The Oil Panic: Dont!

It’s happening again as it always does. In every major catastrophe, in every crisis, we tend to underestimate human beings’ collective resilience, strength and adaptability. What’s generally missed is an appreciation of our ability to recover.

As I write the extent of Hurricane Katrina’s destruction is still overwhelming the various American authorities, resulting in hyperbole such as “it will take years to recover”. Well, for individuals hit by tragedy, yes, but for the economy, no. It would take more than one disastrous hurricane to cause more than a temporary blip in US economic growth.

Much has been made of the potential loss of oil and gas production and refining capacity with our own little stock market apparently providing one of the earliest and silliest responses. As the Sydney Morning Herald reported on Tuesday:

“BHP shares shed 57c or 2.8 per cent to $20.03 as investors worried about the potential for a prolonged outage of the group's producing assets in the Gulf.”

According to the same story, BHP’s Gulf activities account for just 8 per cent of its total production. The value of the other 92 per cent was jumping thanks to the rising oil price, There also is the fact that production shut-in is production delayed, not lost. For any intelligent investor, a delay of weeks is neither here nor there in the broader strategy of the company.

Over the past 14 years, there have been many scary headlines promising doom and gloom '” and all of them proved to be “buy” opportunities for the independent-minded Australian investor. Those who ran with the herd would have lost money every time.

The developing oil panic is looking like another occasion to be wary of the herd mentality. Yes, there are some interesting fundamentalsand growing demand from China coming after years of under-investment in oil means oil isn’t going to be cheap. (See our Woody Brock and David Wyss interviews). But the market mechanism still works and there is no reason to think we won’t adapt to that without too much trouble.

Going beyond the general trend, any effort to forecast oil prices now is as reliable as forecasting foreign exchange rates. Indeed, the same pattern is evident as brave and/or foolish analysts generally do little more than extrapolate the latest movements.
Traders thrive on the volatility of these times, but investors need to take a broader view and not be swayed by one day’s headlines. It made sense to invest in hydrocarbons when you identified the fundamental increase in demand and which companies were best placed to exploit it, not when a headline shouted oil is breaking $US70 a barrel and someone predicts it’s going to $100.

US oil traders love playing with tropical storms. If no other game is on, just the news of a storm forming in the region lifts oil futures. Once in a while the storm gets serious and does some damage, but most don’t, making it a generally profitable trade to buy on the first signs of a decent tropical low and close out the position just before it’s eventual direction can be ascertained.

I have written elsewhere about one of the early lessons I learned when I was assigned to cover Sydney Futures Exchange trading for the Financial Review in 1981 '” the “Raining in Redfern” syndrome. In those days the live cattle contract was a major SFE business with plenty of speculative interest. It’s a fundamental of the cattle market that farmers hold back stock from the sale yards when a dry spell breaks, thus pushing up prices.

City speculators of course realised this '” but they began to punt on higher prices when they felt it raining whether or not the precipitation ever made it over the Great Dividing Range. I know a weather man who claims he made a nice little earner out of anticipating the speculators’ anticipation.

Oil prices have become a bit like that, running ahead of the game. For the investor, the question about Katrina and other supply interruptions is whether they have caused such a severe disruption as to cause lasting economic damage. So far, there’s no sign of that. Extra spend on reconstruction once the US gets moving should at least compensate for delayed production and a price spike.

Macquarie Bank economist Mark Tierney made a nice point to his clients earlier this week though about how Katrina does give good warning of ever-present risk. He argues that risk premiums are extremely low and need to be built up. Tierney wrote:

In a recent speech at Jackson Hole, Alan Greenspan highlighted the drop in risk premiums in financial markets. Dr Greenspan argued that this trend was a consequence of a long period of economic stability. But he went on to say that risk premiums could rise, with potentially devastating consequences for some asset values. Well it is not just economic stability that has lowered risk premiums. And the performance of the US economy is not the only risk to asset values. One of the underestimated factors is relatively benign weather in the US.

In the 1940s and 1950s, hurricanes were a regular feature in the US. There were ten major hurricanes in the 1940s and eight in the 1950s. But from 1961 to 1990, there were hardly any severe hurricanes. This was the period when the US south suddenly blossomed. For example, population growth in Florida was four times the national average. Almost 80% of the population of Florida lives in the coastal zone. In other words, there has been a massive increase in population in an area that used to be particularly vulnerable to severe weather conditions. Reduced hurricane activity, however, meant that risks were judged as low. Over the past fifteen years, this risk assessment has started to look far too optimistic. In the 1990s there were nine major hurricanes. Hurricane Andrew, in 1992, was particularly destructive. And half-way through the current decade, the tally stands at six. Alarmingly, four of these were last year and a fifth is happening at the moment.

It is not just the risk to lives and property that is an issue. Relatively calm weather allowed a significant expansion of off-shore oil/gas production in the Gulf of Mexico. Refineries dot the Gulf coast. If hurricane patterns are returning to the pattern of the 1940s and 1950s, supply disruptions could become a regular feature.

There is an important lesson here. One of the un-stated assumptions of the modern global economy is security of supply. Just-in-time inventories and globalisation are dependent on this assumption. Hurricane Katrina is a timely reminder that this assumption is debatable. The same can be said of the current blow up in Europe over textile imports. Of course, these powerful economic trends are not about to reverse. But the case for higher risk premiums in a wide range of financial assets is gathering strength.

There’s also a subtle message about historical weather patterns as Katrina will inevitably be used as an example of global warming. Maybe that’s one more reason for a higher risk premium, but it is not a sufficient reason for panic.