After years of strong returns, the commodity sector has taken a serious beating the last few months. Crude prices in particular have been hit hard, with a barrel of oil falling from a peak of $145 in July to around $58 in mid-November. With one of Canada’s most prized growth areas suddenly stalling, what’s going to happen to the industry and its investors?
“It makes investing in the sector a challenge,” says Garey Aitken, CIO of Bissett Asset Management. “The most important part of these companies’ business plans is really the price of the commodity they hope to be producing, so it’s inherently unpredictable and hard to make capital decisions around that.”
Bob Lyon, AGF’s senior vice-president and portfolio manager of AGF Canadian Resources Fund, among other commodity-related funds, says many companies can’t forge ahead with new projects when oil prices are so low.
“You need $90 to $200 oil to make new oil sands projects today,” says Lyon. “If oil gets down lower, to the $45 or $50 range, we’ll see an absolute collapse in investments in energy infrastructure, because not many projects generate a return at those levels. Some do, so everything doesn’t stop, but things like deep offshore oil, or oil sands projects will virtually grind to a halt.”
“We’re seeing some deterioration in investment plans,” adds Avery Shenfeld, managing director and senior economist at CIBC World Markets. “Oil sands projects, particularly upgraders, are being pushed off to the future, when prices might be better. We’re also seeing some constraints on natural gas drilling.”
Crude’s quick rise
Not long ago, economists were touting Canada’s sturdy resource landscape as one of the big reasons why we weren’t experiencing the same economic troubles as our southern neighbours.
A CIBC World Markets economic report in April saw Jeff Rubin, the bank’s chief economist, say that Canada’s energy- and resource-rich economy has “translated into soaring growth in Canadian personal and corporate incomes. Those gains show up in a very healthy increase in domestic spending and enriched government coffers.”
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Now, just six months later, energy companies are halting projects and losing money, and the country’s GDP growth is almost at a standstill.
To understand why prices dropped the way they have, it’s important to look at how they jumped so high in the first place. Lyon, who doesn’t like to call the run-up in the commodity sector an energy bubble, says prices increased due to supply and demand.
“It was largely determined by fundamental factors,” he explains. “Commodities are the most basic supply and demand-priced thing in the marketplace, because there’s no differentiation between a pound of copper in Ontario and a pound of copper produced in South America.”
“We shouldn’t dismiss some speculative forces,” adds Aitken. “At the same time, with the strong global growth we saw for a big part of this decade, there were underlying fundamental reasons for the run in crude.”
Aitken also attributes the strong commodity growth to supply challenges and sustained demand, but “those forces have really unwound in the last four or five months.”
Plummeting prices and the credit crisis
To blame the plummeting prices on the credit crisis would only be half right. Lyon explains that the current economic conditions have made it difficult for companies to secure financing for equity or new operations, which then pushes up costs, but it’s hard to know if this is the reason why prices have fallen.
“At this stage, given the depth of the credit crisis, it’s very hard to know what amount of slowdown is being caused just because of the basic business cycle, and how much is being forced by the crisis,” he says.
Lyon attributes much of the sector’s downturn to demand destruction, caused by the summer’s high oil prices.
“It comes to a point when there’s a certain level of tightness in the market, and the only way to balance the market is to destroy demand,” he explains. “The way you get there is to get the price high enough that it forces the destruction. I think it’s fair to say that we got to that point 12 months ago, where we needed demand destruction to balance the market.”
Aitken agrees that part of the sector’s decline stems from destroyed demand. “With the spike we saw earlier this year, there probably was permanent demand destruction,” he says. “With those types of high prices, there is a signal for consumers of energy to change their behaviours and patterns.”
He also says that much of the “speculative zeal” that drove up prices is gone now, while the fundamental picture has “really deteriorated.”
Shenfeld points out that supply and demand are not elastic. He says “a little bit of tightness in the oil market can cause a big spike in the price, but the converse of that is a modest amount of slack in the market can result in large drops in prices to generate additional demand.”
However, he also says that if credit were not restricted, and the world wasn’t facing its worst economic period in decades, it’s unlikely oil would have dropped the way it has. “Oil prices might have caused a deterioration of economic activity and would have been a bit self-defeating,” he says. “But we would have seen a modest retreat in oil prices. The steep drop we’ve seen is tied into the parallel decline in economic activity.”
Higher prices to come
Most analysts agree that commodities will rebound. Legendary investor Jim Rogers said in early October, “if history is any guide, this bull market on commodities will end sometime around 2020. Eventually there will be hundreds of mutual funds investing in commodities, though that still has a way to go.”
CIBC’s Rubin recently wrote that he thinks the low oil prices we’re seeing now signal an end to the global recession. “The impact from the even larger decline in oil prices over the last two quarters should give its maximum boost to the economy over the next six months,” he said. “If triple-digit oil prices are what started the recession, then $60 oil prices are what will end it.”
Lyon and Aitken think that a price of $90 to $100 for a barrel of oil should be high enough to keep resource companies funded and consumers satisfied at the pump.
The question now, however, is when will prices rise and how high will they go? Lyon suspects that prices will push well over the $100 mark, but the increase will be gradual, similar to the four-year climb from $20 to $60.
“Oil went up by 500% without upsetting anyone’s applecart too much because it was done in a slow, orderly manner,” he says. “Consumers were able to adapt. Income was going up; the economy was doing well. It wasn’t necessarily a good thing for the average consumer, but it wasn’t causing much pain.
“If oil responds the same way we moved up in the first place, in an orderly fashion over a number of years, the world will be fine,” he adds. “If it happens in a knee-jerk reaction, and I fear it will, we might just go through this ongoing zigzag where we overshoot and undershoot around the natural price.”
Shenfeld agrees that prices could increase slowly, but doesn’t dismiss the notion that there could be another dramatic bounce. “Initially the price has to absorb some of the excess supply. But once demand gets tight you can have another spike in prices.”
Either way, with China and other emerging markets still growing rapidly despite the global economic slowdown, demand for energy will remain high.
“By no means does this derail a secular story of increased demand for energy globally,” says Aitken. “As countries move toward a more developed status, there are more efficiency gains and a sheer increase in wealth globally. The move toward the middle class in China bodes well for increased energy demand.”
Filed by Bryan Borzykowski, Advisor.ca, bryan.borzykowski@advisor.rogers.com
(11/14/08)