Oil is the subject of the week, the month and the year so far. Prices just keep declining and crude is trading down about 60% from its highs in 2014. We keep hearing dire forecasts of continued lower prices and oil below $20 as the doom and gloom crowd gets into high gear.
There are some 2016 bulls, like T. Boone Pickens and the CEOs of Chevron (CVX), Conoco Phillips (COP) and Saudi Aramco, but they are few and far between.
I was way early on oil as I started buying in 2014. Now prices are getting to the point where I have started doubling down on some in the past week and bought two energy-related stocks, Geospace Technologies (GEOS) and CDI Corporation (CDI), that now trade for less than net current asset value.
I have a commitment to oil, but it is not as large as that made by Cale Smith of Islamorada Investment Management in the Florida Keys. Smith is one of the good guys and I have read his shareholder letters and other commentary religiously for years. I met him on a trip to the Keys and we had a long discussion about value investing and the markets. His most recent four-part letter outlines his decision to go all in on oil. He makes a strong case, and with his permission I will share his view with you as it is not all that different from mine.
The key to his oil thesis involves "massive cutbacks to drilling programs and natural decline rates across the world's oilfields." These cutbacks may make OPEC and the U.S. shale oil industry "unable to increase production enough to control the pace of an increase in oil prices as demand begins to exceed supply." The reason is that OPEC is already operating at close to maximum production. The U.S. shale oil industry is also restricted as it has more than half of its fleet stacked.
Smith's reasoning sounds a lot like the comments delivered by Deputy Oil Minister Prince Abdulaziz bin Salman last month. He warned that capacity cuts could cause a huge price spike.
Smith also pointed out, as I have recently, that one of the biggest risks to weak oil prices was geopolitical issues. You need a calculator to total up the number of ongoing conflicts in the region right now. I count four nations actively engaged in air campaigns against ISIS right now. As Smith wrote in his latest epistle, "Is it just me, or does the Middle East right now look like a Tom Clancy novel that ends in massive sectarian war?" It would not take much for a larger war to break out in the region with significant impact on oil prices.
Smith calls the talk of weaker demand from China one of the greatest myths of the year, emphasizing that oil demand from China rose by 6.9% year-over-year in the third quarter. OPEC estimates currently call for about a 4% increase from China in 2016. He adds that "demand for oil in China has been and should continue to be quite strong, due to growing consumer demand, efforts to fill the country's SPR or Strategic Petroleum Reserve and the country's transition to a mass automobile culture."
Smith also said that in the last six big bear oil markets, prices fell by an average of 60% and the decline lasted 227 days. It was followed by a rebound of 76%. The current decline has lasted more than 300 days, and prices are down more than 60%. It can go much longer, however, as history does not always repeat itself. But this bear market, while vicious, is getting a little on the old side.
I saw as I was writing this article that Morgan Stanley analysts had come about and are recommending the oil sector as Overweight. Dubravko Lakos-Bujas, Bhupinder Singh and Scott Linstone said that short oil is becoming a crowded trade. They said that 1998 was the last time momentum had been this negative for this long in energy. The team believes that oil prices will rise as non-OPEC supply comes offline and that the sector will be a relative outperformer next year.
I have been long and wrong on oil-related stocks this year. I have taken an appropriate whipping because of it and only high cash balances and community bank stocks have covered my once again horrendous timing. In my defense, I said that I was buying the stocks with a private-equity timeframe of five to seven years, so we have lots of time for this to work out.
I resisted doubling down most of 2015, and as recently as early November said I was having a hard time finding safe and cheap energy stock to add. As energy prices have continued to plunge and energy stocks have been hit hard, that's starting to change. If Cale Smith and the Morgan Stanley analysts are correct on the energy market, I may well be joining Cale as a permanent resident of the Keys a little sooner than planned.