine if they have hedged themselves with futures contracts. How have they protected themselves from oil price volatility? Some are hedged for years. They have a fixed selling price for the next long period of time. Others are unhedged. Investors now must do serious homework and take nothing for granted.

5.    2015 may be an entry point for those who are underweight in Energy. The sector will experience rapid volatility. Some entities will reach washed-out pricing. They may be purchasable at the right (cheap) price under current circumstances. A drop in the oil price from $115 to under $70 is monumental.

In the geopolitical arena, the ramifications are also monumental. Budgets of many foreign countries are coming under duress. Civil unrest is unlikely to increase in those countries due to their inability to fund subsidies that have acted to bribe the population. We look for more geopolitical turmoil worldwide and regime change in some countries. In others, dictators suppress the population with machine guns, so the unrest is below the surface until it explodes.

There is one more dynamic set in motion in circumstances like this. The strongest of the currencies and most durable of the economies get stronger and more durable. We expect a continual increase of capital flows into the US. America is the safest of havens in the world. These flows are bullish for US stocks and high-grade bonds, as global agents from throughout the world safety seek safety.

Lastly, US policy could take advantage of these opportunities to strengthen America and make it more independent and self-sufficient. Achieving that goal, however, depends on political agreement. Therein is our country’s weakness. The White House, the Senate, and the House of Representatives, Democrats and Republicans, still have not found a way to set aside partisan poison so that they can act cohesively for the benefit of our country.

Our biggest risk comes from the stymied political sector. Meanwhile, Main Street and Wall Street will enjoy the lower gasoline prices and the lower energy price dividend resulting from a global oil glut. We remain bullish on US stocks and constructively barbelled or hedged in the bond market.

David R. Kotok, Chairman and Chief Investment Officer