See
also:
General Index
of all guest columns written by Dennis C. Butler,
CFA
January 2015
F
or
many years we have felt that the best thing to do with America's domestic
petroleum reserves would be to leave a large portion of them in the ground
for the benefit of future generations. Chances are they will need it. U.S.
oil is relatively expensive to extract and the business benefits from
various tax breaks designed to encourage drilling. Saudi Arabia maintains
that the biggest shares of the world oil market should go to the most
efficient producers, including Saudi with its low-cost reserves. Let them
have it. Accelerating the exploitation of the American resource only brings
forward the inevitable day when it depletes or becomes prohibitively
expensive to produce, leaving us even more vulnerable to foreign suppliers
than we are now. Handled wisely (a big "if," obviously), a policy of
acquiring energy from the cheapest sources now, even if they are foreign,
could extend the period over which domestic reserves are available, reduce
the potential
severity of future supply disruptions, and
buy more time for the further development of alternatives.
Market action may
bring this about if policy cannot. The biggest economic news story of 2014
was the collapsing price of crude oil — down about 50% between June and
year-end. While some people in Texas, Russia, and a few other places may not
like it, the rest of the world benefits through lower gasoline prices and
falling input costs. Weak consumption growth due to economic malaise in
Europe and other places; stable OPEC production even as some cartel members
discounted prices in an over-supplied market, and years of elevated prices
supporting innovation and efficiency all helped to slow the growth in demand
for petroleum products.
The real story, however, was about supply — most
importantly, the so-called "shale revolution" in the U.S., where advances in
drilling technology have permitted the exploitation of previously
inaccessible petroleum (and natural gas) reservoirs. Once believed to be a
declining oil province, the U.S. has gone from producing five million
barrels per day (bpd) in 2004 to over nine million bpd in 2014,
confounding all the experts. Because oil trades in international markets,
the falling U.S draw on foreign production has hit prices everywhere.
Lest the reader think we have finally reached the long-sought nirvana of
"energy independence," it should be noted that the U.S. still imports about
7.5 million bpd of crude oil (net imports are roughly 6 million bpd), but
that is down from nearly 9 million bpd only a few years ago. Furthermore,
moves are afoot to permit the exportation of U.S. crude, something that the
government prohibited 40 years ago. Exports would absorb excess U.S.
production and take advantage of higher prices elsewhere while not affecting
the prices Americans pay, according to the industry. We'll see. Expect to
hear more on this subject from energy companies and their supporters in
government.
In the meantime,
lower pump prices (under $2 per gallon in some places) have cut fuel bills
and stimulated consumer spending, helping the economy. Chemicals and other
industries have invested in new U.S. plants to take advantage of cheap
hydrocarbon-based raw materials, also a fillip for business activity. Might
this pleasant (for consumers) state of affairs continue? We think not, at
least not for long. Trends contain the seeds of their own demise, and in
this case many have been sown. Low prices eventually stimulate demand, and
they also threaten supply, especially the newly-created bounty in the U.S.
Due to the nature of the wells, so-called "unconventional" U.S. shale oil
is unconventionally expensive to extract and requires constant drilling just
to maintain output. At recent prices of $60 per barrel and lower, some shale
projects are already uneconomical, and drilling plans have been cut back, as
have conventional oil company exploration and drilling budgets, indicating
that less new crude will be coming online in the future. As the Saudis (who
can still produce oil at a cost of less than $20 per barrel) have intimated,
"efficient producers" rule, and given Saudi's aggressive production plans,
it is clear they aim to prove it.
U.S. shale producers have also benefited from abundant and cheap financing during an
era of ultra-low interest rates, including those prevailing in the "junk"
bond market, which is where shale companies have raised $200 billion of
capital for drilling projects. Some shale producers actually rely on this
funding because their cash flow is insufficient to cover their costs. Energy
company issues now make up about 18% of the junk bond market. The collapse
in oil prices, especially since October, has had a severe impact. Some junk
bond prices have fallen almost 20% since June, making the yields on the debt
of some small oil companies approach 20%. To put things in perspective, the
average yield on junk paper fell to below 5% at its nadir during the current
cycle. Junk is called "junk" for a reason, namely risk, but that did not
stop yield-hungry speculators from chasing the market. The window of
financing opportunity for less well-capitalized shale operators may be over,
and this, too, will impact shale project affordability.
Political
considerations promise to come increasingly into play as well. Many
oil-export-dependent OPEC members (including Saudi) have national budgets
that require far higher prices (as high as $160 per barrel) to bring into
balance. A few (like Saudi) have large rainy-day funds. Others may face
rioting in the streets if the petroleum revenues on which their governments
depend remain weak and force cuts in spending.
The trend of
declining prices could continue for far longer than anyone imagines. Enjoy
it while it lasts, but we wouldn't recommend investing in a new gas-guzzler
just yet.
Banking's New Order
Banks are not popular institutions. Their behavior prior to 2008 engulfed
the world in a financial crisis that only taxpayers acting through
governments could subdue in order to avert economic depression. Since 2008
the shareholders of these same banks have paid over $250 billion in fines.
By contrast, the pre-crisis leaders of those companies escaped with their
fortunes intact, and no individual has had to serve time in jail — a fact
that still rankles the great unwashed who are unfamiliar with the ways of
limited-liability capitalism.
As a result, banking worldwide is now subject to new regulations (most
notably, the Dodd-Frank law in the U.S.) that restrict certain activities,
ban others, and require larger capital buffers to absorb potential losses.
Bankers have predictably complained. They claim that the new rules will cut
lending (i.e., hurt the economy and cost jobs), and, because they will be
less profitable, limit banks' ability to pay dividends. That a large portion
of industry earnings reported under the prior regulatory regime proved to be
fictitious and were erased by write-offs is not a fact they care to
remember.
Although no
one likes the red tape and expense of dealing with rules, they exist for a
reason. Excesses of the past are prevented when regulations work. Rules
mandating more prudent banking behavior may very well increase costs and
reduce business activity to some extent, but so, too, it might be argued, do
fire codes. Banker protestations should be taken with many large grains of
salt.
Indeed, recent bank activities justify the need for tight oversight.
In early December ten of the biggest banks were fined for illegally
promising favorable analyst coverage while bidding for underwriting
business. The group included some of the same institutions that former New
York State Attorney General Eliot Spitzer had fined $1.4 billion for
committing similar violations in 2003.
Other risky (but not illegal) practices are making a comeback, too. Banks
have loosened lending standards — perhaps to be expected after a severe
contraction, but something to be watched. At least one Wall Street
institution has returned to old pay practices — more up front, less later
which is the opposite of what is necessary to tie staff to long-term
commitments and have them face the consequences of poor judgment. In other
words, the perverse incentives that played an important role in causing the
crisis remain well entrenched.
Charles Munger
(co-chairman of Berkshire Hathaway) predicted in the midst of the financial
crisis that it was unlikely the banking industry would be fundamentally and
permanently reformed because of its clout with politicians. True to form,
Wall Street is "re-emerging as a force in Washington," as Bloomberg reported
last month, when industry lobbying succeeded in persuading Congress to
repeal a portion of the Dodd-Frank law restricting bank dealings in
derivatives. Ironically, Wall Street financiers themselves do not value
banks very highly where, to them, it counts most — in their own stock market
— a fitting corollary to banking's low level of public esteem.
The S&P 500 equity index hit 53 new record highs in 2014 and ended the year
with a return of 13.7%. It was another solid year for stocks, or at least
for the larger company issues represented in the S&P. Gains for smaller
company shares were, on average, significantly less robust. Surprising all
forecasters, U.S. treasury bond prices rose smartly and rates fell — the
opposite of what had been expected a year ago.
The last six
years have been banner years for stockholders, despite the many hurdles
facing investors. Going forward, there are many potential risks that could
upset economies and financial markets: rising interest rates, slowing growth
in parts of the world, and geopolitical tensions, to name a few. Beyond
these are the risks inherent in security prices themselves, which after six
years of gains bringing them to record highs, are now such that they promise
a more subdued rate of increase, even without confidence-sapping external
shocks. We learned long ago that markets are unpredictable; it is possible
that we will see another 53 new highs this year, too, but we wouldn't bet
the bank on it.
______________
Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over 27 years and has been published in Barron's. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at
www.businessforum.com/cscc.html.
"Current low valuations reward the long-term view", an article by Dennis Butler, appears in the May 7, 2009 issue of the
Financial Times (page 28). "Intelligent Individual Investor", an article by Dennis Butler, appears in the December 2, 2008 issue of
NYSSA News, a magazine published by the New Yorks Society of Security Analsysts, Inc. "Benjamin Graham in Perspective", an article by Dennis Butler, appears in the Summer 2006 issue of
Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, "Gold Coffin?" in Barron's (March 23, 1998, Volume LXXVIII, No. 12, page 62) or
"What Speculation?" in Barron's (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at:
Dennis C. Butler
President
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139
Telephone: 617.441.9695
Email: cscc@comcast.net
URL: http://www.businessforum.com/cscc.html
Your comments and suggestions for these pages are most welcomed!
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