2014 Year End Letter
As 2014 comes to a close, we want to provide an update on the energy sector. Energy has been making headlines as oil prices have reached unexpected lows. As discussed below, while the decline in oil prices is creating volatility in the energy sector, we believe that there continues to be opportunity in this sector and that the low oil prices should prove beneficial to U.S. and global economic growth.
The price of oil began to slip from its highs in June with the decline continuing through the third quarter before plunging in late November. The proximate cause is a mismatch between growing global supply and stagnating demand. The weakness in demand was not a big surprise given the well documented, recent economic slowdown in Europe, Japan and China. The growth in supply did not come as a surprise either. U.S. and Canadian producers delivered sharp increases in production in each of the last two years and the consensus view was that North American production would continue to expand at a nearly 1.0 million barrel-per-day rate in 2014 and again in each of the next several years. The big surprise that undermined the oil markets occurred in September, October and November, when Libyan production came back on stream and Saudi Arabia did nothing in response. As the weeks passed without any sign of a reduction in Saudi production, the price of oil started to fall. When OPEC met formally on Thanksgiving Day and the Saudis officially and definitively said that they would not cut back production to steady the price of oil, the markets collapsed. For all intents and purposes, the Saudi message to the world was that the OPEC cartel is finished.
There has been much speculation about the motivation of the Saudis. The official Saudi position is that they needed to cut the price of oil to maintain market share in critical Asian markets. This is no doubt true, but the universal expectation was that the Saudis would do just that in the name of steadying the price of oil in the $90-$110 range. After all, they are the largest OPEC producer by a factor of more than two and they ramped up capacity and production over the past several years to keep prices from quickly rising when political unrest in other OPEC countries led to supply shortfalls. It stood to reason that they would pull back their production to pre-Arab Spring levels as output resumed from other OPEC producers. Why, then, did the Saudis decide to keep producing this fall at these new higher levels at the expense of prices dropping below the range they had been defending for the past three years? We think the answer is that they determined that longer term prices above $90 per barrel would lead to ever increasing supply out of North America and therefore require the Saudis to continuously reduce their production to keep markets balanced. They concluded that no other producer would step in and reduce output. The result over just the next 3-5 years would have been a massive reduction in Saudi output and market share — possibly in the range of 30-50%! We believe their bet is that by letting the price of oil fall, market forces will now slow the rate of production increases globally, especially in North America. They believe that many of the new unconventional oil wells in the U.S. are unprofitable with prices below $70. The same is true for many of the mega ultra-deep water, oil sands and Arctic projects around the world that may have very low extraction costs but very high capital costs.
With prices nearing $60 per barrel, it is a good bet that the pace of oilfield development around the world will slow meaningfully in the coming 6-12 months and remain at subdued levels until the price rises back above the $80 level. It is impossible to know just how low the price will fall in coming weeks and months. Some high cost production should get shut down at a price below $50, but, more importantly, we think fewer new shale wells will get drilled and even some drilled wells waiting for completion may not get completed. Consequently, supply should start to contract by next spring/summer and oil prices will likely rebound by next fall.
The macro level implications of lower oil prices are positive for all net oil consuming countries, including the U.S., Europe and the major Asian economies (Japan, China, India, et al). The U.S. seems likely to be the clear winner. The benefits of lower oil prices should be greater for the U.S. than for most of our trading partners because the rising U.S. dollar (driven by low global interest rates and commodity costs) offsets some of the benefits to these other economies. The clear losers are Russia, Iran, Nigeria, Venezuela and a number of other net oil exporting countries that are heavily dependent on oil revenues and who need a price in excess of $100 per barrel to balance their fiscal regimes.
For the U.S. economy, lower oil prices generally increase discretionary income for consumers. This can translate into higher spending on both durable (cars, houses, etc.) and non-durable (clothing, leisure, dining, etc.) goods. Consumers are likely to buy larger, less fuel efficient cars and trucks, which means the auto industry should sell both more vehicles and more of their most profitable larger models. The combination of lower oil prices and a stronger dollar (which leads to lower import prices) suggests that inflation will stay lower longer than would have been the case had oil prices remained in the $90-$110 range. Lower inflation likely means that the Federal Reserve (the Fed) will be able to keep interest rates lower for longer, allowing unemployment to fall further and wages to rise more before the Fed feels the need to raise rates. Slowing domestic shale development will probably detract from U.S. economic growth, but lower oil prices should be a net benefit to the economy.
In terms of what declining oil prices mean for our equity strategy, we have been uncomfortable with commodity companies for some time, going back to the collapse in the natural gas markets in 2008 and more recently with the slowing in the Chinese economy. History has shown us that a worldwide investment boom to increase supply of any commodity in response to high prices almost always results in a price collapse when the new supply hits the market. For this reason the focus of our investing in the energy patch for the past five years has been on companies that benefit from rising volumes – not prices. Our investments make their money moving other people’s energy around without actually taking title to the commodity itself.
At present, our equity strategy has only one direct commodity company: Occidental Petroleum (OXY). We own OXY because its current management team is conducting a sweeping restructuring and downsizing initiative that should result in a smaller, more profitable and more focused company with little or no debt, the lowest costs in the industry and decades of attractive growth potential even if prices never get back above $100 per barrel. All of the other energy holdings in our strategy are infrastructure companies with little or no direct commodity exposure. These companies own and operate strategically critical gathering, processing, storage and/or shipping assets that generate fee-based revenues. While it is certainly possible that these companies’ growth will be slower in the years ahead with oil prices closer to $60 than $100 per barrel, we believe they should still be able to both maintain and grow their earnings, cash flows and dividends/distributions to equity holders. In fact, the collapse in oil prices may make their storage assets more attractive given that the expected future price of oil is higher than the current price. This creates an incentive to store oil today and sell it at higher prices in the future. Also, consumption of oil, as well as the refined products derived from oil such as gasoline, diesel and jet fuel, may rise in response to lower prices. This could increase demand for certain pipeline and storage assets. Ironically, natural gas could also get a lift from lower oil prices, because of one of the odd secrets of the boom in shale oil production: Much of what comes out of many shale oil wells is natural gas and related natural gas liquids. If far fewer oil wells are drilled in the next 6-12 months, this will likely result in less natural gas, potentially firming its price, which would benefit a number of our infrastructure holdings.
None of this means that our energy holdings will be spared from short-term volatility related to the collapsing price of oil. As we recently saw, Master Limited Partnerships (MLPs) experienced indiscriminate selling in the wake of declining oil prices. However, we continue to have high conviction in our MLPs and believe that longer-term they will prove to be valuable assets for our investors. Additionally, as the price of oil continues to be under pressure, we may be able to find some high quality energy exploration and production companies that would normally be out of our price range.
Looking at fixed income, our exposure to energy is also underweight commodity energy producers. While we have felt for some time that the next possible bubble would be in energy commodity producers, given the huge investments made in the past several years, we have made selective investments in service companies that are focused on treating waste produced mainly from producing wells. These wells are less likely to be shut down as the discovery and drilling costs are behind them. We have also made investments in infrastructure and storage companies, which, as discussed above, are much less sensitive to the price of the commodity and may actually benefit from a positively sloping future price curve for oil. This has not, however, prevented them from being tarred with the energy label as many investors who were overweight the sector attempt to pare holdings going into year end. If our view is correct that as future supply is curtailed and economic strength gains momentum, we could likely see a rebound as early as late 2015.
We will further discuss our economic perspective in our January Investment Outlook, but in general we continue to believe that the U.S. is well-positioned to maintain its slow growth trajectory. Some are even saying that the U.S. has entered into a period that none of us here have ever seen – a deflationary boom. We don’t expect weakness in Europe, Japan or China to spill over to the U.S. because the U.S. is well insulated from global trade flows. That said, we are mindful of the many risks that could affect our outlook, such as geopolitical unrest, sudden declines in consumer/business confidence, a downdraft in economic activity or a corporate profit collapse. Right now we think these risks are remote, but we continue to vigilantly monitor them.
Best wishes for a very happy and prosperous 2014.
John Osterweis Matt Berler Carl Kaufman
Past performance is no guarantee of future results.
This commentary contains the current opinions of the author as of the date above, which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
OPEC refers to the Organization of the Petroleum Exporting Countries.
Fund holdings and allocations are subject to change at any time and should not be considered a recommendation to buy or sell any security. As of 9/30/2014, the Osterweis Fund, the Osterweis Strategic Investment Fund and the Osterweis Institutional Equity Fund held 2.99%, 1.88% and 3.16% of Occidental Petroleum, respectively.
Cash Flow measures the cash generating capability of a company by adding non-cash charges (e.g. depreciation) and interest expense to pretax income.
© Osterweis Capital Management
© Osterweis Capital Management