value and opportunity

My oil price forecast

To be honest, I have no fxxxing clue where oil will be tomorrow, in 1 month, 1 year or 10 year. The good news is: Absolutely nobody has a clue, too !! Yes, you can read now a lot of comments, interviews etc. of people who have suddenly turned into oil experts and predicting either a jump back to 100 USD/barrel or oil for free for the next 100 years.

I did some research and one of the very few analysts who was actually bearish on oil prices was a guy called Ed Morse from Citibank. I found comments from him in 2012, 2013 and beginning of 2014. But even he only predicted prices down to 75 USD/barrel.

So it is pretty fair to say that no one saw this coming. Therefore one should be extra careful on listening to people try to tell you what is happening next. They are all just guessing. And no, I am not interested in any Saudi/US/Russia conspiracy theories.

My personal opinion is that the current fall in prices could be a combination of additional supplies (indebted oil companies and governments have to pump more oil as prices fall to meet obligations) and momentum riding traders (hedge funds. But this is just an opinion, I have no prove for this.

Is a low oil price good for the economy ?

Although I have no clue where oil is going, I think it is still important trying to understand what this could potentially mean if oil prices remain low. Oil, in contrast to gold, silver or even iron ore is such an important factor in the global economy that it would be naive to believe that this has no impact.

Conventional wisdom is that low oil prices are good for the American consumer as he has more to spend on “stuff” and as a consequence for the US economy. But wait a minute ….wasn’t deflation the biggest “Enemy” of the recovery ? Then why should now deflation via the oil price suddenly be great news ? Is ther good deflation vs. bad deflation ?

I am not a macro guy, but I would say there are doubts if low oil prices are really good for indebted economies struggling with deflation. In the UK for instance, inflation already was at a 12 year low for November. Oil and gasoline taxes are important revenue bases in southern Europe as it is not easy to dodge those taxes.

One other thought: A lot of Oil money got recycled into the stock market. Norway is the biggest shareholder in most European stocks and increasing their stakes continuously. If the oil price stays that way, they clearly have less money to invest.

On oil (and related) companies

Clearly, most oil related companies are negatively effected by lower oil prices. There are business models with more exposure (e.g. oil rigs) and less (oil storage), but in general, the whole oil industry is not happy about a -50% drop in oil prices.

However they do look extremely cheap on a historical basis. But be very careful here. If you look at trailing P/Es or trailing EV/EBIT like the Alpha Architect blog did, be aware that those cheap trailing multiples are based on 110 USD/Barrel and not 55 USD.

Nevertheless, a stock which has just fallen 50% or more often looks irresistible for value investors. This is buying at a huge discount, right ? But just buying on a recent drop in prices is in my opinion “fast thinking”, the typical “catch a falling knife” reaction.

The “slow thinking” and real value investing would be to make sure that the VALUE (not the price !!) of such a company has remained constant.

The problem with this is the following: In order to justify an investment into oil related stocks based on historical profitability you have to assume 2 things at the same time:

1. the oil price has to go back up
2. oil related companies have to be able to earn their old margins again.

Those are basically two bets in one. Especially for capital-intensive companies, the second point does not automatically follow the first. If the oil cycle has actually turned for a longer period, than we will see a lot fewer investments going forward and anything related to Oil capex might be in trouble (and yes Siemens, you might think of directly writing of all of your nice Dresser Rand goodwill purchased at a PE of 32). A good example for instance for this effect are the Steel and shipping industry. All that capacity is not going away quickly and the companies are willing to operate at a loss as long as variable costs are lower than the price.

As a trader, you can clearly speculate on a rebound, as we are just seeing on a daily basis. As an investor, you should make sure that your chosen investments will experience “mean reversion”. For companies with a high capital intensity and lots of debt there a big risk that someone else will reap the benefits of the recovery after shareholders have been wiped out. I am pretty sure, Oaktree is already hiring energy experts by the dozen.

“Collateral damage”

Apart from oil related companies, one should be aware that problems could surface elsewhere. Banks who lend to oil companies are an obvious example. Oil traders or hedge funds who are long oil are another example, an early casualty was OW Bunker, a shipping fuel supplier from Denmark.

Less obvious issues could come up for instance at airlines. Yes, long-term they might benefit, but short-term they could run into a cash crunch due to their hedges. If an airline uses forwards they have to put up a lot of collateral to banking partner at the moment as their forwards are deeply underwater. If then competitors with less hedges then start reducing ticket prices early, this could get interesting.

In Germany, gasoline tax is around 40 bn per year or 4-5% of total tax revenues. In countries like Italy, that percentage is much higher (gasoline is much more expensive in Italy than Germany due to higher taxes…). Especially for those countries, the drop in tax revenues will hurt. I didn’t find hard numbers on that but my guess is that budgets in countries like Italy will not surprise to the upside if oil and gasoline prices stay low.

Potential opportunities

However there is also the chance of what I would call “positive collateral damage”. For instance companies in the oil sector or in oil economies which are not directly hit by the oil price like distributors etc.

Norway could be interesting too. I am suffering at the moment with Bouvet, but I do think that med term this could be interesting. The Norwegian Government has enough fire power to jump-start some supporting initiatives and Bouvet could profit as the Government is one of their biggest clients (Statoil too, I know….).

Turkey and the Lira have been hit badly by the Ruble crisis. I do not fully understand why. Turkey is a big oil importer and lower oil prices will most likely lower inflationary pressures. I guess this has to do with investors selling out local currency EM funds.

Other examples could be oil related distribution companies or infrastructure companies (oil storage, natural gas grids) who earn money based on volume independent of underlying prices. Or Oil tankers, but that is again another story.

Summary:

If oil remains at current levels, this would be clearly significant, both for the world economy and the stock market. I have no clue what oil will be doing, but it makes a lot of sense to think about potential impacts.

My advice at the moment would be:

– ignore oil price forecasts from people who didn’t see this coming (basically everyone)
– avoid anything which has a lot of leverage and is oil related unless you want to trade short-term
– make sure you understand what parts of your portfolio have direct/indirect oil exposure and in which direction and ask yourself if you are comfortable
– better look for “collateral damage” kind of investments (non oil companies in oil countries etc.)
– don’t rush, let your “slow thinking” part of the brain gain control