Select excerpts from the latest note by Oaktree's Howard Marks "The Lessons Of Oil [12]"
The following list is designed to illustrate the wide range of possible implications of an oil price decline, both direct consequences and their ramifications:
- Lower prices mean reduced revenue for oil-producing nations such as Saudi Arabia, Russia and Brunei, causing GDP to contract and budget deficits to rise.
- There’s a drop in the amounts sent abroad to purchase oil by oil-importing nations like the U.S., China, Japan and the United Kingdom.
- Earnings decline at oil exploration and production companies but rise for airlines whose fuel costs decline.
- Investment in oil drilling declines, causing the earnings of oil services companies to shrink, along with employment in the industry.
- Consumers have more money to spend on things other than energy, benefitting consumer goods companies and retailers.
- Cheaper gasoline causes driving to increase, bringing gains for the lodging and restaurant industries
- With the cost of driving lower, people buy bigger cars - perhaps sooner than they otherwise would have – benefitting the auto companies. They also keep buying gasoline- powered cars, slowing the trend toward alternatives, to the benefit of the oil industry.
- Likewise, increased travel stimulates airlines to order more planes – a plus for the aerospace companies - but at the same time the incentives decline to replace older planes with fuel-efficient ones. (This is a good example of the analytical challenge: is the net impact on airplane orders positive or negative?)
- By causing the demand for oil services to decline, reduced drilling leads the service companies to bid lower for business. This improves the economics of drilling and thus helps the oil companies.
- Ultimately, if things get bad enough for oil companies and oil service companies, banks and other lenders can be affected by their holdings of bad loans.
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To give you an idea about how events in one part of the economy can have repercussions in other economic and market segments, I’ll quote from some of the analyses I’ve received this week from Oaktree investment professionals:
- Energy is a very significant part of the high yield bond market. In fact, it is the largest sector today (having taken over from media/telecom, which has traditionally been the largest). This is the case because the exploration industry is highly capital- intensive, and the high yield bond market has been the easiest place to raise capital. The knock-on effects of a precipitous fall in bond prices in the biggest sector in the high yield bond market are potentially substantial: outflows of capital, and mutual fund and ETF selling. It would be great for opportunistic buyers if the selling gets to sectors that are fundamentally in fine shape . . . because a number of them are. And, in fact, low oil prices can even make them better.
- An imperfect analogy might be instructive: capital market conditions for energy-related assets today are not unlike what we saw in the telecom sector in 2002.
As in telecom, you’ve had the confluence of really cheap financing, innovative technology, and prices for the product that were quite stable for a good while. [To this list of contributing factors, I would add the not-uncommon myth of perpetually escalating demand for a product.] These conditions resulted in the creation of an oversupply of capacity in oil, leading to a downdraft. It’s historically unprecedented for the energy sector to witness this type of market downturn while the rest of the economy is operating normally. Like in 2002, we could see a scenario where the effects of this sector dislocation spread wider in a general “contagion.” - Selling has been reasonably indiscriminate and panicky (much like telecom in 2002) as managers have realized (too late) how overexposed they are to the energy sector. Trading desks do not have sufficient capital to make markets, and thus price swings have been predictably volatile. The oil selloff has also caused deterioration in emerging market fundamentals and may force spreads to gap out there. This ultimately may create a feedback loop that results in contagion to high yield bonds generally.
Over the last year or so, while continuing to feel that U.S. economic growth will be slow and unsteady in the next year or two, I came to the conclusion that any surprises were most likely to be to the upside. And my best candidate for a favorable development has been the possibility that the U.S. would sharply increase its production of oil and gas. This would make the U.S. oil-independent, making it a net exporter of oil and giving it a cost advantage in energy – based on cheap production from fracking and shale – and thus a cost advantage in manufacturing. Now, the availability of cheap oil all around the world threatens those advantages. So much for macro forecasting!
There’s a great deal to be said about the price change itself. A well-known quote from economist Rudiger Dornbusch goes as follows: “In economics things take longer to happen than you think they will, and then they happen faster than you thought they could.” I don’t know if many people were thinking about whether the price of oil would change, but the decline of 40%- plus must have happened much faster than anyone thought possible.
I said it about gold in All That Glitters (November 2010), and it’s equally relevant to oil: it’s hard to analytically put a price on an asset that doesn’t produce income. In principle, a non-perishable commodity won’t be priced below the variable production cost of the highest-cost producer whose output is needed to satisfy total demand. But in reality and in the short run, strange things can happen. It’s clear that today’s oil price is well below that standard.
It’s hard to say what the right price is for a commodity like oil . . . and thus when the price is too high or too low. Was it too high at $100-plus, an unsustainable blip? History says no: it was there for 43 consecutive months through this past August. And if it wasn’t too high then, isn’t it laughably low today? The answer is that you just can’t say. Ditto for whether the response of the price of oil to the changes in fundamentals has been appropriate, excessive or insufficient. And if you can’t be confident about what the right price is, then you can’t be definite about financial decisions regarding oil.
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Full note below (pdf [12])
