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FOURTH QUARTER 2014 COMMENTARY:

Sizing Up Oil Prices, Volatility, and Opportunity

Posted January 26, 2015

The decline in oil prices took center stage in the fourth quarter, igniting a debate on its impact that will likely linger well into the New Year. The issue looms large because carbon fuels are – and will likely remain for a very long time – the lifeblood of economic activity. Every corner of the global economy feels the tremors, positive and negative, from sliding oil prices.

From the perspective of decades of following energy markets as investors, we see more opportunity than peril. There is little doubt that significant forces are reshaping the global energy market. Gaining clout are the government-owned producers, in some cases desperate for dollars from oil sales to prop up their economies and domestic budgets. These state-owned oil companies, almost exclusively located in politically unstable countries, often fail to reinvest adequately in their oil fields, endangering future supply sources. Private energy companies find themselves locked out of these countries and their massive reserves, or required to abide by onerous financial and operational terms in order to operate in these countries.

The contribution of the boom in U.S. shale oil has added to the swelling supply. Much lower prices will no doubt push some smaller producers with vulnerable balance sheets to the wall, where agile, better capitalized companies will see a chance to acquire assets at attractive prices.

Broadly Beneficial

In similar fashion, the stresses caused by much cheaper oil create attractive price points for the patient value investor.  Over time, the positive impact of lower energy costs should become increasingly evident, and energy markets should right themselves.  The actual magnitude of the net stimulus from lower energy will be endlessly debated, but ultimately it should lead to more economic growth, which begets more energy demand.  In the meantime, we expect the normal bouts of volatility.

Few economic benefits are more widely distributed than a decline in energy prices.  As Secretary of the U.S. Treasury William Simon said in 1974, “I can think of no single change that would improve the outlook for the world economy more than a substantial decrease in the price of oil.”  Consumers worldwide have just received a massive financial stimulus in the form of lower energy prices.  The more modest the family income, the bigger the impact of saving $25 or $30 per week at the gas pumps.  Outside the energy sector, few, if any, businesses will not see some degree of positive impact on demand and margins.  Auto sales, travel and entertainment are just a few of the sectors buoyed by cheaper gasoline, as dollars once earmarked for gas will now be redirected elsewhere in the economy. 

It’s worth noting that this latest drop in oil price comes as the U.S. economy is growing and the employment picture is improving.  These conditions contrast with the previous sharp decline in oil prices in late 2008, when U.S. crude plummeted to $34 a barrel as the world economy fell into recession and layoffs filled the headlines.  By mid-2011, the price had rebounded to around $120, a rebound largely unrecalled in today’s dire commentaries and bearish forecasts.  While we don’t know what will happen with energy prices in the short-term, we believe the current negative environment offers compelling opportunities for long-term investors.

O Canada!

Our two favorite energy companies - Canadian Natural Resources Ltd. and Birchcliff Energy -are domiciled in Canada, a country blessed with the rule of law, a stable democracy, and the glorious, oil-laden province of Alberta.  Among the country’s attractions are low royalty rates that leave the owners of resources with more in their pockets.  Adding to Canada’s allure is a well-developed infrastructure, the North American Free Trade Act, and a massively thirsty customer to the south.  With the highest per capita energy consumption in the world, Americans love their SUV’s, and lower fuel prices will only strengthen this attachment.  

We know our Canadian energy holdings well and added to both of them in the 4th quarter as prices came in.  We believe management at both companies to be first-rate and well prepared to deal with lower commodity prices.

Diversifying Its Market

Not content to rely on its neighbor for all its energy exports, Canada is busily diversifying its markets, working to develop pipelines to both coasts to carry potentially vast quantities of oil and gas exports for shipment to ‎thirsty markets in Asia and elsewhere.  A liquefied natural gas terminal, such as the one recently suggested by Exxon, could provide cleaner energy to Asia, with its voracious appetite for energy.

Exxon, Petronas of Malaysia, and other potential coastal exporters will need vast resources to feed the hungry energy demand of billions in emerging Asia.  Odds favor decades of strong growth in the region, powered by Asia’s youthful populations and growing ranks of middle-class consumers and entrepreneurs.

In the meantime, Canadian oil-producers are quite sensibly battening down the hatches.   The stronger, low-cost producers (such as Canadian Natural Resources and Birchcliff) will emerge from this price cycle with less competition and better positioned in world markets. 

Not surprisingly, we saw declines in our positions in Birchcliff Energy (-26.3%) and Canadian Natural Resources (-17.4%) in the fourth quarter.  Helping offset these declines were positive contributions from MasterCard (+16.7%), Consolidated-Tomoka Land (+13.7%) and Cie. Financière Richemont (+13.5%).

Next year may be a different story for energy within the diversified structure of our portfolio.  Even a modest shift in sentiment could prove highly rewarding to investors.  Low prices for commodities tend to increase demand, driving prices back up, and vice-versa.  While energy prices will almost certainly remain volatile, buying first rate oil and gas companies during times of oil price induced panic has been profitable over time.  We believe opportunities abound.

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The views in this material were those of Fund management as of the date written and may be subject to change. The preceding examples of specific investments are included to illustrate the Fund’s investment process and strategy. There can be no assurance that such investments will remain represented in the Fund’s portfolios. Holdings and allocations are subject to risks and to change. The views described herein do not constitute investment advice, are not a guarantee of future performance, and are not intended as an offer or solicitation with respect to the purchase or sale of any security.


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