A look at the energy markets shows that the prices of the US benchmark oil (WTI) and the international or European benchmark oil (Brent) have been falling since the middle of August 2013. These are two geographically distinct markets with separate forces at work in each. The usual arbitrage that once kept the two prices close to each other seems to be gone, and the spreads (currently about $15) between them have been unusually wide for several years.
Downward Pressure
The US price is influenced by the build-out of America's energy infrastructure and exploration sector. As a nation, we are producing more of our own oil and natural gas. We are consuming more of our own domestic production and we are importing less than we used to. We are now more efficient in the way we consume energy. All of this is beneficial to the US. And all of this exerts a downward pressure on US energy prices.
Let's add to that mix the discovery of huge new fields and the development of new technologies in the production of oil and natural gas. The resulting energy outlook for the US is favorable for the next several decades.
Geopolitics
Things are different when it comes to Brent Crude and non-US oil pricing. Geopolitical events are acting adversely in Iraq, Libya, Nigeria and other places where crude oil is sourced. Saudi production is up and has closed some of the gap. The ongoing turmoil in the geopolitical sphere injects higher costs and the need for larger inventories. Hence additional risk premia factor into the pricing. Were peace to break out in a durable fashion in the world, the price of Brent oil would drop significantly.
Back in the US the marginal cost of oil production is arguably somewhere in the $70s. The trading price is in the $90s. We may expect the price of US oil to fall over time as additional production is developed. That may cause continuing downward price pressure on gasoline prices. It will also mean that transportation cost pressures will be alleviated because energy is a great portion of that cost.
Inflation
This trend translates to downward pressure when it comes to inflation. Take the pervasive cost structure of energy, lower the price, and have it trend downwards. You will ease inflationary pressure, both directly in terms of lower energy costs and indirectly in terms of the prices of all of the things that depend, in one way or another, on our domestic energy.
The energy sector amounts to about 11% of the S&P 500 Index. That is a heavier weight within the stock market and substantially influences market performance. Big-cap American companies like Exxon and Chevron are large weights in some of the ETFs that are broad-based like those that cover the Dow (DIA) or the S&P 500 Index (SPY). Of course, we also track an array of exchange-traded funds that expose investors to various components of the energy sector. There are selected Master Limited Partnerships that also enable investors to participate strategically in various components of the energy sector.
Sector Securities
This sector of the stock market has been trading somewhat heavily. It is doing so because of the correlation that exists between the energy price and the prices of the energy-sector securities, which are influenced by energy prices.
Jim Roemer, a Sarasota-based meteorologist and consultant on commodity prices, notes there is one wild card now in the forecast. In a recent writing, he mentioned the change in polarity of our sun. He observed how it is happening earlier than expected and how the transition comes in a year in which weather patterns are setting up for what might be a very cold winter in North America. There is a link that describes the polarity issue. We are suggesting it as a very quick study for readers.
We find this notion of changes in solar polarity fascinating. This idea introduces a whole new dimension into the debate over global warming, cold versus hot weather, and the dynamics that generate our weather.
There are a lot of things in our solar system that we do not understand and are just learning about. The influences of the sun are only partially observed and understood. We may encounter such an influence this winter. Roemer thinks there is a chance that cold weather will cause a spike in natural gas prices as consumption rises rapidly in response.
Falling Trend
At Cumberland, we are underweight in the energy sector because we see the trend of falling prices. Our allocations are below market weight. We expect that the dominant price trend in oil is downward, though we do have to be prepared for short-term shocks, whether from the sun or from geopolitics. We recall the shock forty years ago when war in the Middle East spiked the oil price from $3 to $12. Certain things never change: we must always be prepared for the unpredictable.
Wildcards aside, however, our bullish view on stock markets does not extend to the oil patch.
David R. Kotok, Chairman and Chief Investment Officer