Oil – The Imperfect Storm

At Gould Financial Planning, we operate a disciplined investment process aimed at minimising the impact of market volatility upon your financial wealth. Our investment process is very much risk-focused in so far as we believe that investing is all about time in the market as opposed to timing the market. Therefore, we will rarely speculate that certain areas of the market offer better value than others (i.e. smaller UK companies over larger UK companies, or emerging markets over developed markets), preferring instead, to allocate sensible amounts to each of these areas in accordance with an investors’ appetite for risk; if an investor is willing and able to take risk, so the proportion in the more volatile areas of the market will increase in pursuit of higher returns.

The idea behind this approach is that having spent a requisite amount of time in the market the risks being taken will begin to pay off.

This is a mantra we firmly believe in; however, there is little doubt that certain sectors will test the patience of advisors and investors alike on occasions. One such area of the market which has certainly tested patience in recent years has been the commodities sector. There is no hiding place; returns from this sector have been ugly and this article looks to explore why this has happened, when the tide may eventually turn, and what might happen thereafter.

The Factors at Play

For many years, right up until 2010, a commodity super-cycle was in full swing. Growth in emerging markets was seeing huge demand for oil and industrial metals in particular and OPEC countries, holding a monopoly over global energy markets, were able to effectively set the price as they saw fit. In a world of finite resources versus a rising global population, the general consensus amongst investors and advisors alike was that this trend was likely to continue over the long term, even if short term volatility was unavoidable on occasions.

The graph below plots performance of the JPM Natural Resources fund from January 2000 to the beginning of 2010.

We believe there are multiple factors at play which are suppressing the price of commodities, but oil in particular, including;

 Slowing of growth in emerging markets
 Geo-political issues in Russia and Iran in particular
 Increased American and Russian production levels

Emerging Markets

To a large extent the fortunes of many commodity markets are highly dependent upon economic growth in emerging markets and, in particular, China. It is no coincidence that the slowdown in Chinese growth from a GDP level of 14% in 2007 to around 6% today has also seen the prices of energy and industrial metals fall in value considerably. Industrial slowdowns and the subsequent lower levels of consumption see a rapid decline in demand and, as demand subsides, so the price falls in turn.

Fracking up Production Levels

In its own right this could see many commodity markets suffer; however, the problem has been exacerbated by the emergence of fracking in the US. In 2000, there were about 276,000 natural gas wells in the United States. But by 2010, that number had almost doubled to 510,000 according to the U.S. Department of Energy (DOE). Every year about 13,000 new wells are drilled. According to a 2014 a study at least 15.3 million Americans have lived within a mile of a fracking well that has been drilled since 2000.

Many of these fracking companies are highly leveraged and unable to turn a profit at the current low oil price of around $50 a barrel. Therefore, OPEC countries have been deliberately pumping more oil than is required globally in order to suppress the price of oil. Whilst most, if not all OPEC countries are unable to turn a profit at current prices either, in many cases their oil is under state control and many of these states have strong financial reserves which can stomach short term losses in order to maintain a monopoly over global markets in the long run.

Geo-political Issues

Russia is under effective financial sanctions due to its own “currency crisis”. At this moment in time, in a quest to lay their hands on US dollars, the country is pumping out plenty of the brown stuff to get their hands on the green stuff. These increased levels of production, if not countered by lower levels of production elsewhere in the world, have a negative impact on prices as demand heavily outstrips supply.

The graph below plots performance of the JPM Natural Resources fund from January 2010 to the present day, following large falls in Chinese consumption, the rise of fracking in the US and the issues faced by Russia.

Short Term Prospects

Depending on who you listen to, the price of oil could end up anywhere between $20 and $100 a barrel within the next twelve months! Goldman Sachs has been particularly vocal over their view that the price is likely to fall further before things get any better.

With the prospect of American interest rate rises in the near term strengthening the dollar, this could indeed see further falls in the price of dollar-denominated commodities as overseas countries will have to pay higher local currency prices in order to purchase the same amount of produce. Furthermore, some emerging market countries which drive much of the consumption in commodity markets, have much of their debt issued in dollars. As the relative value of this debt increases due to a strengthening dollar, this in turn could weaken their economies, leading to lower consumption still.

Another potential curveball is the lifting of UN sanctions upon Iran. Iran will undoubtedly wish to set about regaining their market share of oil markets in particular and, in the short term at least, may look to do this without too much concern over profitability. However, other OPEC countries are unlikely to take too kindly to this and this in itself could cause some interesting outcomes in the months and years ahead.

We feel that there could be more volatility to come when US interest rates begin to rise; however, whilst we cannot be certain in which direction commodity markets may turn next, we do feel that the worst of the damage is now done. The fundamentals for growth are certainly there in our opinion.

The Fundamentals

Commodity markets are complex, and calling the direction each of the individual sub-sectors could turn is a thankless task. As far as we are concerned there are a number of key points to remember;

 In so far as oil is concerned current prices are unsustainable. There are very few (if any) countries able to turn a profit at current prices. We therefore feel that, in spite of the potential for short term losses, the long term trend is likely to reverse and continue upwards.
 We are beginning to see a fall in the number of US rigs undertaking fracking. If this trend continues this could trigger a drop in production levels from OPEC countries which will allow a degree of normality to resume.
 Despite worries over the Chinese economy, they are not slowing down in our view. The government there has recently announced plans to issue bonds in order to plough money into infrastructure spending after being spooked by the sudden stock market crashes, the first batch of which will be valued at around $48bn. Increased infrastructure spending leads to increased consumption of energy, metals and other commodities.
 The global population continues to rise, whilst the level of resources on the planet continues to fall. This should lead to rising prices over the long term.

We feel that these factors point towards rising prices over the long term. Shorter term there could well be some further headwinds for investors to face and this is why we will be advocating increased diversification of commodity portfolios in the short term, and for portfolios of a certain size we will be looking to introduce agriculture, renewable energy and water investments into portfolios.

If this is something you wish to discuss outside of your normal review window please let us know. Please note past performance is not a reliable indicator of future results.