We have had numerous conversations over the past few months with clients, colleagues, economists, and oil industry professionals with the intent of gaining some insight into the causes of last year’s dramatic slide in energy prices. As energy prices are a substantial component of most everyone’s budget, the answer to this question will have a profound impact on how consumers spend this windfall and on where investment may be directed. Therefore, we have dedicated considerable research into the matter over the past several months.
The big question on everyone’s mind centers on whether these new energy prices are a short-lived and transitory phenomenon or if perhaps there is some new dynamic in place that might sustain these low energy prices for the longer term. Our research leads us to believe that there are two very powerful forces at work pushing energy prices down. To the extent that either, or both, of these forces can be relieved soon, then certainly commodity and energy prices could recover relatively quickly. However, for reasons outlined below, we are decidedly not in that camp. We believe the forces at work are longer term in nature and will prevail in holding energy prices at substantially lower levels (lower than the average $90/bbl for the past several years) for the foreseeable future.
Strong US Dollar: The first theme at hand is the recent strength in the US Dollar. To the extent the US Dollar is strong relative to other global currencies (i.e., the Eurodollar, the Japanese Yen, the British Pound Sterling, etc.), dollar denominated assets will fall in a price relative to those other currencies (all else being equal). As a point of reference, virtually all global commodities (oil, gold, silver, copper, etc.) are priced in US Dollars; that is, they are dollar denominated assets. We believe the trend is much more than coincidental that commodity prices have been falling ever since the US Federal Reserve started winding down its massive Quantitative Easing campaign last year. In fact, the program was concluded completely in October, 2014 which was the point at which WTI Crude Oil prices really began to accelerate to the downside.
We further believe that the US Dollar may remain relatively strong for a considerably long time. Although US interest rates are historically low (1.83 % on 10 Year US Treasury debt), as improbable as it sounds, these interest rates could continue even lower when viewed in the context of other developed country 10 Year maturity government debt:
In fact, there are some countries, most notably Switzerland, that “enjoy” negative nominal interest rates today.
The relatively higher investment yield on US Treasury debt, coupled with the fact that the US seems to be the only developed economy in the world that is growing, should continue to drive relative US Dollar strength.
In addition, the European Central Bank (ECB) seems to have finally accepted the idea that inflation in the Eurozone is dead and that perhaps a strategy of growth should be pursued. Considering the ridiculously high unemployment levels in Europe, we would certainly concur. Therefore, we believe in the coming weeks, the ECB will finally concede to a Quantitative Easing campaign of its own. The details will need to be worked out, but we believe the ECB will begin purchasing the sovereign debt of its member nations in order to pursue even lower interest rates with the idea of stimulating investment and growth (and discouraging savings). Whether Quantitative Easing will work in Europe is a complicated matter and way beyond the scope of this commentary. But it will certainly drive further weakness of the Eurodollar relative to other currencies, particularly the US Dollar. In fact, depending on the scale of the ECB QE campaign, we would not be too surprises to see the Eurodollar trade back down to parity (1:1) with the US Dollar at some point in the next year or so. As a point of reference, the US Dollar and the Eurodollar have not traded at 1:1 parity since 1998.
In that context of even further US Dollar strength, dollar denominated commodities should continue to fall in price, including oil. In fact, on this point of US Dollar strength, we believe that until a reasonable and credible argument for US Dollar weakness can be advanced, a huge headwind will prevail for WTI Crude Oil prices under this powerful dynamic.
OPEC: Monopolist or Competitor?: The second theme that we are focused on in respect to this thesis of lower energy prices only became apparent at the last OPEC meeting on Thanksgiving Day. As you might recall, Saudi Arabia shocked the oil markets when it strong-armed the rest of OPEC into holding oil output levels stable. In the past, at least going back to 2005 anyway, OPEC has been very predictable in cutting output whenever crude prices fell in order to support higher prices. We believe this very dramatic move by OPEC marked a watershed event in the global energy market when OPEC moved from a monopoly pricing model to competitive market pricing model.
Under a monopoly pricing model, the monopolist, in this case OPEC, will set the price of their good and modify production of that good up or down depending on demand. During times of strong demand, the monopolist maximize profits by increasing production (price x output). And during periods of weak demand, the monopolist will maximize profits by cutting production, which pushes prices higher. All the while maintaining a relatively stable price in the long run. We would argue, as the Kaletsky article argues as well, that OPEC has employed this monopolist pricing strategy since at least 2005 which generated the high oil prices we saw over that period.
As with any product where the price is set substantially higher than the production cost, competitors will be attracted to the market place. In the case for global oil, much of this competition has come from higher marginal cost producers, such as Venezuela, Iran, and US shale oil.
We believe that on Thanksgiving Day, OPEC reasserted its dominant position and lowest marginal cost advantage in the global oil market by effectively abandoning its monopoly pricing strategy and instead adopting a competitive pricing strategy. Under a competitive pricing strategy, the low cost provider will maximize profits at that price where MC = P (marginal cost = price). Profit maximization for the lowest marginal cost producer is achieved by maximizing output and leveraging the monopolist’s lowest cost advantage and effectively expanding its share of the (oil) market.
One could certainly argue that as higher cost producers are forced to leave the marketplace over the next few years (should low prices prevail), OPEC could reassert higher prices. However, with the new knowledge of the massive global oil reserves available at higher prices, raising prices and attracting new competitors would not seem to make much sense to the Saudi’s or any other low cost producer. Therefore, under this new competitive pricing scenario, it seems reasonable to believe that OPEC will effectively maximize its profits over the long run in a price range above their marginal cost (around $20/bbl) and below that price that seems to attract global competition (which “feels” like around $55/bbl). Anyway, until proven wrong, those are the WTI crude prices we are planning on for our investment models for the foreseeable future.
In a world where the US Dollar is strong and WTI Crude Oil remains range bound and capped around $55/bbl, US consumers will be the vast beneficiary. Not only will they have more dollars to spend (from the energy savings), those dollars will buy more goods from foreign producers (imports). Therefore, we are focusing in on owning the stocks of companies that should benefit from this pricing environment. Industries in that realm should be transportation companies (from lower fuel costs and higher consumer demand). Although airlines would probably do well, we prefer railroads and shippers due to their cost advantages. Other industries that should do well are manufacturing firms, particularly chemical producers that rely on energy related feedstock, and automobile manufacturers and suppliers.
Mark P. Culver
 Kaletsky, Anatole; A New Ceiling for Oil Prices, Project Syndicate; http://www.project-syndicate.org/commentary/oil-prices-ceiling-and-floor-by-anatole-kaletsky-2015-01
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