Monday, December 1, 2014

A few thoughts on the recent decline in price of oil ...

We thought to make a few comments regarding the recent dump that oil prices have taken.  Such a drastic decline (nearly 15% in less than a week) will impact the consumption side of the economy positively, as it has led to decline in gasoline prices, which at the end of the day leaves more cash in the pockets of the always-driving American consumers.  However, we believe such positive impact will not last very long, and is more likely to be more than offset by increase in oil prices.

Let's first discuss why the positive impact on our disposable income will be short-term.  Various studies have shown that while movements in oil and gasoline prices are positively correlated, such correlation is higher when gasoline prices move up.  In other words, when oil prices increase, especially after sudden significant declines such the one that we have seen recently, gasoline prices will spike up faster than the rate at which they declined when oil prices were going down.  This is just one example of the existence of asymmetry when it comes to the relationship of oil prices and GDP growth (a huge component of which is consumer spending).    

Many may ask: why would oil prices go up after such a decline, and after the increase in supplies brought forth by oil exploration and production in the US?  

Well, let's not assume that it is all rosy just because US has increased its oil production and lowered OPEC's control over oil distribution around the world, a bit.  In fact, it is for this reason (or at least one of the reasons) that Saudi Arabia and some other members of OPEC decided not to cut supplies - to put pricing pressure on US oil companies.  Such a move is bad news for US oil companies, as we have already seen by how their stocks have performed.  And let's not forget that most of these companies are highly levered, which could pose additional risks in the future if oil prices do not increase soon.  So while right now dependence on OPEC oil has declined a bit, it may increase in the future if oil prices continue to decline forcing US oil companies to burn more cash.  

Stagnation in wage growth, which we have discussed for a long time, is another reason why positive impact on the economy from falling oil prices will be only for the short-term.  Lower oil prices may also help reduce various companies' opex, but historically, companies are well aware of volatility of oil prices.  For this reason, even if companies take steps to hedge against higher oil prices in the future, we do not expect the savings from lower opex to be offset by higher wages.  So, take your pick: higher earnings the next 1 or 2 quarters due to lower oil prices and lower opex, or higher wages going forward which could have a longer lasting positive impact on the entire economy as it may increase consumption.  We think it is more likely that those great company executives will go with the first option.  

Now let's talk about why oil prices could increase again, although we have no idea when this might happen.  Decline in oil prices was driven mainly by two things, in our opinion: slower growth in demand, especially in the emerging markets and China (whose latest PMI was disappointing) and India; and higher production in US.  One thing that has not changed, and has actually worsened since the last time oil was above $115/barrel (in Apr. '11): geopolitical factors.  With ISIS creating more instability (although it is clearly linked to Saudi Arabia), and the failure, for the time being, of an Iran/P5+1 agreement, we think geopolitical factors could drive oil prices a bit higher, or at least slow down the recent decline that we have seen.  Combined with lower demand, this is not necessarily good news.  

In addition, such significant declines could lead to further instability as they are likely to bring about significant economic hardships on not only Iran and Iraq, but also Russia.  With more instability in the Middle East, with US oil companies having a difficult time, sooner or later supply may decline or the risk of a decline may increase, pushing prices a bit higher and/or significantly increase price volatility, which is not good news for many reasons.

Of course, all of this is just our opinion.  Let's discuss the political side of this 'oil price dump'.  Such a dump is nothing but good news for US political war hawks, more specifically, the neocons.  And the dump came just at the right time - the deadline for Iran and P5+1 to reach a deal.  What Saudi Arabia did (opposing a reduction in oil supplies) was not only to hit the US oil companies where it hurts, but also to severely damage Iran and Iraq.  We can all thank the Saudi government for backing ISIS (and its bloodthirsty 'skilled beheaders') in Iraq and Syria; and now the US neocons can thank the Saudis for further damaging Iran's economy and pushing higher chances of a military conflict.  As always, that Saudi government has its hands in nearly everything inside Saudi Arabia (yes violating human rights 1000x worse than Iran or any other country in the Middle East ever did) and in nearly everything outside of Saudi Arabia.  

We will post our Nov. '14 NFP guesstimate later this week, in addition to a quick review of how some of our favorite names (AVID, CNK, GCI, and others), along with our non-favorite ones (IACI, BCOR, TWTR, and others), have performed.

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