This is the second article in a series of three. These articles link the apparently fearsome, but probably mundane, events impacting stock markets these first few weeks of 2016 to their underlying significance for long run market value. The series is a response to the article by Robert Shiller in the New York Times, found here.
The point of the Shiller article was that the ties between events that have occurred in the opening weeks of the year and long run creation of market value are weak or nonexistent.
The Shiller article summarizes the position of a school of finance, called behavioral finance. To put their basic belief about the decisions of market participants in its simplest, bluntest, form - they think market participants are sometimes irrational. Not thinking straight.
I see this frenetic market behavior differently. My argument is that there is a collection of fundamental issues that drive long run values in securities markets, but the relative importance of any one of these fundamental issues at any point in time may vary. And markets, like people, depend on a memory, which is less than perfect. So in my world, what happened at the beginning of the year was a series of reminders.
My last article, "Wealth, And Stories Of Wealth, Part 1: Finance At The Crossroads," argues that the market is "remembering" a very painful fact. Capital investments outside the United States are a visit to the Hotel California. Money is welcome to come, but departure is another matter. When capital arrives in China - or for that matter most of the less developed world - it becomes part of the Chinese plan. If you mess with China's plan, China will mess with your investment.
Consider Shiller's next story, the collapsing value of a barrel of crude. Shiller has reason to question why the market might have such a strong reaction to the falling price of crude oil. Here is the chart that I use to conclude that I have a difficult time being surprised by any particular price of crude oil.
Oil prices have been unpredictable for a long time.
Much has been made of the surge in oil production in the United States due to the innovative new method of oil extraction known as "fracking." But while fracking might conceivably put a ceiling on the cost of oil, it can obviously do nothing to put a floor on the price. If fracking producers and investors thought otherwise, they were looking at something I don't see.
And as the chart below suggests, unless your memory of oil prices begins in the year 2000, there is not much shocking about a price per barrel below $30.
There was much made by the press as the fracking process of oil extraction made the US a factor in oil production once again as this decade progressed. And it appears to me that there is more to this story than there was to the story of the explosion of production in the oil patch in the 1980's, which was simply a reach for a high-cost production method in the presence of high oil prices. We learned a hard lesson then, including the collapsing Texas banking system.
But if I am to believe the expert engineering opinion I read, the fracking process is more than opportunism. Fracking has the properties of an infant industry. The two infant industry properties interesting to me are:
- The possibility that there is a learning curve. That is, the cost per barrel of oil extraction by fracking is going to fall as the use of the technology increases.
- The source of the oil in shale formations may result in the first meaningful expansion in global estimates of potential oil extraction as geologists redefine the sources of oil.
But all this wonderful technology is of little help at the moment if fracking producers require $70/bbl. to develop their new extraction cost reductions.
And there is apparently a new risk in the markets that is only indirectly related to fracking. This is not the world's first experience with the fluctuating price of energy. But what we think we learned from earlier experiences might be only half of what we needed to know.
There is a major difference between the quality of the oil hedging and price volatility management toolkit available to commercial players in the oil patch today and the tools available in the 1980's. And the evidence is that some producers had availed themselves of oil price protection, with the result that they are able to pump at a price of $30/bbl. because with the hedge, revenues per bbl. are closer to $50 or $60/bbl. But let us consider the implications of this outcome for a moment. By pumping $30 bbl. oil on revenues of $60 bbl., what a producer is doing is adding to the excess oil inventory.
This brings up an uncomfortable fact about hedging. All hedges must end. If the hedger has simply added to oversupply, the pumping is generating a larger problem after the hedge. Just as levees on the upper Mississippi can lead to greater flooding downstream, if the hedges produce worry-free increases in production, too much production in the face of an oil glut could end in tears.
A system designed to handle a small, temporary blip in the price might, with an adverse political climate abroad, lead to a genuine problem.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.