December 2014 Investor Letter

Below is a letter that is written monthly for the benefit of Avondale Asset Management’s clients. It is reproduced here for informational purposes for the readers of this blog.  If you are interested in receiving this letter monthly by email, sign up here.

Dear Investors,

Stock prices rose again in November, but the significant news is that oil prices continued to slide. The price of oil is now back to where it was in late 2009, when the global economy was still recovering from recession. The decline in oil prices has important implications for the broad economy, but the drop may either be bullish or bearish depending on how you interpret the reasons for the decline.

If you believe that prices have fallen because oil production is booming, then you might be more inclined to believe that this has been a positive development. Low oil prices are a bad thing for energy companies, but a good thing for the rest of the economy because they effectively give consumers more disposable income. If prices are really only lower because US oil companies have found a way to produce more oil using new technology, then that’s a net positive signal for the larger economy.

On the other hand, it’s not positive if oil prices are being driven by weak demand rather than strong supply. If this is the case, the falling price of oil is more a canary in the coal mine than a welcome stimulus. Commodity prices are often the most sensitive market segment to an impending recession, and a lower oil price could be a harbinger that economic growth has slowed.

Judging by the fact that the S&P 500 has risen as oil prices have fallen, most investors appear to be buying into the bullish argument. However there is some reason to believe that the impact of US supply growth has been overstated, and that the decline is more demand driven than supply driven.

According to Schlumberger, the largest global oil services company in the world, “The North American supply surge continues to be just enough to equal the world’s growing demand, while all other growth regions, including Iraq, Brazil and the Caspian are struggling to meet their production targets” (April 2014). Oil production in the US has increased by 61% since 2008, but global oil supply has only grown by 7% over the same period. To this point, the US is not large enough of a producer by itself to create a real shift in the supply dynamics for the world oil market.

Additionally, supply growth from US shale may be starting to slow. EOG, the pioneer of shale oil drilling, had this to say about production prospects earlier this year: “it looks like the rate of growth in 2013 slowed compared to 2012 and we expect this trend to continue in subsequent years…We are still bullish regarding U.S. oil prices because of slowing domestic oil growth and we are not particularly concerned about a surplus of U.S. light sweet oil” (February 2014). Nothing has fundamentally changed about the supply picture since these comments were made. There haven’t been significant new reserves discovered, nor has there been a material change in the expectations of the amount of oil that could be recovered using these new techniques. Further, oil markets reacted negatively to an OPEC meeting last month, but the big “news” was that the cartel decided to hold output targets constant.

Since supply dynamics have been relatively unchanged as oil has fallen in price, there must be other dynamics at play in oil’s price decline. Truthfully, there isn’t evidence to say for sure that demand has weakened either, but oil’s price decline does match with other markets that are signaling slowing growth. Oil’s decline is consistent with other commodities, like iron ore, copper and gold, and is also consistent with movements in currency and fixed income markets. Whatever force is moving the oil markets, it’s not an oil specific one. It is weighing on nearly every market besides large cap equities. It is not a positive force, and oil’s strong reaction in November shows that it is a force that is gaining strength.

It is very significant, for instance, that credit spreads on debt also widened last month. Credit spreads are frequently leading indicators of a weakening economic environment and often see signs of recession well before equity markets do. If credit quality is starting to fray around the edges there is no way that equity markets will be able to maintain their bull run. We should be particularly careful to watch credit markets because regulatory changes have left these markets with significantly less liquidity than before 2008. If sellers come to market, prices could drop very sharply without liquidity providers to grease the wheels.

As I mentioned last month, either equity markets are wrong or currency, commodity and fixed income markets are, but both can’t be right. I believe that the current price of oil is much more indicative of the trend of where stock prices “should” have been headed over the last several months. Because of this divergence, I am preparing for a sharp convergence.

As 2014 winds down, December is rarely a negative month, so it would be somewhat surprising to see stocks decline between now and year end. However, markets tend to reset in the New Year. 2015 will bring a new focus on when the Fed may raise rates. There is also pent up demand to take taxable gains come January 1. This could start us off in 2015 with a wave of selling. Frequently mass tax selling creates opportunities, not sustained declines; however, with the market hovering at all time highs with limited value support, a nudge in one direction could change a lot.

Scott Krisiloff, CFA


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