My favorite bits from Howard Mark's Dec 18 2014 memo :
Lessons of Oil
Despite
my protestations that I don’t know any more than others about future
macro events – people insist on asking me about the future. Over the
last eighteen months , most of the macro questions I’ve gotten have been
about whether the Fed would move to increase interest rates, and
particularly when.
Since
mid-2013, the near-unanimous consensus has been that rates would rise.
And, of course, the yield on the 10-year Treasury has fallen from
roughly 3% at that time to 2.2% today. I mention it to provide a reminder that what “everyone knows” is usually unhelpful at best and wrong at worst.
• Not only did the investing herd have the outlook for rates wrong, but it was uniformly inquiring about the wrong thing.
In short, while everyone was asking whether the rate rise would begin
in December 2014 or April 2015 (or might it be June?) – in response to
which I consistently asked why the answer matters and how it might alter
investment decisions – few people I know were talking about whether the price of oil was in for a significant change.
-I
included “$100 oil” (since a barrel was selling in the $70s at the
time) and ended with “the things I haven’t thought of.” I suggested that
it’s usually that last category – the things that haven’t been considered – we should worry about most. Asset
prices are often set to allow for the risks people are aware of. It’s
the ones they haven’t thought of that can knock the market for a loop.
• In my book The Most Important Thing, I mentioned something I call “the failure of imagination.” I defined it as “either
being unable to conceive of the full range of possible outcomes or not
understanding the consequences of the more extreme occurrences.” Both aspects of the definition apply here.
The usual starting point for forecasting something is its current level. Most forecasts extrapolate, perhaps making modest adjustments up or down. In other words, most forecasting is done incrementally,
and few predictors contemplate order-of-magnitude changes. Thus I
imagine that with Brent crude around $110 six months ago, the bulls were
probably predicting $115 or $120 and the bears $105 or $100. 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.
Most
believed that the price of oil would remain around present levels.
Several trillion dollars have been invested in drilling over the last
few years and yet production is flat because Nigeria, Iraq and Libya are
producing less. The U.S. and Europe are reducing consumption, but that
is being more than offset by increasing demand from the developing
world, particularly China. Five years from now the price of Brent is
likely to be closer to $120 because of emerging market demand.
.
As a side note, it’s interesting to observe that growth in China already was widely understood to be slowing,
but perhaps that recognition never made its way into the views on oil
of those present at Byron’s lunches. This is an example of how hard it can be to appropriately factor all of the relevant considerations into complex real-world analysis.
•
Turning to the second aspect of “the failure of imagination” and going
beyond the inability of most people to imagine extreme outcomes, the
current situation with oil also illustrates how difficult it is to
understand the full range of potential ramifications. Most people easily
grasp the immediate impact of developments, but few understand the
“second-order” consequences . . . as well as the third and fourth. When
these latter factors come to be reflected in asset prices, this is often
referred to as “contagion.” Everyone knew in 2007 that the sub-prime
crisis would affect mortgage-backed securities and homebuilders, but it
took until 2008 for them to worry equally about banks and the rest of
the economy.
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
prices mean reduced revenue for oil-producing nations such as Saudi
Arabia, Russia and Brunei, causing GDP to contract and budget deficits
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 the earnings of oil services
companies to shrink, along with employment in the industry.
- Consumers have more money to spend on things other than energy, benefitting consumer goods companies and retailers.
- Cheaper gasoline causes driving to increase, bringing gains for the lodging and restaurant industries.
- With
the cost of driving lower, people buy bigger cars – perhaps sooner than
they otherwise would have – benefitting the auto companies. They also
keep buying gasoline-powered cars, slowing the trend toward
alternatives, to the benefit of the oil industry.
- Likewise,
increased travel stimulates airlines to order more planes – a plus for
the aerospace companies – but at the same time the incentives decline to
replace older planes.
- By
causing the demand for oil services to decline, reduced drilling leads
the service companies to bid lower for business. This improves the
economics of drilling and thus helps the oil companies.
- Ultimately,
if things get bad enough for oil companies and oil service companies,
banks and other lenders can be affected by their holdings of bad loans.
• Further, it’s hard for most people to understand the self-correcting aspects of economic events.
- A decline in the price of gasoline induces people to drive more, increasing the demand for oil.
- A decline in the price of oil negatively impacts the economics of drilling, reducing additions to supply.
- A decline in the price of oil causes producers to cut production and leave oil in the ground to be sold later at higher prices.
In all these ways, lower prices either increase the demand for oil or reduce the supply,
causing the price of oil to rise (all else being equal). In other
words, lower oil prices – in and of themselves – eventually make for
higher oil prices. This illustrates the dynamic nature of economics.
•
Finally, in addition to the logical but often hard-to-anticipate
second-order consequences or knock-on effects, negative developments
often morph in illogical ways. Thus, in response to cascading oil
prices, “I’m going to sell out of emerging markets that rely on oil
exports” can turn into “I’m going to sell out of all emerging markets,” even oil importers that are aided by cheaper oil.
In
part the emotional reaction to negative developments is the product of
surprise and disillusionment. Part of this may stem from investors’ inability to understand the “fault lines” that run through their portfolios. Investors
knew changes in oil prices would affect oil companies, oil services
companies, airlines and autos. But they may not have anticipated the
effects on currencies, emerging markets and below-investment grade
credit broadly. Among other things, they rarely understand that capital
withdrawals and the resulting need for liquidity can lead to urgent
selling of assets that are completely unrelated to oil. People often
fail to perceive that these fault lines exist, and that contagion can
reach as far as it does. And then, when that happens, investors turn out to be unprepared, both intellectually and emotionally.
A
grain of truth underlies most big up and down moves in asset prices.
Not just “oil’s in oversupply” today, but also “the Internet will change
the world” and “mortgage debt has historically been safe.” Psychology
and herd behavior make prices move too far in response to those
underlying grains of truth, causing bubbles and crashes, but also
leading to opportunities to make great sales of overpriced assets on the
rise and bargain purchases in the subsequent fall. If you think markets
are logical and investors are objective and unemotional, you’re in for a
lot of surprises. In tough times, investors often fail to apply
discipline and discernment; psychology takes over from fundamentals; and
“all correlations go to one,” as things that should be distinguished from each other aren’t.
- Energy
is a very significant part of the high yield bond market. In fact, it
is the largest sector today (having taken over from media/telecom, which
has traditionally been the largest). This is the case because the
exploration industry is highly capital-intensive, and the high yield
bond market has been the easiest place to raise capital. The knock-on
effects of a precipitous fall in bond prices in the biggest sector in
the high yield bond market are potentially substantial: outflows of
capital, and mutual fund and ETF selling. It would be great for
opportunistic buyers if the selling gets to sectors that are
fundamentally in fine shape . . . because a number of them are. And, in
fact, low oil prices can even make them better.
- An
imperfect analogy might be instructive: capital market conditions for
energy-related assets today are not unlike what we saw in the telecom
sector in 2002. As in telecom, you’ve had the confluence of really cheap
financing, innovative technology, and prices for the product that were
quite stable for a good while. [To this list of contributing factors, I
would add the not-uncommon myth of perpetually escalating demand for a
product.] These conditions resulted in the creation of an oversupply of
capacity in oil, leading to a downdraft. It’s historically unprecedented
for the energy sector to witness this type of market downturn while the
rest of the economy is operating normally. Like in 2002, we could see a
scenario where the effects of this sector dislocation spread wider in a
general “contagion.”
- Selling
has been reasonably indiscriminate and panicky (much like telecom in
2002) as managers have realized (too late) how overexposed they are to
the energy sector. Trading desks do not have sufficient capital to make
markets, and thus price swings have been predictably volatile. The oil
selloff has also caused deterioration in emerging market fundamentals
and may force spreads to gap out there. This ultimately may create a
feedback loop that results in contagion to high yield bonds generally.
•
Over the last year or so, while continuing to feel that U.S. economic
growth will be slow and unsteady in the next year or two, I came to the
conclusion that any surprises were most likely to be to the upside. And
my best candidate for a favorable development has been the possibility
that the U.S. would sharply increase its production of oil and gas. This
would make the U.S. oil-independent, making it a net exporter of oil
and giving it a cost advantage in energy – based on cheap production
from fracking and shale – and thus a cost advantage in manufacturing.
Now, the availability of cheap oil all around the world threatens those
advantages. So much for macro forecasting!
•
There’s a great deal to be said about the price change itself. A
well-known quote from economist Rudiger Dornbusch goes as follows: “In economics things take longer to happen than you think they will, and then they happen faster than you thought they could.”
I don’t know if many people were thinking about whether the price of
oil would change, but the decline of 40%-plus must have happened much
faster than anyone thought possible.
• “Everyone
knows” (now!) that the demand for oil turned soft (due to sluggish
economic growth, increased fuel efficiency and the emergence of
alternatives) at the same time that the supply was increasing (as new
sources came on stream). Equally, everyone knows that lower demand and
higher supply imply lower prices. Yet it seems few people recognized the
ability of these changes to alter the price of oil.
A
price that’s kept aloft by the operation of a cartel is, by definition,
higher than it would be based on supply and demand alone. Maybe the
thing that matters is how far the cartelized price is from the
free-market price; the bigger the gap, the shorter the period for which
the cartel will be able to maintain control. Initially a cartel or a few
of its members may be willing to bear pain to support the price by
limiting production even while others produce full-out. But there may
come a time when the pain becomes unacceptable and the price supporters
quit. The key lesson here may be that cartels and other anti-market mechanisms can’t hold forever. Maybe we’ve just proved that this extends to the effectiveness of cartels.
•
Anyway, on the base of 93 million barrels a day of world oil use, some
softness in consumption combined with an increase in production to cut
the price by more than 40% in just a few months. What this proves –
about most things – is that to Dornbusch’s quote above we should append
the words “. . . and they go much further than you thought they could.”
The
extent of the price decline seems much greater than the changes in
supply and demand would call for. Perhaps to understand it you have to
factor in (a) Saudi Arabia’s ceasing to balance supply and demand in the
oil market by cutting production, after having done so for many years,
and (b) a large contribution to the decline on the part of psychology
The
price of oil thus may have gone from too high (supported by OPEC and by
Saudi Arabia in particular) to too low (depressed by negative
psychology). It seems to me with regard to the latter that the price
fell too far for some market participants to maintain their equanimity. I
often imagine participants’ internal dialogues. At $110, I picture them
saying, “I’ll buy like mad if it ever gets to $100.” Because of the way
investor psychology works, at $90 they may say, “If it falls to $70,
I’ll give serious thought to buying.” But at $60 the tendency is to say,
“It’s a falling knife and there’s no way to know where it’ll stop; I
wouldn’t touch it at any price.”
But it’s usually smarter to buy after they’ve fallen for a while.
• I said it about gold in All That Glitters (November
2010), and it’s equally relevant to oil: it’s hard to analytically put a
price on an asset that doesn’t produce income. In principle, a
non- perishable commodity won’t be priced below the variable production
cost of the highest-cost producer whose output is needed to satisfy
total demand. It’s clear that today’s oil price is well below that standard.
It’s hard to say what the right price is for a commodity like oil . . . and thus when the price is too high or too low. Was
it too high at $100-plus, an unsustainable blip? History says no: it
was there for 43 consecutive months through this past August. And if it
wasn’t too high then, isn’t it laughably low today? The answer is
that you just can’t say. . And if you can’t be confident about what the
right price is, then you can’t be definite about financial decisions
regarding oil.
Regardless, it seems that a market that was unconcerned about things like oil and its impact on economies and assets now has lost its composure.
Especially given the pervasive role of energy in economic life,
uncertainty about oil introduces uncertainty into many aspects of
investing.
“Value investing” is supposed to be about buying based on the present value of assets, rather than conjecture about profit growth in the far-off future. But
you can’t assess present value without taking some position on what the
future holds, even if it’s only assuming a continuation of present
conditions or perhaps – for the sake of conservatism – a considerably
lower level. Recent events cast doubt on the ability to safely take any position.
One
of the things that’s central to risk-conscious value investing is
ascertaining the presence of a generous cushion in terms of “margin of
safety.” This margin comes from conviction that conditions will be
stable, financial performance is predictable, and/or an entry price is
low relative to the asset’s intrinsic value. But when something as central as oil is totally up for grabs, as investors seem to think is the case today, it’s hard to know whether you have an adequate margin.
On the other hand – high levels of confidence, complacency and composure on the part of investors have in good measure given way to disarray and doubt,
making many markets much more to our liking. For the last few years,
interest rates on the safest securities – brought low by central banks –
have been coercing investors to move out the risk curve. Sometimes
they’ve made that journey without cognizance of the risks they were
taking, and without thoroughly understanding the investments they
undertook. Now they find themselves questioning many of their actions,
and it feels like risk tolerance is being replaced by risk aversion. This paragraph describes a process through which investors are made to feel pain, but also one that makes markets much safer and potentially more bargain-laden.
In particular with regard to the distress cycle, confident
and optimistic credit markets permit the unwise extension of credit to
borrowers who are undeserving but allowed to become overlevered
nevertheless. Negative subsequent developments can render providers
of capital less confident, making the capital market less accommodative.
This cycle of easy issuance followed by defrocking has been behind the three debt crises that delivered the best buying opportunities in our 26 years in distressed debt
But we knew great buying opportunities wouldn’t arrive until a negative “igniter” caused the tide to go out, exposing the debt’s weaknesses. The current oil crisis is an example of something with the potential to grow into that role. We’ll see how far it goes.
For the last 3½ years, Oaktree’s mantra has been “move forward, but with caution.” For the first time in that span, with
the arrival of some disarray and heightened risk aversion, events tell
us it’s appropriate to drop some of our caution and substitute a degree
of aggressiveness.
