David R. Kotok
September 14, 2015
One major investment house made news on Friday afternoon by lowering their forecast for the oil price to $20. Lots of arguments go into this forecast, and most of them have been repeated ad nauseam: Iran is increasing production; Saudi fears Iran and uses low price to deny Iran cash flow; fracking is still growing, so US supply is still growing; emerging markets are growing slowly, so demand is low; and natural gas is so abundant it competes with and exerts downward pressure on the price of oil. Also, geopolitical risk premia have collapsed in the global oil-pricing mechanism. Yemen, ISIL, and Russia-Ukraine are old news.
I will stop. The list could be longer, but we all know the news flow.
We don’t think the downward pressure on the oil price is over, so we are still underweight the Energy sector with the exception of selected MLPs that benefit from volume and not from price. All MLPs have been hurt in the selloff. Some have sold off to irrational extremes, so we see opportunity in the MLP space.
Let’s look at this oil price collapse from a different viewpoint. There was a large run-up in the price of oil in the 1970s. The 1973 oil embargo and the Arab-Israeli War saw the price spike from $3 to about $12 a barrel. Subsequently, the Iranian revolution, the hostage crisis, and more Middle East pressure took the price to about $30. At the time of the Iranian revolution, the forecasted price was as high as $100 when the going price was $30.
This writer remembers those turbulent days. At its peak the Energy sector was carrying a weight of nearly 25% of the US stock market. As an ironic historical note, Israel and Egypt fought bitterly in the 1973 war. Now they are both expanding large natural gas finds offshore in the Mediterranean.
So guess what happened after oil went from $3 to $30 in eight years?
Things changed. Prices collapsed. OPEC lost its power. Non-OPEC production rose. Substitutions for oil accelerated. Efficiencies rose. It took 20 years for OPEC to recover. During those two decades the inflation-adjusted price of oil returned to near its pre-Middle East war level. By the way, in today’s dollars a $20 barrel is again at that lowest of levels when inflation adjustments are applied.
As the millennium turned, we heard talk of “peak oil.” Best-selling books told the Malthusian story of the world running out of energy. And then what happened? Fracking started in earnest in 2010. In just five years it has resulted in abundance. In natural gas we now measure future supply availability by the century. We will soon see the US as an exporter of LNG.
And the forecasts of price, which were in the $100s, are now down to $20 or even lower.
History suggests that the downward price adjustment will be in place for years. That is how such adjustments have worked in the past. And the lower prices of oil and gas and derivative products will eventually lead to increasing consumption and growing demand. Energy producers will suffer. The pressure mounts on them. Energy consumers will change their behavior as they begin to believe that the price change will be durable.
What about stability of governments? Here is where the rubber meets the road.
The Saudis have large reserves, and they are highly motivated to keep Iran from obtaining revenue to expand its nuclear program. It is in the Saudis’ survival interest to maintain maximum production and lower prices so as to reduce the amount Iran gets from selling oil. Various estimates center on Saudi Arabia’s needing about $70 oil to keep its current account in balance, so the shortfall means the Saudis will be tapping reserves. The Saudi government has even begun to issue debt. Nonetheless, Saudi staying power is measurable in years.
Iran is estimated to need $45 oil or thereabouts to balance its current account; so if the Saudis can hold the price below that level, they will be able to keep Iran under economic pressure. The marginal cost of producing an extra barrel of oil is very low in both Saudi Arabia and Iran. Thus the two enemies each have a motivation to maximize production, albeit for different reasons.
What about other places? This is where it gets complicated. Venezuela is a complete mess. Any dramatic change in government would immediately result in more oil production. Nigeria is not stable and needs revenue. Other places, like Algeria, are presently stable; but shrinking oil revenue threatens their social compact. In Algeria the worry is about instability from a second round of the “Arab Spring.” For an excellent discussion of Algeria see the September 5th edition of The Economist, page 51.
To sum up, $20 may be a possible spike down, but we don’t think the price would be sustainable at that level. Today, $50-$60 seems high. There are many forces at work that will drive the price lower. Our guess is that the price will hover somewhere around $30 or so, but only for a while.
Watch global geopolitics. And watch demand and emerging economies. We do. It is still too soon to raise our weight in the Energy patch. But the entry is getting closer, and external shocks could occur at any time.
David R. Kotok, Chairman and Chief Investment Officer, Cumberland Advisors