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Commentary:   January  2015

Dennis C. Butler, President
Centre Street Cambridge Corporation
Private Investment Counsel

See also:
General Index
    of all guest columns written by Dennis C. Butler, CFA 
                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             January 2015

        For 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


 

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