Following the Crowd


By Kevin Grant McClernon

Last summer, I decided that I wanted to invest in the market. I knew the basic principle of ‘buy low, sell high’ and with that in mind, I set off looking for deals. I perused the WSJ and Bloomberg. I wanted to find a so-called ‘value pick’ – one that was fundamentally undervalued and that I could hold for a long time. Eventually, I found a couple good picks. Stocks were pretty jumpy this fall so I figured I could buy one quick after it had a rough day. But, every time I decided to buy, the markets seemed to reverse course and my ‘deal’ had vanished. I couldn’t keep up with the movement of the market. Everything that was hot one was day cold the next, it seemed.

Then I found oil. It wasn’t too hard to find – it was a top story line all through the fall. But I figured trading commodities was only for the pros. I looked around and found there were hundreds of individual stocks related to oil and gas companies. And they were all taking a beating. I wondered why. By November, the market price of crude oil had fallen about 25% since its high in the summer. The price of a barrel of American oil as of November 21st was $78. I ran the math – there are 42 gallons of oil in a barrel – and found that it was selling wholesale for $1.78 per gallon. The price of gas at the pump near my house had been falling sluggishly by Thanksgiving to around $3.10. At those prices gas companies were profiting just under 50% per gallon sold. I knew gas margins were normally high, but that seemed almost monopolistic. My economics classes taught me that each of these gas stations could gain a large share of the local business if they cut prices beneath their competitors’.

I sat in the car with my mom one day.

“I’m gonna pull over and get gas,” she said.

I interjected, “but your tank is half-full already.”

“The price is too low not to take advantage.”

Too low, I questioned.

“Hold off on it,” I said. “Prices are gonna be below $3 sooner than you think.”

“Whatever you say,” she mocked.

We drove on.

I had very little data to support my statement. Only articles I’d read about in the WSJ where business columnists worried that the US had out-produced demand and was headed for a big drop. My emotions kicked in. That sounds bad, I thought. And that’s when I decided I should buy.

I wanted to invest in distressed, highly leveraged oil companies who would suffer the most from low oil prices. When the depressed prices began to cut into their margins, they’d have less cash with which to pay their debts. Default was a possibility. Or they’d get bought out. Oil companies with stronger balance sheets and strong cash flows could buy them out at bargain prices and pay off their debts.

Thank goodness I didn’t. A couple buyouts have occurred (see Repsol S.A. and Talisman Energy), and some analysts have since jumped on my side. But since November 21, 2014 – the day I wanted to pull the trigger – prices have dropped another 33%. I would’ve bought very high.

To understand why this happened, and why I couldn’t have foreseen it, I began to ask why exactly prices were falling so significantly. “Oversupply!” market experts cried out, “we’ve produced too much oil!” As the old adage goes, “pigs get fat, hogs get slaughtered.” Energy companies expanded rapidly in the wake of the recession on the basis that oil would remain around $100 per barrel. As of August 2014, energy companies (oil and gas, etc.) had outstanding debts of roughly $350 billion – in the junk category alone. That’s a scary thought.

Anyway, US oil production is booming, and global demand is cooling. That’s the story, at least. But when you look at the data – it just doesn’t hold up. Let’s look at a 2014 report from the US Energy Information Administration (EIA) detailing global oil supply and demand and make a judgment for ourselves.

In 2013 global oil production was 90.90 million barrels per day. Global consumption was 91.24 million barrels per day. Then, the US surged and global oil production jumped in 2014 to 92.94 million barrels per day. Meanwhile, consumption grew to 92.13 million barrels per day. As of the end of 2014, daily supply exceeded demand by 800,000 barrels per day in a market that consumes more than 92 million every day. The world is producing .85% more oil than we’re consuming. That marginal “oversupply” has resulted in a nearly 60% drop in oil prices.

It doesn’t add up. There are other factors influencing prices that don’t show up on a data set. What are they?

Fear, anxiety, and uncertainty. As Chud likes to call it, animal spirits. The market reaction has as much – if not more – to do with people’s emotions than it does with fundamental economics. If traditional supply and demand can’t adequately explain the seismic shift in prices, behavioral economics might.

Take Goldman Sachs for example. As recently as October 2014, the bank forecasted prices of Brent Crude to be $100/barrel for Q2 2015. Later that month, they changed their mind and lowered their forecasts to $85/barrel. Goldman, an investment bank with what one would believe to be almost ubiquitous fundamental information about oil supplies and demand, couldn’t even see this coming. When Goldman revised their forecast, they issued a statement. In it they said, “WTI could fall as low as $70 in the second quarter and Brent as low as $80, when oversupply would be the most pronounced, before returning to first-quarter levels.” They were dead wrong. They didn’t - they couldn’t - have predicted such a free fall. And they weren’t alone, other major investment banks with divisions devoted entirely to oil price speculation made the same error, though I use that term loosely.

Well, what else happened? Why is the market panicking?

On November 27th, 2014 the Organization of Petroleum Exporting Countries, known as OPEC, held a meeting in Vienna to discuss the fall in prices. OPEC is headed by Saudi Arabia, the pre-eminent global oil supplier for the past 40 years. OPEC produces anywhere between 30 and 40% of world crude supply annually. The market waited anxiously for a response from the group on how they would react to the fall in prices. There was tension amongst the group members. Venezuela needs oil to trade for about $120/barrel to balance its government budget. They wanted to cut production. Saudi Arabia didn’t care about price. They were concerned with market share. The Americans were impeding on their territory and they were ready to defend it. They had a $750 billion cushion in currency reserves accumulated from godly high margins over the last 30 years. They’d learned their lesson since oil crashed below $10/barrel in the 1980s. They’d prepared for this.

The market held its breath. Analysts said they would need to cut 1.5 million barrels/day to keep prices afloat. After six hours of congregation, the Saudis won out and OPEC would continue its current pace of drilling. Oil prices dropped 7% that day. They haven’t looked back since.

OPEC’s stance was clear: they want to keep their market share and wipe out American oil producers. Saudi Arabia, the leader of OPEC, is willing to withstand low – even negative – profit margins as a result. Saudi Arabia’s state-owned producers bet they could ride out the storm longer than the private United States producers. In January, Saudi Arabia released a 2015 budget outline. The key statistic – they forecast a $38 billion deficit. In 2014, they ran a $54 billion surplus. A major reason? Total exports are expected to decline by 4.4%. Meanwhile, non-oil exports are expected to increase by 3%. They’re bracing for a significant reduction is oil revenues. Insert the price war.

Reports have surfaced that Saudi Arabia is offering drastic price cuts in its exported oil to Europe and Asia. They’re selling oil as low as $4.10 below the benchmark price, nearly 10%.

There is no real question that there is a competition – some call it a war – to hold onto market share and outlast competitors in the oil market. Saudi Arabia and OPEC are betting that they can drive out US producers and eventually get supply back to a ‘healthy’ level, where the market price will stay at the elevated levels we’ve been used to. The upstart Americans are a nuisance – and a real threat - to the stronghold OPEC’s had on the market for decades. Neither side is willing to give in. Production in both areas is expected to continue to grow through 2015.

So, what is driving the oil prices down? The confusion that arises from all of this hoopla. Investors just want to know. They want to know who’s gonna win. They want to know if the Saudis will stay on top. They want to know if the Americans are for real. They want to know how long this battle will last. Uncertainty in financial markets creates hysteria. It produces emotional responses. It drives people to make judgment calls on the spot that may not be fully informed. And passive investors get caught up in the mix. It’s biology that says we like to follow the crowd.

Take, for example, the tulip craze of the 1630s in Holland. Through pure speculation, tulip bulbs became so vastly overpriced that Dutch citizens were trading their properties and life savings for a single bulb. Eventually, the market realized its folly. The price of a tulip reverted back towards its value and subsequently crashed. Some people lost everything. Why would anyone trade a farm for a flower?

We humans are not always as rational as we think. We tend to make hasty, uninformed decisions.  As oil continues its slump, some investors are yelling “buy, buy, buy!” Some are fleeing the market with their tails between their legs, selling all they’ve got and living to fight another day.

It’s hard to judge how the price will move in the future. It’s very low right now – but we said the same thing $30 ago. Will it continue to fall? I don’t know. But as I wait, I’m observing people’s emotions just as closely as the facts. The headlines and the numbers may tell different tales.