2014 was another positive year for the US stock market. The US bond market also produced competitive returns.
On the surface it may seem that things are going well in the US financial markets. However, it has been a relatively bad year for diversification.
Many assets have not been correlated with the U.S. market and in fact ended the year in the negative category for 2014.
For example, the MSCI EAFE (developed international) index fell 4.5% in 2014. The MSCI EME (emerging market) index fell 1.8%.
Most glaringly, commodities prices fell abruptly (oil prices have been more than cut in half from their highest point). We have also seen some turbulence in the currency markets as the dollar has recently appreciated.
As value investors we always are intrigued by falling prices in an asset category.
Although people tend to look for bargains in many aspects of their lives, (such as clothing or electronics shopping) they often miss these opportunities when it comes to investing.
The large downturn that we have seen in oil prices will most certainly create a good opportunity at some point. Commodity (commodities include different kinds of fuel, metals, and agricultural products) investing is unlike that of stock and bond investing.
Commodities do not pay a dividend, earn free cash, or produce income. For this reason traditional methods of fundamental valuation simply do not apply.
A stock or bond can be valued with fundamental analysis to come up with some present value of future cash flows. However, commodities do not have those same characteristics.
Sizing things up
Therefore, we have to rely on these three factors in order to come up with some value for commodities:
Historical prices: There is a range of technical analysis that investors use to try to draw conclusions about future prices based on historical prices. One simple example is to look at the long term historical trend line.
When prices are extremely low or heightened, they could be considered to be over or undervalued. Investors may place a “reversion to the mean” trade, in which the investor would expect that eventually the price will go back in line with it’s long-term historical trend.
Supply & Demand: Prices for any financial asset are largely determined by supply and demand of the financial instrument being traded. More supply has a negative price impact as does declining demand for a commodity.
As an example, if there was an unexpected discovery of a massive amount of gold, which theoretically doubled the supply of gold, prices of gold would immediately plummet.
Future Supply & Demand Expectations: Financial assets (including commodities) are leading indicators. They reflect, not only consumer sentiment today, but also expectations about the future.
For example, if investors expect the price of an asset to increase in the future, these investors will begin to buy assets at the current lower prices, which will in turn drive prices higher.
With the historical prices of oil, we can see that there are periods in which oil has gone lower and stayed that way for longer than it has gone recently.
In early 2008, oil reached a height of $145 a barrel. In late 2008, it reached a low of $33. One thing to keep in mind in regards to oil price movements in 2007 to 2009 period was that there was massive deleveraging which caused investors to have to dump investments to raise cash.
This affected hedge funds, investors on margin, and many commodity and currency investors. This swelling supply of sellers caused downward price pressure.
Another trend putting downward pressure on prices was declining current and future demand expectations. Due to a weak global economic environment investors expected less commodity demand.
For example, if the economy were in a depression, we would expect consumption of oil to decline as belts are tightened. Also, prices did not stay that way for a long period of time. By 2009, prices went above $80. By 2011 prices went above $100.
Oil prices have been extremely volatile over the past few years. There is as much potential for upside as downside volatility in oil.
Massive historical movements in the price of oil have also coincided with some sort of geopolitical events such as recessions and wars.
Oil demand globally has not changed much over the past 2 years. We are forecasted this year to have increased global demand over 1% annualized. Supply has changed less than 3% over the last two years.
The most striking change in global supply has been the increased supply in the US. This is primarily due to the shale and fracking boom.
Better technology has allowed oil drilling companies to access more of a supply of oil than has been accessed previously.
Although US energy production has been increasing at a double digit pace, the increased supply levels, globally, is still in the low single digits. In other words global supply has not outpaced global demand by a wide margin.
Overall, low oil prices are a big stimulus for most Americans and energy consumers. Oil prices may not stay low for a long time.
There is a saying that the best cure for low oil prices is low oil prices. The lower prices go for oil, the less economically feasible drilling becomes. Less drilling equals less supply, which leads to increasing prices.
The US has been the primary driver of increasing supply driven by the fracking boom. This type of oil drilling operation is far more sensitive to low prices than traditional oil drilling.
Fracking operations are more capital intensive and wells are shorter lived than their traditional counterparts. As the US drilling industry shutters production plans, there will be less supply and likely higher prices.
Also, lower prices puts less price sensitivity on consumers. Both companies and individuals can loosen their belts a bit as prices of oil goes lower.
Lower oil prices is a boon for most individuals and countries that are net importers of energy. This includes countries like the US, Japan, most European countries, China, and India.
Oil has had the added characteristic of being sensitive to geopolitical instability. If there are concerns about geopolitical instability in the Middle East or Russia, oil prices can adjust to the upside.
Although it is not clear that there is one fair price for oil, there are several forces that can push oil prices higher in the future. The futures market for oil reflects the expectations for oil in the future.
The long-term expectations for crude oil are significantly higher than they are today (we know this based on the longer dated oil futures contracts).
Oil investing has been treacherous lately, but we are confident that the abrupt selloff will generate some compelling investment opportunities.
We have a shopping list of investments that we think will benefit if oil recovers. However, we will not be taking action until we have seen some recovery in oil prices. We will therefore miss the early part of a recovery in oil.
But, we will reduce the probability of “catching a falling knife,” whereby we would be investing in oil when prices continue to fall.
The problem with investing in oil is that we can say that the price appears to be low, but we could have said the same thing a month ago, a month before, and so forth.
Photo Credit: Vicky Broth via Flickr Creative Commons
DISCLAIMER: The investments discussed are held in client accounts as of December 31, 2014. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. Past performance is no guarantee of future results.