The recent price drop of oil has taken the spotlight of the media almost everyday. Plenty of experts have expressed their opinions on why they think it dropped so fast and what “should” happen in the future. Personally I found most of them uninspiring as what they said reflect upon almost what the public knows. However, there are two brilliant memos from two legendary investors, Howard Marks (Trades, Portfolio) and Jeremy Grantham (Trades, Portfolio), who offered far superior insights on what happened to oil price and where it is headed for the future. I’ve taken the time to organize my notes on these two articles in a way that illustrates a few important topics in investing. This is by no means an article on oil per se. What I wanted to share with the readers is process by which these two legendary investors go through in analyzing the situation. Also, as I have written about second level thinking and second-order consequences before, I consider Marks’ and Gratham’s memos the perfect examples of these concepts. The memos can be found on the following links:
Howard Marks (Trades, Portfolio)’ memo:
http://www.oaktreecapital.com/memo.aspx
Jeremy Grantham (Trades, Portfolio)’s memo:
http://www.gmo.com/websitecontent/GMO_Quarterly_Letter_4Q14.pdf
Below are my notes from three seemingly independent but actually inter-connected perspectives. All words are direct quotes from the memo without personal modification:
On Second Level Thinking (or Things That Others Don’t Know)-
Howard Marks (Trades, Portfolio): I suggest that it’s usually the things that haven’t been considered – we should worry about the most. Asset prices are often set to allow for the risks that people are aware of. It’s the ones they haven’t thought of that can knock the market for a loop. Forecasters usually stick too closely to the current level, and on those rare occasions when they call for change, they often underestimate the potential magnitude. Very few people predicted oil would decline significantly, and fewer still mentioned the possibility that we would see $60 within six months.
Everyone knows that the demand for oil turned soft at the same time the supply was increasing. Equally, everyone knows that lower demand and higher supply imply lower prices. Yet it seems very few people recognized the ability of these changes to alter the price of oil. A good part of this probably resulted from belief in the ability of OPEC to support prices by limiting productions.
Jeremy Grantham (Trades, Portfolio): U.S. fracking, which accounted for over 100% of the U.S. increase, went from about 0% to 4% of global production in only five years – have not been seen since the early glory days in Texas, Pennsylvania, and Baku in the 19th century and in the Middle East in the 1950s and 1960s. Exhibit 1 also shows that in 2013 and 2014 increases in U.S. fracking production equaled 100% of the increase in global oil demand. Worse yet for OPEC, the estimate by June 2014, with the price still around $100, was for U.S. fracking production in 2015 to be even higher than the estimated total increase in global demand this year! More importantly, the increasing surge from U.S. fracking had absolutely not been expected as recently as 2009.
Prices can move between the marginal cost of providing the cheapest next unit, in a glut, to whatever the most desperate marginal user is willing to pay in a shortage.
Most critically, politics, both local and global, can play a much bigger role in commodities, especially oil, than for stocks as we are seeing once again.
What is not realized yet, although very shortly will be, is how rapidly fracking wells deplete. Even some of the recent impressive improvements in “productivity” have been moving more of the total output into the first year. Up to 65% of all of the available oil is now often delivered in the first year! Even in the heyday last July, 75% to 80% of all new production in the Bakken was needed to offset the decline from existing “legacy” wells. It could be worked out that daily production would start to decline with only a 25% reduction in oil rigs at work, a level we are rapidly approaching. Thus, at current or lower prices, Bakken production should turn down by June and possibly by the end of the first quarter.Meanwhile, back at the head office, several of the “majors” are also savaging their capex budgets for regular oil development. Unlike fracking, which takes days to adjust, old-fashioned oil, which is increasingly deep offshore or in countries that we can all agree are more difficult to operate in than, say, North Dakota, can take 5 to 10 years (and occasionally 15) before a planning dollar becomes gas in the tank. Spending cuts, therefore, will echo into the quite distant future as reduced oil production for which there will be no quick fix, for by then any increases from fracking will be distant memories. And this is a key point: U.S. fracking is the only important component of global supply that can turn up almost immediately by bringing in new rigs and drilling wells in under two weeks, adding 20-30% to production in a year as it did for each of the last two years. It is also the only important component that can turn off quickly by depleting almost completely in three years.
On Second-order consequences-
Howard Marks (Trades, Portfolio) : Most people easily grasp the immediate impact of development but few understand the “second-order” consequences…as well as the third and fourth. The following list is designed to illustrate the wide range of possible implications of an oil price decline, both direct consequences and their ramifications:
- Lower oil prices mean reduced revenue for oil-producing nations such as Saudi Arabia, Russia and Brunei, causing GDP to contract and budget deficit to rise.
- There’s a drop in the amounts sent abroad to purchase oil by oil-importing nations like the U.S, China, Japan and the United Kingdom.
- Earnings decline at oil exploration and production companies but rise for airlines whose fuel costs decline.
- Investment in oil drilling declines, causing earnings of oil service companies to shrink, along with employment in the industry.
Jeremy Grantham (Trades, Portfolio): To move back to Saudi Arabia’s decision not to cut back, one thing they may have overlooked, as most of us investors do, is unintended consequences. It is important to recognize in this case that the short-term benefits are spread widely and thinly, but the negatives are concentrated painfully and thus may destabilize the system. The economic pain from the lower oil price on Venezuela, Iran, Nigeria, Libya, Russia, or the Gulf States might set off regional political disturbances or provoke some rash action. Their debt problems combined with those of overleveraged oil sector companies might set off global financial problems. Major shocks like this to the status quo are just plain dangerous, and Saudi Arabia, which loves stability much more than most, may come to regret not having sucked up the pain of selling less for a few years. Cutting back up to half the Saudi oil would have certainly cleared the market for several years and very probably until U.S. fracking supplies peak. Even at its worst for the Saudis, in four or five years isn’t selling half the oil at twice the price a real bargain? All of the fracking oil that can be produced for under $100 a barrel will almost certainly be produced eventually anyway. Current events are very probably merely postponing the production for a while. And the same goes for the bankruptcy of some U.S. oil companies, whose properties will just be taken over by stronger players. Neither of these events appears to be of any longer-term benefit to Saudi Arabia or OPEC in general.
On the Rapid Decline of Oil Prices (or Risk):
Howard Marks (Trades, Portfolio):In economics things take longer to happen than you think they will, and then they happen faster than you thought they could.
Jeremy Grantham (Trades, Portfolio)- The problem I have is in understanding why this oil glut came as such a shock. The month-to-month gains in output from fracking could be studied. Yearly productivity increases per well were substantial – over five years, output from new wells in their first year more than doubled in the Bakken – but productivity moved up pretty smoothly month-to-month. The number of rigs being used could be followed. The steady increases after mid 2012 were thus in a sense unremarkable, just a continuation of trends in play. Both the rig count and the increase in productivity rose steadily so that the year-over-year increases remained quite smooth for over two years. If kept up, such large and steady increases would have to break the market price, ex some offsetting reductions, and the rising oil in storage could be measured showing the increasing pressure on the system. Demand was also reasonably predictable, coming in steadily a little less than earlier expected, but not much less. Clearly, though, global oil demand was not growing fast enough to absorb the new U.S. fracking increases indefinitely. We were rapidly approaching a binary choice: either OPEC, particularly Saudi Arabia, would decide to lower its production or the oil price would break. Only those utterly confident in the Saudi’s willingness to cut should not have been nervous about the price, and it is hard to say where such certainty would have come from. The correct strategy for investors in such a situation would probably have been to buy put options. Then if the probability of a major break (over 10%) was more than 1 in 15 you would have made money. My motto in investing is always cry over spilt milk, for analyzing errors is how you learn almost everything. And, yes, my major regret for 2014 is, “How on earth did I miss this!” A combination of laziness and distraction is my lame excuse. What is yours?
