Financial Markets Analysis and Outlook

Looking to the future…2015

With a tumultuous end of 2014 with commodities selling off, the U.S. dollar accelerating and deflation fears abound one is left considering what happens going forward.

The facts are; the U.S. continues to grow.  Europe’s lack of growth and fear of further slowdown has put them squarely in a position where Quantitative Easing seems ever more likely and the question is not if but how much.  The world continues to call for China’s demise but its stock market was the best performing market in the world last year.  The government has gone a long way in weeding out corruption but at the same time continues to add stimulus in areas to help it meet its 7% growth target.  India too, unnoticed by many has had stellar returns in its stock market and has been able to ease its artificially high interest rates given the collapse of oil and the reduced fear of inflation.

Rewind a year ago and I think the story was fairly similar.  The big difference to a year ago is the collapse in oil prices.  Why did oil collapse?  I think in hindsight, plain and simple, oversupply coming from non OPEC countries and an OPEC cartel which finally had enough of watching their market share shrink further to keep prices up.  But now that we are sitting at approximately $45.00 WTI how do we move forward.  Is $45.00 the right price?  Looking back at past oil collapses one thing that seems common is that after stabilization, global equity markets tend to perform better as the stimulative effects of lower priced oil take place.  Oil equities also tend to have a significant rally as initially the commodity generally overshoots fundamentals but truly a rally and not a recovery ensues.  Where does that leave us?  At current levels the majority of heavy oil is uneconomic when you incorporate the capital required to get these projects to production.  However any projects currently in the process of being built will most likely continue given the difficulty of changing course once half way through.  The shale projects and resource plays are a totally different matter.  Many but not all of these projects are uneconomic when looking at full cycle economics (most energy companies quote half cycle) and net backs are insufficient to provide good pay backs.  These are the projects that I see curtailing production quite quickly.  Oil and Gas companies in North America are generally heavily leveraged and spend greater than their cash flow to continue to grow production.  Companies drilling the shale and resource plays have usually quite high decline rates due to the nature of the reservoir and the desire for growth.  Both of these issues conspire together and make the current environment quite difficult for companies to continue to grow their production.  In fact, as reserve reports for this year get posted on a lower price deck the borrowing power of the company will be reduced, companies will be forced to spend within cash flow.  Rig utilization is already declining.  How long will all this take to filter into the supply equation?  Historically without these heavy declines the supply equation was right sized within a year and a half to maybe two.  This time I believe it will be quicker due to the nature of the new production; sometime within 2015 or just beyond.  At this juncture I am comfortable holding a slight overweight in high quality, great balance sheet energy companies with strong management who are nimble and focused on maintaining financial flexibility for opportunities that arise from the debacle.  If there is a significant rally in these stocks I suspect I may need to readjust the weight lower.  Favorite names include Raging River, Sparten, Tamarack Valley and DeeThree.  Reading many articles on the oil collapse, I don’t believe it is in the OPEC cartels best interest to have oil at these prices either, but they certainly can afford to wait out the poor prices as supply comes more into balance re-establishing their market share.  Globally the oil price will be stimulative for those non-oil producing countries; but initially it will continue to add to the deflation fears.

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