2018 Year-End Letter, Part 3: Sectors: Materials and Energy

Materials:

I could essentially copy and paste our outlook for the industrials sector and insert materials. Recall that I cited materials as vying for the top spot with industrials as 2018's most frustrating sector.

In a nutshell: Materials still warrant a 15% target weighting in our view; based on generally decent (still) macro conditions, the prospects for a sizable infrastructure spending bill in the U.S. sometime in 2019 (yes, this one has bipartisan support), and, contrary to our view coming into last year, the prospects for an on balance weakening U.S. dollar during the course of 2019.

The monster risk, and the reason for 2018's miserable results for the sector, is of course the trade war. As it stands, the rhetoric has -- by necessity, given the now all-too-apparent damage it's inflicting on the global economy and equity markets -- turned markedly positive. If recent rhetoric becomes reality, while general conditions remain okay, materials could have a very good year.


Energy:

After last year's drubbing (the worst performing sector), the presently depressed price of oil, the prospects for no recession in 2019, and the desire for OPEC and Russia to maintain a profitable per barrel price, I'm tempted to bump up our target to the energy sector going forward.

The thing about the problem of low commodity prices is that it's always remedied by low commodity prices. Meaning, when something that people want or need gets cheap it's usually because more of it's been produced than people are presently demanding. Therefore, the price declines until it meets a level that entices the buyer. Call it equilibrium.

In terms of oil, given its global application, when the price plummets the world asks what the heck's going on? Is the price falling due to lack of demand? If so, the economy's in trouble! Or is it due to too much pumping? If so, the economy's going to accelerate, as the savings will just add juice to already strong consumer spending, and business investment, patterns!

On that last paragraph, the jury's still out. Although, clearly, we're not in recession mode just yet, so while it may be a bit of both, it's more likely a supply rather than a demand issue -- at this juncture, I should say.

For the rest I'll cut and paste from last year's letter, with amendments in red:

Here are some key themes we see impacting the energy sector going forward:

1. High demand: Energy products will remain high in demand in an expanding global economy.

2. OPEC: OPEC, along with Russia, have agreed to keep 1.8 million barrels of oil per day off the market through the end of 2018. Which has indeed helped out the price of late. However, OPEC's nemesis, North America, will continue to exploit its efforts to the fullest. I.e., as OPEC cuts (and supports the price) North America ramps up production, effectively quelling the desired rise in price.

3. Profitability: Amid strong demand, and OPEC's efforts, a price per barrel back below $40 is highly unlikely in 2018 2019. However, at a price much below $50, we should see any expansion in North American shale production slow measurably, as we've seen estimates of the break-even price for shale producers of between $40 and $55 per barrel. The share price action of the companies that comprise our core energy ETF are of course highly correlated to the fluctuating price of oil. However, if prices can remain stable above $50, the renewed strength we mentioned above can persist, and it'll show up in company earnings.

4. Renewables: While the world will continue to consume fossil fuels into the future, anyone who would deny the fact that the industry faces major challenges, as the world pushes to clean itself up, is, well, in denial. Thus, while we'll indeed see geopolitical, etc.-induced spikes in the price of a barrel from time to time well into the future, the longer-term trend will indeed be a lessening of dependence on fossil fuels and, thus, a massive structural rebalancing that, again, poses major challenges for the industry in the years to come.

5. Tax reform: Energy companies -- with a whopping 25.9% boost to earnings -- are estimated to be the chief beneficiaries of the corporate tax rate cut. This helps for sure!

6. The dollar: Oil is still traded primarily in U.S. dollars throughout the world. Thus, the price of a barrel is indeed influenced by fluctuations in the U.S. currency. A rising dollar in 2018 2019 can, therefore, become a notable headwind. Although we think odds favor a weaker dollar going forward, which favors the energy sector...