Oil is perhaps the world’s most “fungible” commodity… one which modern economies cannot live without. With this in mind, many would believe oil prices to be rather stable. However, commodity pricing is driven not by total supply and demand, but by marginal supply and demand. The market is normally in balance. A rather small change in demand or supply can have an outsized impact on pricing. Perception of increases in supply and demand can also, over the short term, affect pricing.
This scenario is happening now in the oil markets – irrespective of your thoughts as to what is driving oil prices down. Are oil prices moving downward because of a marginal increase in supply? Yes. Are oil prices moving downward because of a marginal decrease in demand? Yes. Which is the most powerful? In my opinion, the supply of oil is the real issue, but a slowing level of marginal demand also impacts pricing. Lastly, the perception that oil prices will continue to fall until someone reduces production is also impacting pricing today… acting as a self-fulfilling prophecy.
The Dark Lining to a Silver Cloud
I have consistently made the case that a decline in oil prices (from a high of $106 per barrel in June of this year to $54 per barrel currently) is positive for the U.S. economy. The cut in oil prices (expressed in gasoline prices) acts as a tax cut for consumers. If prices stay low long enough, it will spur discretionary spending. I stand by that analysis.
However, we are witnessing a dark lining to this silver cloud. The non-OPEC producing countries (Russia, Brazil and Norway, as examples) are starting to become backed into an economic corner. In all of these countries, oil represents a major export and helps finance other economic activities. For example, as Russia sells oil in the open market (priced in dollars) at $60 per barrel, the revenue in dollars is 50 percent less than was the case in June of this year. Since June, the Russian Ruble has declined by 59 percent (to the U.S. dollar). A “crash” in the value of any currency leads to very high inflation (imports are now more expensive than would have otherwise been the case), which leads to potential civil unrest. On a global scale, the “wealth” of Russia as a nation, priced in Rubles, has declined by 59 percent in the last six months.
This is the stuff that leads to revolutions. Oil, other commodities and vodka are about the only exports Russia creates and helps fund their country’s spending. They are net importers of most all consumption goods (health supplies, food, etc.). In their own currency, those imports are now 59 percent more expensive than they were this past summer.
Russia’s Problem – Their Problem?
To some, the problem Russia currently faces sounds like something Vladimir Putin created by his dalliances in the Crimea and Ukraine. There is some truth to this as those actions led to economic sanctions unleashed by the West on Russia. The oil pricing issue is indirectly due to his destructive behavior. What really matters to the rest of the world at this stage is the potential for economic weakness to spread to the rest of the world from Russia… monetary contagion, anyone?
How would this happen? Why would the rest of the world be negatively affected by weakness in the Russian Ruble? Russia’s economy is the world’s eighth largest (as measured by the IMF), a little larger than Italy and a little smaller than Brazil. At about $2.1 trillion in GDP, Russia is dwarfed by the United States at $17.5 trillion. If Russia’s economy contracts by 4 percent (which potentially is in the cards for 2015), it will impact the world’s GDP by about $84 billion, or .1 percent. No big deal. However, let’s think not about the world’s income statement (GDP) but rather about the world’s balance sheet – the world’s banking system.
Most Russian national debt is priced in Rubles and the value of that debt has collapsed from six months ago when the Ruble was higher and Russian interest rates were dramatically lower. Russia’s public debt is $216 billion. The Russian benchmark interest rate was at 7.5 percent in June of this year – that interst rate is now 17 percent.
If an American investor had purchased $1,000,000 in Russian soverign bonds in June of this year, those bonds would be worth around $262,500 today. That represents a loss of 74 percent of the investment made six months ago. Now, let’s say you’re a German banker who decided to do the same thing, but in this case, you purchased the bonds in Euros (and you have to mark-to-market in Euros). Your investment would have lost 70 percent of its value. That 70 percent loss needs to be reflected on the bank’s balance sheet – which effectively errodes the capital base within the bank.
In this case, the banking system (primarily in Europe) may act as the transmission agent for the Russian Ruble problem to spread to the rest of the world. The real cost of this to the European banking system will probably be muted. But, potential dislocations such as this fuel volatility when markets are unstable.
Now, we care. Now, the global capital markets care. Consequently, the S&P 500 has declined by a 4.9 percent from its recent high and the EAFE Index is down 12 percent from its high earlier in the year.
Russia is getting crushed economically. The economic pain and uncertainty to Russia, Brazil, and others will continue until oil prices find a bottom. By today’s trading action, it appears that bottom has not yet been found.
Long ago, I came to the conclusion that successful investors keep their heads while others lose theirs. Oil-based assets are cheap. Will they become cheaper? Perhaps – but, perhaps not. What I do know is: the world hasn’t found a replacement for oil. The 3-5 year demand for oil won’t be lower than it is today. I also know that oil is priced at a 49% discount compared to what it was trading at six months ago. Additionally, I believe the finding costs for oil will continue to decline due to technological advances. Even if oil prices remain low, profits will be made.
Bernard Baruch, the old-time Wall Street sage once said: “Buy your straw hats in the winter.” From what I’m seeing, the current investment climate is pretty cold for oil-based investments.
The views expressed are for commentary purposes only and do not take into account any individual personal, financial, or tax considerations. It is not intended to be personal legal or investment advice or a solicitation to buy or sell any security or engage in a particular investment strategy.