Home' Trinidad and Tobago Guardian : December 18th 2014 Contents There is a saying in invest-
ment circles: "He who tries
to pick bottoms usually
ends up with smelly fin-
gers." Today, this is very
relevant to the discussion
on oil prices.
Almost daily foreign and local experts
alike are offering their forecasts on how
low the price of oil will go. Everyone is
trying to pick the oil price bottom and
there is a battle for attention.
Headlines such as "Oil can get to $30-
$40 per barrel" have been offered. The
operative word is "can". Of course it can,
just as in 2008 when oil was at $147 per
barrel and Goldman Sachs and others were
suggesting that oil "can" get to $200 per
barrel. We all know how that turned out.
Be careful with those forecasts as many of
those who are forecasting now were not
forecasting last year that oil prices would
be where it is now.
Here is another popular investment
quote: "Amateurs want to be right, pro-
fessionals just want to make money." This
should be the perspective that guides your
actions. From this vantage point, you should
be more concerned with the impact across
various countries, sectors and, ultimately,
companies as a result of the move in oil
prices. The high or low in price is largely
inconsequential as the money is made or
lost between the range.
You would have read in this space the
argument that the actions of the US Federal
Reserve and central banks, in general---
which have seen interest rates hit the zero-
bound globally---will eventually cause the
mispricing of risk on a scale that will lead
to bubbles and eventually precipitate anoth-
er crisis. In other words, the debt induced
mortgage financial crisis of 2007 was not
solved by Central Bank action but was
rather set up to be transferred to another
crisis in some other sector of the market.
This is no different to what obtained in
2000 when the solution to the technology
sector s "Dot Com" crisis in the US was
one per cent interest rates, which provided
the genesis for the mortgage crisis in the
financial services sector of 2007.
Another seven years later and the mis-
pricing of risk on account of a zero interest
policy has now hit the oil market. The
argument of whether there is a surplus of
supply or a lack of demand is a moot one.
The reality is that low interest rates in
the US facilitated the expansion of the very
capital intensive oil and gas industry in the
US. Low rates also created an artificial level
of global demand that propped up a number
of emerging market oil producing
A Deutsche Bank report, referenced by
Bloomberg, suggested that since early 2010
US$550 billion of new bonds and loans
were raised by the US oil and gas sector.
Just as during 2001 to 2006 when sub
prime mortgage borrowers in the US hous-
ing market were able to get access to credit
they may not have otherwise had because
of the then record low interest rates, the
same principle applied in the oil and gas
sector since 2008 with many small, spec-
ulative operators in the US.
These operators are responsible for the
marginal supply on the oil market and are
the ones at risk during the price shakeout.
Regardless of where oil prices go these
debts need to be serviced and a failure to
so do will have knock on effects.
Beyond the debt servicing which is a
function of cash flow, the other consider-
ation is the ability to raise additional capital
in order to remain in business.
According to Bank of America Merrill
Lynch yields on below investment grade
(junk) energy related bonds averaged 5.7
per cent in June but are now averaging 9.5
per cent, a five-year high.
Overall up until a few months ago the
average yield on junk bonds were lower
than what an investment grade company
was able to raise capital at before the credit
crisis. This highlights the mispricing of
Always expect a reversion to the mean
and the sell off in junk bonds has not been
restricted to the energy sector. Investors
are setting themselves for a rush to the
exits and trying to beat the crowd. It
remains to be seen whether, and to what
extent, there will be a knock-on effect.
Investors should be paying close atten-
There is also as expected some measure
of correlation between the high yield (junk)
bond market and the stock market. Some
divergence is apparent here as well, so it
is either the junk bond market will rebound
quickly or there may be some challenges
ahead for the stock market.
The bottom line is that when markets
move as fast as they have in terms of the
recent 40 per cent drop in oil prices, rela-
DECEMBER 2014 • WEEK THREE www.guardian.co.tt BUSINESS GUARDIAN
COMMENTARY | BG15
tionships will become misaligned and there will be
some amount of pain.
However it is not just the price of oil that is an
issue. Oil demand and supply did not suddenly go
out of whack. These things take months and years
to build on both sides. The catalyst for the sudden
movement in oil prices has been the recent and
rapid appreciation in the US dollar against other
global currencies. Recognise that oil is priced in US
The stronger US dollar, especially against the
yen and the euro is due to looser monetary policies
in Japan and Europe against the potential for tighter
monetary policies in the form of rising short-term
rates in the US.
This has resulted in the following warning from
the Bank of International Settlements: "The appre-
ciation of the dollar against the backdrop of divergent
monetary policies may, if persistent, have a profound
impact on EMEs (emerging-market economies) For
example, it may expose financial vulnerabilities as
many firms in emerging markets have large US dol-
"A continued depreciation of the domestic cur-
rency against the dollar could reduce the credit wor-
thiness of many firms, potentially inducing a tight-
ening of financial conditions."
So just as energy-related junk bonds are now
challenged, there are also risks to emerging market
corporate debt, which can ultimately impact the
sovereign. While my outlook for 2015 is still to come,
what I will say at this stage is investors should
expect more divergence in policy across countries
and with it more pronounced stock market volatil-
ity.If oil prices stay low for an extended period then
this is ultimately disinflationary. How will central
banks react to this when they are already at the zero
bound in interest rates and have expanded their
balance sheets to cater to the last crisis?
Lower gasoline prices in the US is roughly equiv-
alent to a tax cut for the US consumer that reduces
the pressure for wage increases, a key component
of the higher inflation story, necessary for sustained
rate hikes by the US Fed.
Further, capital investment and employment on
the margin came from the US oil and gas sector
over the past seven years. To the extent that this
is tempered the US Fed may slow the pace of rate
hikes from the initial forecast. This is, of course,
consistent with my established long-term view of
low rates for longer than expected.
Beyond that, because central banks in Europe
and Japan require looser monetary policy than the
US there is a flow of funds into longer dated US
treasuries, both in search of comparative yield as
well as for safety. This has resulted in a flattening
of the US yield curve.
A flatter curve over the longer term ultimately
reflects more muted economic growth prospects in
the US. This is reflective of the following argument.
While the US is growing at a reasonable clip now,
the rest of the world is slowing and it remains to
be seen if the current pace of US growth can be
maintained for an extended period with a strong
Dollar which makes exports more expensive and
lower levels of growth amongst their trading part-
Appreciate that it is not about picking the bottom
of the oil market. Even if you are successful there
are so many knock-on effects that using the pre-
oil slide investment approach after oil prices have
bottomed out may still see losses in your portfolio.
Globally investment dynamics are changing, which
makes for a very interesting 2015.
Ian Narine is a broker/dealer and investment
adviser registered with the SEC.
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