“…gas prices, they go up and they come down and then they go up. So I just want everybody to know that you should enjoy this.” – President Obama
The nature of our line of work is that we are in constant dialogue with our friends, family and clients about economic and investment-related topics. The conversation naturally ebbs and flows with current events and what seems to be impacting peoples’ financial lives the most at any given point in time. Not surprisingly, the majority of questions and comments we’ve heard lately have been related to cheap gas prices, how long they will last and whether or not energy-related investments might represent a good opportunity. So although we’ve written about the decline in oil several times on this blog in recent months (see posts here, here and here), we’ve decided to turn back to the topic yet again this week to take another look at why fuel prices are so cheap and whether or not we might expect them to stay that way.
In the last six months the US national average price for regular unleaded gas has fallen by 41% from $3.64 to $2.14 a gallon. This has led to a barrage of analysis over who the winners and the losers are in the aftermath of such a decline, with perhaps the most obvious winner being the US consumer. According to AAA, depending on how low gas prices stay in 2015 the aggregate savings (and re-directed spending power) realized by America’s consumer base could amount to upwards of $75 billion.
Any conversation about falling gas prices obviously has to center on the decline in the primary input to those prices – oil. The nearby graphic, borrowed from the US Energy Information Administration, shows that as of November 2014 oil prices accounted for 62% of the price of gasoline, with the balance being attributed to more static variables in taxes, distribution and refining costs. Thus, understanding why gasoline prices have dropped largely comes down to understanding why oil prices have dropped. There are a variety of explanations for this, but the most glaring one is increased global supply.
As we pointed out in Oil’s Winners and Losers, world oil production has increased dramatically in recent years – driven primarily by gulf drilling and the shale revolution right here in the US (see chart).
Given the increase in US supply, market participants anticipated other major producers to begin scaling back in order to prevent excess supply from having the effect on oil that it’s had. OPEC, in particular, was expected to announce production cuts in response to a world awash in oil (as a major exporter they are incentivized to keep prices as high as possible). However, in late November OPEC shocked the world with its announcement that it would continue pumping the black gold at its current pace. As we stated in December,
There are a number of reasons OPEC may have decided to go this route, some of which are covered in our October post. One of the more popular explanations is that OPEC would like to see US shale oil extractors slow their pace of production. Global supply is being pushed higher by production right here in the US, and our oil imports have already been cut by nearly 60% since 2006. This trend represents a direct threat to the economic well-being of the world’s largest oil exporters. Shale production generally carries a higher cost structure than more conventional extraction methods, and many of the players here in the US are smaller more highly-levered companies that may be strongly dis-incentivized by lower prices. So it appears, as Michael Lynch of Strategic Energy and Economic Research was recently quoted as saying, “The Saudis have decided to squeeze the shale producers.”
Regardless of OPEC’s motivation, the current reality is that there is a lot of oil being pumped out of the ground right now all around the world – and the pace doesn’t look like it will be slowing anytime soon. This has prompted most of the major Wall Street banks to aggressively cut their oil price forecasts (Goldman is calling for $40.50 on average through Q2), citing that sustained low prices will be necessary in order to stoke demand and clear out excess supply. Indeed, a consensus narrative is taking shape that would suggest the oil bust is here to stay – at least for the foreseeable future.
A follow on question we are repeatedly asked is whether or not, in light of the collapse in prices, energy-related investments represent a good buying opportunity. Our best guess is that some of them do – or rather they will – eventually. However, as Louis-Vincent Gave of Gavekal Research recently penned in a note to clients, “Most investors go about their job trying to identify ‘winners’. But more often than not, investing is about avoiding losers.” We couldn’t agree more, which is why we implement systematic risk management disciplines throughout our portfolio management process.
MarketVANE, for instance, is a proprietary trend following model designed to identify and get in line with uptrends in the market while stepping aside when the trend breaks down. We have two MarketVANE models, one for global stocks and one for hard assets, and they have both been spot on in “avoiding the loser” by sidestepping the collapse in oil prices. MarketVANE Stocks gave us a sell signal for the energy sector at the end of September, while MarketVANE Hard Assets gave us a sell signal for commodities two weeks prior. These signals resulted in both models significantly outperforming their benchmarks in Q4, not necessarily by picking the winners but rather by avoiding the losers.
At some point energy-related investments may once again be in favor, and depending on how much farther they go down from here there could be a lot of money to be made in the next up cycle. A new uptrend will eventually assert itself, and we will re-enter the sector at that point. For now we are content treating energy as the “loser” that it is while heeding the advice of our President to enjoy the savings at the pump!
Author David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.
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