What The Energy Crash Really Tells You About This Market

There’s no bear on Wall Street – only a giant brass bull.

That pretty well encapsulates the attitude of all the “experts” who are now hastening to assure investors that the current sell-off is not a reprise of 2008. (Here’s how my own 2016 forecast stacks up against the status quo.) Take Justin Lahart of The Wall Street Journal, who wrote on January 16 that, “there are crucial differences between now and those dark days. While losses could continue, the U.S. appears, at the moment, to be in a better position to weather them.”

Don’t be fooled.

If I had a dollar for every person who told me I was wrong when I wrote a year ago that low oil prices would be bad for the U.S. economy, I’d have a lot of dollars.

I’d also still be right.

Oil last week traded below $28/bbl (WTI) – a 14-year low and close to 40% down since I predicted oil would fall by 50% again on September 28, 2015. And I think it still has further to fall.

In reality, the energy crash serves as a disturbing litmus test for how bad this market really is.

Here are the signals you should be watching…

The Dow Transports Point Straight to a Recession

On January 12, the Energy Information Administration (EIA) cut its 2016 oil demand forecast to 95.19 million barrels/day from 95.22 million barrels/day in December while increasing its production forecast from 95.79 million barrels/day to 95.93 barrels a day.

In other words, even after prices have crashed, supply is still rising while demand is still falling.

There are other ominous signs that the global economy is slowing. The Baltic Dry Index – a key measure of global trade – dropped to new lows in January. Global trade has collapsed.

Exxon just cut its annual energy-demand forecast for China to 2.2% a year through 2025 – a record reduction of almost a 10th. A study from consultancy ESAI Energy estimates that between now and 2030, China’s oil-demand growth rate will be less than half of the rate from 2000-2015. Since Chinese energy demand is one of the most crucial benchmarks for determining the price of crude oil, these numbers are profoundly disturbing.

Oil is the lifeblood of the global economy. When the lifeblood drains away by more than 70% in a year-and-a-half, notice must be paid. There is something seriously wrong with the global economy and markets are reacting.

Traditional analysis has consistently wrong-footed investors with respect to the current collapse in energy prices. For example, while the normal inclination is to believe that Mideast tensions will push oil prices higher, that is not how things work in today’s world. Current tensions between the Saudis and Iranians are a case in point.

Competition between these two oil producers for control of the Arab world is leading the Saudis to increase production and lower prices to pressure Iran and Russia. At the same time, the lifting of sanctions on Iran are allowing that country to start selling oil in order to relieve the strain on its finances without regard to price. Iran filled a huge number of tankers with oil that were sitting offshore just waiting for the lifting of sanctions on January 17. That oil is now being sold on the global market, further depressing prices.

Oil prices went into a free fall in January, which signals worsening trouble in the global economy and for many U.S. energy companies.

Despite lower oil prices, the Dow Transports entered a bear market during a period when the price of oil has collapsed.

When a sector enters a bear market while the price of its key raw material drops by 70%, it is signaling that there is something seriously wrong with the global economy.

When that sector is the transports, which sit at the crossroads of the American economy, investors need to pay serious attention.

Dow Theory, of course, holds that the transport sector is a harbinger for the rest of the stock market due to the key role the transportation sector plays in the economy. The fact that this sector entered bear market territory at precisely the same time that oil prices are plunging is extremely disturbing and one more indication that a recession may be closer than many think.

Watch Credit Ratings in the Energy Sector

The list of U.S. oil companies at imminent risk of default is growing. Banks were more lenient than expected last October in conducting their semi-annual review of energy companies’ assets and borrowing bases; with oil prices down significantly since then, the next review in March is likely to be a bloodbath.


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Figure 2, taken from Zerohedge and Bloomberg, is a list of companies whose borrowing bases were recently reduced by their banks. In the most recent biannual review by a trio of banking regulators, the value of loans considered “substandard, doubtful or loss” among oil and gas borrowers nearly quintupled to $34.2 billion or 15% of the total energy loans reviewed, compared with $6.9 billion or 3.6% in 2014 according to The Wall Street Journal.

With oil prices moving lower, the next cut may be fatal for many of the companies on this list.

Smaller companies seeing the largest reductions in their borrowing bases are the most vulnerable; larger produces such as Linn Energy and Whiting Petroleum have more tools at their disposal to live another day though prolonged prices at current levels will eventually take down even the largest companies.

Many of these companies executed large-scale debt exchanges in order to reduce their debt loads; unfortunately, these transactions often end up being cases of “too little, too late” because companies are reluctant to engage in debt-for-equity exchange when their stock prices are high enough to make a difference.

Conditions in the energy sector are worse than they were during the financial crisis. According to law firm HaynesBoone, more than 30 small energy companies that collectively owe more than $13 billion already filed for bankruptcy during this downturn. Alix Partners reports that North American oil and gas companies are losing nearly $2 billion a week at current prices, a figure that will increase as prices drop below $30/barrel.

The pain is not confined to junk-rated companies, however. According to Markit, there are 110 investment grade companies whose bonds were trading at junk bond levels in mid-January, up from only 21 last November. On January 21, Moody’s placed the ratings of 69 U.S. E&P and oil field service companies on review for downgrade.

Rating agencies are always behind the curve in forecasting trouble in part because their downgrades can worsen deteriorating market conditions, but it is clear that the markets have a far more dire view of credit quality in the energy sector than Moody’s and S&P. Of course, investors stand to lose money if they are wrong, while credit rating agencies will merely suffer reputational damage (and not for the first time) if they misjudge the severity of the energy slump.

I remain convinced that oil acts as a benchmark for the overall economy – as energy goes, so go the markets.

Keep checking Sure Money as we navigate this bear market together. The year is only just beginning.

Stay safe out there.

Sincerely,

Michael

10 Responses to “What The Energy Crash Really Tells You About This Market”

  1. Clifford Sondock

    The drop in oil prices is a market phenomenon related to the confluence of greater supply through innovations and technology and a constraint on demand by the larger economic problem of mal-investment caused by profligate central banks inflating currencies which drove over capacity in most every good and service particularly in China. Oil prices, economic activity (recession) and equity prices are both related and independent phenomenon. Innovation and technology in energy could easily have been a very positive variable for the economy and equity markets had the central banks not behaved so irresponsibly. Thus. The wisdom of free markets.

  2. Michael from Oz

    Hi Michael…if the saudis or iran reduced production of oil due to a increasingly possible major geopolitical event….thereby increasing the price of oil….how …or would that affect your view on the sp500….regards Michael

  3. I bought some HYG Mar $79 puts on Dec 14/15 when HYG was $80.23 /sh. It’s $78.75 currently. I don’t understand why HYG isn’t crashing more with all the energy company bonds under stress. Any comments appreciated. Thanks, Love your writing & insights.

  4. Mike – your honest assessment and forecasts of the energy sector are greatly appreciated. Recent performances of the oil prices underscore your accurate assessment. I look forward to your continued forecasts and recommendations you make. Keep up the good work.

  5. Dear Michael;
    Oil is the life-blood of the economy, Population is what drives the economy. Likewise, food shelter, and a healthy environment is what sustains a healthy population. To focus at a drop of rev.,consumption, margin, or any other metric in the global or largest consumers in the world of .2 or even a 1 % drop in statistical measurements and claim that the sky is falling, in my view it is greatly misleading and manipulating investors views of the economic reality that needs to be met if not on a tick by tick, daily, weekly, monthly and yearly basis for humans still to function and be certain that tomorrow the sun will shine and the rain will water the country-side and life will continue.
    We all know that at certain times we may eat less and at other times we eat more. If the amount of food varies by 1 or 2 % from these extremes, no one would consider this variance catastrophic.So why it is such a hoopla when the same thing is observed in the quarterly earnings reports or on any statistical metric? whether it is the GDP, employment numbers or oil inventory, or consumption. Without being told the available workforce number, the employed work force and the unemployed numbers, the same applies to all metric data that we are bombarded on a daily basis, we have no reference point to relate to as to what is normal or what is plainly outrageous.
    Is it normal or outrageous that any stock crashing a dollar a day over the past month that suddenly on the 1st. of the new month it reverses by $10 each day for the first three days? There is certainly something drastically wrong in this behavior. This reminds me of an experience in my younger days that I observed a gambling con man in the public square. Little did I know that he had partners that wagered bets to lure innocent targets like me. These con-men were exchanging funds at every cycle of the game. The game mastermind would loose for a few rounds and then his buddies would loose when they would bet the house on the game. Having observed how simple the game was I thought I could make some easy money. Of course there was one trick that escaped completely my observation. Really there was no winning side for the naive gambler. Whether I would go long or short I would always loose. So I ask is the stock market today rigged in the same manner that whether one goes long or short the investor is always hanging by the donkey’s tail and trampling over the donkey’s buns?

  6. Hi guys, About Oil Price take your attention to Midle East and Ukraine wars. Both countries fight Russia whose source of money is Oil and Gas. If you look when Wars started and Oil goes down you will see same time. Now as I am ukranian i watch very close to the Russia economy and see that oil price reflected economic ability in these wars. I have a strong opinion that Oil will be down till wars ended and Russia stop fighting countries. So Oil price is just instrument.to stop Russia aggression.

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