What are the key drivers of the steep drop in oil prices?Mr. LeBlanc: The market has become oversupplied. High inventories, especially in the United States, indicate that the market is imbalanced. Even though there’s some evidence of production declines in the United States and some other areas, U.S. imports have remained high largely because two OPEC nations (Saudi Arabia and Iraq) increased their production last year.
And much of the U.S. supply increase has come from shale oil, a new source of oil that over the past five years or so has helped to balance the market and meet growing global demand.
We hear so much about the global impact of slower economic growth in China. What’s been happening on the demand side?Mr. LeBlanc: Here in the United States, 2015 was one of the best demand years in the last two decades. Miles driven was one of the highest since tracking of this data began, surprising many forecasters, and gasoline demand growth was almost double normalized levels. In China, it’s true that demand growth has slowed for other commodities such as steel, aluminum, and copper. But, and this may also surprise you, gasoline demand in China grew last year in the high single digits. Demand for diesel, more of an industrial fuel, also grew, but at a much slower pace.
Mr. LeBlanc: Dollar strength does play a role, because most of the growth in oil demand in the next five to ten years is expected to come from the emerging markets, and with a stronger dollar, oil becomes more expensive in local currency terms. Even so, my view is that oil prices are much more about supply and demand than the dollar.
What role does the stronger dollar play?
Mr. LeBlanc: Yes, we do, because self-correcting forces are being triggered. It’s always tricky to predict the timing of price changes, but today’s price is too low for the industry to work. The financial pressure has become severe; last year there were about 40 bankruptcies, and we expect even more this year if low prices persist. We’ve seen a significant reduction in rig counts—down almost 70% in North American shale. This retrenchment means lower production in many areas. So the capital cycle is working toward higher oil prices, although inventories haven’t improved yet. A bottom may be close as low prices are leading to less supply and stimulating demand, which will help prices recover to a more sustainable level.
Do you see a bottom for oil prices?
Mr. LeBlanc: Each cycle is of course different, but in many ways they are often the same. The biggest difference today is the supply of shale oil, as North American shale has proven to be viable and economic. Another difference today is OPEC, which isn’t regulating supply as it has in the past. And, as I mentioned, demand is forecast to be driven more by emerging markets and less by developed countries.
We’ve seen many boom-bust cycles in oil, and the bust has always been followed by a recovery. Is it different this time?
Mr. LeBlanc: It could certainly play a role, and vice versa. Several large economies have been hurt by low oil prices, including Brazil, Russia, Canada, Mexico, and Norway, as well as parts of the United States. Government revenues have been reduced, and there’s more uncertainty. On the flip side, capital market uncertainty can affect economic growth. Here again the emerging markets are key.
Has oil been driving the stock market’s volatility?
Mr. LeBlanc: Commodity prices reflect expectations for both supply and demand, and certainly weak prices may reflect worries about demand and may foreshadow economic weakness. I come back to the importance of China and other emerging markets as demand growth drivers. As far as the historical relationship between bear markets and oil prices, correlations aren’t very high. Of course, there have been times when oil prices have surprised us by spiking, and that’s been a negative for stocks. But oil tends to have its own cycle, its own volatility—and that can certainly affect countries that are highly dependent on oil exports.
Does the steep drop in oil prices foreshadow a recession, and what might that mean for the stock markets? Is there a historical relationship between oil prices and bear markets?
Mr. LeBlanc: Within the context of a balanced and broadly diversified portfolio, energy can play a role by providing diversification and serving as an inflation hedge, and to some extent, an event hedge, too. A spike in oil prices can impact the rest of a portfolio, so owning energy stocks can help hedge against that. Also, energy can often offer attractive returns after periods of aggressive retrenchment by the industry, like we’re experiencing now. The eventual rise that we expect will be good for most oil-related stocks. And some companies that are creating a lot of value by advancing shale technology are performing counter-cyclically.
How do you view the role of an investment in energy, and commodities more broadly, in an investor’s portfolio?
Mr. LeBlanc: We’re finding opportunities in several of the U.S. resource owners. Shale development and the technology progression signal some pretty interesting futures for some of the companies that were first-movers in capturing high-quality acreage.
Where are you finding opportunities in this market?
Mr. LeBlanc: Oil prices are obviously key to just about the whole industry, because they’re such a big part of revenues. But we take a balanced approach with our investments, focusing on assets and business models that can work through a range of oil prices. The past year and a half has been a great reminder of the wide range of outcomes the oil market can have, with prices above $100 per barrel and below $30, and fears they can go lower. In today’s environment, capital flexibility is key. So are high-quality assets and a clean balance sheet. We also emphasize management teams that have a good history of capital allocation and creating value—and that have steered well through different market cycles and can take advantage of such cycles. Although we don’t significantly change the portfolio based on oil prices, we have been trimming what has worked well to buy some companies that are out of favor. At the margin, we added to some of the oil names, which present an interesting opportunity given where we are in the cycle. And we may own a bit less refining, as we see a few drivers that may start to move in the opposite direction.
To what extent does your positioning of Vanguard Energy Fund depend on oil prices?
All investing is subject to risk, including the possible loss of the money you invest.
Past performance is no guarantee of future success.
Diversification does not ensure a profit or protect against a loss.
Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk.
Funds that concentrate on a relatively narrow market sector face the risk of higher share-price volatility.
Opinions expressed by Mr. LeBlanc are not necessarily those of Vanguard.