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| Monday, December 8, 2014 | Issue #2432 | |
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What an Investor Should Do in This Oil Bust Alexander Green, Chief Investment Strategist, The Oxford Club
 Whenever things heat up - or cool off - in the natural resource markets, the first man I turn to is Rick Rule, CEO, president and director of Sprott U.S. Holdings, a securities brokerage and asset manager specializing in natural resource plays.
Rick and his team have decades of experience and success investing - and speculating - in oil and gas, mining, forestry, agriculture and alternative energy. He is a frequent - and highly rated - speaker at many of our conferences.
I interviewed him last week about the recent volatility in the oil patch. His thoughts, as always, were both insightful and provocative. Here are a few of them:
Alex: Rick, oil prices have plunged close to 40% from the mid-June highs. Why?
Rick: I think it's mostly demand-related. North Americans tend to think that because we have doubled our own production we have an inordinate impact on worldwide supply. And, sure, we've had an aggregate increase in production of 4 1/2 million barrels a day. That's an amazing testimony to technology and free markets. But the world market is 95 million barrels. Our extra production doesn't offset the decline in supplies from Mexico, Venezuela, Ecuador, Peru, Indonesia and Iran, countries where the national oil companies have diverted free cash flow from sustaining capital investment to politically expedient domestic spending programs, including - ironically - subsidizing domestic energy. So the "culprit" in this situation is softening demand.
Demand growth in China has slowed. In Europe it's negative. In Japan and North America it's flat. That's partly because the economic recovery in the Western world is more financially related than economically related.
Alex: Yes, for instance, it's clear that the recovery in the equity markets over the last five years has been much stronger than the recovery in the economy itself.
Rick: Right. And lower oil prices are an abject lesson in how markets work. As you know, the cure for high prices is high prices. Just as the cure for low prices is low prices. But resource markets are different from many industries in that they are so capital-intensive - and therefore extremely cyclical.
That's partly because of the time element. Remember, you have to go out and find the stuff. Permit the stuff. Drill the stuff. Transport the stuff. The capital-intensive nature of the industry precludes an immediate response to changes in the supply and demand equation.
Alex: Explain why.
Rick: It takes so much time and money to ramp up and shut down production, periods of oversupply and undersupply last longer than they would in conventional industries.
When the price of oil falls below the total cost of production, the industry will continue to produce all the way down to and sometimes below the cash cost of production. Producers will try to generate revenue even in the absence of making profits.
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Because of the extraordinary stranded capital involved in physical infrastructure, companies will produce commodities in a way that is unprofitable at the corporate level as long as they can cover their cash costs and make some contribution to the ongoing concern. That is precisely what is going on in the oil markets now.
Alex: You're saying this is the producers' strategy while they wait for higher prices to return?
Rick: Correct. There's a phrase in resource businesses called "the last man standing." It takes money to shut down an oil field or a mine. And it takes money to restart them. Companies often gamble that it will cost them less to produce through the bad period - and that way they will be in a better position when prices rebound.
Alex: How about natural gas?
Rick: Gas is a regional market. North American gas has stayed firmer as a result of unexpected cold weather on the East Coast a few weeks ago. But global natural gas prices are really being set by other factors like, for instance, Japan importing liquefied natural gas to replace nuclear power in the aftermath of the Fukushima nuclear disaster.
Alex: Any suggestions on how to play the plunge in oil?
Rick: What you should do right now depends on how hard you're willing to work. For example, a passive resource investor might benefit by selling puts on a closed-end fund that trades on the New York Stock Exchange called Petroleum and Resources (NYSE: PEO).
It has mediocre 20-year performance. It has fairly high fees. (I'm doing a great job of selling it, right?) But it trades at more than a 15% discount to net asset value, which amortizes many years of those fees. And it has a forward yield of about 4.7%.
I would suggest that during periods of high volatility, a put writing strategy is probably the best strategy for a passive investor. You collect the put premium - or you collect the put premium and you also end up buying the stock at a discount to the current market, also a good thing.
Alex: Do you think oil prices will stay this low?
Rick: I can assure you that $65 per barrel is an insufficient price to maintain global oil production at anywhere near current levels. I can also assure you that markets work - and that this is a capital-intensive business. So if people are going to continue to drive, oil prices will have to rebound. But while markets do work, they sometimes take their own sweet time. So it won't necessarily happen quickly.
Alex: Thanks, Rick. It's always a pleasure to hear your thoughts.
Incidentally, Rick offers a complimentary, no-obligation review of Investment U subscribers' resource portfolios, including buy, hold and sell recommendations. Feel free to contact him at 800-477-7853 or Rrule@sprottglobal.com.
Good investing,
Alex
Editor's Note: On one of his many travels, our Resource Strategist Sean Brodrick recently discovered a little-known company that's done what most thought was impossible: It's found a way to produce gasoline without using a drop of oil. The implications for this company - and its investors - are staggering. Click here for the details. | |
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1948-2015
America's most beloved industry is on its last dying breath.
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