Don’t Try to Catch a Falling Knife: Reflections on the current price of oil (Part 1)

12.05.2014 By

The price of oil has fallen precipitously in recent months. WTI now trades at around $67 per barrel, a far cry from the $100 level attained this past summer. The move is akin to a large rock dropping into the investment pond: we expect ripple effects.

When the commodity that most fuels the global economic engine experiences such a dramatic price move, nearly all investors take notice. Yet it is the investors from the oil-exporting nations that are most keenly impacted. For Canadians, the impact of oil prices extends far beyond the gas station; it is felt in the level of unemployment, the purchasing power of the Canadian Dollar, and the overall Canadian economy. Oil prices are a sore tooth to the Canadian investor and they are impossible to ignore.

This begs the question, now what? In our view, this is not the time for panic or indifference. The current situation is highly complex, uncertain, and could unfold in at least two very different ways: either prices could rebound or we could be in an oil bear market. Therefore, a measured approach is warranted. Before loading up on energy names or selling all of your positions, it might be worthwhile to reflect on the possibility that prices have become discontinuous – dislocated from their recent price range. And it is a good time to remember it is often wise not to take unnecessary risks and that alternatives do exist.

 

When the Teeter Totter Breaks

Mark Twain’s quote that history does not repeat but it often rhymes is frequently used within the investment industry because it speaks to the tendency of markets to mean revert— i.e., the theory that asset prices will return to their average price level after they’ve been overextended. It is the teeter totter effect. Most asset prices— like those for stocks, bonds and houses— fluctuate within a range. This range is shaped by both the underlying economy and human psychology. When the price of an asset moves to the furthest end of its price range, forces propel it the other way. Ultimately, this teeter totter effect creates what we refer to as asset cycles.

Oil prices operate in this way. When the price of oil becomes so high that every producer generates attractive returns, more supply comes onto the market. Prices lower. Conversely, when the price of oil drops so low that producers can no longer meet their cost of capital, production shuts down, supply reduces and prices rise again. A back-and-forth pattern naturally emerges. And all the while, the marginal cost of production serves as the middle anchor: the sweet spot that oil prices tend to move toward over the long-term.

At least, this is what happens when prices operate within a “continuous” mien. The challenge is when an event occurs that shifts the teeter totter. When something structural changes, the entire price range can dislocate. And that’s when things get even more challenging for the investor, as the previous “guide post” that used to exist, moves. We saw this happen in 1973 when the members of the Organization of Arab Petroleum Exporting Countries (OAPEC) proclaimed an oil embargo, which resulted in the price of oil rising from $3 per barrel to nearly $12. And we are potentially seeing it now, as new technologies have allowed producers to extract significant amounts of oil and gas from shale rock at a reasonable cost. When prices dislocate in this manner – due to structural reasons – the move can be called “discontinuous.”

The biggest question within the current environment is whether prices have become discontinuous. Many investors are treating the current price of oil as a normal swing on the teeter totter and are buying into the corresponding stock market declines with the assumption that prices will rebound. But this is dangerous if the move we have seen is, in fact, discontinuous.

 

Don’t Try to Catch a Falling Knife

This reminds us of the adage that has served our team well over the years: don’t try and catch a falling knife. Buying energy stocks now is a reasonable decision if you know for sure that oil prices will rebound (soon). But it is a dangerous proposition if we are truly in an oil bear market.

Let’s entertain the possibility that we are, indeed, in an oil bear market. If this is the case, our best bet would be to wait until we have an indication that we are close to the point of maximum pessimism. The question is whether we have reached this point. The answer from our team is that “we simply don’t know.” Moreover, we believe we cannot know – not, at least, until after the entire affair has blown over.

Here’s what we do know: on the one hand, the stock prices of upstream producers and service providers in Canada have already been hit. Energy names are down significantly since the summer. On the other hand, multiples have not compressed to the point which usually indicates despair. Earnings have yet to be impacted by these big falls. And sectors that are likely to be impacted indirectly have yet to see a shake-up. If this is a bear market, we expect the other shoe to drop.

These facts suggest two important reminders for investors. First, investors will generally want to treat a price decline differently in a bull versus bear market. In a bull market – when prices are supported by improving fundamentals – a decline in prices is usually an opportunity to “buy on the dip.” But at the beginning of a bear market, aggressive buying can be problematic because the degree of negative sentiment is not yet high enough to fully account for the new information. Buying at this point is like trying to catch a falling knife: it is unnecessarily risky.

The second reminder is that investors don’t need to reach for the falling knife. Alternatives always exist.

 

To be continued…

 

This post is part one in a two part series. Part two deals with investment opportunities given the current oil price. Your best bet might be to sell oligarchs and despots and buy soccer moms. Stay tuned.

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