DECEMBER 2014 COMMENTARY
Luckily a very large customer was just around the
corner. A forward thinking First Lord of the
The energy released from conventional oil is still
Admiralty, Winston Churchill, was about to switch
unrivalled. It releases 16 times the energy needed
the British navy, then by far the world’s largest,
to produce it; shale oil by comparison releases
from coal to oil. Oil’s much higher energy density
only 5 times. Hydro electricity and wind are much
meant ships could travel much faster and farther
higher at 40 and 20 times,
for a given weight of fuel.
Real Oil Price 1946-2014
respectively, though
This was essential in the
electricity transmission
early 20th century’s naval
$160
loses up to 50% of the
rivalries and marked oil’s
$140
original energy produced
new importance.3
$120
by the time it reaches
Anglo Persian was perfectly
consumers.1
$100
placed to supply to its new
$80
Even so, the saw-tooth
big customer and invested
price of oil bears almost no
heavily to develop oil
$60
relationship to the
production in Iran. By the
$40
smoothly rising supply and
1950s though, politics had
$20
demand relationship over
shifted and an awkward
the past 35 years (Charts).
compromise lead to a
$0
The 1974-1981 spikes now
consortium dubbed “The
look like an aberration, at
Seven Sisters” that now
least until the end of the
Source: St. Louis Fed FRED. BLS
controlled much of the
20th century, when prices
Middle East’s vast oil
began a gradual ascent. But oil prices have always
reserves. OPEC formed in 1960, eventually
been a strong mix of economics and politics.
nationalising these reserves, and in 1974
quadrupled prices by strangling supply. Now, 40
This month we look at some of the reasons why
years on, OPEC are doing the reverse.
crude oil has dropped over 50% in 6 months and
what investment opportunities may come from
Paul Thomas Anderson’s film There Will Be Blood is
this sudden and unexpected decline. The risk and
about unbridled greed and dependence on oil.
logistics of bringing oil to
Daniel Day Lewis’ character
market have always been
Daniel Plainview tells his
Global Oil Supply/Demand 1980-2013
immense, so the supply
young protégé they will not
95
response tends to lag.2 By
pay landowners oil prices
90
mid-2014, soft demand
but rather quail prices.4 It
85
coincided with sharply
seems a similar plot might
80
rising production and
be unfolding in the global
75
turned the market on its
oil market today as core70
head.
OPEC continues to pump
65
oil into an oversupplied
THERE WILL BE RISK
60
market, which puts intense
55
Oil giant BP’s predecessor
pressure on competitors.5
50
company, The Anglo
Clearly core-OPEC and
45
Persian Oil Company, grew
western powers,
directly from oil explorer
respectively, benefit from
William D’Arcy’s large 1908
squashing upstart US shale
Total Oil Supply
Total Petroleum Consumption
discovery in what is today’s
producers and Iran, whose
Source: US Energy Information Agency
Iran. D’Arcy’s first brush
nuclear ambitions have
with bankruptcy was the
upset regional neighbours as well as the west.
near decade trying to find the oil in the first place.
WHAT TO DO WITH QUAIL PRICES
The second because there were no buyers for his
massive new discovery. High sulphur content Gulf
How does the oil price collapse affect various
oil turned out to be unsuitable for home use and
hedge fund strategies, and our hedge fund
widespread car ownership was decades away.
managers?
1996
2001
2006
2004
2007
2011
1991
2001
1981
1986
1976
1971
1956
1951
1961
1966
2013
2010
1998
1995
1992
1989
1986
1983
1980
Millions of barrels per day
1946
ESSENTIAL OILS
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No. 168 8108 78.
DECEMBER 2014 COMMENTARY
In the equity space, clearly energy exploration and
production names have suffered. But some
refiners, and integrated majors, are broadly flat on
the year as they are not necessarily geared to the
oil price. Indeed a lower price can even increase
refining margins. Oil is of course an input cost for
many businesses, and airlines have been some of
the biggest beneficiaries of the oil price slump.
Lower correlations between equities and credit
instruments also improve scope for generating
alpha from security selection, in strategies such as
equity or credit long short.
names, might not be unrelated to Deutsche Bank’s
departure from CDS trading. In this type of
environment we would not want to invest in
corporate credit funds with unfettered daily,
weekly or even monthly dealing – as they could be
forced by redemptions into fire-sales, as could
overly leveraged funds. We feel more comfortable
in credit funds that have at least quarterly
liquidity, and limited amounts of leverage, so that
they can take a longer term view – and actually
take advantage of these dislocations.
Millions of barrels per day
The volatility seen in the second half of 2014 is
All in all equity markets are perhaps a little
here to stay because new regulations have
myopic, but are behaving rationally to the extent
deliberately discouraged banks from holding
that they are extrapolating current oil prices into
substantial inventories, and so far alternative
the future. In credit markets the story is very
liquidity providers have not yet entered the fray.
different. We are told that high yield energy
Just as hedge funds are complementing banks
names are suffering a completely indiscriminate
through direct lending strategies, we would not
sell-off that has dragged some of them down to 60
rule out the possibility of hedge funds making
cents on the dollar or less.
markets in credit, but so
This is despite the fact that
far we have not noticed
Global Oil Supply/Demand 2013-2014
research from RBC shows
this occurring on a large
94
that “almost all E&P credits
enough scale to
93
would survive two years of
compensate for the exodus
oil at $60”.
of bank capital.
92
91
Make no mistake, current
GREEDY OR FEARFUL?
levels of oil prices will
90
This perhaps depends on
seriously eat into returns
89
how long you think the
for equity investors, but
current oil surplus will
88
cash flows are more than
persist (Chart). Low prices
1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14
adequate for most
will eventually cure
Total Supply
Total Demand
creditors. One of our
themselves.
Source: International Energy Agency
managers owns a basket of
All of this volatility is the
energy credits with costs
lifeblood of tactical trading strategies. The CTA
around $30 per barrel that should, over the long
community had no special premonition of the oil
term, prove very resilient. Yields are now close to
price dump, but simply latched onto the
10% on some of these names, which is 50% above
downtrend. In macro lower oil prices result in
the 6.4% yield on the Bloomberg Global Corporate
obvious losers such as oil producers Russia and
High Yield index. Anomalies have also emerged
Venezuela, where sovereign yields have blown out
within the capital structure of individual
to around 10% and 20% respectively and some of
companies, with some senior loans now yielding
our managers have profited from shorting the
more than more junior high yield bonds. Another
Rouble.
of our managers uses this to construct trades that
should generate a positive net yield, and also
At the same time lower oil prices are tantamount
profit in the event of default.
to a tax cut of the order of hundreds of billions, for
oil consumers, which even leads some of our
Why has the pullback been so savage and uniform
managers to become cautiously optimistic about
in energy related credit? Because US broker dealer
Europe’s sclerotic economy! Cyclical equities in
inventories of corporate bonds are at decade lows.
Europe are deemed to be at the largest discount
There is simply less slack in the system to absorb
to defensives in fifty years, and given the
the ebb and flow of investor redemptions, so a
substantial operational leverage entailed in
small outflow has a disproportionate and
corporatist Europe’s high fixed costs, a small
exaggerated impact on pricing. We conjecture that
improvement in the top line can translate into a
the blow out in basis between cash instruments
huge fillip in earnings. The oil price moves in 2014
and credit derivative swaps (CDS) on the same
Tomlinson Research Limited is an Appointed Representative of Generation Asset Management (UK) Limited, which is authorised and
regulated by the Financial Conduct Authority. Registered in England & Wales with Company No. 08517955. VAT Registration
No. 168 8108 78.
DECEMBER 2014 COMMENTARY
have taken most economists and strategists by
surprise, but nimble and free thinking hedge fund
managers will always find that economic surprises
produce investment opportunities. As for our
energy investments, now is probably as good a
time as any, historically speaking, to top-up.
Hamlin Lovell, CFA & Keith Tomlinson, CFA
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1
(Inman, 2013)
(Coll, 2012) Author Steve Coll describes how the 1980s oil price slump lead to budgets cuts and a 40%
headcount reduction at Exxon which contributed to the Valdez disaster.
3
(BP, 2015)
4
(Anderson, 2012)
5
Core-OPEC generally considered to include Saudi Arabia, Kuwait and UAE as the most dominant members.
2
REFERENCES
Anderson, P. T. (Director). (2012). There Will Be Blood [Motion Picture].
BP. (2015, January 12). Our History. Retrieved from www.bp.com:
http://www.bp.com/en/global/corporate/about-bp/our-history/history-of-bp/first-oil.html
Coll, S. (2012). Private Empire: ExxonMobil and American Power. New York: Penguin.
Inman, M. (2013, March 19). How to Measure the True Cost of Fossil Fuels. Scientific American, pp. Volume
308, Issue 4.
Tomlinson Research Limited is an Appointed Representative of Generation Asset Management (UK) Limited, which is authorised and
regulated by the Financial Conduct Authority. Registered in England & Wales with Company No. 08517955. VAT Registration
No. 168 8108 78.