Who could have predicted these oil prices? I’ll tell you.

The following prescient quote is from February 2014:

shale gas rigThe economies of China and India have slowed, and the U.S. is trending towards energy self-sufficiency thanks to production growth nobody envisioned back then.  The question today is why oil prices haven’t fallen further?  The current price certainly can’t be explained by inflation.  Picking a random starting point, say 1994 – inflation should imply a current price of crude about 124.2% higher today.  But since the price of oil in 1994 was $14 that would mean today’s price should be $32.

 

Oil WTI graph January 2015

Yup.  I’m quoting myself, although I didn’t really expect to see $30 oil.  Nothing is impossible, and nowadays its possible for speculators to buy the stuff and store it, short it and all those actions that increase volatility.  Also in a blog I posted (here) I made the case that ultimately falling energy prices will prove to be the shot in the arm the world needs, but after a correction I expected and which did occur.  Once the market had some of the wind knocked out of it (March 2014) I said this:

If we believe that inflation can remain at 2% or less (rather than hitting levels of  3.5% to 4% like in 2005) then a 10-year yield hovering at around 3% to 3.5% would not be outrageous.    To me this means that the earnings yield on the S&P 500 still has room to continue to decline (i.e. stock prices can go even higher).

A couple of years ago I estimated that earnings growth (coming out of recession) would take the S&P 500 (there would be bumps, and there always will be) through the 2000 level.  But what next?  It is important to do what many experts are doing – trying to come to grips with the short term impact lower energy prices will have on the index earnings.  We’re seeing a plethora of opinions and statistics painting a rather dark outlook.  Since the energy industry accounts for 35% (according to Deutsche Bank AG) of all capital spending, and there are announcements daily of cap spending cuts by producers, the impact on stock market earnings will be substantial.  If oil stays below $50 a barrel then index earnings could be reduced by $6, suggest Bank of America analysts.

S&P PE January 2015If we assume that S&P 500 earnings are around $105 and in the short-term drop to say $99 (minus $6), why wouldn’t the index fall about 6% as well?  That would imply we’re almost there, down 4% (as I type this) from the 2070 peak, holding the P/E ratio constant.

Two problems I can identify.  Should the P/E on current earnings remain constant?  Part of the current valuation is biased by future earnings expectations.  Based on estimates I’ve seen (see WSJ exhibit) the forecast for 2015 remains about $120.  Expectations are adjusting downward quickly, which in my experience influence valuations negatively.  It is also inevitable (human nature) that revisions will overshoot  due to our propensity to overweight recent events.  Put an 18X multiple on earnings of $99 takes us back to closer to an 1800 target on the S&P 500 – at least a 10% correction.

Winners & Losers

starbucks coffeeIt’s pretty easy to determine who the losers are now and will be for this year.  My nephew (a bright portfolio manager in Latvia) asked if it might be a good time to short the US railways – since there’ll be fewer barrels of shale oil to deliver.  Tongue-in-cheek, I reminded him that railways also use fuel, so the net effect is hard to determine just yet.  On the other hand I feel it safe to predict that low gasoline prices will no doubt prompt more driving and more stops at the local Starbucks.  Determining those companies that will enjoy better profit margins due to falling energy prices, and overweighting them is a good defensive measure in equities.  As always, even when the broad market indices decline, there are winners.

Perhaps more important, when it comes to energy the have-not countries are now at a relative advantage.  As I have said over many years in print and on television – do the opposite.  The euro certainly has its issues, but the Eurozone stands to benefit LARGE with lower energy costs.  Foreign money is poised to abandon the U.S. and go back home where the action “will be.”  Perhaps even troubled Greece will see real tourism revenues again. Russia, Mexico, OPEC members, and even Canada will struggle some, but low crude prices will provide a needed boost to emerging markets.

 

 

 

 

 

About Mal Spooner

Malvin Spooner is a veteran money manager, former CEO of award-winning investment fund management boutique he founded. He recently authored A Maverick Investor's Guidebook which blends his experience touring across the heartland in the United States with valuable investing tips and stories. He has been quoted and published for many years in business journals, newspapers and has been featured on many television programs over his career. An avid motorcycle enthusiast, and known across Canada as a part-time musician performing rock ‘n’ roll for charity, Mal is known for his candour and non-traditional (‘maverick’) thinking when discussing financial markets. His previous book published by Insomniac Press — Resources Rock: How to Invest in the Next Global Boom in Natural Resources which he authored with Pamela Clark — predicted the resources boom back in early 2004.
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4 Responses to Who could have predicted these oil prices? I’ll tell you.

  1. Mac Balkam says:

    Hi Mal, with insight like this, maybe you should start another fund. Mac

  2. Stephen Bishop says:

    Always like reading your commentaries and also always surprised at how right you are. You are much smarter than a 5th Grader… : )

  3. Ray says:

    Nice to see you blogging again.

    >

  4. Paul Miklasevics says:

    I hope you treated yourself to a fancy Starbucks coffee today! Nice call!

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