November 2014

“Sometimes it's the things that are all around us that are hardest to see….”

- Tonya Hurley, Novelist

We believe Ms. Hurley was talking about love when she made the above quote—and while we at Talbot Financial are sentimentalists at heart, we thought the quote aptly applied to oil and the US energy complex as well. 

In July of 2008, gasoline prices hit an all-time high of $4.11/gallon.  At that time, the global economy was white hot (think Asia and, in particular, China) and there were concerns about “peak oil” and diminishing supply.  As an aside, “peak oil” posited that the world’s major oil fields were in irreversible decline.  Further,  without significant new discoveries, easily accessible, cheap, light sweet crude oil would be a thing of the past.  Add to that rising global demand and the case for permanently high energy costs seemed strong.

In that environment, had you asked Americans whether they thought gas prices would be higher or lower in 2014, the vast majority would have said higher.  Yet, this week (over 6 years later!), gas prices across America are averaging $2.96/gallon and Congressional investigations on oil company pricing habits are non-existent.  Supply/demand relationships have again proven to be more than theory.

It is difficult to overstate the structural energy change that has altered both the geo-political and economic landscape in favor of the US.  And while we are hesitant to say, “This time it is different,” we could make the case that we have not seen a situation like this since 1949.  That is when the US last exported oil.

To understand how important US production has “suddenly” (this trend started in earnest 5-6 years ago) become, one need only look at Saudi Arabia’s latest action.  Saudi Arabia has been the world’s “swing oil producer” for decades.   In times past, the Saudi’s could move the oil price quickly by merely opening or closing their numerous oil spigots….or, even threatening to.  OPEC meetings used to dominate the news when they convened.

The latest drop in oil prices, however, seems not to have been triggered by Saudi spigots, but rather by political/business decisions.  Many have speculated that the Saudis have become increasingly concerned about losing market share.  Thus, they decided to mimic Macy’s and hold a 25% off sale.  This is a new twist! 


Source: New York Times.  Sliding Gas and Oil Prices Give Americans More Money to Spend. (13-Nov-14).


The results, however, may not be as the Saudis intended.  Despite the price drop, the US is continuing to explore and drill.  Current US production is 8.7 million bbl/day, which is more than a million bbl/day more than only a year ago….and up from 5 million bbl/day in2008.  The Russians are doing the same as evidenced by their latest arctic oil find.  Meanwhile, inside Saudi Arabia---where oil is the only significant revenue source--- there are concerns about how long the Saudis can withstand lower prices (and margins) given the Kingdom’s demand for cash and a need to support the expectations of their population. 

Nonetheless, while the road which the Saudis are traveling is untested, the reaction is not.  We have noticed that it is human nature to want to take a trend and extrapolate into the future beyond what may be reasonable.  When oil hit $115/bbl it was certain to go to $150/bbl and now that it is $80/bbl, $40 is the next logical stop.  Right?  Yet we all know trends have a way of reaching bottoms (and tops) and then reversing, and usually when people least expect it.  This is why when investors ask, “If oil prices are destined to go lower, shouldn’t we sell our oil stocks?” We respond in the negative.

First, in the near-term, lower oil prices could adversely affect the top line and earnings for some of our holdings in “big, oil.” Still, current production capabilities are not slowing and technological advances are making energy firms more efficient.  Unlike bread, oil doesn’t go stale on the shelf.  Production can slow and the oil will still be there if /when prices turn up.  The only oil sold at current prices is a small fraction of proven reserves.

In addition, if oil prices remain low, marginal producers may be forced to sell at bargain basement prices to larger energy firms with strong balance sheets and heavy cash positions.  So, when oil prices turn north, those who bought troubled assets should be well positioned to profit…and even be disproportionately awarded.

Finally, we are also cognizant of how geo-political events can swamp fundamentals very quickly.  For instance, last week ISIS blew up an Aramco pipeline and within minutes the price of oil swung upward.  These types of “black swan” events (if allowed to escalate) have the tendency of making low-price predictions today seem folly tomorrow. 

Putting all of this aside, we see a sea-change in the global energy space.  And here is the key point of this blog.   There is both increasing supply and increasing demand…and the supply component is increasing faster than the demand component.  Moreover, the increasing supply is coming from more stable parts of the world.  This is beneficial to both manufacturing and consumer economies.

According to Deutsche Bank. Every 1 cent drop in gas prices puts $1 billion in consumers’ pockets.  It was only six months ago that gas was $3.70/gal.  Today, it is $2.96/gal.  In the short term, that translates to $74 billion less spent on tanks of gas and $74 billion more to spend toward Christmas in 2014.  And, if the money is not spent at the mall, it may go toward paying down debt, buying airline tickets (because ticket prices dropped as well), or investing at Talbot Financial!   In the medium-to-longer term, it encourages manufacturers from all over the world to consider moving their plants to the US as energy is a large cost component for many manufacturers. It also bodes well for continuing US economic strength and influence in the world.  Thus, the “certain” diminution of American power and influence may once again be proven to be premature.

The US is not the only beneficiary.  The good news is the world’s “economic pie” has been growing for decades and the energy revolution has increased world trade exponentially.  This is positive on many levels for as Frederic Bastiat so succinctly stated, “When goods do not cross borders, armies will.”

We see lots of goods crossing lots of borders ----and abundant energy supplies help that process.  We are hopeful that there are enough players with enough at stake to prevent ISIS type events from escalating out of control.

So, to circle back to Ms. Hurley’s romantic quote, we love “seeing the (energy) things that are all around us” and we do not think they are that hard to see.  We have a bright future.  Here is to enjoying a great finish to 2014.

Happy investing!



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