Consider the following example today. Oil prices are cratering and decisively fallen through the $80 level. Saudi Aramco announced earlier in the week that it was cutting its US crude price. OPEC scaled down its global growth and crude oil demand two days later.
Following Warren Buffett
I can point to bargains in the oil patch. Most famously, Warren Buffett revealed large stakes in Exxon Mobil and Suncor Energy, both of which were bought in Q2 2013. The prices of XOM and SU have been declining and approaching the levels which Buffett bought. Would you buy them if they fell further to those levels in the near future?
Here is the XOM chart, with the zone at which Buffett bought shaded in grey:
Here is the Suncor chart:
If your answer is yes. Then consider this question. Buffett bought his XOM and SU stakes when oil prices were a lot higher. The bottom panel of each of the charts above show the ratio of XOM and SU to the WTI price. If we were to consider the XOM/oil or SU/oil ratios, our buy targets for XOM and SU would have to be a lot lower than levels that Berkshire Hathaway acquired those stakes.
If oil prices were to fall off a cliff to $40 or $50 and the XOM/oil and SU/oil were to crater to those buy zones, which would likely mean a further 50% downside from current levels, would you be willing to step up and buy?
USD strength = Commodity weakness
Before you answer that question, consider the kinds of macro headwinds that commodity prices and the Energy sector is facing with a strengthening US Dollar. It seems that my call for a retracement of USD strength was either early or the weakness was too brief (see my previous post Overbought USD = Commodities poised to rally). The chart below shows the USD Index (inverted) and the relative performance of the Energy sector.
Currently, bullish USD factors include:
- A hawkish Fed relative to other major central banks;
- A better US growth outlook relative to other major economies;
- The BoJ has launched QE9, which is an effort to devalue the Yen;
- The ECB is talking dovishly, whose effect is to weaken the euro; and
- Chinese growth is slowing, which is putting downward pressure on commodity currencies like the AUD, CAD and ZAR.
With numerous bullish factors underpinning the USD (and therefore bearish for commodity prices), would you still be willing to buy large cap energy stocks? Now you see why contrarian value investing can be a very lonely activity and can involve considerable career risk.