Market Update: A Crude Day for Oil Prices
You’ll excuse us if these market updates are getting a bit out of hand (we naturally prefer to write about things that play out over years, not months) but these past few weeks have given us a front-row seat to the market’s panic-driven, short-term irrationality – a trait that investors (especially passive investors) might have forgotten about after a decade long bull market.
As you might have seen, the market declined almost 7% yesterday (with how volatile things are, it might be up 7% by the time you read this). It might surprise you to learn that the intrinsic value of businesses we own doesn’t actually change 7% in a day. Instead, what causes these types of moves is nothing else but panic. Investors, while still dealing with the fallout of COVID-19, woke up to fresh new headlines about a substantial drop (c20%) in oil prices due to a potential price war among Russia and Saudi Arabia.
In the past, a drop in oil prices might have been something to be cheered on as it provided a clear and direct economic stimulus to millions of consumers around the country. However, with the dramatic surge in US oil production over the last decade, things aren’t that simple.
Consider that today in the US, the energy sector makes up roughly 8% of GDP and supports north of 10 million jobs. If half of those jobs were to disappear tomorrow, that would roughly double the unemployment rate in the country. Recall that US production growth has been largely due to onshore shale production which is quick to be brought online but also quick to be taken offline. With crude prices now in the $30s, below breakeven for most US producers, it is likely that a lot of this production will be cut, as well as many new projects being shelved. It is safe to say this will have a negative effect on the energy sector.
But what about the effect on the other 90% of GDP? When your input costs are falling by 20% it tends to boost your fortunes. This kind of stimulus is fast-acting, far-reaching, and a substantial positive to the economy as a whole. Today, it is far cheaper to produce goods, power factories, transport goods, and even commute to work.
Trying to establish the net impact of these two forces on the economy is a fool’s errand – though it is likely you will see many commentators trying to do just that over the coming days, believing that an answer is not only attainable but also useful and relevant. The answer is none of those things.
The important question today is what is the impact on the companies we hold in our portfolio? In other words, how have our expectations of company’s earnings changed over the next 5, 10, 20 years? This is a question that is not only answerable but actually useful and relevant.
As you know, we do not hold any ‘Energy’ sector stocks in our portfolio. We are of the mindset that exposing our capital to commodity prices that are both volatile and unpredictable, as well as entirely outside of management's control, is akin to speculating rather than investing. If we cannot predict one of the major drivers of a company’s future, then we have no business investing there.
Such positioning has proved very valuable in the last few days (and to be honest far longer than that). It is true that some of our holdings will be hit by lower demand in the geographies hardest hit by a reduction in energy production, but this is more than offset by a very steep drop in input costs. As a result, this recent move is likely to be a net positive for our portfolio. And you can combine that with the fact that the portfolio is now cheaper than it was at the beginning of the week, and even cheaper still compared to the beginning of the year. So once again, the market (via its irrationality) is gifting us a better situation at a lower cost.
As an aside, we are proud to say that you as a group of clients are excellent, and we are fortunate to have you. Most investment firms were inundated yesterday with calls and messages from panicked clients wanting to sell their holdings. We received no such calls- in fact, the only communication we did have was from several clients who took the opportunity to add cash to their portfolios to take advantage of the lower prices. Such an approach has always proved to be beneficial in the long run, and we are pleased and proud to have a group of clients who share our long term, fundamental approach to investing.
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