Oligarchs, Despots and Soccer Moms (Part 2)

by Kara Lilly, Mawer Investment Management

Reflections on the current price of oil (part 2)

Last week, we weighed in on the recent drop in the price of oil. We likened the move to a rock thrown into a pond and cautioned against reaching for the falling knife. Since then, the price has dropped further, hitting a low of $60.  Given these developments, it’s prudent to examine the possible ripple effects and what, if any, lessons we might glean.

Oligarchs and Despots

When a flood hits, not all neighbourhoods are impacted equally. Upstream oil producers and service providers will clearly be impacted by the current price of oil, but it is unlikely that they will be uniformly affected.  And they are not alone.

Service providers with exposure to exploration should be among the first to be hit. This just makes intuitive sense—if oil is at $60 and you are the CEO of Suncor or Imperial, would you rather squeeze your suppliers or fire your people in order to cut costs? We wager you would make the less painful decision and most likely reduce noncritical activities or squeeze suppliers (we would not be surprised to see contract negotiations begin with servicers in the New Year).

While upstream producers will all feel some pain, some will fare better than others. Those that will be in the best position are those with the lowest cost bases. Clearly, if a company produces a barrel of oil at $50, it can withstand a price decline to $65, but the company that produces barrels at $70 is in trouble.  (Now this is a bit of an oversimplification as there are two oil price points for producers: the “stop drilling” point, at which new drilling and capital expansion programs are halted, and the “shut in” point, at which production itself is stopped.) Upstream producers with the lowest cost bases are like the houses that sit on top of the hill in a flood: they have the greatest buffer when the storm hits.

Upstream producers with strong balance sheets will also be better positioned. Many junior oil and gas companies have significant amounts of outstanding debt, and with the value of their assets plummeting, they will face a much worse overall debt position. It is no surprise that we are already seeing companies cut their dividends to shore up cash. A strong balance sheet also means a company is unlikely to go bankrupt and may even have the opportunity to acquire financially-troubled companies with good assets at attractive valuations.

It is not merely oil companies that will be impacted by the current prices—oil-exporting nations will also feel the effects. Within Canada, the Alberta, Saskatchewan and Newfoundland economies are significantly influenced by the energy industry. With a lower oil price, companies will start reducing their expansion programs, thereby draining economic potential within these communities and supply chains. Layoffs will be unavoidable.  Sectors such as real estate and banking might feel knock-on effects.

But while a low oil price could be painful for Canada, it is unlikely to be politically destabilizing. The same cannot be said for the oil oligarchs and despots of the world.

For example, Russia is already in a precarious economic position because of the European and American sanctions imposed on it earlier this year. Before Russia invaded Ukraine, the Russian economy was already facing serious economic headwinds. Now that the price of oil is low, the country’s economic woes have been exacerbated – since our last blog about Russia the yield curve has remained inverted and the total cost of capital has shot up another 2% across the curve. This is all very worrisome for the Russian financial system and it has at least two major global implications.

First, it means that Putin is in a corner. And a bear backed into a corner usually lashes out. While it is possible that Putin maintains the Presidency in the midst of an economic downturn – he still has many supporters – it seems likely that support for the shirtless-horse rider will start to slip…unless, of course, he succeeds in re-framing the perception of the populace. One way to do this would be to whip up a nationalist frenzy, perhaps through increased international disputes. Unfortunately, this is already what seems to be happening.

Second, it puts the creditors to the Russian banking system at risk. Remember the blow-up of LTCM in the late 1990s? The firm went under after it sustained significant losses from the 1998 Russian financial crisis when the Russian government defaulted on their bonds. If Russia ends up facing a major crisis, a similar risk will arise for credit holders.

Venezuela is another case in point. Oil accounts for roughly 50% of the country’s GDP and 95% of its exports. The steep fall in oil is not only likely to push the country into recession, but will probably also trigger a severe shortfall in USD, which could become a major challenge for the financial system. And these concerns are already visible in the spreads on Venezuelan Credit Default Swaps. The spreads on these instruments reflect market views on the probability of default (the bigger the spread, the greater perceived risk of default) and they have skyrocketed since the summer. Venezuela faces major headwinds. And it is possible that these economic hardships destabilize its political situation.

Soccer Moms Rejoice

Yet low oil prices are not all bad. In fact, low oil prices should be beneficial for many companies and most countries.

Within Canada, the companies and industries that should benefit are those for whom a low Canadian dollar is a blessing. Exporters may benefit from the lower dollar, allowing their goods and services to better compete on the world market. In particular, Ontario’s manufacturing industry may benefit from a weaker currency (although a lower dollar does not absolve the sector from its problems with inefficiency).

Globally, low oil prices should benefit the consumers and manufacturers of oil-importing nations. Consumers can spend more on other things when they pay less at the pump. Likewise, manufacturers who rely on oil as an input cost should see improved margins. Regions that are most likely to benefit include Japan, China and India. Europe may also benefit, although the boosts in consumption and manufacturing might be overshadowed by the additional deflationary pressures of lower oil prices.

Another group that is likely to see the upside of low oil prices is the U.S. “soccer mom” – i.e., the U.S. consumer, who spends a lot of time driving. While not the highest per capita usage in the world, the U.S. still consumes a significant amount of oil per day. Roughly 368 million gallons of gasoline – an end product of crude oil – are consumed per day within the U.S. This is equivalent to filling up 25 million SUV tanks. More money in their wallet means more spending on other goods.

Final Musings

So what do we make of all this? We see three main takeaways.

First, oil and gas producers have difficult business models. As commodity businesses, they are price takers, and are consequently subject to the fluctuations in international supply and demand. And yet many of their costs are enormous and fixed which makes planning very challenging. From a relative standpoint, upstream oil and gas businesses are certainly not the most attractive business models in the world.

Second, true diversification means going international. According to the IMF, Canadian investors allocate ~ 59 per cent of their equity holdings to Canada. And yet Canada accounts for approximately 3.6 per cent of the world’s stock market capitalization. Home bias persists here. And yet the benefit of investment globalization is the ability to go anywhere in the world to search for excellent opportunities and to diversify. Low oil prices should be a wake-up call that Canada is vulnerable to this one industry.

Third, when an event like this occurs, it is necessary to reflect on both the direct and indirect implications. A shift in the range in oil prices is bound to come with far-reaching consequences. While not everything discussed in this piece may unfold, reflecting on second-order risks is an important process. One that is best incorporated deeply into an investment routine.

In our team, we are responding to the drop in oil prices in the same way we always manage our portfolios. We focus on building resiliency. Consequently, we continue to invest in wealth-generating companies, run by excellent managers, which trade at a discount to their intrinsic values. In the energy sector, there remain companies that fit this bill and we continue to own them. Outside of the energy sector, we are cognizant of the indirect implications of the lower oil prices and are positioning our portfolios to account for what has been a shifting of the odds.

Kara Lilly

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