By nature, we tend to be more contrarian at High Rock. For instance, as we started last year, the global market was looking for 10yr US Treasury bonds, which started 2014 at 3.05%, to move to 3.50%. We got rather bullish at the beginning of the year on 10yr and 30yr bonds. Why? Quite simply they were not doing what everyone expected them to do, which was rise in yield. And our former Merrill Lynch colleague Bob Farrell's Rule #9 of Investing..."When all the experts and forecasts agree -- something else is going to happen". And low-and-behold, what did 10yrs do? They rallied...all the way to 2.17%...for a Total Return of about 10% on the year 2014. The bond market was and continues to give us important insight into global financial markets.
So what can hurt us in 2015? Well oil may just be at the top of the list. The question becomes, was there a demand problem at $107/bbl or was it a supply problem? To be sure, I don't know the answer to that question. What I do know is that oil is going to keep going down for quite a while yet. OPEC has changed it's mandate and seems prepared to see it fall to the point where marginal/swing producers are hurt rather badly.
So if the problem with oil is a supply issue, then I think the price will keep falling until producers hit what we refer to as Negative Netbacks, ie, their cost of producing goes negative...and we are getting pretty darn close to that in N Am right now. This will be the only thing that actually cuts production. When the price plummets like it has, the first response by most producers is to produce even more because the price has fallen. But when the price falls below their cash costs, they will actually pull back production. This will take some time yet.
And if this drop in oil is a demand problem, then look out below because that has global economic consequences. If the world was happy consuming oil at $107/bbl just 7mos ago, can it not take up supply and consume at $50/bbl?? If this is the case, and oil continues to get cheaper, then the global economy is indeed in dire shape.
Again, look at what the bond market is telling us. 10yr Treasury bonds are at 2.05% as we write.
And what could turn oil back up in a hurry? I put a very low probability (20%) on this but I think the only thing that can turn oil higher is a snap statement out of OPEC. Why would they do such a thing? Because, although Saudi Arabia has cash costs of about $15/bbl, they need oil in the $70-80/bbl to maintain a balanced budget. Why is a balanced budget so important to them and many of their OPEC members? Because the last thing the House of Saud need/want is an Arab Spring 2015 on their soil. With oil at $40/bbl, it would make it very difficult to keep the masses happy with social programs.
How do we protect ourselves? We have limited exposure and less than our benchmark weight in Energy. Within Energy, we like owning some producers with lots of liquidity...those with no bank debt ahead of us, or with lots of room on their credit facilities, those with strong Netbacks, and those with low Fixed Charges. We do not like oilfield services companies like drillers because we think that as the price continues to drop, the response from producers is to cut costs and the first place they will look are their service providers.