Oil swooned again on Wednesday, with the benchmark West Texas Intermediate closing at $60.94. And on Thursday, WTI dropped below $60, currently trading at $59.18. It’s down 43% since June.
Yesterday, OPEC forecast that demand for its oil would further decline to 28.9 million barrels a day next year, after having decided over Thanksgiving to stick to its 30 million barrel a day production ceiling, rather than cutting it. It thus forecast that there would be on OPEC’s side alone 1.1 million barrels a day in excess supply.
So the bloodletting continues: the Energy Select Sector ETF (XLE) is down 26% since June; S&P International Energy Sector ETF (IPW) is down 34% since July; and the Oil & Gas Equipment & Services ETF (XES) is down 46% since July. They all got hit. And in the junk-bond market, investors are grappling with the real meaning of “junk.”
Six years of the Fed’s easy money policies purposefully forced even conservative investors to either lose money to inflation or venture way out on the risk curve.
John J. Xenakis
Oil prices have been plunging due to increased supply from US shale production (fracking), and due to falling demand caused by a slowing world economy. The oil importing countries (Indonesia, India, Taiwan, South Korea, Japan) are benefiting enormously from the plunge in oil prices, while it's a disaster for several oil exporting countries -- Venezuela, Russia, Iran, Iraq, Nigeria. Saudi Arabia has announced it will try to increase oil production, presumably in the hope of putting the US fracking industry out of business.
An analysis by the US Energy Information Administration (EIA) that may shed some light on what's going on. Even though the price of oil is plummeting, US fracking production is going to continue increasing, though perhaps slightly less rapidly than has been previously predicted.
Oil production in 2014. WTI is West Texas Intermediate (EIA)
The graph on the left shows that drilling permits have been holding steady, while the number of rigs has fallen slightly. The graph on the right shows that oil production continues to increase, despite the fall in oil prices.
The existing wells are backed by hedge funds and junk bonds that are now in distress because of the fall in prices. As a result, production in the existing wells will actually be increased as much as physically possible, to generate revenue at low oil prices to meet margin calls for these junk bonds.
It occurs to me that the Saudis may be in a similar situation. They may also have shaky investments backing up their oil wells, and so they too would have to keep production as high as possible to make their own margin calls.
This is a good illustration of how deflation feeds on itself, and how some deflation causes more deflation, almost as if were caused by a deflationary attitude. By the law of supply and demand, falling prices normally should cause production to decrease. But the current situation we're in, a highly leverage debt bubble, is an anomalous situation. Falling oil prices are causing production to increase, not because of the oil market, but because of the debt market, resulting in a deflationary spiral. Businesses desperately increase production and sales in the hope of making up for lost earnings, in order to meet their debt margin calls, but the increased supply simply causes prices to fall even faster, resulting in more deflation.
This is a dangerous situation because, as the price of oil continues to fall, one or more of these funds may go bankrupt, and that may cause a chain reaction of multiple bankruptcies.
When Conn’s – a retailer of furniture, home appliances, and consumer electronics with 91 stores in Texas and surrounding states – announced earnings on Tuesday, its stock crashed 29% premarket and ended the day down 41%. It has lost 73% from its peak a year ago when it still had been a hot miracle retailer that could do no wrong. And the junk bonds it issued six months ago at the very peak of the junk-bond bubble went into “price discovery.”
Turns out, it also finances in-house about 75% of what its customers buy.
And people buy at Conn’s because they can’t buy anywhere else. They’re subprime. They’re the strung-out consumers with bad credit and no cash, the modern American proletariat, the hollowed-out, hard-working middle class whose real wages have declined for years. buy, buy, buy what they can’t afford and didn’t want and may not need. But no problem because Conn’s is going to finance it all.
John P. Hussman, Ph.D.
Policy makers learned little from that episode. In recent years, a similar reach-for-yield has driven equity valuations to levels that are now about double their historical norms, based on historically reliable measures that are about 90% correlated with actual subsequent 10-year market returns. Suppressed interest rates do not “justify” this elevation. Any standard discounting approach can be used to demonstrate that if “normal” valuations are associated with short-term interest rates averaging say 4%, the promise of even 3-4 years of zero short-term interest rates should result in longer-term risk assets being priced only 12-16% above their respective valuation norms. Likewise, current or year-ahead earnings projections do not “justify” present equity valuations, unless one ignores a century of evidence that major peaks in the equity market are always associated with cyclically elevated earnings well above their long-term trend, which in turn always understates observed price/earnings multiples at major peaks. A century of historical evidence can also easily be brought to bear to demonstrate that valuation measures having limited sensitivity to cyclical swings in profit margins have a dramatically stronger correlation with actual subsequent equity market returns.
Once again, investors and speculators have also reached for yield in low-quality debt, producing a boom in junk bond issuance and leveraged loans (loans to already indebted borrowers), with the majority of those new loans having “covenant-lite” features that reduce the protection of the lender in the event of bankruptcy. Moreover, much of the trillion dollars of outstanding leveraged loans are held by major U.S. banks in the form of “participating shares,” an indirect form of ownership that has been repudiated by the FDIC. As KBRA bond rating agency recently observed, “Today, many leveraged loans continue to be participated to banks, insurers, and bond funds in a manner that raises similarly questionable rights in the event that the lead bank or non-bank sponsor fails. The intense competition for assets among institutional investors caused by low interest rate policies has, it appears, caused a deterioration in both the perception and the terms of structural protections that we believe could create future risks for investors and the global financial system. The lesson of finance and financial law is that protection which ends at the doorstep of a trustee or receiver is no protection whatsoever.”
DYI Comments:
If the big banks get into trouble I don't believe the American public will stand for a bailout.
Vanguard's Energy Fund VGENX from its peak on June 23, 2014 at $77.57 is currently at $54.06 for a 30% decline. This is an excellent time to dollar cost average while waiting for the opportunity to lump sum when this industry goes into disrespect as the market puts their shares on the give away table.
DYI
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