Market Commentary
December 15, 2014
Oil price commentary
Roger Mortimer, Senior Portfolio Manager
Harbour Growth & Income Fund
Harbour Global Growth & Income Corporate Class
As has been well documented in the media, subsequent to the OPEC meeting on November 27 the price of oil
has fallen dramatically, severely impacting the value of energy stocks globally, the energy-heavy S&P/TSX
Composite Index and the Canadian dollar, driving it down 3%.
In this note, we will explore the factors contributing to the oil price weakness, and make some observations
on the positive and negative beneficiaries of this phenomenon. Forecasting commodity prices is notoriously
difficult, so rather than speculate about the timing or nature of the price recovery, our objective is to provide
some thoughts on what factors might need to be in place before we see a sustained recovery in the oil price,
and to talk a little bit about winners and losers in this environment.
What happened?
On the face of it, an OPEC meeting in which its members were unable to agree on supply cuts resulted in the
view that OPEC was willing to let the oil price fall to a level set by the market.
There has been considerable speculation that OPEC’s action was motivated by a desire to harm Iran, Russia
or the U.S. shale producers. The reality is likely more nuanced and the price collapse is probably the result of
a confluence of a multitude of factors.
Here are the key points to consider:

As a globally traded commodity, the price of oil reacts to pure supply and demand
characteristics. When demand is strong, the price rises, and when there is too much supply for the
available demand, the price falls. Coming into the meeting, there was a supply imbalance influenced
largely by non-OPEC production. It now seems clear that demand was perhaps weaker than
previously anticipated, suggesting a weak underlying global economy.

At some level, OPEC is becoming increasingly marginalized and may have lost its ability to
“finesse” the market, resorting instead to blunter market signals. As the charts below illustrate,
OPEC’s own ability to deliver incremental supply has struggled over the past three years, with only
Saudi Arabia and Kuwait really capable of bringing incremental supply to the market. Political and
financial upheaval in other OPEC members, combined with a lack of reinvestment has caused many
OPEC members to be in a position where they are unable to materially expand production.
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Market Commentary
December 15, 2014

During this same period, North American supply growth has been extremely robust. As
OPEC members have run up against their own production capacity constraints, non-OPEC
supply has had a greater influence on price.
Ironically, while shale oil development has recently grown so quickly as to put some pressure on
OPEC, the cartel has maintained a price level over the last few years that has encouraged shale’s
development. As high-cost capacity that comes on at nearly triple-digit oil prices, shale is a helpful
tool to mitigate overly high prices for OPEC: sustained prices at too-high levels are bad for long-term
Market Commentary
December 15, 2014
oil demand. With OPEC likely happy with the price in some sort of high equilibrium range – perhaps
$90 to $100 – if shale oil production is curbed in the short term by a period of price weakness, OPEC
has reminded its unruly child to not get carried away with uneconomic production growth.

OPEC’s own cohesiveness appears to be as fractious as ever. Key members Saudi Arabia and Iran
are at odds over nuclear issues, and the Arab Spring legacy of ISIS is destabilizing the Arab Gulf
region considerably. At its most functional, OPEC is an alliance of shared economic interest. But other
than a mutual interest in the oil price, there is not a lot of commonality across the group, and multiple
OPEC members are currently struggling with considerable internal turmoil (Libya, Nigeria and Iraq,
to name a few). This instability may make it more difficult to reach consensus decisions within OPEC.

Power politics play a major role. Ceding production share within OPEC is a surrender of power: if
you agree to produce less of the whole then you exert less influence overall. The Saudis are clearly
loath to take the production cuts themselves at a time when OPEC itself has become less influential.
Saudi Arabia has one of the lowest break-even costs among the OPEC nations, and a strong sovereign
balance sheet. We should not think for a minute that this is not painful for them, but their actions
likely reflect a desire to maintain share and power within OPEC and ensure that OPEC’s relevance to
the world oil price is also intact. As the chart below illustrates, some OPEC nations, most notably
Libya, Algeria and Iran, require much higher oil prices to breakeven on their fiscal budgets.

The U.S. dollar is also a factor. Sustained strength in the currency, which is essentially priced
relative to the euro and the Japanese yen, is causing weakness in all things priced in U.S. dollars – this
particularly applies to commodities.
Market Commentary
December 15, 2014
As the dollar rises, the buyer needs fewer dollars to buy a barrel of oil and the oil price falls. As U.S.
interest rates remain lower than those in most developed countries, and U.S. growth is widely
expected to be better, sustained strength in the U.S. dollar is a distinct possibility. This chart shows
the index of the trade-weighted dollar over the past three years:

While physical demand and supply ultimately set the price over the longer term, financial
market activity (oil trading) has a substantial impact on the global oil price. While difficult to
quantity, this activity is a multiple factor of physical trading in oil by people who actually use it –
meaning that financial markets can have a significant impact on the oil price over shorter periods of
time. Some estimates suggest that the financial market for oil is as large as 40 times the volume of the
physical market. Financial players “go long” when the price is rising, and unwind those long positions
to “go short” when the price is falling. This can exert considerable volatility on the oil price and make
it impossible to forecast over shorter periods of time.
In short, the likely reasons for the fall in the oil price since the November 27 OPEC meeting are some
combination of:
1. Excess supply and weaker than expected global demand for oil;
2. a stated desire by OPEC to let the market solve for price; and
3. the aggressive action of financial players in unwinding long oil trades and possibly moving to go
short.
Market Commentary
December 15, 2014
So how can we determine when and how the low price period may end?
It’s not easy, but framing a thought process within the following variables might be helpful in forming a view.
1. Think about the timing of the next OPEC “signal.”

OPEC only pronounced their view on November 27 – less than a month ago. While there has been
considerable market reaction, I think it may be optimistic to suggest that OPEC will change its course
quickly just because the market has reacted strongly. If part of the intent is to influence the behavior
of marginal (non-OPEC) suppliers in the market, then it seems reasonable to assume that OPEC will
leave the current situation in place to allow the full gravity to sink in on all of the market participants.
The next formal OPEC meeting is scheduled for June 2015. There is speculation that there might be
an “emergency” OPEC meeting in March, which would be welcome, but we wouldn’t count on that.
The pain will be felt most acutely by non-OPEC members including Russia, U.S. shale producers and
Canada, and will impact capital allocation in these markets, but this will take some time to take effect.
Within OPEC, as Saudi Arabia sits low on the cost curve, other members will feel greater pressure
earlier and this will eventually cause greater desire for OPEC cohesiveness and a shared burden of
production cuts.
2. Think about the timing of supply curtailments.

U.S. shale oil production – a massive source of production growth over the past three years – is
tremendously capital intensive and requires continuing access to equity and high-yield credit
markets to maintain its pace of development.
Market Commentary
December 15, 2014
Ultimately, capital will be rationed to producers in Canada and the U.S. (and presumably Russia). As
their cash flows fall they will have less to reinvest; they will lose cost-effective access to debt and
equity markets, and their production declines will work against them. In the short term, however,
they are funded and have near-term programs locked in place – so behaviour through the first
quarter will not change, adding to an already well supplied market.
If we look back to the global financial crisis, North American oil companies maintained production all
the way down to their cash marginal cost before they were sufficiently frightened by the
environment to change their capital allocation programs. This industry’s marginal cash break-even
cost number is likely somewhere around $35 a barrel. In December 2008, oil traded at $33 a barrel.
We will be watching closely for early signs of future production cuts from E&P companies over the
next few months, as this is an important self-correcting mechanism and will provide insights as to
how quickly supply could come off.
3. Think about the timing of evidence appearing of the benefits of a lower oil price stimulating the
economy and the demand side.

The lower oil price is effectively a tax break for consumers and a stimulus for governments that are
net importers of oil. In the U.S., the benefit will be felt most markedly at the low end, where the
savings on a tank of gas have the greatest impact to marginal consumption. For oil importers like
China, India, Japan and continental Europe, a lower oil bill has a stimulative effect which should feed
back into the economy. Watching for evidence of the growth tailwind from the energy subsidy will
be an important signal – as this should stimulate greater demand. This sort of data might be visible
by the second quarter of 2015.
Market Commentary
December 15, 2014
Other factors to watch include a reversal of the U.S. dollar strength and geopolitically induced supply
disruptions in OPEC.
Financial players will be following these same cues in formulating their trading strategies on oil. I
think it is important to consider that in the near term, this group will likely set the market price. Oil
traders will be watching closely for information flow that will cause momentum and inertia to shift,
and in the absence of demand “green shoots” they may continue to pressure oil prices lower until
there is evidence to go the other way.
What are we doing?
For our client’s portfolios we think carefully about the difference between making a prediction and
understanding causality.
In Harbour Growth & Income Fund and Harbour Global Growth & Income Corporate Class, the
concept of balance is paramount.
We think constantly about the impact to our client portfolios from various events, and work hard to ensure
that a single factor will not cause the entire portfolio to behave the same way.
In the short term, the lower oil price should be economically stimulative and disinflationary, removing a
high-cost item from the inflation calculation. In theory however, it may be more inflationary in future if the
lower oil price results in faster growth and higher demand in a few years’ time. This adds complexity for
policymakers as in the short term the need to raise rates is lessened, but if global growth benefits, it may
hasten the rate tightening cycle.

Those negatively affected by low oil prices include oil companies, oil service companies, the
currencies of countries who produce oil (including Canada and Australia), and the broad index
valuations of those nations’ stock markets. We are watching closely for the potential negative
Market Commentary
December 15, 2014
financial effects of the price decline, as entities with a lot of financial leverage are disproportionately
negatively affected.

Low oil price winners are energy importing nations (many emerging markets including China and
India), lower end consumers (where the energy cost saving is a larger proportion of their
discretionary cash flow), industries that are very energy intensive, and in theory, growth generally.
We are also keeping an eye out for indications of financial stress resulting from oil’s rapid fall. Big moves in
major global financial levers can occasionally cause dislocation and threats to financial stability.
In the Harbour balanced portfolios we are mindful that the concept of “balance” provides stability and
conservatism to our clients. We invest in high-quality companies, led by strong management teams, and
bought at prudent prices. Rather than make predictions about what might happen next, we endeavour to
structure our portfolios to ensure that their wealth can be protected and grow under a range of outcomes.
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Harbour Advisors and Harbour Funds are registered trademarks of CI Investments Inc. Published December 2015.