The Global Oil Economy, Key Economic Indicators and Financial Suggestions


· The oil sector has faced a significant decline over the last 2 years

· This is correlated with the increase in US dollar strength

· We are exiting a global deflationary cycle and entering higher inflation periods

· Investment sectors of Interest: Retail

Oil is a vital backbone to our global economy and a fundamental interest for investment analysis, particularly due to the 2014 oil bust and its effect on the current state of the US economy. One can analyze the current state of the World’s global oil economy in order to assess various impacts and second round effects on an array of industry sectors for predictive benefits on investment decisions.

The oil industry is indirectly correlated with consumption and prices, as energy supply is a fundamental resource for production and historically a propulsion for technological revolutions such as the British Industrial Revolution. Additionally, oil has played an inverse effect on currency strength, of which the US dollar has seen its strongest levels since the turn of the century.

[1] 1999-Present US Dollar to Euro Strength

As can be seen from the chart, the period of 2014 experienced a significant increase in US dollar strength, significantly higher to the 2006 peak prior to the mortgage crisis that led to the “Great Recession”. The US experienced this significant increase for a multitude of factors. Firstly, during the period of mid 2014, the US energy sector reached its highest peak at over $100 per barrel. The following year oil reached a historical low at $25 per barrel.

This is important to consider, as the fundamental causal root of such peak was fueled by the fact that, for over a decade, investors believed the world was running out of oil. Secondly, investment managers predicted a significantly faster rebound period following the Great Recession, with economic growth foreseen to continue rivaling the aggregate figures of the last 50 years.

One of the largest miscalculations developed by economists were the predicted future supply/demand of oil. As speculation led to a massive investment influx; the advent of hydraulic fracturing and other technologies led producers to seek expensive oil projects with production costs as high as $75 per barrel, such as deep sea drilling and Canadian tar sand projects.

They couldn’t have been more wrong, as a with a combination of slow economic growth, over speculation and a massive influx of supply, oil has now dropped to roughly $50 per barrel.

[2] Crude Oil Index

Starting mid 2014, hundreds of small US oil producers have filed for bankruptcy. High cost producers such as deep water drillers and expensive shale production produced a barrel of oil at $70/bbl. This has led to a crumbling of our US sea rig count. Furthermore, it has become expensive for producers to leave oil in the ground rather than store it at a cost of $5 per barrel per year.

However, do you also see the above graph’s inverse correlation with the US dollar strength? The US dollar’s strength spiked sharply following to its highest peak in 2016 and now virtually equal to the euro. There is undoubtedly an inverse correlation with oil and the US dollar. More importantly, what can we make of how the market will react over the next couple of years given low energy prices and a strong US currency?

It is difficult to predict where the oil sector is headed, however there are a couple of economic indicators that can provide information as to the potential of the sector. As the oil bust contributed to the rising value of the dollar, it also resulted in a major deflationary effect on the US economy. As historically there have been global deflationary and inflationary cycles, based on the below graph, one can see that there is an anticipation for higher inflation. This should have a positive effect on the oil sector as well as income levels.

[3] Inflationary Cycles, Inflation Rate (%) 1960–2016

Secondly, The Trump Administration has a very pro-domestic energy plan targeting to increase oil prices, which favors a weaker dollar and targets higher inflation that can potentially raise middle income wages. A strong US dollar increases the difficulty for manufacturing competitiveness and higher inflation. A weakening of the US dollar provides potential for increased competitiveness in the manufacturing sector, an area where historically the United States has experienced high paying jobs requiring low education.

Should there be both a tax reduction and reasonable regulation reduction that accounts for environmental impact in the total cost of ownership, one can anticipate that domestic energy focus would gain independence from unstable Middle Eastern countries in which we currently receive oil from. Stability and independence from global turmoil as a country are good elements to security of private property rights, peace and protection.

This is all good for an economy. Remember, Mr. Market is quite emotional and hates instability.

However, considering the policies that were put in place in the 1970’s following the oil embargo, the US is not allowed to export fossil fuel energy produced to foreign nations. In order for a domestic energy policy to have a high degree of positive growth as an investment, this policy needs to be reconsidered, as it contributed to a portion of the bankruptcy of US domestic oil companies. As these companies have gained a surplus of oil, they were forced to store it rather than sell it on the international market, in part leading to their bankruptcy or closure in many cases.

With that being said, the oil sector has an array of facets that influence the future of the industry, and it is an investment that will face slow growth moving forward. If you are a growth investor seeking guidance in a foreseen inflationary period fueled by the Trump Administration, I would suggest focusing interest to investments positively affected by inflation rather than oil.

Consider retail as a sector that has seen significant suppression in the stock market from low inflation, as margins have squeezed profits, resulting in P/E ratios well below the industry average. Such companies to focus are Coty, Inc. (COTY), a 100-year-old company conglomerate owning timeless retail brands from Revel and Chanel to Adidas.

[4] COTY Inc. 6 Month Chart

The investment is a pure Benjamin Graham play, with a current price of $20/share, a P/B value < 1 and a P/E ratio < 10. Michael Burry of Scion Capital (best known from “The Great Short”) also holds over 30% of his portfolio with Coty stock at $23/share. Regardless, we believe in conducting your own research to match investment decisions to your comfortable level of risk and growth. For a value investor looking for an investment with a large margin of safety and huge upside potential in an economy with high anticipated inflation, she’s looking sexy by our metrics.

Disclosure: I am/we are long COTY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Bates White). I have no business relationship with any company whose stock is mentioned in this article.

John Walsh, Independent Analyst