Weekly Investment: Downside is leading to better values

Oil has played a big role in markets so far this year and last week was no different

Claude-Henri Chavanon
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Oil has played a big role in markets so far this year and last week was no different. The oil market could “drown in oversupply” grabbed the headlines as prices plummeted through the 2008 lows, only to find support late in the week. With so much coverage of this market recently, most of the relevant information is in the public domain and where the price goes from here seems to depend on a mixture of perception and known unknowns. Perception has clearly been bad, and Friday might mark a turn in that perception.

However, a lasting turn probably requires more information about the known unknowns. Of these, the top of our monitored list are: how quickly US shale production declines, and how much impact the colder weather in the northern hemisphere has and prompted the 240 million barrel short position in the futures markets to be unwound.

Expectations about the decline in U.S. shale production seem to be centered on a figure of 500,000 barrels/day this year, with the most extreme forecast around 1 million. A decline at the upper end of the range, cutbacks by one or more of the other major producers (there is some talk of an OPEC meeting in March) and the market could look quite different.

These factors seem important beyond our region too. The fall in energy and commodity prices has not played out according to the standard economic models. They would have suggested that the increases in real incomes due to the commodity price falls would have been spent and hence increased economic growth.

In contrast, not only does it appear that much of this windfall has been saved instead (or used by governments to reduce subsidies), but also the drop off in investment in the energy sector and spending by oil producers has been so sharp in terms of scale and time that this has been the dominant driver of growth.

And not just growth, it would appear that the selling of assets by sovereign wealth funds and reserve managers, and fears of more selling, have pushed markets down as well. Going back to our earlier comments on Japanese equities, it is quite likely that they have been a victim of their own liquidity, whereby in falling markets investors often sell what they can and not necessarily what they’d like to, as this would be harder to achieve in size.

The uber bears have got a lot of airtime so far this year and we have no problem with that. Many of them raise a number of important issues about debt, the dangers of quantitative easing, valuations and China (to name a few).

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