“If a deal is reached with Iran, the global oil glut could swell significantly within a year.” Wall Street Journal, April 9, 2015 (http://www.wsj.com/articles/irans-strategic-petroleum-reversal-for-oil-markets-heard-on-the-street-1428599066?mod=djemheard_t)
Cumberland Advisors remains at maximum underweight in the Energy sector in its US exchange-traded fund (ETF) strategy. We believe the risk of oil pricing is to the downside. We believe the risk to the stocks that represent the oil patch is also to the downside. That is not true of certain of the master limited partnership (MLP) space. Our rationale follows.
· The Standard & Poor’s (S&P) 500 Index contains 41 energy stocks, which constitute approximately 8% of the S&P 500 weight. Strategas Research Partners notes that 8% is the “average” weight over the last 25 years. The lowest weight, also noted by Strategas, occurred during the 1999-2000 stock bubble. At that time Energy sector weight was down to 3% of the S&P 500.
· In the S&P 600 Small-Cap Index, Strategas estimates there are 36 issues tied to the Energy sector. Strategas notes that both the large-cap and small-cap percentages of publicly traded issues in each index are near record highs.
· The highest percentage weight in the Energy sector occurred in 1980. We were in the business then, and we watched the unfolding of the 1973 Arab-Israeli War and the two-stage rise in the oil price that followed. Preceding the war, the oil price was about $3 per barrel. Following the war, it was $12 per barrel. The oil price subsequently reached a high of about $30 per barrel when the Shah of Iran fell and the new, religious regime took power in Iran.
At that time, President Jimmy Carter faced daily media reports about American hostages held in Iran by the new regime. The change in geopolitical risk premia and the rise in the oil price from the pre-war $3 level to the regime-change $30 level caused a remarkable economic shock in the US and abroad. Central banks responded with very high interest rates in the late 1970s. Inflation reached double digits by the end of the decade.
· Political winds cost President Carter reelection. Former California Governor Ronald Reagan won that election in 1980. As Federal Reserve Chairman, Paul Volcker quashed the inflationary forces with the highest interest rates in the history of the US. At some point during this period, America’s commercial interest rates were in excess of 20% annualized. Residential mortgage interest rates were well into the double digits.
Thus was huge, negative shock to the world economy caused by a violent upward movement in the oil price. It had drastic effects on interest rates, inflation rates, and the securities markets throughout the globe.
We are now in the midst of what appears to be a large downward price shock. It has the making of a reverse effect of that which we saw for an 8 year period in the 1970s-1980s. Even with the activities in the Middle East and North Africa that are raising geopolitical risk premia, the current direction of the oil price seems to be down. At the same time, the US still has controls in place that limit its ability to export oil. Those controls have their origins in the memories of the previous negative oil shock four decades ago. Pressures continue to build in favor of relaxing those controls.
We think market forces will continue to pressure changes in the Oil sector. We expect one result of those changes to be greater production volumes of oil. Greater volumes benefit those who process them. That is why we like sections of the MLP space that are tied to rising volume. That is also why we dislike sections of the MLP space that are tied to price. If your business model depends on a rising oil price, you have a problem. If your business model depends on rising volume, it is a different story entirely.
So we look forward to a decline in the oil price. We think there is a second leg down ahead of us. We may be wrong here but we see the risk as high enough to cause us to avoid the sector exposure. Offsetting that trend are the rising geopolitical risks of Saudi Arabia’s being involved in a shooting war in Yemen, the violence in Nigeria, and instability and the possibility of governmental overthrow in several other oil-producing places in the world. The result is a tug-of-war in pricing between geopolitical risk premia on one side and expanding volumes and downward price pressure through market forces on the other side. Additional factors are China and India. In China there may be expanded acquisition of oil to satisfy an additional enlargement of their strategic petroleum reserves. In India we have a growing import economy. Both large importers may add to global oil demand. At the same time, there are crosscurrents around the issue of the US becoming an oil exporter. We witness those crosscurrents daily in the Washington political struggle. And we watch the outcome of the Iran sanction negotiations that the Wall Street Journal discusses today.
Add to those factors the question of the transportation of oil and how much of it moves by pipeline or by rail. The controversy over rail carriage continues in the US as it does in Canada, where new rules are being written for rail safety. The Canadians are simultaneously developing their own pipeline system because they cannot wait for the US to go through its political wrangling. So we expect to see the creation of a pipeline running east-west in Canada, as well as improved rail safety. That will mean some shift in the carriage of oil from rail to pipeline. The rail stocks already reflect some of this transition in their pricing models, and the transportation stocks that include the rail stocks reflect today’s lower energy costs. We think that repricing of rail carriage expectation is complete.
At Cumberland Advisors, we maintain our position in the transportation ETFs because we like the domestic character of the sector and its strong dollar benefits that flow to the stocks and companies within the sector. On the other hand, we note that within the sector there are companies that will have to manage shifts in the energy distribution mechanism.
In sum, we remain underweight the Energy sector in the extreme. We think the risk is to the downside. We do not know the final price of oil, but we note that some forecasts are that a price as low as $10 or $20 per barrel will be needed to trigger a full capitulation of market agents who seem to be complacent about their exposure in the Energy sector. We do not anticipate changing our weighting structure; however, it is clear that geopolitical forces could explode at any time, driving oil prices higher. Saudi Arabia is the largest producer, and it is now engaged in a military conflict in coalition with other Sunni Arab countries. Its adversary is Iran, which lies directly across the Persian Gulf and is the leader of the Shiite sector of the Muslim world. The next-largest oil-producing nation engaged in military conflict is Iraq. And so the complexities of the Middle East create geopolitical risk premia that can swing high or low and quickly affect oil pricing, based on news flows.
In such circumstances, one has to be nimble. So Cumberland could be at its maximum underweight in the Energy sector right now and could quickly shift based upon events.
As for those who are pundits and making claims of perfect foresight, we invoke the sage words of Will Rogers. “There are three kinds of men: The ones that learn by reading. The few who learn by observation. The rest of them have to pee on the electric fence and find out for themselves.”
About The Author
Images: Flickr (licence attribution)
About the Author
David R. Kotok cofounded Cumberland Advisors in 1973 and has been its Chief Investment Officer since inception. He holds a B.S. in economics from The Wharton School of the University of Pennsylvania, an M.S. in organizational dynamics from The School of Arts and Sciences at the University of Pennsylvania, and a masters in philosophy from the University of Pennsylvania.
Mr. Kotok’s articles and financial market commentary have appeared in The New York Times, The Wall Street Journal, Barron’s, and other publications. He is a participant in Bloomberg radio programs. He is a frequent contributor to CNBC programs, including Morning Call, Power Lunch, Kudlow & Company, Squawk on the Street, Squawk Box Asia, and Worldwide Exchange. He co-authored the book Invest in Europe Now!
Mr. Kotok currently serves as a Director and Program Chairman of the Global Interdependence Center (GIC) (www.interdependence.org), whose mission is to encourage the expansion of global dialogue and free trade in order to improve cooperation and understanding among nation states, with the goal of reducing international conflicts and improving worldwide living standards. Mr. Kotok chairs its Central Banking Series, and organized a five-continent dialogue held in Philadelphia, Paris, Zambia (Livingstone), Hanoi, Singapore, Prague, Capetown, Shanghai, Hong Kong, Rome, Milan, Tallinn, and Santiago, Chile. He has received the Global Citizen Award from GIC for his efforts.
Mr. Kotok is a member of the National Business Economics Issues Council (NBEIC), the National Association for Business Economics (NABE), serves on the Research Advisory Board of BCA Research, and is also a member of the Philadelphia Council for Business Economics (PCBE).
Mr. Kotok has served as a Commissioner of the Delaware River Port Authority (DRPA) and on the Treasury Transition Teams for New Jersey Governors Kean and Whitman. He has also served as a board member of the New Jersey Economic Development Authority and as Chairman of the New Jersey Casino Reinvestment Development Authority.
Mr. Kotok hosts an annual Maine fishing trip, where, it is rumored, most of the nation’s important financial and economic decisions are actually made.