Jan 4

A Bad Year for Jed Clampett Means an Unpredictable New Year for You

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FROM THE NORTHWEST QUADRANT

By Alton Cogert

You remember Jed, don’t you?  The head of the once famous TV comedy of the 1960s, The Beverly Hillbillies?  Well, if you don’t, maybe you’ll remember this opening sequence:

Of course, Jed’s good fortune in the show’s opening was all about finding oil.

However, with oil prices having dropped like a rock in late 2014, we come into 2015 with trepidation and expectation at what this will mean for global economies, interest rates, financial markets, credit risk and, of course, geopolitical nastiness.

I’ve read quite a few summaries of ‘what to expect’ in this arena, but perhaps the best, cautiously reasoned summary comes from the Longbrake Letter, written by Bill Longbrake and published through the law firm of Barnett, Sivon & Natter.  You can easily access this Letter through our InsurerCIO website.

Bill puts the incredibly shrinking oil price in perspective as he describes the Investment Accelerator Cycle – with our current situation being excess supply created by previously high oil prices incenting more oil exploration and development.  Add to that slowing global growth in most developed economies and you get a supply/demand imbalance that must be met by quickly falling prices.

It matters not whether we are talking about oil or residential home prices, price is what gets adjusted such that supply and demand is eventually put into balance.

Bill calls OPEC’s decision to keep pumping oil despite lower prices as classic monopolist behavior (though OPEC is more an oligopoly than monopoly):  forgo short term profits to drive out higher cost producers in order to maximize profits in the long run.  (I can still hear my Econ 1 professor lecturing about that.)

Importantly, Bill notes the dynamics of the ‘Producers Lose-Consumers Win’ scenario that this creates.

Of course, who hasn’t heard that a drop in oil prices (gasoline prices at the pump) is like a tax cut for the consumer?  But, we are already starting to read about layoffs and decreased investment by oil producers.  The net impact, Bill estimates, will be about a positive 0.5% to US GDP.

Importantly, he notes the impact on leveraged loans and corporate bonds tied to the energy fields, quantifying the net negative impact of loss of inventory value used to finance operations at over $300 billion.  Not as large a loss as the housing bubble, but still quite material.

To the extent such debt is held at financial institutions, there is the potential for some financial contagion, depending upon the institution’s concentration in these types of credits.

This brings up the importance of going back to your investment manager with key questions such as:

What is our portfolio’s direct and indirect exposure to oil prices?  Specifically, which bonds and/or leveraged loans should we be most concerned about?  What would be a reasonable ‘stress test’ loss on such credits, assuming oil prices remain where they are, or assuming prices drop another $x per barrel?

The best managers will be able to do their best at quantifying this exposure for you –within a reasonable range.  The ‘less than best’ managers will get out their best ‘tap shoes’ and try to assuage any concerns.

Finally, Bill discusses the dichotomy of “Producing Countries Lose – Consuming Countries Win”

Here he notes that Japan and Europe would fall into the ‘win’ category, but one must watch how things play out.  Will the benefit of lower oil prices be a one time event for these economies that is offset by further downward pressure on prices (e.g. deflation)?

Of course, producing countries that lose include Venezuela and Russia (to which I would add several Middle East countries).

In my opinion, if you want to watch one geopolitical hotspot it would be the former Soviet Union.  Of producing countries that lose with much lower oil prices, only Russia has nuclear weapons.  With their economy under pressure (with economic sanctions, lower oil prices, a plunging currency and raging inflation), the probability of civil unrest rises – even in an authoritarian state – and that would definitely be upsetting to all financial markets, to say the least.

Finally, Bill notes that falling oil prices do have many positive attributes for the global economy, but we should keep an eye on some negative consequences, which might include debt defaults, tighter financial conditions and deflation.

As you can see, Jed Clampett (or his banker, Mr. Drysdale) never had to deal with the current state of oil prices.  “Bubbling crude” and the geopolitical environment were different in the 1960s.

As 2015 begins, let’s hope the positives of lower oil prices far outweigh the negatives.


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