We've spent the first week of the New Year with much of the world entering new lockdowns. For many, the excitement at leaving the dreaded 2020 behind has been replaced with a realisation that 2021 is simply 2020, but older.
Anyway, with that relentlessly cheery thought in mind, here's a puzzle for Friday: if lockdowns are going on for longer than expected, why is the oil price higher?
Coronavirus is still wreaking havoc and sparking new lockdowns across the globe. That's unlikely to be great news for air traffic in the near term. And yet the oil price has risen strongly in the last week. Brent crude kicked off the New Year trading at around $51 a barrel. This morning, it's well above $54 a barrel.
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The surprising generosity of Saudi Arabia
It's partly down to the continued enthusiasm for assets generally. Investors who missed out on rebound gains last year feel that they need to make up for it by buying laggards in the hope that they'll catch up with all the popular assets.
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But there's a more specific reason behind oil's gain. Earlier this week, the “Opec+” oil cartel – consisting of the Gulf states led by Saudi Arabia, and Russia – got together, and decided to restrict supply by more than markets had expected. Russia still plans to raise production (co-operative as ever), but Saudi Arabia pledged to cut another million barrels of production to compensate, while most of the other countries in the cartel said they would hold production steady.
Presumably, oil producers are worried that the new spread of the virus will trigger a new slide in demand, and thus hit prices. That's one argument. That said, some analysts suggested that the generosity of the Saudi cut seemed “too good to be true”. After all, Saudi Arabia and Russia are rivals as much as allies. And that's before you consider the US shale oil producers.
On the other hand, you could argue that this is a simple “belt and braces” move. And the US election result probably helps. Under a Democrat-led US government, shale oil producers will struggle to expand as rapidly (if at all) as they would have under a Republican government. And that's before you consider the fact that the shale oil sector (like much of the wider commodities sector) is currently in consolidation mode – they need to start showing investors that they can be trusted with their money, rather than just splashing it wildly on every project that comes to hand. So the Saudis might just be making a short-term move to try to ensure that the oil price doesn't crash hard again. It's as much about sentiment as anything else.
The reason it's interesting is because the importance of oil prices is consistently underestimated. Oil price spikes are not helpful for the global economy. Oil is an input price into just about everything. So it acts as both a tax (it sucks up money that could otherwise be spent elsewhere) and an inflationary pressure (it drives up prices). There's even an argument to say that spiking oil prices actually triggered the 2008 financial crisis. (I think that's going too far, but they certainly contributed to the pressure).
Yet right now, oil is still largely dismissed as being on its way out. It's a dreadful fossil fuel that will be replaced by hydrogen or sunshine or wind or the power of positive thinking or something like that. Well, what if we're not quite there yet?
Could rising oil prices prick the US stockmarket bubble?
Charles Gave of Gavekal makes the interesting observation in a recent research note that “in the past, a major rise in the oil price has always been followed by a fall in the Shiller p/e ratio.” Now, for those who remain blissfully unaware, the Shiller price/earnings ratio, or Cape ratio, looks at the valuation of a market (or stock) based on an inflation-adjusted average of its earnings over the past ten years, rather than a single year (you can read more on it here).
The point is to smooth out earnings over the economic cycle. If you rely on one year's data, you might be getting the high point or the low point in earnings, and so get a skewed view of how cheap or expensive an asset really is. For example, mining stocks will tend to look very cheap on a p/e basis when their earnings are at peak levels (during a commodity boom), while they'll look very expensive when a commodity bust is underway (because earnings plunge).
The Cape is not much use for timing the market, but it does have a history of predicting future returns better than most other measures. (Note, that doesn't mean it's foolproof – it just means that if you're going to use a valuation measure, this one has a better track record than most.) If you buy when the Cape says a market is cheap, history indicates that your long-term returns will be better than if you buy when the Cape says a market is expensive.
The debate over the Cape has been more heated than usual recently, because the US stockmarket – the S&P 500 – has been expensive on a Cape basis for a long time. Now, all the caveats about Cape not being a timing tool are well known. But we're all human beings, and thus impatient. So when we think a market is overvalued, we want to see the thing fall there and then, not seven years later.
The conclusion – even by Robert Shiller himself – is that low interest rates are what's keeping market valuations high. That makes some sense. If your alternative to owning stocks is to own a bond in which you lose money after inflation, then that suggests you should be willing to pay a bit more for stocks than you would if the return on bonds was higher.
But what happens if oil prices perk up? And inflation perks up as a result? And interest rates grow harder to keep down? Jeremy Grantham, co-founder of GMO, just put out a note declaring that he thinks the US is in an epic bubble, on a par “with the South Sea bubble, 1929, and 2000”. Grantham tends to be early, but he also tends to be right.
To me the simple answer is to stick with assets that are undervalued and reduce your exposure to those that are very expensive. We look at the importance of rebalancing in the current issue of MoneyWeek out today. If you don't already subscribe, take the opportunity of a new year to get your finances in order, and get your first six issues free here.
