The biggest news of the capital markets in 2014 is likely to be energy. The price of oil has dropped from ~$106/barrel in late June to a low of ~$64 in December, a decline of approximately 40%. The carnage quickly spread throughout the energy value chain. Since energy is one of the largest and most widely owned sectors of the capital markets, it's safe to say that many people have felt the pinch in their portfolio and wonder what to do. Here's my appraisal of the situation.

The energy value chain starts with the commodity itself; it's the handle of the bullwhip, so to speak. All commodity markets are cyclical and prices are determined by the balance of supply and demand. Therefore, let's break things down in the context of supply and demand.

Energy is a basic input cost to the global economy. Changes in the demand for energy are largely a function of global growth. While certain economies have been performing well (U.S., U.K., etc.), many large blocks have been dragging down the pace of global GDP growth (E.U., China, etc.). While the demand for energy is still growing, the level of growth has been weak. This is not anything new; global GDP growth has been disappointing since "The Great Recession" of 2008/09. What is new is the picture for energy supplies. U.S. shale gas production is a phenomenon that has added enough production that supply has outstripped demand. When you have too many sellers chasing too few buyers, prices turn south. Hence, the dramatic decline in the price of oil.

Prices are now hovering around levels last seen in 2009, near the bottom of the last energy cycle. How are the supply/demand kinetics likely to affect the value chain going forward? For the demand side of the ledger, lower energy prices will reduce one of the primary input costs of a modern economy. Reducing input costs frees up capital for other purposes and is therefore a stimulant to global GDP growth. As discussed above, stronger global GDP growth will in turn increase the demand for energy. The supply side of the ledger is more difficult to understand because the incremental supply has come from North American shale production, a new industry comprised of thousands of independent producers. Additionally, key characteristics of shale gas production are that the shelf-life of oil/natural-gas wells average about three years, and the production thereof is front-loaded. Given these characteristics, combined with the challenging economics of production at these lower commodity prices, we're likely to see production go offline fairly quickly. Combine these supply/demand kinetics and you will see a picture of how the cycle self-corrects: lower oil prices stimulate global GDP and reduces incremental production.

For these reasons the cycle will eventually self-correct. As market participants search for a new equilibrium price, they often overshoot both to the upside and downside. I do not believe that oil prices in the mid-$60 range will become the new normal. It seems likely that pendulum has swung too far and that prices will eventually recover up. However, over any short-term time frame sentiment and momentum are unpredictable factors that could continue the current trends.

If you are one of the many investors with positions somewhere along the energy value chain, you've just been through the tough part of the cycle. Though it's impossible to say if there is more pain to come, we can see that there are many high-quality companies whose valuations haven't been this low since 2009, indicative of extreme pessimism. The best thing to do then would have been to wait it out. And for those with enough courage, look for bargains.

Brennan R. Redmond, CFA - Vice President


(This article contains the current opinions of the author but not necessarily those of Brighton Securities Corp. The author's opinions are subject to change without notice. This blog post is for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. References to specific securities and their issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities.)