Good morning

I hope this finds everyone safe and well. I've been working from home for over five weeks now and in addition to discovering how many gardeners work in my neighborhood, I reverted to a skill from high school and gave myself a haircut last weekend.  Video available upon request.

This morning's note is entitled "We've Never Seen…" because I am sure I have heard that phrase used to describe at least twenty different economic or market scenarios evolving during the past two months. This week we added another to the list as oil prices collapsed and went NEGATIVE!.  What does that mean?  On Monday, as the price of oil (WTI) collapsed to -$40 per barrel, as oil producers pulled a barrel of oil out of the ground, they had to pay someone else $40 to haul it away.  While that's a simplification as I expect a large speculator probably blew up, it shows the absolute carnage in the energy sector so far this year.  The chart below shows oil prices, adjusted for inflation, going back to 1870, 150 years. When we say "We've never seen..", this one takes the cake. 
 

As with any other asset class, this is not simply  a case of "price down, asset bad."  (Sorry that sounded like a GEICO Caveman commercial-bad tone comes with three hours of sleep). Energy, specifically oil, is a tough sector to make money because the overall economics for energy are bad. When you analyze the sector across an entire energy cycle, from glut to shortage and back, you have one of the few industries which does not earn its cost of capital.  What does that mean?  It means that for every dollar invested to develop a unit of energy, the return on that investment is negative. As an example, Exxon can arguably be considered the best operator among the major oil companies. Their cost of capital is 8%, which means they pay 8% to investors for every dollar they invest into the business. Their long term return on invested capital is 2%, which means for every dollar they invest, they earn 2%.  It doesn't take a math wizard to recognize that if Exxon's capital cost is 8% and their return on that capital is 2%, Exxon is losing 6% on every dollar they invest in their business.

How does the industry keep attracting capital with poor long term returns? Tax incentives are one enticement. The other is the overconfidence of investors, who are certain that 1) they can time the energy market, and 2) they can find the company in the space that will outperform. Item one, timing the market, is tough because the cycles are so long. The last great opportunity to invest in oil was 1998, when oil touched $10 per barrel (note that was the last time I was bullish on the space). The cycle was strong for roughly nine years, but has been in a morass since the GFC.  Item two, picking the best company, is truly folly in the energy sector. Long term analysis shows the correlation among energy stocks at 0.9, which effectively means you could throw a dart at the names in the sector and have a 90% probability of performing in line with market. In other words, stock picking in energy doesn't matter!

The question is what to do now that oil is in turmoil?  My short answer is stay away for now. I am going to speculate that oil won't touch -$40 again (note it's $17 today), however, the fundamentals today are worse than when the last big collapse started in the mid-1980's, a cycle that took 13 years to find its bottom, in October 1998. Demand destruction is occurring because of the Covid-19 situation, however, even prior to this crisis oil prices were collapsing. Note in the chart below that the price of crude in December 2019 was $61, and began falling well in advance of the shutdown. Global production was running ahead of demand, a situation that was exacerbated by a series of political events. President Trump sanctioned Russian oil company Rosneft for evading sanctions on Venezuela. OPEC plus, effectively OPEC members plus Russia, could not come to agreement on production cuts and Saudi Arabia and Russia entered a production war. While demand was collapsing, the 2nd and 3rd largest producers in the world ramped production. Saudi Arabia, Russia, and the United States now all produce roughly 11 million barrels of oil per day.

One of the three large producers is going to blink. Russia and Saudi Arabia do not get along and are happy to hurt each other, however, the United States energy sector is taking hard hits as a result. Because the other two are effectively government run and owned, they can be coordinated in their actions. In the United States, our energy market consists of scores of private energy companies and thus do not act in unison. Layoffs have begun in the sector, rig counts are declining. It would appear that, at least initially, the US energy sector will be the first to have capacity cutbacks.

Is this the type of cycle where a long term bottom is established and a resulting investment cycle will develop. I believe so, however, it will take a couple of years for the production destruction to occur and supply-demand to come back in balance.  Oil prices will continue to fluctuate, dependent upon market sentiment and announcements regarding production levels and demand. The long term supply/demand most likely will not come back into balance until sometime in late 2021 or 2022. This means that while we may have seen a bottom in oil prices, there are many bankruptcies, production shutdowns, and acquisitions coming to rationalize the production  capacity.

The upshot is gas prices should remain low for some time, hopefully we will all be back in our cars soon to benefit. I haven't filled my car since March 7th but am looking forward to paying $2 for a gallon of gas. 

Have a great day

Ned