Fundamental valuation is the foundation of our investment process. We want to buy markets and currencies that are priced below our estimate of fundamental value and sell those that are above it.
Commodities are not an asset for which one can derive a fundamental value, but rather are driven by supply and demand forces. As such, we don’t transact directly in commodities, such as oil, but we do operate in commodity-sensitive sectors and currencies. For this reason, the outlook for oil (and other commodities) is important to us.
We believe the current equilibrium price (fair value) for oil is around $45 a barrel—in a range of $40 to $50. That’s probably a little lower than what some investors believe, but our view is that supply is playing a much larger role than before and that may keep prices pinned lower than we’ve seen in the recent past.
On the downside, prices plummeted to about $30 a barrel on an extreme technical situation. That’s not something we’d expect to see again in the near future. On the upside, we see oil prices topping out at about $60 a barrel. That’s because there’s a lot of marginal crude oil that the United States can bring to the market. As oil prices get up to $55-$60 a barrel, we would expect to see more shale oil rigs turned on, and this could potentially double oil production in the U.S.
The high inventories in the United States are keeping a lid on oil prices, while OPEC and the recent OPEC production cut are putting a floor on prices.
OPEC (Organization of the Petroleum Exporting Countries) is no longer a swing producer like it was, Saudi Arabia in particular. The U.S. is now the swing producer, and shale oil is the supply that it will provide. In fact, the U.S. can bring that shale oil to market much faster than traditional wells, which makes the supply more responsive to demand as we go forward.
The high inventories in the United States are therefore keeping a lid on prices, while OPEC and the recent OPEC production cut are putting a floor on prices. Current inventories are still high, but we think they will dissipate over time as OPEC production is reduced. But if you look at all of the OPEC quota agreements since the 1970s, adherence to the quotas typically last for a few months before the OPEC countries start cheating.
And there’s nothing that suggests that OPEC won’t cheat again this time. In fact, they all ramped up production in November so they could squeeze as much out as they could before the recent production cut hit. This certainly gives you a sense of their willingness to cheat on their production as we go forward.
I’m not sure that the price support provided by OPEC is going to be as solid as some might think. After all, countries like Russia are not going to hold to any quota, even if they notionally agreed to it.
As far as our portfolio positioning, we’ll tend to increase our exposure to the energy sector and energy sensitive currencies when oil is in the $30-$40 range and decrease exposure when it is in the $50-$60 range.
Currently, we’re slightly long the U.S. energy sector, which remains one of the more fundamentally attractive U.S. equity sectors on a relative basis (U.S. equities in aggregate appear expensive). Additionally, we feel that the energy sector may benefit more than other sectors as a result of a slowdown—or decrease—in regulation coming from a Trump presidency.
We are also long fundamentally cheap commodity-sensitive currencies such as the Mexican peso and Russian ruble, but short fundamentally expensive commodity-sensitive currencies such as the Canadian dollar and New Zealand dollar.