Still Cautious On Energy and Materials
From the international investment professionals at Euclid Advisors
Many investment professionals have been calling for a bounce in commodities-related equities based largely on their big declines in recent years and the perception of value in the energy and material sectors. Yet there are good reasons to disagree with this conventional wisdom.
With regard to energy,oil prices will likely stay lower for longer than the market expects for two primary reasons. First, oil storage remains close to record levels (see chart below). With U.S. and OECD crude oil inventories at, or nearing, new highs (seasonally-adjusted), it will take a long time to work through the excess supply, and that should keep a damper on prices.
Chart source: BCA Research, used with permission.
Second, increasing global production is expected to meet slower-than-expected demand growth in the emerging market economies, led by China’s deceleration. This will also contribute to elevated inventory levels and lower prices. Saudi Arabia and Russia continue to increase their output, while U.S. supplies may be greater than expected later this year as hedged production is brought on line. Additionally, some global energy experts have estimated that Iran could raise its oil exports by 500,000-800,000 barrels per day, following the conclusion of its nuclear negotiations at the end of June.
China’s excess manufacturing capacity and slowing growth rate are the driving forces in the global materials market. The Wall Street Journal recently reported on the excess supply from China in everything from steel to tires. According to the article, China exports enough excess steel each year to build 75,000 Eiffel towers! While global demand for energy and materials is still positive, it is not growing fast enough to absorb at current prices the tremendous supply coming to market. Prior to 2008, China was the marginal buyer that set prices higher in numerous commodity markets. Now, in 2015, it is the marginal suppliers that are setting prices lower for most commodities.
As a result of these views, we continue to underweight the energy and materials sectors in the international portfolio. Looking forward, the supply side will wield the greatest influence over our exposure. It would be difficult to increase the weightings in these sectors without evidence of noticeable supply cuts or a pick-up in global demand, and we will be watching both metrics closely. Our high-conviction active approach to international investing demands that we ascertain appropriate compensation for the risks we choose to undertake.