Breaking Up Is Hard To Do
by Tony Scherrer, CFA, Smead Capital Management
At Smead Capital Management we are in the business of attempting to gain a clear understanding of what we refer to as a “Well Known Fact.” A Well Known Fact is a body of economic information which is known to all market participants and has been acted on by nearly anyone with access to capital.
With that in mind, as we assess what has gone on in the back-half of 2015, we are cognizant of the question we get asked about the most. This question beats most others by a wide margin: what is our view of the commodity complex in general, and oil in particular?
It’s an understandable question given the love affair that market participants have had with the idea for the better part of the last 15 years. The recent drop in oil prices and many of the securities involved in the energy business has caused an outcry for real answers. This outcry has intensified in light of what now appears to be another seemingly attractive entry-point for value investors or speculators who view the drop in oil to be an aberrational phenomena or temporary dip.
We understand. Most difficult breakups start with denial and always include a healthy dose of drama along the way. Consider the drama involved in 2008: the spot price of West Texas Intermediate (WTI) Midland Crude Oil cratered from $145.54 to $31.66 inside of the six-month period starting in July. You would think a 78% decline in a vehicle which doesn’t pay a dividend in the first place might invoke responses more similar to victims of attempted murder rather than simply jilted lovers.
But as Neil Sedaka’s hit song from 1962 would remind us, “Breaking Up Is Hard to Do.” The jilted lovers returned around Christmas of 2008, only to bull the price of oil back above $110 by April 2011. Thereafter, the affair over the following 3 years might be described more like a dysfunctional love-hate relationship, as oil grinded in a range from $110 to $80 with plenty of emotion and commentary. But affairs based on jilted lovers desperation and dismay never last. If anything, they’re really hard for outside observers to watch.
We continue to watch from the sidelines, owning nothing in the area.
We think the dramatic drop and bounce-back in mid-2008 that oil inflicted on its fans was the worst kind of domestic abuse. Because of its brevity, the healthy reaction that might otherwise have introduced its affected addicts to the first step of any good recovery program, denial, was never required. We would argue that we are now 7.5 years away from the 2008 peak, and the jilted crowd remains as dismayed, disbelieving, and confused by oil as they have ever been. We are almost uniformly told about the inevitability of a return to more “normal levels” of $70-90 from today’s $35 spot price on WTI. We see several problems with that because it defies the psychological trajectory you would normally expect among the tortured and abused, yet they are still fundamentally in love.
1. Oil has a new girlfriend called technology. She knows how to drill horizontally. She has learned words like hydraulic fracturing. Above all else, she has shown oil how to stretch a buck in terms of productivity. Consider the chart below, implying that a new rig produces about 10x the amount of oil today than it could just 8 years ago: