The State Of Oil: Lower For Longer

Oil

As people are being forced to learn, central banks have made markets incredibly unstable. In few places is this more clear than the oil market. The artificial demand that their free money policies created, led to an equally artificial rise in oil prices. The high oil prices created an environment for higher priced oil projects to come online. Throw in artificially low interest rates which incentivized leverage and debt and you start to realize how a 20% drop in the price of oil can cause it to drop another 50%.

As of writing, the price of oil is trading in the mid 30’s. I remember back when oil crashed to $55. The market and its participants reaction were in pure and utter disbelief. The little caveman in their heads told them this move was unnatural, and it was, just not for the reasons they thought. After all, a major commodity such as oil shouldn’t drop 50% in six months…

But it did, so everyone and their aunt was trying to pick the bottom.  Oil traders bought oil and stored it on ships out in the ocean, or piled up crude on shore in the hope that the price would rebound. But that never happened. It’s been 16 months now since oil peaked in 2014, and most anyone who bought oil to sell at a future date has lost considerable amounts of money. As time goes on, storage costs increase as storage space declines. In short, the traders created an artificial front load in demand, and an artificial backload in supply. At some point this oil will have to come back to market, and with double the number of oil tankers waiting at sea from the beginning of the year, it will have considerable downward pressure on the price.

It’s not just oil traders that have been storing vast quantities of oil. Countries around the world are filling up their tanks to the brim. The US crude storage is at a record high 490 million barrels. According to OPEC, crude oil stockpiles in OECD countries currently exceed the running five-year average by 210 million barrels. To put it mildly, the world is pumping out more oil than is being consumed. The price will continue to fall until this trend is reversed.

It is pretty obvious that, this is a supply side issue. Demand didn’t fall off over night. No, supply has been steadily increasing. Especially since the price of oil started to fall, countries and companies have been forced to pump out even more oil to maintain revenues with even more production. Which is why we see in the face of decade low oil prices that production has increased. Russia, Saudi Arabia, and the United States have all reached multi decade highs in oil production in 2015.

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Perhaps one of the most interesting domino effects due to low oil prices is the surprising ingenuity of producers. Even if at unprofitable levels in the long term, in the short term if the well is tapped, and the oil is gushing, there’s no point in stopping. Break even prices for a tapped well are still much lower than the current $36 dollar per barrel at the time of this article. But that’s not all. US shale companies have drastically been able to reduce costs. In the early days of the shale boom the break even price for shale was thought to be around $80, now the breakeven price is much lower, in the 50s or even lower. The point is that US Shale is dying a lot slower than certain invested parties thought.

But it’s not just the Americans that are thriving under the pressure of low oil prices. Armed with new technology, Russian companies are effectively finding and extracting oil from old Soviet wells. As a matter of fact, in 2015,  Russia recorded its highest oil production since the fall of the Soviet Union. Another boon to Russian oil, is the fall in the ruble’s price against the dollar. Since most of Russia’s oil operations are priced in rubles, Russia’s cost of extraction has fallen tremendously over the past few years.

Saudi Arabia doesn’t have the fortune of a weak currency that Russia does. And there’s a good reason for that. Saudi Arabia is a desert kingdom. Nothing grows there. There’s no mining sector. There’s no agriculture. They used to grow vast quantities of wheat at a very high cost, but that has been slowly phased out. There’s nothing but oil sand and religion. They have a very young and undereducated population. The fact that the kingdom needs 6 million foreigners to pump their oil is not a good sign either.  The point is, that Saudi Arabia produces nothing but oil which it’s own citizens aren’t even capable of doing. Saudi Arabia’s life blood, is the wealth it receives for its oil and nothing else. Thus the country must important almost everything it needs to survive and or thrive.

If the currency falls, import prices rise, which is essentially the price of everything Saudi Arabia needs, the result of which is rising inflation. Faced with rising inflation, a weakening currency, falling revenues, and declining wealth, how do you think Saudi Arabia’s young, uneducated and highly religious population will respond? Which leads me to believe that the very last thing the Kingdom will do is unpeg the Riyal. I’m not saying it can’t happen, I still think it could, but if you look at the effects a currency devaluation will have on the Saudi Arabian social order, it doesn’t seem likely in the short term. Saudi Arabia would have to be in dire straights to be forced to unpeg it’s currency. And although it is headed in that direction, it would take a few years of significant FX reserve drain or a few very important factors that would have to occur that would make the peg unsustainable.

What are those factors? First and most importantly, is the forex reserves. This is their ammunition to defend the peg. As long as the reserves don’t dwindle too quickly, Saudi Arabia should be able to defend the peg. But as you can see the currency reserves have fallen off a cliff in 2015. After peaking at roughly $740B in 2014, forex reserves have fallen to $633B as of december 2015. The government posted a budget deficit of 15% for 2015. At this rate, with all things being equal, in 5 years, the country won’t have enough FX reserves to defend the peg. So we have our ticking, but must keep in mid, all things won’t be equal. Obviously the price of oil will change, but so too will the Saudi Government Budget. Steps have already been taken to reduce the deficit dramatically. The Saudi Government has reduced a wide range of subsidies for its citizens, as well as reigned in some spending. But not on weapons, because the Kingdom is busy fighting a few wars at the moment and needs to be prepared. With all that said and done, the Saudi Arabian government still projects it will run a deficit of 13% of GDP. Of course, this is under the assumption that the price of oil for 2016 will be $50.

Given the current market dynamics: increased production from Iran,  Iraq’s 25% increase in production over the course of 2015, record amounts of oil in storage, major countries producing record amounts of oil, the fed tightening monetary policy and US shale companies being unwilling or unable to shut off their wells at a fast enough to pace to make way for new and cheaper production, the price of oil looks to be headed in only one direction, down. That’s not to say we will see a spike or two back up to the 40s, but they will be temporary till more production comes off line.

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But the only place we could see a significant drop in production would be US shale. The EIA predicts that US production will lead to a paltry 500,000 bpd drop in production. This is not of significant magnitude to cause a rally in the price of oil. There’s just too much supply coming to market within the next year and not enough unsustainable production falling off. Despite a lot of the current supply being unsustainable in the long term, the short term should continue to get ugly. However, if oil drops into the 20s, which I believe short term is where its headed, then we could see a much larger drop in production from the US shale than the EIA is predicting. I doubt any US shale is sustainable in the 20s and we should see quite a few companies go the way of the dodo. Once again, it appears that the EIA like the Saudi Arabian Government is forecasting an optimistic oil price. Which leads me to believe that oil falling into the 20s could have enormous psychological effects on the market. Which could lead to extremely imbalanced positions in the currency markets.

To make matters EVEN WORSE, the Federal Reserve, in all its wisdom, has decided to raise interest rates!  At a time when the oil nations of the world are drowning in oil, here comes Janet Yellen stomping her steel toed boot on their heads! If the dollar strengthens, the price of oil in dollars will fall even further. But oil isn’t the only thing priced in dollars, so is the Riyal. After all it’s pegged to the dollar. And if it is to stay pegged, the Saudis will have to spend a lot more money to keep it that way!

The bottom line, is that oil is most likely headed even lower for the near term and will stay low for the remainder of the year. However, this goes against the forecasts of various governments and the markets. If I am right, the global economy will not be prepared for the dramatic events and knock on effects that even lower oil prices will have, whether that be excessive bankruptcies in US shale, falling inflation in across India, Japan, South Korea, China and Southeast Asia, or broken currency pegs. The point is, with these oil prices something will break, it’s a matter of time.

 

 

 

Fallout From The Fed’s Rate Hike Cycle

“I’ve never been more optimistic about a year ahead than I am right now. And in 2016, I’m going to leave it all out on the field.” ~President Barack Obama

I’ve tried coming up with a snarky sarcastic comment but I’ll let the quote speak for itself…

Just remember, this is a president who has never seen a rate hike let alone an actual interest rate. This is a president whose legacy has been built on the back of free money, and now that the Fed is hiking interest rates (for the first time in ten years), he’s never been more optimistic… Yeah… Um… Yeaaaah.

The most obvious consequence of a fed rate hike is a stronger dollar. As conditions tighten here in the US and dollars become harder to come by, increasing its value. When you take into account the amount of dollar denominated debt that foreign companies OWE, you start to see the possibilities of a very strong rally in the dollar.  A lot of these foreign companies do not operate in dollars so the only way for them to get more dollars is to go into the market and sell their currency in exchange for dollars. But when the Fed hikes it is essentially telling these companies that “the dollar is going to strengthen”. Thus it is in the best interest of these companies to buy dollars now before their value increases further. The result is a lot of dollar buying and emerging market currency selling.

If emerging market currencies continue to fall, then the central banks of these nations will be forced to intervene and prop up the currency by also tightening economic conditions. According to the WSJ,

The Bank of Mexico raised interest rates for the first time since 2008, despite record-low inflation and relatively slow economic growth, as the central bank seeks to avoid further pressure on the peso after a sharp depreciation this year.

Thus we can start to see how a Fed rate hike forces the entire global economy to tighten whether it is ready or not.

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Source: IMF

 

And let’s face it, EM corporations are not ready for a tightening cycle because they like their US counterparts have piled on debt in record fashion, more than doubling since 2008. Thus these corporations should do quite poorly during this tightening cycle as their debt burdens become unmanageable.

With their currencies and stock markets falling in tandem, we can expect a large flow of capital out of emerging markets and into developed markets, especially into the US. This flow will benefit US safe haven assets like treasuries but more importantly, I think that the flow of capital will eventually become so severe that countries will enact capital controls.

So let’s think, what asset does well in a scenario of falling currency, rising economic uncertainty and capital controls? The first and obvious answer is gold, but I’m looking past that at a smaller more volatile asset, Bitcoin. Bitcoin is a globally traded currency that ignores capital controls, which is why it so desired during times of crisis.

The fed rate hike cycle should spark an incredibly strong rally in Bitcoin. I would go as far to say that Bitcoin could be the best investment for the next few years. And because of its relatively small market cap, a small inflow can cause a big spike in value.

And there are many events that could cause a size able inflow into Bitcoin. For example, a strengthening dollar threatens a few very important currency pegs. Much like the ECB’s QE forced the Swiss National Bank to unpeg the franc from the Euro, I suspect Fed’s rate hike cycle will force the PBoC to reconsider the Yuan peg. Any significant devaluation in the Yuan will send millions of Chinese searching for a hedge against further devaluation and I believe one of the answers to their problem will be Bitcoin. Now this is just one such scenario but I find it even more likely than I did when I first mentioned it in a previous article.

But it’s not just the global economy that isn’t ready for a rate hike. Even the US economy isn’t ready for a tightening cycle right now and yet the Fed is raising rates. In the US we’ve already had our massive build up in credit. In an “ideal” world, the central bank is supposed to prevent this credit bubble, but the Fed was too late to tighten. After all their mandate said nothing about credit. They only cared about inflation and employment. A shame they didn’t realize how important a factor credit plays in both those indicators. Since inflation never reared its head, the Fed never considered hiking interest rates. Meanwhile, useless credit continued to pile up in the economy, flooding every asset known to man on a biblical scale.

So here we are with a too much credit, rising interest rates, and tightening credit conditions. Obviously this bodes quite poorly for US growth stocks, inflation, and heavily indebted corporations. I won’t go as far as saying US real estate is in danger, because Congress just repealed a thirty year old law that essentially prevented foreign pension funds from purchasing US real estate. With yield starved pension funds around the world looking for a place to jam their money, US real estate could be a tempting choice. I will say however, that all the conditions I listed above do bode well or at least not poorly for US treasuries. I expect the yield curve to flatten, as short term interest rates rise and long term interest rates to fall or stay the same. The resulting environment would be quite bearish for US banks who will surely try and raise lending rates to make any profit. Thus we could see a spike in mortgage rates even as 30 year treasuries decline. Something similar has occurred in Europe as a result of negative interest rates. The banks need to make more money than before since their cash stored at the central bank now carries a negative yield so they carry that cost on to their customers through higher mortgages rates. That’s all for now. I think my next post will be about the current oil glut and hopefully how to profit from it.

 

The Fed Hikes: The End Game Accelerates

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Seven years into this “experiment”, I like a lot of other common sense inclined individuals found myself scratching my head at the FOMC’s decision to hike interest rates. After all, they’ve had seven years to cherry pick their moment and somehow we are led to believe that December 16th, 2015 was the best they could come up with? I don’t buy it. Given all the data: slowing economy, rising inventories, declining corporate profits, strengthening dollar, falling inflation, rising junk bond yields, I am hard pressed to find an actual economic reason to hike interest rates at this point in time. But let’s not get into the “why?”, because as important as that is, the “what the hell comes next?” is even more important.

I must admit I enjoyed watching Fed Chair Yellen try to explain their decision. I thought she performed admirably, at times I almost believed that she believed what she was saying was true and someone who knows nothing about economics or common sense might even be inclined to fall for her incantations.

But unlike Jon Snow, I know some things. Due to the Fed’s cheap money policy  credit growth exploded over the last few years. Rather than fueling investments and Capex, most of this credit growth went straight into stock buybacks and dividends. One of the few sectors where this cheap debt actually went into Capex was the OIL AND GAS sector, and we all know how well that’s doing, because the fall in oil prices is supposedly “transitory” according to Yellen.

EVERYTHING IS TRANSITORY! NOTHING LASTS FOREVER! SO TO CALL SOMETHING TRANSITORY IS FED SPEAK FOR I HAVE NO CLUE BUT I’M HOPING IT’S OVER SOON!

I’d be laughing if this wasn’t so serious, if the Fed’s miscalculations merely took place on a chalk board rather than a world with 7 billion people living on it.

Instead we find ourselves, on the verge of another catastrophic stock market explosion. Junk bond yields have spiked considerably in the last few months, which will make it harder for companies to service and acquire more debt. Once debt growth slows credit bubbles burst. So what was first attributed to the fall in oil prices causing debt bloated oil and gas companies to cry for help, has now spread to other sectors including the investment grade bonds. To make matters worse, inventories are on the rise in the US and profits are declining for the first time since the crisis. Like I said in the opening, the Fed could not have picked a worse time to hike except for perhaps tomorrow.

Let’s not forget that while the US may be the center of the world’s economy at the moment, it’s not the only one that matters. Emerging market nations OWE roughly $5 trillion in USD denominated debt. This means these companies, which do not have direct access to dollars, are going to have an even harder time paying back their debts as the Fed is now actively strengthening the dollar. The rush on the dollar will be enormous unless the Fed back tracks but it is probably already too late.

I don’t know the timescale for the collapse in the global economy but rest assured with the Fed hiking rates it has been accelerated substantially. We have now entered the end game and it’s time to get defensive.

 

Investment Tips:

If you read my articles for the past few years, I’m going to sound like a broken record here. But with the Fed hiking interest rates, the deflationary phase that my calls have been based around will only become stronger.

So if you listened to me over a year ago back in August 2014, you wouldn’t even be in the US equity market. The Dow is up only 5% since I made that call. It’s safe to say that I’m still not touching the long side of the US equity market with a barge pole, nor any equity market around the world for that matter. I still like long term US bonds, as inflation slows and the dollar rallies these should look like extremely attractive investments to other investors as well.

Another point of emphasis, is long/short currency positions. I’ve already mentioned the strengthening dollar but you still have to hold it against something. I prefer emerging market currencies that also are heavy commodity exporters. Saudi Arabia certainly falls under this category. As the Riyal is pegged to the dollar there is no risk of the trade going against you. It’s one way! Just sit back and wait for the fireworks, literally! Saudi Arabia is fighting a proxy war in Iraq/Syria as well as Yemen. It’s bleeding money as it struggles to defend its fellow Sunnis as well as its currency peg.

I’ve also talked a lot about China in the past, and we’ve seen the Yuan which is also pegged to the dollar weaken, but there’s still a long long way to fall. A 20% decline in the currency would certainly be a start. Then there are developed economies that are heavy exporters with divergent monetary policy that also look attractive for long dollar short their currency plays. Australia and Canada look particularly attractive. Both nations have housing bubbles high debt levels, large commodity exporters, high dependencies on Chinese consumption and are loosening monetary policy.