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A Few Quick Observations On Crude
Nov. 28, 2014 8:01 AM ET | 330 comments | Includes: HYG, IWM, QQQ, SPY, USO
Summary
Crude is crashing in such a way that I feel compelled to update, and change, my outlook on it.
There are other broad implications, both for high yield and for stocks.
I believe this crude crash, along with other commodities crashing, will lead to a negative impact on stock markets in general.
This article updates my opinion on crude (NYSEARCA:USO), as well as comments on a few other related subjects that are bound to happen in light of the ongoing crash in crude prices.
Going neutral, longer-term positive
First of all, after having said crude was going to correct, and having maintained the opinion that it could go lower still, I am here, at $68.90, turning neutral on it. I simply believe the long-term equilibrium will be set at a price higher than this, even with the concerns regarding speculative positioning, Libyan output and U.S. output and inventories I explained in my last article.
The defaults are coming
At the present levels, it doesn't matter if shale is profitable or not (as many are commenting on, lately). The fact is that every lending committee on every bank exposed to these things is going to turn the taps shut. No more credit, mostly new renewals, etc. Companies in this sector, which face the need to refinance large slugs of debt are going to be taken to the cleaners.
This also has a possible impact on the high yield markets. There has been a tremendous explosion in investment in the crude sector in the U.S. and worldwide. Drilling for crude is expensive and capex is front-loaded. Quoting Carbon Tracker:
From 2000-2013, worldwide capital expenditures (CAPEX) related to oil and gas production increased from $250 billion in 2000 to nearly $700 billion (both figures in 2012 dollars).
These are yearly numbers. And very few of these companies are free cash flowing or are sitting on piles of cash to make due on their financing commitments.
As a proxy, the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA:HYG) lists Oil & Gas as the largest sector by exposure, at 14.66% of the fund (Source: iShares.com)
I'd expect the news of defaults to start hitting soon, as the main problem won't be a lack of profits (which should be gone, too) - the main problem will be the lack of refinancing as every finance institution will be seeking to reduce exposure at the same time.
Furthermore, since this might lead money to withdraw from the high yield sector - seeking to avoid these losses - the impact should then spread to high yield bonds outside the oil sector.
Economic and stock market implications?
It's not usual to see crude, iron ore, coal and other commodities break down so hard without there being some economic distress out there. While the most affected industries (again, crude, iron ore, coal) each have industry-specific problems, namely excess supply problems, the breakdown is still incredibly large indicating that demand must not be that healthy.
Furthermore, we should see a quick collapse in capex in the shale sector - as well as a wave of staff dismissals, etc, which will have a direct economic impact.
The breakdowns in several commodities are also surprising in that they could go to such lengths without demand kicking in and stabilizing prices. For me this has overall negative implications for the equity markets (NYSEARCA:SPY) (NASDAQ:QQQ) (NYSEARCA:IWM). Especially in light of the massive rally we've been observing, which shows many signs of a speculative frenzy. This Seeking Alpha article explains it more thoroughly: "Irrational Exuberance - Descriptive Superlatives Exhaustion Point Is Reached."
Conclusion
At the present levels, I find myself going neutral on crude due to expecting a higher long-term equilibrium price. At around $50, I'd actually turn a buyer even if fundamentals and speculative positioning remained unfavorable. At the present levels, however, I am just neutral with a positive long-term expectation that's not enough to commit to long positions.
I also expect a wave of defaults in the energy sector, mainly by shale drillers/explorers/producers, leading to a significant negative impact on high yield bonds in general (though the defaults will obviously be concentrated in the oil sector, I believe this will lead to high yield seeing money fleeing, thus also affecting overall prices for other bonds).
Finally, I believe this might be the final straw that breaks the speculative stock market mania. There's still a chance that ongoing money printing in Europe and Japan can hold everything together, but the level of speculation together with the economic impact (capex in shale should abruptly drop), together with high yield seeing a quick collapse ought to be enough to put an end to the speculative frenzy.
Nov. 28, 2014 8:01 AM ET | 330 comments | Includes: HYG, IWM, QQQ, SPY, USO
Summary
Crude is crashing in such a way that I feel compelled to update, and change, my outlook on it.
There are other broad implications, both for high yield and for stocks.
I believe this crude crash, along with other commodities crashing, will lead to a negative impact on stock markets in general.
This article updates my opinion on crude (NYSEARCA:USO), as well as comments on a few other related subjects that are bound to happen in light of the ongoing crash in crude prices.
Going neutral, longer-term positive
First of all, after having said crude was going to correct, and having maintained the opinion that it could go lower still, I am here, at $68.90, turning neutral on it. I simply believe the long-term equilibrium will be set at a price higher than this, even with the concerns regarding speculative positioning, Libyan output and U.S. output and inventories I explained in my last article.
The defaults are coming
At the present levels, it doesn't matter if shale is profitable or not (as many are commenting on, lately). The fact is that every lending committee on every bank exposed to these things is going to turn the taps shut. No more credit, mostly new renewals, etc. Companies in this sector, which face the need to refinance large slugs of debt are going to be taken to the cleaners.
This also has a possible impact on the high yield markets. There has been a tremendous explosion in investment in the crude sector in the U.S. and worldwide. Drilling for crude is expensive and capex is front-loaded. Quoting Carbon Tracker:
From 2000-2013, worldwide capital expenditures (CAPEX) related to oil and gas production increased from $250 billion in 2000 to nearly $700 billion (both figures in 2012 dollars).
These are yearly numbers. And very few of these companies are free cash flowing or are sitting on piles of cash to make due on their financing commitments.
As a proxy, the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA:HYG) lists Oil & Gas as the largest sector by exposure, at 14.66% of the fund (Source: iShares.com)
I'd expect the news of defaults to start hitting soon, as the main problem won't be a lack of profits (which should be gone, too) - the main problem will be the lack of refinancing as every finance institution will be seeking to reduce exposure at the same time.
Furthermore, since this might lead money to withdraw from the high yield sector - seeking to avoid these losses - the impact should then spread to high yield bonds outside the oil sector.
Economic and stock market implications?
It's not usual to see crude, iron ore, coal and other commodities break down so hard without there being some economic distress out there. While the most affected industries (again, crude, iron ore, coal) each have industry-specific problems, namely excess supply problems, the breakdown is still incredibly large indicating that demand must not be that healthy.
Furthermore, we should see a quick collapse in capex in the shale sector - as well as a wave of staff dismissals, etc, which will have a direct economic impact.
The breakdowns in several commodities are also surprising in that they could go to such lengths without demand kicking in and stabilizing prices. For me this has overall negative implications for the equity markets (NYSEARCA:SPY) (NASDAQ:QQQ) (NYSEARCA:IWM). Especially in light of the massive rally we've been observing, which shows many signs of a speculative frenzy. This Seeking Alpha article explains it more thoroughly: "Irrational Exuberance - Descriptive Superlatives Exhaustion Point Is Reached."
Conclusion
At the present levels, I find myself going neutral on crude due to expecting a higher long-term equilibrium price. At around $50, I'd actually turn a buyer even if fundamentals and speculative positioning remained unfavorable. At the present levels, however, I am just neutral with a positive long-term expectation that's not enough to commit to long positions.
I also expect a wave of defaults in the energy sector, mainly by shale drillers/explorers/producers, leading to a significant negative impact on high yield bonds in general (though the defaults will obviously be concentrated in the oil sector, I believe this will lead to high yield seeing money fleeing, thus also affecting overall prices for other bonds).
Finally, I believe this might be the final straw that breaks the speculative stock market mania. There's still a chance that ongoing money printing in Europe and Japan can hold everything together, but the level of speculation together with the economic impact (capex in shale should abruptly drop), together with high yield seeing a quick collapse ought to be enough to put an end to the speculative frenzy.
