“Peter Pan, Oil & Portfolio Management”
David R. Kotok
December 8, 2014
Magic ensued when Mary Martin flew across the stage as Peter Pan. The audience was spellbound, and Broadway theater soared to a new height in wonder. The fog of this memory parts for me to recall her flying across the stage, arms out, one leg bent, a brilliant smile, and the uplifting of her voice and song.
What a wonderful world where kids never age and the threat of time is reliably revealed by a tick-tock from a crocodile. This storyline entices children and seduces adults back into their youth. In Neverland, things are so clear. The good guys win and the bad guys lose. Heroes and heroines are easily identified. In Peter Pan there is hope for the future world.
Fantasy with a magical story, like Peter Pan, is still fantasy. The issue for investors is whether we can actually be optimistic. Is there a pleasant outcome that may yet surprise us as we proceed through this dangerous and fear-inducing world? Or is there a negative outcome ticking ominously like Tick Tock the Croc?
I personally believe that hope is not an investment strategy. I believe that while fantasy may be pleasing or threatening, it is only pretend. So please do not consider the rest of this commentary a forecast. The purpose is to identify some possible risk/reward surprises.
During a recent interview with Johanna Bennett of Barron’s, she asked what might be the single biggest surprise that is not priced in the markets. What is totally unexpected? I thought of two, one positive and one negative. Each has portfolio management implications.
The negative surprise may evolve but is certainly not priced in now. It would be a full-blown currency crisis like the one we had in the 1990s. Coincident with an abrupt oil price decline, violent currency adjustments are taking place (examples are ruble and yen weakness and dollar strength). Emerging markets are impacted, though their debt spreads do not show it yet. In the US, high-yield spread widening is limited to the energy patch right now. Is this a warning?
Is the market ignoring another warning in the investment-grade bond sector? Does the widening of the baa bond spread versus low level of VIX indicate trouble coming? These are usually aligned. (Hat tip to Carsten Valgreen of Applied Global Macro Research.)
Will energy credit trouble lead to shocks like the Long Term Capital Management (LTCM) blowup in 1998? What would central banks do in 2015 if they had to confront a currency crisis, spread widening, and banking system risk? The central banks are already at the zero bound. Collectively, they have already tripled their balance sheets.
The potential positive surprise is also sourced in the falling oil price. It just might yield a peace dividend.
Johanna asked how that is possible, with ISIL, Boko Haram, Shabbab, and Al Qaeda and with news events from Ferguson, New York, Los Angeles, Raqqa, and Yemen. With all that is going on, she asked, how is it possible?
No one believes it is possible, I said. We are besieged by violence on a daily basis. That is why markets have zero anticipation or expectation that any of the nasty and horrible events in the world are going to stop. Like the market, I have no anticipation or expectation that will happen. Peace breaking out seems to be a fantasy like Neverland or flying.
Portfolios and investment strategies are designed with the idea that politics and governments are poorly convened, impoverished, and worsening. The globe seems to be a threatening and deteriorating place. That assumption underlies asset allocation strategies. The notion that peace could break out seems far-fetched to any reasonable person. We certainly are not betting real money on that outcome.
But is it far-fetched?
Maybe, just maybe, there is a long-shot possibility that the Saudi Arabians dropping the oil price to $60 per barrel and keeping it there might just induce some reduction in violence. They may deliver a form of a peace dividend that is not obtainable by using drones. Why?
The oil price at $60 per barrel impacts the naughty folks more than the friendly folks. The naughty folks – Iran, ISIL, Vladimir Putin, Nicolás Maduro in Venezuela, Al Qaida funding sources, and other culprits –are all negatively impacted when oil is at $60 per barrel, if the low price is sustained. Cheap oil denies revenue for many bad actors. Having less money undermines their ability to make mischief.
Now let’s be very clear. I am not convinced that, in the halls during the discussions in Riyadh, this topic was the premier reason to keep the price low and production high. But I am also attributing to Saudi Arabia enough intelligence and foresight for them to realize how threatened they are. They may have thought through what it would mean to hold the oil price low. Maybe, just maybe, there is another beneficial aspect from the decision of the swing producer in OPEC (Organization of the Petroleum Exporting Countries). Remember, the Saudis have the ability to put the oil price wherever they want and keep it there for a while. Their current production rate is 10 mbd (million barrels a day). The US is approaching 9 mbd, up from 5 mbd only a few years ago. These two countries with a common interest in their security now produce 19 of the world’s 87 mbd of oil. No other actor comes close.
So, the remote, unlikely, and impossible long-shot prediction for 2015 or 2016 is that global violence may actually diminish. It will not disappear but it may lessen. That is if $60 oil undermines the bad actors and makes them weaker and more vulnerable to response from their domestic populations.
Hope is not a strategy. But we can have a wish list.
We think that currency and political turmoil is coming in Venezuela. We hope the good people win. Putin is under pressure; the ruble is plummeting. We hope the good people win. Iran now has to face the worst of all circumstances: inflation, falling revenue, sanctions, and economic pressure. We hope the good people win. ISIL and Boko are rotten murderous bastards. Gradually the world is coming around to mounting action against them. We hope the good people win.
In Ferguson, there are many who do not burn buildings and who try to balance household budgets. Cheap energy helps them. We hope the good people win. Cheap energy means more economic growth, more jobs, and more spending power in the hands of many. Maybe that lessens violence. We hope the good people win.
Remember, this is not a forecast. Hope is not a strategy. I’m as cynical and fearful as everyone else.
But, the long-shot negative surprise, not priced in markets, is a global currency war that grows out of oil at $60 a barrel and other factors. And the positive surprise comes from the same oil price.
Wouldn’t a positive outcome be something? Tick Tock the Croc gets his bad guy. And the good guys do better.
Like Peter Pan, we could be flying.
PS. We just passed December 7. This is an anniversary of the worst kind, the surprise attack on Pearl Harbor that started World War II.
PPS. Our media labeled the attempted rescue in Yemen as “failed.” Shame on American TV. 40 well-trained American servicemen traveled with very high risk and attempted a most difficult rescue, yet the hostage was killed by his terrorist captors. Of course, it would have been better to succeed and have him alive. But stop and think about it for a minute. What other country in the world would mount such an effort to rescue its own citizen and others who happen to also be there? No failure in my book. The attempt is testimony to what makes our nation distinguished above the others.
David R. Kotok, Chairman and Chief Investment Officer, Cumberland Advisors: http://www.cumber.com