By Tom Bradley

Oil is the topic of the day. It’s in every section of the newspaper and rivals the weather for Christmas party conversation. And the price at the pump is all the rage.

Well, I’m not here to tell you what’s going to happen to oil or oil and gas stocks. I can’t predict when the price will bottom or at what level. I certainly don’t know when the rebound will come. But I can provide some perspective on this slippery topic.

Wow, that was fast

Wow indeed. I can’t think of many/any economic or market cycles that turned so dramatically. In his latest client letter, Howard Marks addresses the speed of the drop with a quote from economist Rudiger Dornbusch – “In economics things take longer to happen than you think they will, and then they happen faster than you thought they could.”

It’s the cycle Baby!

While I don’t know what's going to happen in the near term, I do know that oil is cyclical and as such, is highly sensitive to changes in supply and demand. Lower prices will spur additional demand and undoubtedly reduce supply. The business news is full of energy companies announcing significant cuts to their capital spending budgets. The impact on supply in the next few years will be meaningful. The more jolting and stressful the downturn, the more powerful the recovery.

As for this cycle, we need to keep the $40-50 price decline in perspective. By most measures, $60 is too low a price (below the cost of production in many regions) and is not sustainable, but we shouldn’t get anchored on $100 either. It was probably too high. For whatever reason (geopolitical uncertainty I presume), the price stayed high for an extended period even though the world was awash with oil.

A number of analysts have suggested that the rebound will take longer to come because this downturn has been ‘supply driven’ (too much oil for sale) as opposed to demand driven. Suppliers of oil can’t react to price changes as quickly as consumers do. I’m not sure whether I buy this line of thinking or not. Time will tell.

Good until it’s not

Lower oil prices will be good for the world economy, and ultimately diversified portfolios. Oil-producing regions like Alberta are taking a hit right now, as are oily portfolios, but most of the world is getting a much-needed boost. The energy dividend the U.S. was enjoying over the last couple of years (plentiful, cheap natural gas) has now spread to the rest of the world.

There is a caveat that comes with this view, however. Low oil prices could be a bad thing if they cause a major disruption to the world economy – i.e. Russia and Venezuela go broke, banks become less accommodating and uncertainty pervades business and consumer spending. The world economy has a shaky foundation due to high debt loads, and is not likely to deal with vibration very well.

Be careful. It’s contagious.

At the early stages of any economic trend, the potential for contagion to other parts of the economy is usually underestimated. For instance, if Alberta were to go through a difficult time, the job losses, fiscal deficits, bankruptcies and lower housing prices would be felt well beyond its borders.

Dividends – not a valuation tool

Speaking of contagion, dividend cuts have become an epidemic in the oil patch. It’s been interesting to watch investors react to the news.

One of the earliest cutters was Canadian Oil Sands (COS). It reduced its dividend rate by 42%. The stock was down 20%, which makes sense ... or does it? Aren’t stock prices based on what the underlying company is worth? Was there something in the dividend cut that caused shareholders to significantly alter their long-term forecasts for cash flow, cost of production and years of reserves? Was the outlook for COS really 20% worse on Friday than it was on Thursday, or was the firm being valued on its dividend yield?

Dividends are a good, tax-efficient source of income, but a stock’s yield is not a measure of value. At Steadyhand, dividends are an important part of our process – specifically, dividend growth – but the value of the underlying business has to make sense before our managers will buy a stock.

The emperor’s clothes

As I’ve written before, these kinds of dramatic shifts separate the good from the bad, the strong from the weak and the calm from the anxious. So far, the market has been ruthless is battering the companies that have a high cost of production and/or a highly-levered balance sheet. With divergence and disruption comes over-sized investment opportunities. We just don’t know how big they’ll be and when the payoff will come.