Why Should You Care About The Energy Sector?

The collapse in energy prices has been one of the more sensationalistic headlines in the financial media during the last few months. The continued month over month declines in crude oil, natural gas, energy stocks, and other associated industries has been quite remarkable. The entire sector has defied calls for a bottom and continues to trade with extreme oversold readings.

A simple look at the United States Oil Fund (USO) shows just how deep this correction has been since hitting a high last June. This ETF tracks the daily spot price of West Texas Intermediate Light Sweet Crude Oil futures contracts and has declined nearly 60% from its 2014 peak.

Source: Stockchart

So what macro factors are behind such a large price slippage?

First and foremost, global growth is slowing. Central banks over the world are experimenting different types of unconventional monetary stimulus programs to fight this trend but as of today with no success. A new worrisome chart is circulating this week on social media: The Baltic Dry Index, a composite of various global shipping rates tied to the movement of raw materials hits a 30 years low. The price of the BDI is an indicator of the level of global demand for shipping raw materials, specifically. It is also considered by many to be an indicator of the level of global economic growth, in general.

Source: Zerohedge

Second, it is important to understand Saudi Arabia's decision not to cut oil production, despite crashing prices. It marks the beginning of an incredibly important change, with near-term and obvious implications for oil markets and global economies. 

For decades, Saudi Arabia, backed by the Persian Gulf emirates, was described as the “swing producer.” With its immense production capacity, it could raise or lower its output to help the global market adjust to shortages or surpluses. But on Nov. 27, at the OPEC meeting in Vienna, Saudi Arabia effectively resigned from that role and handed over all responsibility for oil prices to the market, which the Saudi oil minister, Ali Al-Naimi, predicted would “stabilize itself eventually.” 

OPEC’s decision was hardly unanimous. Venezuela and Iran, their economies in deep trouble, lobbied hard for production cutbacks, to no avail. Afterward, Iran accused Saudi Arabia of waging an “oil war” and being part of a “plot” against it.

But Ali Al-Naimi reiterated Saudi stance just a few days before Christmas, with this shocking statement:

“It is not in the interest of OPEC producers to cut their production, whatever the price is… Whether it goes down to $20, $40, $50, $60, it is irrelevant.”

Economics of this thing are simple. Saudi Arabia has the lowest production costs in the world (see chart below). Saudi Arabia also has roughly $900 billion in reserves, give or take, which means they have the savings to absorb government budget deficits for years and years.

Source: FT

So it is not hard to understand that Saudi Arabia want to shake the weak production out of the market. This strategy would undermine the economic viability of a meaningful amount of global production. Following the correction there will be a return to business as usual along with higher prices, but with Saudi Arabia commanding a relatively larger share of that market. 

So, do not expect the start of a meaningful reversal any time soon, even more considering the trap some of the producers in the world find themselves in at this time...

Take for example american shale oil, probably Saudi's most wanted competitor, that has become the decisive new factor in the world oil market in a way that could not have been imagined five years ago. It has proved to be a truly disruptive technology. But will that impact continue in a world of low prices?  

Oil is now below $50 a barrel, a price too low for a good deal of the new shale oil development to make economic sense. Yet output is likely to continue to rise by another 500,000 barrels per day in the first half of 2015 because of sheer momentum and commitments already made.

The pent up appetite for yield due to persistently low interest rates, have seen capital, including tremendous amounts of high-yield debt, flood into oil companies. As john Dizard writes for the FT:

“Much of the lending that supported the US unconventional resource (aka “shale”) boom long after the operational cash flow became inadequate was done by people who believed they were taking little risk. Institutional investors were not, for the most part, buying unlisted equity from inexperienced operators. Tens or even hundreds of billions of dollars of capital came from non-bank participations in leveraged loans to exploration and production companies”

The oil business thus has the WORST combination of economics now possible: A structural drop-off in demand (due to widespread global slowdown)… a vicious commodity price war (with well-funded players behind it)… and economics as such that even the dying losers will take quite a long while to fully die off (and may even keep pumping to pay debt).

Now you should start to understand the reason why I shorted the Energy Sector ETF (XLE) after what looked like a typical first wave in bear market. As already advised on this blog, I sold in early December just after the large breakout gap seen on the chart. My target remains 70$.

Source: Stockchart

But I would like to make the point that developments in this part of the market could have large ramification and should note be consider in isolation. For investors that are saying «That is confined to energy, it is a pocket of the economy, everything else is OK and insulated.», remember that this argument usually does not work. When the housing market started to get weak in the subprime category, even Ben Bernanke said: «That does not matter, it is just subprime.» But things are linked together.

This is why we should all care about the energy sector and follow price developments of Oil, XLE ETF, Emerging market, commodity currencies (in particular CAD) and the high-yield bond market for any risk of contagion.