FDx Advisors Blog

What I learned at the 69th CFA Institute Annual Conference

June 7, 2016 Written by George Chen, CFA, CIPM

One of the featured speakers at the conference in Montreal, Quebec was Amy Myers Jaffe, Executive Director of Energy and Sustainability – University of California Davis Institute of Transportation Studies.  Her presentation to the over 2,000 delegates in attendance centered on global energy markets.  She started by stating that three major linchpins to high oil prices have now dissipated:  peak oil theory, increasing Chinese demand based on industrial growth, and rising upstream services costs.  Technology has disrupted the productivity and landscape for the long-term oil price outlook and costs to produce a new barrel of oil continue to fall.

Currently, Wall Street analysts are predicting oil prices will stay low and then creep higher through 2017.  However the supply outlook in the short-term could be affected by continuing civil unrest in the Middle East.  The conventional wisdom of endless trending growth in oil demand is now under increased scrutiny as slowing China growth and urbanization trends are potentially driving structural changes in the industry.  According to Uber, more young people in China are using Uber to carpool to meet people, and they are not looking to purchase or lease a car.  Additionally, Gulf state countries viewed their reserves as increasing in value over time for ‘future generations’.  However, Paris climate accords and U.S. shale boom throws this future scarcity model into question.  Flattening or peaking global oil consumption can lead to the situation where not all oil-producing countries will be able to exhaust their reserves.  In turn, the big question is whether to produce now to monetize reserves immediately or to delay development and production of reserves knowing that you could miss out in a game of ‘musical chairs’.  Does it make sense for Saudi Arabia to cut production so that other players could produce and sell at the expense of the Saudis?  They don’t want their reserves to get stranded.

What does this mean for investors?  Junk-rated energy companies do face a debt wall of returning principal in the next few years, especially starting in 2019.  This might portend an unexpected increase in defaults.  This will have knock on effects on banks that hold energy loans with Comerica and SunTrust in the U.S. holding the highest percentage of their loan book in energy companies.  Non-diversified coal mining firms face decapitalization with the announcement by Peabody Energy declaring bankruptcy last month as the most glaring example.  Finally solar costs have fallen dramatically as panel costs have dropped 85% since 2008 which will make renewables more affordable to more consumers.  Eventually, the strongest companies in the oil and gas industry will have to consider whether it can be more profitable to shareholders to develop low-carbon sources of energy as supplement and ultimately replacements for oil and gas revenue sources.  The weaker companies will be consolidated.  With all of this volatility, we continue to have a minimum allocation of 3% to commodities in our VisX Portfolios reflecting both muted inflation expectation and our belief that oil prices will stay low for the time being, in concurrence with Amy’s outlook above.