Oil Spills: Winners and Losers

 

WTI Crude Oil Trailing 6-mo Price Performance." WTI Crude Oil (Jan'15). CNBC, n.d. Web. 05 Dec. 2014.

Summary: Oil prices have plummeted in recent weeks. There are many reasons why the downward pressure in prices is unlikely to stop anytime soon. The oil producers will likely be able to weather the storm, but will have to curb aggressive growth expectations. There are winners as well as losers, and investors should consider adding exposure to companies that benefit from lower gas prices.

                

OPEC made headlines on Thanksgiving Day by refraining from cutting oil production, despite the price of Brent Crude oil declining over 30% year to date and over 25% in the fourth quarter alone. There are various reasons for this drop in prices, most notably rising oil production (especially in North America), decelerating global economic growth, a plateauing of demand for oil in China, and the multi-year trend towards increasing energy efficiency. Increased production and the move towards energy efficiency are long-term trends that will likely continue to keep downward pressure on the oil market.

The investment impact has been dramatic this quarter. The stocks of oil exploration and production, service, and equipment companies have slumped along with the price of oil. Seemingly any company with exposure to the booming oil production conditions in the U.S. has sold off as well. Investors are calculating that lower oil prices will curb growth in the oil producers. While the sharp reaction in oil prices may overshoot to the downside, a prolonged period of lower than $85 per barrel is not out of the question. This will temper the aggressive expansion in oil production in the U.S. but will not severely damage the industry. Existing wells will continue to pump oil profitably, but companies will likely delay or cancel new well projects if oil prices stay low. Many oil companies’ profit expectations are contingent on the creation of new wells and thus will be lowered. Investors should be wary of exposure to the industry for the next several months. Those who want to maintain long-term exposure should look to well-capitalized industry leaders with global assets. The price of oil will fully recover to over $100 per barrel once global growth picks back up, or suppliers cut production levels enough that prices rise.

On the other hand, there are companies that have received a stock price boost from lower oil prices. Companies in industries where fuel is a major cost (such as airlines and trucking) should post better than expected profits. Additionally, lower gas prices act similarly to a tax cut and put dollars directly into consumers’ pockets. This may well spur discretionary spending and make for a strong holiday shopping season for retailers. Investors should consider increasing exposure to companies that benefit from lower oil prices.

Marietta Welcomes Jim Rauh

Marietta Investment Partners is pleased to announce that James M. Rauh has joined the firm as a senior advisor.

Jim has extensive knowledge of and experience in wealth management and held senior executive positions with leading investment firms including Northern Trust and Robert W. Baird & Co. Throughout his career, Jim has provided valuable counsel to high-net worth individuals and their families, and has led teams delivering investment management, retirement, philanthropic and estate planning strategies.

In his role as Executive Vice President of Northern Trust, Jim led the Advisory Services group of the company’s Wealth Management division, with national responsibility for services to business owners, families and individuals in the areas of financial planning, investment strategies, family education & governance, and planning for future generations. Before taking on national responsibilities, Jim established Northern Trust’s Milwaukee office and served as the Midwestern States’ regional chief investment officer.

Prior to Northern Trust, Jim was a member of the Management Committee of Johnson Financial Group, a bank holding company owned by the Samuel C. Johnson family, and President of Johnson Asset Management and Johnson Trust Company. Before that, Jim was Senior Vice President and Director of Robert W. Baird & Co., where he was a member of the Management Committee and Investment Policy Committee.

Jim is a director of the Centers for Transfusion and Transplant Medicine, BloodCenter of Wisconsin, and City Year Milwaukee. He is a member of the University of Wisconsin Department of Economics Advisory Board, Milwaukee Art Museum’s President’s Circle, and a former director of Northern Trust Bank fsb, Northern Trust Global Advisors, Northern Trust Securities, Inc. and Robert W. Baird & Co. He earned a BA degree in Economics from the University of Wisconsin – Madison.

Said founder and managing partner, John Evans, "Jim’s vast experience with investment markets and the financial services industry will strengthen Marietta for years to come."

All Eyes on the Fed

Now that the Federal Reserve’s asset purchase program is coming to an end, the focus of financial markets is shifting quickly to the Fed’s policy in 2015. Members of the Fed have already announced their intention to raise short term interest rates as soon as they are convinced the economy has achieved sufficient strength and momentum to weather such a rate hike. A lively debate has begun within and outside the Fed as to when the interest rate normalization process should commence, how aggressively it will proceed, and what impact this will have on the U.S. economy and financial markets.

What is at stake is the continuation of the five year economic expansion and stock bull market. Pessimists argue that early and aggressive rate increases would break the U.S. economy, possibly foment a recession, and cause a significant stock market retreat. Other Fed watchers are concerned with the opposite outcome; the Fed will proceed too slowly and cautiously, thereby permitting a buildup of inflation and the formation of asset bubbles. Optimists, on the other hand, have confidence that the Fed can lift rates gradually to a long-term norm without disrupting the economy and the stock market. Marietta falls into the latter camp in our response to the key questions of the debate:

1. When do we expect the Fed to begin raising rates?

Members of the Fed itself disagree on an appropriate start date. Kansas City Fed President Esther George has stated that the U.S. economy is already strong enough to withstand higher interest rates. Conversely, Charles Evans, Chicago Fed President, thinks that economic conditions will not be suitable until at least 2017. The key viewpoint will almost surely be that of Fed Chair Janet Yellen, who has expressed that a probable date would be six months following the end of tapering, but with the assumption that the economy would continue to strengthen into 2015. We consider April 2015 to be the most probable start date. This is based on our six month forecast for GDP of approximately 3%, inflation below 2%, and unemployment below 6%. During this period we expect a growing consensus within the Fed supporting Chair Yellen’s prediction that economic circumstances would justify taking action at that time.

2. How aggressive do we expect the Fed to be in implementing rate increases? 

We expect that economic growth will be strong enough and inflation sufficiently tame to support a gradual increase in the Federal Funds Rate to about 1% by the end of 2015. This prediction assumes that the Fed will want to be cautious and, if necessary, err on the side of being too slow rather than being too aggressive. We consider Chair Yellen to be especially dovish. This pace would also be consistent with precedent: in each of the last three rate raising periods following recession and accommodative low rates (1984, 1994, 2004), the Fed started with a .25% rate raise and proceeded cautiously.

3. What is the likely consequence for the U.S. bond market?

We expect the yield on the benchmark 10-year U.S. Treasury to rise from its current 2.5% yield to 3% or slightly above by the end of 2015. This modest rise would be consistent with the two most recent periods (1994, 2004) when prior Fed policy normalizations started. We think such an increase in the benchmark yield would be consistent with approximately 3% GDP growth and the perception that the Fed was proceeding with caution. Nevertheless, this rise in yields would probably result in a slightly negative total return from now through 2015 for many bond mutual funds.

4. What is the outlook for the U.S. stock market? 

From now until April 2015, as the debate over Fed policy becomes more feverish, market volatility will probably increase. We think the market will hold and possibly advance into year-end based on continued strength in the economy and corporate profits. Further, investors will be reluctant to take gains, and performance oriented hedge funds will feel pressure to achieve competitive performance. A correction, however, becomes more likely in early 2015. As the first rate hike approaches, anxiety could cause market weakness. In subsequent months, additional rate hikes could intensify economic uncertainty and exacerbate a market downturn. Nevertheless, we think that by the end of 2015 the market will recover and hit new highs as it becomes increasingly apparent that the economy has not been damaged and corporate profits continue to rise.

A historical perspective supports our outlook. J.P. Morgan has examined the last six Fed policy normalizations and has drawn attention to two observations. The first is that there was a clear market weakness averaging -4% over the three to four months following the first rate increase.  The second is that in five of the six occasions, the stock market made a new cyclical high within twelve months. We agree with their conclusion that “any potential dip due to policy uncertainty should be bought into.”

Although some investors will greet the next phase of the economic cycle with apprehension, we consider a normalization of rates to be healthy. We emphasize that our views are based on certain assumptions, one of which is an absence of a surprise geopolitical development that significantly alters economic and market forecasts. We consequently think that it is especially important to remain vigilant and flexible in what could well prove to be challenging conditions ahead.