Connections: Oil, mortgages, and stock markets in the modern world

Markets have provided no shortage of comment-worthy events over the past year, and increasingly so over the past few months. In fact, it has been difficult for me to put the proverbial pen-to-paper in the past month to write this commentary. Firstly, there is so much to be discussed that I was fearful of the postage costs unless I could edit down from 30 pages! But with markets moving in such dramatic fashion and circumstances evolving so rapidly, every other day the commentary I had in my mind would change. I will start the discussion, make some points and advance some theories, and draw some comparisons and lessons from the past, and invite you to further discussion in person if you wish.

It is rare that we encounter truly unprecedented and new economic and market events. At the very least, the past often provides some instructive parallel. We have seen oil cycles in the past and seen periods of rapid appreciation in commodity prices, but I will discuss some differences in this cycle. We have seen mortgage and loan problems (subprime as it’s called this time) in the past – e.g. the Savings and Loan Crisis circa 1990 – and we have seen housing bubbles burst. We’ve had Middle Eastern conflict, well, forever. We’ve had financial, or “liquidity” crises, with a degree of regularity. We’ve even had them all coincide as we’ve have had in the recent past.

Oil is the world’s largest and most important commodity. It is also the one with the most predictably cyclical price. That is, we can predict that it will cycle, just not how high or low it will go. When oil prices are low (remember: commodity prices are always determined in the long run by supply and demand – in the long run this is ALL that matters) it is usually because supply has outpaced demand for some time. The low price provides little incentive for exploration or development of new oil reserves. The lack of new oil supply, in the face of generally increasing demand, eventually causes the price to rise. However, it takes years for new supplies to be discovered, developed and brought to market. By that time, demand will be near or slightly above supply and cause the price to spike. High prices make for a boom in exploration and development and bring supplies, slowly, to higher levels than demand. In the past few years we have seen this play out yet again. Oil averaged $22.81 in 2002. It moved to around $65 a barrel last August. Most worthy of comment, it has more than doubled since then hitting $146 in early July, making this upward cycle in oil a 700+% move. You may have read about new finds for oil (e.g. Brazil found a field estimated at 30billion barrels offshore recently) and have read for a few years about the boom in the Canadian tar sands as they develop that massive reserve. We’ve also heard about the decline in demand for oil, particularly this past year. Economies and markets are self-correcting. They fix themselves. SUV sales are plummeting, gasoline consumption has dropped dramatically this year, and will continue to do so in the years to come as people gradually change their behaviour. The spike in price this past year has brought demand down while increasing supply now and for years to come. I expect this will bring prices lower in time.

It’s all happened before. The OPEC oil embargo in 1973 (their response to Middle East conflict) quickly cut oil supplies. Since demand cannot instantly move lower, the world suffered nearly a 400% increase in price in a year and a half. Oil dependant North America had to quickly adjust. Honda was one of the few automakers offering small, fuel efficient cars and owes much to this crisis. Fuel efficiency became a concern and demand fell. In time, so did prices. The fall of the Shah of Iran and rise of a fundamentalist regime spiked prices in 1979, only to fall sharply again. The Gulf War in 1991 saw prices run up from the mid-teens in 1990 to touch $40 per barrel – only to fall to the mid teens through much of the 90s. Clearly, politics can move oil in the short term, however, supply and demand rule and win out in the long term. We will see lower oil prices again.

Let’s turn to housing and the mortgage crisis. After a severe drop in the stock market, money turned to real estate, aided by cuts in interest rates, and generated many years of substantial gains in property prices. The booming property market and rising prices were used to justify aggressive lending practices since the higher prices anticipated in the years to come would provide greater security for the loan. When property prices eventually corrected and turned down, many loans turned bad and financial institutions suffered losses in the hundreds of billions as foreclosures increased at a time of falling prices. I speak of course of the Savings and Loan Crisis in and around 1990. Our current mortgage-related financial crisis is virtually identical. The crash of the stock market brought on by the tech collapse helped fuel property prices and aggressive lending. The eventual correction in property prices left these risky loans exposed. In the early 90s government action to inject liquidity and instill confidence in the stability of the financial system turned the corner on the S&L Crisis. Lower interest rates and a massive injection of funds not only marked the turning point, but, importantly, also helped fuel the outperformance of the stock market during the 90s as all that liquidity searched for returns, and eventually bid up the price of stocks. We may very well see the same impact this time around.

Other short term liquidity crises have come and gone, but the history is often not well remembered. The Asian currency crisis and the insolvency of Long Term Capital in the summer of 1998 caused a similar problem and financial stocks suffered. Few people still remember that Canadian bank stocks fell over 40% in just a few months that summer, and this presented a great buying opportunity, particularly when compared to the looming collapse of the more fashionable stocks of the day, techs. The more fashionable stocks these days are in commodities.

The parallels to the S&L Crisis don’t end there of course. Remember that we also had a spike in oil at that time due to the Gulf War. The combination of falling house prices, a weakened financial system and high oil prices were largely the cause of the recession at that time. However, cuts to interest rates were the policy response then, as now. Interest rates are sharply lower now than a year ago. What of stock market performance for the year 1991, in the midst of war, high oil, recession, and financial and property distress? Up about 30%! It is vital to remember that stock markets are anticipatory. Essentially, they try to price stocks based on the world as they see it a year from today. They anticipate recoveries and move up well ahead of the economy and a change in the headlines.

Now, let me turn to the areas I feel are new and unprecedented, and discuss the dynamics of how all these events interact and are causing such volatility in the markets, particularly this summer.

We now live in a global marketplace where technology has irreparably changed the way we live and work – and invest. In short, global diversification does not work to the extent it once did since the connections between global markets have multiplied. Technology has made it easier to move vast sums of money in a keystroke, and also made it cheap and easy for millions of participants to react (often rashly, irrationally, and regrettably) to the deluge of news now available but previously ‘not fit to print’. None of this has changed the fundamentals of investing. The laws of supply and demand still exist. The world continues to progress, innovate and produce and this is wealth creation. Stock markets will, over time, stick to the fundamentals and grow at roughly the pace of wealth creation and profit growth. But volatility is here to stay. Markets are more volatile in the short term but nothing has changed over the long term.

Technology and globalization have made the world smaller and made it easier for millions of investors to participate in the markets in ways they could not previously, and the proliferation of hedge funds and derivative instruments has magnified the effect. Not long ago, it was expensive and difficult for individuals to speculate in commodities or currencies for example. With the advent of exchange traded funds (ETFs) this has changed dramatically. For very little cost and a small investment, millions can now speculate on everything from the Australian dollar to gold to corn to soybeans to any conceivable industry grouping. This is new and I believe is having a significant effect on the markets, distorting (for the short term) the effect of the fundamentals. For example, the oldest gold ETF is not yet four years old, but owns approximately 750 tons of gold. There are a great many other ETFs in this sector of various sizes. Together they hold thousands of tons. The annual mining production of gold is roughly 3000 tons. In just over three years, ETFs have increased demand for gold by over 20% per year and therefore increased the price. You may remember a similar run-up in gold in the past. Gold ran up nearly 400% in a year and a half only to give up all those gains, taking over 20 years to recover the $800 per ounce price of the early 1980s. This new speculative interest is true for most commodities to a greater or lesser extent and I believe has allowed speculators to artificially inflate the prices. In the long run, supply and demand will rule.

Speculative forces have been very pronounced in part due to the above effect, but also an increase in hedge fund activity. While I can appreciate the arguments on the other side of my conclusion that oil has been artificially pushed higher, there are problems with their argument I cannot accept. Remember that the Canadian dollar (considered a petro currency) rose to parity with the US$ for the first time in a generation in September of 2007 as oil prices shot higher – oil traded that day under $84 per barrel. Why has the C$ not budged as oil proceeded to rise by over 70% in the nine months since? When oil rises by over 100% in a year, would you not expect Exxon, as the world’s largest public oil company to see their share price increase dramatically as their profits rise? You might expect so, but in fact their shares are down 12% for the year as I write. In the short term, wherever money flows prices rise. In the short term, money leaving stocks, or properties, or anywhere else, can move prices higher wherever that cash is buying. We have seen this happen as money left financial stocks in 1998 to head to tech stocks. I believe we are also seeing it in now as money flows into speculative commodity-based investment vehicles, but it will not change the fundamentals and the effect will be short lived.
The fact that oil company shares have not enjoyed a banner year is further indication that investors interested in oil are not interested in anything other than the commodity itself. Otherwise, there would be buying pressure on the stocks. In effect, the market does not believe the oil price will be sustained and has therefore shown no increase in interest in oil companies, nor the currency of an oil exporter such as Canada.

June was an extraordinary month for volatility, and the month of June and the activity so far in July I believe has buttressed my theory. Oil rose $20 per barrel in June, even as demand continued to fall. Within just one week in July it has fallen by as much. Financial stocks were battered in June, with some very large U.S. financial stocks falling 40% or more from their highs in May (Canadian financials similarly fell during this time as much as 30%). The rebound in prices for these financial stocks was equally stunning, with some rising 50% in two weeks in the U.S. and over 30% in Canada. In fact, the third week of July was the best week in history for U.S. financials. What is the connection between oil and banks?

As I mentioned above, the solution to past liquidity and financial crises has been lower interest rates and government and central bank infusions of capital. But such interventions are designed to stimulate the economy and growth, and are considered inflationary. Oil’s spike in price, particularly in June, created a fear of rising inflation and the concern that interest policy could not be as accommodative as previously hoped. This would mean a longer period of stress for financial companies and a longer period of weakness than previously hoped. The recent downturn in oil prices is the beginning of the return to fundamentals and a reduction in the speculative influence on its price. I believe it reduced the concern of inflation and allowed the funds leaving commodities to seek out great bargains in the financial sector.

While the activity of recent weeks may mark the end of this particular “market event”, and we have seen non-commodity stock prices rise sharply thus far in July, it will unfortunately not be the end of market volatility and short term speculative events. These events provide long-term market participants with the opportunity to invest at prices below their fair value, but also provide the undisciplined, fearful, or poorly diversified investor the opportunity to take very sharp losses should their discipline waver at the wrong time. Over the long term, the fundamentals reign and stock prices will trend to a fair valuation. But we will forever be subjected to these short term phenomena and the risks and opportunities they present.

- Alan Cameron

(The information contained herein is drawn from sources believed to be reliable, but the accuracy or completeness of the information is not guaranteed. Opinions expressed are those of the author and may not necessarily reflect those of Investment Planning Counsel.)