As days go by with the Oil price making new lows globally, investors are beginning to sound more like belligerent children, impatiently sitting in the back seat wondering when their tormentous family road trip will end. Just as kids feel the necessity to transfer their anxiety to their parents, investors have succumbed to doing the same, in addition suffering from obsessive compulsive disorder when ringing their portfolio managers asking the same question.
What is the right price of Oil? $40? $30? or dare I say $20 even? We all talk about how all asset classes are globally correlated, be that as it may, there are some key underlying differences in each one. For instance “cheap” in Equities does not have the same meaning in Commodities. An Equity or the Stock of a listed company has underlying cash flows, tangible assets, physical operations all of which can be assigned some sort of value. A Commodity on the other hand is a resource – a utility! You either need it or you don’t? If you have enough of it, it does not matter what it costs, as no one will be willing to pay a higher price for it. The price of Oil has now become irrelevant really. It all rests on the fact when and how soon the inventories will balance out, with either demand picking up or supply falling, whichever happens first.
The FT reported today that the assets of Sovereign Wealth Funds (SWF’s) have more than doubled since the end of 2007, from about $3.5 trillion to $7.2 trillion, due to ever increasing Oil prices earlier in the decade. As that price falls, their wealth erodes and their purse strings tighten. It is a self-fulfilling prophecy as the world’s largest consumers of Oil in terms of growth in the fuel consumption rate from 2004-2014, China and Middle East, are both now showing signs of stress. The much talked about demand picking up to rebalance the excess supply seems to move further out in the horizon.
Where the price of Oil is relevant is the level at which it causes distress to its producers, when they are unable to produce it at all to meet their capital commitments. As wealth transfers from Oil producing nations to Oil consuming ones, some Oil producers are still in denial about how low Oil prices can go. Banks eager to offer them capital to keep producing, enable them like children demanding that extra piece of candy after dinner. Now it is crunch time. What producers and banks could not do, the Oil market is doing for them, forcing them to pull production fast or risk bankruptcy, as they are now unable to match their cash flows.
It is human nature to hope for the best when licking our wounds or hold onto losses on our existing positions, expecting the next day to be better. Hope and risk management are two different things. Investors need to be cerebral not emotional about the current state of the Oil market. Just as children need to be told when they are out of order, investors and the marketplace too deserve a tap on their wrists so that they can behave better in the future.
