The End of Peak Oil? - Morphic Asset Management


Present weakness is being driven by Saudi decision not to cut production to stabilise prices as they have tended to do in the past.

Saudi motives for this are complex and not fully disclosed, but probably have geopolitical as well as economic drivers including:

  • Sunni oil, ie Saudi, Kuwaiti and the gulf states, is lower cost to produce than Shiite oil, ie Iraq and Iran! Whatever pain the Sunni face will be much less than the Shia, and the vulnerability of the Iranian economy is already extreme.
  • Saudis aren’t upset about causing damage to Russia, which, among other things is the main sponsor of the Alawite (ie Shiite) Assad regime
  • Saudi’s don’t mind if the US shale oil producers become more timid about expansion in the short and longer terms.

Implications on world markets of the sharp drop in oil prices are many and complex.

The ones we are focussing on are:

  • Great for India, where we have a large overweight. India’s biggest imports are oil and gold. Suddenly the trade figures are looking like they may improve a bit… Generally this will be quite good for Asian emerging market economies…. But not good for Brazil, which has a very large amount of now very marginal offshore oil production pencilled in or underway in the so-called “sub-salt” deep Atlantic.
  • Very bad for Frontier Market equities, which includes most of the gulf and most of Africa, other than South Africa. It is particularly bad for West Africa, the Nigerians have already had devalue the Naira. To give you some measure of how severe this is going to be Angola’s GDP growth expectations for next year are being revised down from +6% to -2%. To show how unexpected leverages can flow from these kind of things, the ramifications of this will probably flow as far as Portugal, for whom the sole bright spot in its economy has been business activity in its former colony and remittance income from Portuguese expatriate workers back to Lisbon!
  • Likely to do little to effect short term production in the US as the marginal cost of producing shale oil fields that have already been developed is very low. However also likely to put a sharp stop to new development work in the shale fields, as the high development cost of new shale production, mean that at the current price, new wells will not earn back their cost in their relatively short life of 5-7 years, during which the vast bulk of total production flow in the first two years. This will have adverse effects in the US boom state of Texas, in terms of employment, and possibly credit markets. Many shale oil drillers have quite a lot of off and on-balance sheet debt. Mostly this is being seen through the junk bond market. The US junk bond tracker fund, JNK, has about 1/3 of its reference names in the oil patch. There may also be some second order implications for banks in Texas and along the Mississippi river, if they have been lending for production facilities for the oil sector, or to office space for oil companies, and even possibly to house oil industry workers. Cullen/Frost Bank the largest regional bank in one of the oil hubs of Texas was sharply down late last week after having started a slide earlier in the month, when most regional banks in the US were rallying.
  • The other big debate is what impact will this have on the timing of US rate rises…. The market seems to think that the lower inflation sugar hit from cheaper fuel prices will be enough to delay the Fed rate rise cycle. We are not convinced, and still think Janet Yellen will be like the terminator, and start in June and keep raising for the next 18 months afterwards.
  • Gold:
  • The Swiss voted against the proposition to force the SNB to have at least 20% of its reserves in gold.
  • Even though when we talked about this over a month ago, we said the success of the referendum was an outside prospect, enough people started to factor it in as a risk, to see the gold price rally a little even though the US dollar was rising, which would normally have seen gold fall.
  • Although gold sold off a bit last week as the polls suggested the Swiss referendum would fail, and it has sold off more since it at the weekend, we see the response as quite tepid, and possibly a bullish indicator.
  • Although we are largely on the sidelines in this trade, we are watching closely as we very aware that some odd stuff is happening in the gold market, with a number of reports of a shortage of physical gold for delivery to end buyers, and more and more central banks talking about repatriating their gold from Fort Knox. Meanwhile it is generally believed that both China and Russia are buying physical gold in the open market, and the Indians have just liberalised the rules on gold imports.

Partly out of disclosure obligations, and partly to self-congratulate, I should say that we are underweight Australia, the Australian dollar, long India and underweight most other emerging markets except Turkey (another beneficiary of low oil and gold prices) and have no exposure to FM. We are very underweight the energy sector, gold, and mining and oil services companies. As a result we had another good month and were up 5.3%, out-performing by almost half a percent.

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