Market Commentary Fourth Quarter 2014

During the fourth quarter, the major U.S. stock market indices continued their gradual, albeit irregular, ascent; the S&P 500, Dow Jones Industrials and NASDAQ Composite gained 4.9%, 5.2% and 5.8% respectively. During 2014, those indices recorded returns of 13.7%, 10.0% and 14.8% respectively.


Interest rates remained low in spite of the October termination of the Federal Reserve’s Treasury and mortgage bond buying program. The yields on 10-year and 30-year Treasuries ended the year at a miniscule 2.1% and 2.7% respectively. Many U.S.-focused investors continue to believe that these yields are unsustainably low, but they look like bargains compared to the nano-yields (our term) available in Japanese and European government bonds. Even the distressed nations of Italy and Spain can now issue 10-year government bonds at rates below 2%. Investors in these nations must view U.S. Treasuries as bargains since Treasuries offer better yields, better credit quality and diversification away from the weakening yen and Euro. We see nothing at this moment to upset the equilibrium of very low interest rates across the globe.


The big economic development during the fourth quarter was the dramatic decline in oil prices globally. West Texas Intermediate crude declined from $95 in mid-September to a low of $53 by year end. In the international oil market, North Sea Brent oil similarly declined from a June level of $110 per barrel to a year-end price of $57.   We believe these sharp declines mark the opening of an oil price war pitting Saudi Arabia against the rapidly growing oil upstart, the U.S. shale oil industry. The Saudis appear to believe that they can take market share from the U.S. shale oil producers, given that the Saudis can produce oil for $15-$25 per barrel compared to the U.S. shale industry’s average cost of $57 (estimate courtesy of energy consultant IHS). Furthermore, Saudi Arabia can meet temporary national revenue shortfalls from its $750 billion of foreign asset reserves. In contrast, the shale oil producers, like most U.S. energy producers, have little in cash reserves and plenty of debt, including junk bond issues that need to be serviced. Some of those junk bonds are about to become junkier as their issuers struggle with declining revenues. Some shale oil wells can still break even with oil prices in the 40s, but many others were drilled with the assumption of oil prices remaining at $80 or higher. Some high cost producers are going to be in trouble if prices linger in the $50s or $60s for several quarters. (An extensive discussion of the origins of the U.S. shale energy industry is contained in our fourth quarter, 2013 letter.)


U.S. “conventional” production had been in steady decline from a peak level exceeding 10 million barrels of oil per day (BOPD) in 1971 to only 5 million BOPD by 2007. Oil imports, including some from OPEC, increased to fill that void as American oil consumption steadily rose. Enter “the frackers,” smaller independent producers who had perfected the art of combining the technologies of horizontal drilling and hydraulic fracturing, thereby making new shale oil wells profitable as long as global oil prices remained high (such as $80 per barrel or higher). Since 2009, total U.S. oil production has increased from 5 million BOPD to more than 9 million BOPD, and shale oil production has risen from nearly nothing to 5 million BOPD.   (“Fracking” wells using steam and sand are growing so fast that by 2016, the shale producers are predicted to be using 145 billion pounds of sand, enough to fill railcars stretching from New York to San Francisco and back again!) Oil production from traditional drilling remains in decline.

Shale oil is chemically similar to Saudi Arabian oil and therefore a great substitute for U.S. refineries. Consequently, oil imports have fallen by more than 3.5 million BOPD since the mid-2000s, and most of that decline was taken from OPEC. To stem any further erosion of global market share, the Saudis at a November 27 OPEC meeting refused to cut production in spite of a growing global surplus. If the Saudis stand firm on their production targets, the cutbacks necessary to balance the world oil market will most likely have to come from the U.S. and Canada, relatively high cost producers. The longer it takes these nations to yield market share, the longer the price war could run.

At first glance, the global oil market would not seem to be dramatically out of balance. World demand is running at 91 million BOPD and supply is running at 92 million BOPD. However, rapid production increases from U.S. shale, Iraq and Libya point to a rapidly growing surplus in 2015. Sanford Bernstein projects U.S. shale oil production to continue rising until 2019. So far, the largest shale oil producers are reaffirming production targets in the face of falling prices. Major shale oil producers EOG Resources, Devon Energy, Continental Resources and Pioneer Natural Resources are all projecting 2015 production growth at rates between “double digits” and 29%. Contrarily, however, Drilling Info Inc. reports that only 4520 new well permits were approved in November, down almost 40% from October’s total. Well permits in the biggest shale reservoirs were lower by 28%. But some high-cost producers will likely continue to produce from existing wells just to generate the cash flow to cover debt service and expenses.

Iraq has been producing at a record pace of 3.3 million BOPD, although its oil rig count has recently declined. Analyst Jawad Mian thinks Iraq is capable of adding another 2 million BOPD over the next five years, assuming geopolitical threats such as ISIL are contained. Mian also thinks Libya, now producing 900,000 BOPD, up from 200,000 earlier this year, can increase production another 600,000 barrels, again assuming political stability. However, like Iraq, Libya’s rig count is currently in steep decline. But drilling is what most OPEC nations must do; Bloomberg News estimates that 10 of the 12 OPEC nations cannot balance their budgets with oil prices at current levels, but reducing production would simply make their deficits worse.

The three largest independent oil companies in the world, Exxon, Chevron and Shell, are experiencing flat to declining production, declining profit margins and now declining prices. The Wall Street Journal reports that the “Big Three” are earning profit margins lower than a decade ago when oil was only half its current price. The culprit is rising production costs as the oil “majors” attempt new production from increasingly remote and geologically complex parts of the planet. In November, Shell reported that its oil and gas production is lower than a decade ago, and that one-third of its current projects make no money due to high costs and low product prices. Shell expects further production declines during the next two years and just cancelled a planned $20 billion natural gas to diesel project in Louisiana. Exxon’s output has sunk to a five-year low after selling its interests in marginal projects located in the Middle East. Chevron, whose production has been flat for 10 years, just put on hold a $10 billion project planned for the North Sea. The “majors” are hunkering down.

A protracted price war would further threaten the stability of the Middle East, Russia and Venezuela. (A Deutsche Bank report estimated that Russia needs to average $102 per barrel to balance its national budget, and Venezuela, already in economic tatters, needs $121 per barrel. The Russian ruble has declined 50% against the dollar since this summer.) Economist Daniel Altman estimates that 20 countries depend on petroleum for at least half their government revenues, and another 10 receive between a quarter and a half. Yet a World Bank study shows that between 1983 and 2012, no country receiving at least 20% of its economic output from oil and gas was able to substantially diversify away from its dependence on those revenues.

The effect of sustained lower oil prices on our economy would be mixed. We consume 18.7 million barrels of oil per day, so a sustained $30 reduction per barrel would save consumers $200 billion per annum. However, we produce 9 million of those barrels, so a sustained $30 decline would cut energy industry incomes by almost $100 billion. Oil industry employment would surely contract. But for the lower income classes, cheaper energy is a clear benefit. Families with incomes below $50,000 are estimated to spend an average of 21% of their budgets on energy. Cheaper energy prices could show up as higher sales at low end retailers like Wal-Mart and Costco.

How this price war plays out depends upon the decisions of many energy producers worldwide, most importantly the Saudis. Thus, we wisely decline to predict its outcome. However, we are certain that a sustained drop in oil prices will have significant global geopolitical consequences, given the relative poverty of many oil-producing nations. Stay tuned.

Stock and bond prices have not changed significantly since our last letter, and our attitude concerning them is unchanged. Stocks are priced well above historical norms, so conservative investors are reasonable to maintain only modest allocations to them. However, we see no economic event likely to trigger a large decline, so aggressive investors are not unreasonable to risk their capital by maintaining large allocations to stocks. Bond yields are low in comparison to history and current inflation, but there is no clear catalyst to drive interest rates materially higher. Bond yields don’t “work” to meet many retirement income targets, but money market yields at zero don’t work either. We believe that holding money market reserves gives investors flexibility to respond to unexpected negative events, however, a potentially valuable benefit. But with no obvious negative trigger on the horizon, we expect the investment community as a whole to continue buying stocks and bonds, keeping prices high for the foreseeable future.

As always, we welcome your thoughts and comments.

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