OIL, OIL SHARES, CYCLICAL INVESTING AND THE COBRA EFFECT

The oil price has recently plunged from US$100 per barrel in June 2014 to its current price of about US$44. That is up there as far as price changes go. After all oil is perhaps one of the most important commodities in the world because oil price changes have so many flow on effects on to other things whether this be food, transport and so on. Which then of course influences government, corporate, consumer and investor behaviour whether this be oil company production, the viability and use of alternative energy sources, consumer buying patterns (maybe consumption increases after the price at the pump goes down) and the list goes on and on and on. Inevitably it is going to create both investment opportunities and pitfalls.

So how does one go about trying to position one’s portfolio for the changed circumstances in the oil market. It’s not that easy because there are so many potential flow on effects that can happen and all will all have different weightings of importance. And how does one decide how to weight the different possible outcomes. Uncertainty in the investment world as always reigns supreme.

One thing is, however, certain. There has been and is going to be no shortage of learned sounding articles, analyses, forecasts, fear mongering and guesses coming out about what is going to happen and which stocks investors should be buying and selling. It is just as well we now live in a digital age otherwise there would be whole swathes of rainforest being felled to provide the newsprint necessary. Many of these articles will recommend investing on the basis of what is expected to happen and whether a particular stock is going to be positively or negatively impacted.

For example profits of oil producing companies are going to fall therefore these shares should be sold. This ignores the fact that share prices for oil producers have already, rapidly and unexpectedly fallen significantly. Then again maybe oil company share prices still have a fair way to fall. Or that shares should be bought in companies which are consumers of oil. For example Toll or Qantas. Or if one is a contrarian investor and looking slightly more ahead into the future one might consider buying shares in oil stocks because it is highly likely that the oil price will at some time increase again. At the risk of being simplistic in what is a very complex area the current fall has been caused by the oil market moving into oversupply. This is partly a result of large increases in American production of non-conventional oil like shale oil (the US has ceased to be an oil importer again for the first time in years) and the OPEC response of not cutting production on the basis that at current prices a lot of this US production may now become unprofitable. An even briefer summary of this situation that I read summed it up as Shale v Sheik. At some time in the future either demand will increase or production that becomes uneconomic will fall or both. At which time the oil price can be expected to rise again.

The major potential problem however is that trying to extrapolate out from what has happened into what is going to happen and then basing investment decisions on whatever conclusion one arrives at leaves one open to being caught out by the cobra effect. This is the law of unintended or not forecast consequences.

The term comes from the days of the British raj in India when the governor of Dehli decided that there were too many cobras in the city. Most of us would probably empathise with that point of view. Anyway with the blameless intention of reducing the number of cobras he introduced a bounty for dead cobras. At first this worked a charm and the number of cobras declined. Then as the number of cobras available for the bounty reduced those wily entrepreneurial Indians needed an alternative supply so they started farming cobras. When the governor realised what was happening he stopped offering the bounty. So what does any rational businessman do when the market for his product collapses? He dumps it. In this case the product being dumped happened to be live cobras. So then there were more cobras slithering around Dehli than before the bounty was introduced. Hardly the intended or forecast result of the exercise. This anecdote comes from a Swiss Hong Kong based investment adviser Marc Faber who is the publisher of the Gloom Boom & Doom Report and author of, amongst other books, The Great Money Illusion; The Confusion of the Confusions. This was a fascinating book written just after the 1987 stockmarket crash which, amongst other things, was a post World War 2 history of financial markets until the immediate aftermath of the crash. A knowledge of investment history is vital to an understanding of how to invest today. It was also written in a unique style. Within two pages he could move from an analysis of English wheat price cycles going back to the eighteenth century to discussing the current sharemarket to mentioning who he had lunch with that day.

Anyway I digress. There are going to be many cobra effects from the fall in the oil price. So knowing this how does one invest in cyclical businesses like oil and gas producers? These stocks are clearly cyclical. And the cycle is very easy to see looking back however there is a total fog looking forward. We know that the down cycle will cease at some time and move into an up cycle. How far down and for how long the oil price down cycle will continue is a total unknown. It is different each cycle. The cobra effect says it is futile to form an opinion on this. The solution for investors is to either ignore cyclical stocks like oil or oil related shares altogether (investing in cyclical stocks can however be very profitable if done correctly) or have a strategy as to when one is going to invest. When this will be cannot be determined in advance. My view is that one should not invest in cyclical shares unless there have been significant falls in price and the price downtrend has been in existence for a reasonable length of time. This will not help with picking the bottom but it increases the probability of an investment being made closer to the bottom of the cycle than to the top. What one then is looking for are signs that maybe the price of the underlying commodity (oil in this case) has stopped falling and is showing signs of moving back into price uptrend, that falls in profits and profitability of individual oil or oil related stocks have either have slowed or stopped and that the share price for the particular stock is also showing at least tentative signs of moving back into price uptrend. This approach requires a lot of monitoring and potentially a lot of patience but if followed will certainly give you the potential for sound longer term returns with risk reduced as much as is realistically possible. It goes without saying that an individual stock must still represent a green lights investing situation at the time (refer to the blog Is Cash Trash at www.lifestylefstas.com.au). It is no use investing in an oil stock that, for example, has high debt levels or is coming to the end of its production life, because it may not be around to benefit from the upswing when it occurs.

So one patiently waits for signs of the above indicators to start happening. It could be within the next six months or it may not be for another three or four years. We don’t know. What we can do is to stay alert and patiently wait until we see these signs. We cannot however wait until we are absolutely sure that we are in the next cyclical upswing because by then share prices may already have increased significantly thus diminishing the potential returns and increasing the risks of inadequate returns. Look at how quickly and how much the oil price and the share prices of oil stocks have fallen in the last six months. It may be that we invest too early and there is a further down leg in the down cycle. If that’s the case then we can sell out under the stop loss strategy to conserve the bulk of our capital and implement the strategy again at a later date that is we make sure we live to fight another day.

This blog and previous blogs have generally commented on individual aspects of longer term portfolio investing strategy which should be part of a consistent coherent portfolio strategy. By following a consistent coherent strategy we will, over time, have probabilities working in our favour that is, over time, we should have more successful investments than unsuccessful investments and the returns from the successful investments are expected to more than offset the returns from any less successful investments.
To read about other elements of successful longer term portfolio investing strategy have a look at my previous blogs.

Regards

Curtis