Oil will en­joy an­other day in the sun

En­ergy is highly cycli­cal and will again have its day in the sun, Tom Bradley writes.

Vancouver Sun - - FRONT PAGE - Tom Bradley is chair and chief in­vest­ment of­fi­cer at Steady­hand In­vest­ment Funds, a com­pany that of­fers in­di­vid­ual in­vestors low-fee in­vest­ment funds and clear-cut ad­vice. He can be reached at tbradley@steady­hand.com.

Our per­cep­tions about the fu­ture change dra­mat­i­cally in bear mar­kets. We’re bar­raged with re­vised eco­nomic fore­casts, and the gloomy ones al­ways seem to have the most cred­i­bil­ity. Some­times these neg­a­tive views change how we think about eco­nomic and mar­ket cy­cles. When we’re un­der siege, cycli­cal down­turns get re-cat­e­go­rized as per­ma­nent, sec­u­lar trends. In other words, a cer­tain com­mod­ity or in­dus­try will never come back.

To­day, agri­cul­tural com­modi­ties, in­dus­trial met­als and en­ergy are all trad­ing at 10-year lows and the out­look is bleak. But con­trary to the head­lines, they’re all still highly cycli­cal and will again have their day in the sun.

Oil, a cy­cle that’s on ev­ery­one’s mind, is a good il­lus­tra­tion of how dif­fi­cult it is to see the other side of val­ley. Let’s ex­plore its cycli­cal cre­den­tials.

IT’S CYCLI­CAL

Oil is a de­plet­ing re­source. A huge amount of cap­i­tal is re­quired to keep it flow­ing. With­out in­vest­ment, pro­duc­tion de­clines. For some com­pa­nies, such as the U.S. shale oil pro­duc­ers, de­ple­tion rates are very steep.

In­deed, the de­gree to which an in­dus­try has too much or too lit­tle in­vest­ment is at the core of ev­ery cy­cle, be it oil, real es­tate, semi­con­duc­tors or other re­sources. In good times, money is poured into the ground, which cre­ates ex­cess sup­ply and ul­ti­mately low­ers prices. When prices are at 10-year lows like they are to­day, cap­i­tal spend­ing dries up, short­ages emerge, and prices even­tu­ally rise. As the ex­pres­sion goes, the so­lu­tion to low prices is low prices.

It’s im­por­tant to note that the “cap­i­tal spend­ing equals pro­duc­tion” for­mula ap­plies to both pub­lic com­pa­nies such as Im­pe­rial Oil and sov­er­eign pro­duc­ers like Saudi Ara­bia.

SEWING THE SEEDS

While we watch en­ergy com­pa­nies teeter on the edge of bank­ruptcy and oil-de­pen­dent re­gions such as Al­berta suf­fer, it’s hard to con­ceive of oil hav­ing an­other good run. But cy­cles don’t die eas­ily.

When we get through the coro­n­avirus, the world will still need in the neigh­bour­hood of 100 mil­lion bar­rels of oil each day to keep the lights on. There will be some ex­cess in­ven­tory to chew through, but to meet de­mand, sig­nif­i­cant in­vest­ment will be re­quired in ad­vance. At present, this isn’t hap­pen­ing. The in­dus­try is starved for cap­i­tal and com­pa­nies are slash­ing their cap­i­tal spend­ing bud­gets. The seeds are be­ing sewn for the next pe­riod of high oil prices.

The eco­nom­ics of a cycli­cal in­dus­try are hard coded, and so are the be­havioural as­pects. In­vestor psy­chol­ogy can turn so fast it’ll make your head spin. When we come out of iso­la­tion and the eco­nom­ics of oil eclipses pol­i­tics (more on that be­low), the word “glut” will turn to “short­age” in a heart­beat.

REARRANGIN­G THE DECK CHAIRS

Oil cy­cles used to be eas­ier to man­age through. As an in­vest­ment man­ager, you sim­ply went to the same oil con­fer­ence in Cal­gary ev­ery year. When it was stand­ing room only, you knew we were some­where near the top. When at­ten­dance was down and the only ones there were hard­core oil an­a­lysts, it was time to buy.

This sim­ple rule of thumb, how­ever, had an as­sump­tion built into it, namely that most com­pa­nies will sur­vive, and share­hold­ers won’t be se­ri­ously di­luted dur­ing the down­turn.

This oil cy­cle is far more dire. Sur­vival can­not be as­sumed.

There will be ques­tions about all but the strong­est com­pa­nies be­cause we don’t just have a sup­ply glut, or a drop in de­mand, we have both. The coro­n­avirus has crushed the econ­omy at a time when the Saudis and Rus­sians have es­ca­lated their fight for mar­ket supremacy.

This cir­cum­stance has caused a lot of pain and it’s not yet clear who the win­ners will be when the re­cov­ery comes. Ex­ist­ing com­pa­nies need to slash costs and work with lenders, share­hold­ers and gov­ern­ments if they’re go­ing to par­tic­i­pate. Out­side in­vestors have been miss­ing in ac­tion, but when an as­set (oil in the ground) is priced sig­nif­i­cantly be­low re­place­ment cost, op­por­tunis­tic cap­i­tal is sure to find its way back to the oil­patch. It will all make for an in­ter­est­ing chess match.

So, when some­one tells you that oil is dead, don’t be­lieve them. There will be many cy­cles be­tween now and when it’s re­placed by re­new­able al­ter­na­tives. The cur­rent spend­ing famine is set­ting up the next oil boom. And it could turn out to be as good as this bust is bad.

FREDERIC J. BROWN/AFP VIA GETTY IM­AGES FILES

When we get through the coro­n­avirus, the world will still need in the neigh­bour­hood of 100 mil­lion bar­rels of oil each day to keep the lights on, says Tom Bradley. He be­lieves the next oil boom could turn out to be as good as this bust is bad.

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