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.

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Opportunities in 2015

It is always a very difficult task to predict what will move markets one year forward, and some would go as far as saying it is futile and impossible. I kind of agree with this point of view, but in financial markets, everything is about probabilities, and understanding macro can tremendously help investors ‘predict’ what would be tomorrow’s most likely scenario.

What macro analysis is telling me about the financial world for next year is all about deflation, and let me explain my reasoning.

First the facts: The data flow out of Japan, China and Europe is bad, strongly suggesting appearance of the twin specters of recession and deflation.

Central banks responses to that fact are again more monetary stimulus. Europe is already accepting some negative interest rates, while his central bank chief Mario Draghi, is giving very loud hints that Europe’s version of QE may be coming. On the other hand, the world’s second largest economy, China, cut interest rates last Friday even as out-of-control credit binges threaten exploding debt dynamics… And last, but not least, Japan took the most dramatic pass out of the 3 regions buy going the equivalent of “all-in” - for poker fans - at the end of October, starting what might be considered a currency war.

Here is the logic chain: Japan, Europe and China all rely heavily on exports. Those stimulus strategies ultimately rely on weakening their respective currencies which in turn makes the dollar stronger. A stronger dollar creates global tightening credit conditions as it is the funding currency of the world economy and thus cancels out global stimulus effects.

You have to remember that the dollar still account for 80% of global trade transactions, and accounts for the most part of global borrowing, for a simple reason: investors prefer the liquidity and strength associated with the world reserve currency tied to the strongest and most dominant economy on the planet.

As an example, Turkey has $386 billion worth of debt payable is US dollars. Chinese companies have raised more than $180 billion worth of dollar-denominated debt, according to Morgan Stanley. These are two examples. Countless other EM has huge dollar exposure. The “US dollar carry trade” has been estimated, in total, at 3 to 5 TRILLION dollars. This means that, when the value of the dollar rises, these USD borrowers (companies and government alike) get squeezed. And what happens when export-focused Japan, China, Europe all attempt to weaken their currencies, directly or indirectly, even as the Federal Reserve stays “neutral”? They fuel strong dollar conditions, which in turn increase the risk of economic contraction, capital withdrawal, and credit defaults. The game is self-defeating.

What seems to be clear for me is that we are entering a negative feedback loop that may impact greatly financial markets. If my theory is correct, some exceptional money-making opportunities are at hands.

Commodities are the most at risk in this scenario and the fact that they already started a break out is confirmation of my theory. A stronger dollar means weaker commodity prices: Intermarket Analysis 101. I was alerted earlier this year by the Crude Oil break down that surprised many in financial medias, who failed to apply the saying “what can’t go up on good news must go down”. The price of Oil refusing to move up during the escalation of 2015 geopolitical tensions (Ukraine, Middle East) was a wonderful hint of what would be coming later in the year… Deflationary forces generated by US Dollar strength was  much stronger forces and not surprisingly commodity prices broke down in tandem after the summer.

But I think this is just a start! I believe that the commodity bullish secular cycle has ended. Therefor I opened a short AUD/USD at the start of November from 0.8720 after the completion of the small October consolidation pattern hoping for much lower prices around the 0.8 figure. I choose this currency pair because AUD is a commodity currency, as its economy relies heavily on exporting its resources to other countries, mainly China… which I am not optimistic about as well. I can also profit from the dollar appreciation in the meantime, so with the price action looking good to me it feels like a good play.

I will try to do some follow up on that position here in the blog and gives as much update as possible.

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Dollar Index Breaking Through Long Term Support

We are experiencing a very important market event this month, as the US dollar is breaking through a significant long term support. Such a move, if sustained, is very important for market participants because the USD is one of the most important asset class in macroeconomics. I can give many reasons of the utmost importance dollar has in the global economy, like it being the world reserve currency, but it is not the subject of this article. In the next few lines, I would like to review some strategic implications implied by this important market event, and give a trade recommendation in conclusion.     

First, let’s take a look at a 5 years chart of the US Dollar Index:

During the past 2 years and a half the strong support I am talking about (in green) supported price no less than 6 times. In technical analysis, the longer a support hold and the more times price rebound from it, the more significant it is. A break of that important support should not be taken lightly by market participants in the face of its potential market forces.  

A weak dollar has many inter-market resonances of which the most important one is for me its impact on commodity prices. Due to many of them being priced in dollar terms, a strong inverse relationship exist between the two assets.

As can be seen on the chart above, the CRB commodity index broke out of its recent 3 years downtrend last February. A dollar breakout will therefore be further evidence confirming this nascent uptrend.  

In addition, it is also important to understand that a falling USD is bullish for the relative performance of foreign stocks (see relative performance of the iShares MSCI EAFA ETF vs USD in the chart below). The prevalent under-performance to US stocks before this year stopped, but have yet to decisively turn the other way. I expect this important USD breakout to be the catalyst for a foreign stocks out-performance.

Combining all the above, countries that produce commodities stand to benefit even more from a weaker US Dollar. Not surprisingly, we have seen developed countries commodity producers like Canada and Australia see their stock markets hitting new multi-year highs lately. But from a contrarian point of view, I am very interested in Brazil, another big commodity producer, that have been beaten down lately by the negative sentiment surrounding Emerging Markets in general.

Technically speaking, the iShares Brazil ETF (EWZ) is strong, breaking out of a triangle consolidation pattern to the upside. Since the start of last month, it is performing better than the S&P500 on a relative basis which is confirming the thesis presented above. 

I believe it is a smart idea to begin or to increase exposure on this market as long as the USD is confirming its downtrend.

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Bad News For A Commodities Breakout

After more than two years and a half of downtrend, many analysts and pundits were calling the end to the cyclical commodities down wave this year. Since many of its components, in particular gold and agricultural, were already breaking out to the upside, I tended to agree with that analysis.

Though, this week FOMC meeting shifted my view on what to expect in the next few months for commodities and inflation. Why?

• Wednesday press conference shifted the narrative.
• Emphasis changed from near-zero interest rate to eventual hikes.
• The Federal Reserve revealed a post meeting hawkish bias.
• Bellwether price action deteriorated.
• US economic strength has been re-emphasized. 

From a macro perspective this change in tone is what George Soros refer to as "playing changes in the rules of the game" because that is the kind of event that changes market participants perception of the market place and creates orderflow that speculators can profit from.

In her press conference on Wednesday, Fed Chair Yellen accidentally caused the market to focus, laser-like, on the seemingly casual phrase “six months.” Prior to the presser, the narrative was focused on near-zero interest rates and their positive effects. “The US economy is recovering nicely,” the line of thinking seemed to go, “and we will have super-low rates for quite a while yet.” To hear SIX MONTHS was the needle scratching across the record.

This event is even more damaging for commodities as it happened right at the moment when the market seemed to wonder if it was more concern about inflation or deflation. See below chart of the ratio between bonds and gold, one of the best inflation/deflation indicator:

Just when the ratio was trying to break out to the upside, this week FOMC decision seemed to kill any hope for commodities bull as it created a bearish engulfing candlestick pattern right at the downtrend resistance line.

Some commentators inclined to shut their eyes tight and wish a dovish Fed back into existence, next-day comments from Fed members Fisher and Bullard are a blast of cold water. Consider these wire headlines (Zero Hedge):

*BULLARD SAYS YELLEN'S '6-MONTHS' COMMENT IN LINE WITH SURVEYS 

*BULLARD SAYS FED WATCHFUL FOR 'ANY KIND OF REPLAY' OF BUBBLES 

*FISHER SAYS FED HAS EXHAUSTED EFFICACY OF U.S. QE POLICY

*FISHER SAYS ASSET-BUYING TO END BY OCTOBER AT CURRENT PACE *FISHER SAYS SOME MORE VOLATILITY IN MARKET WOULD BE HEALTHY 

Here is another great comment from Joe Kalash, Chief Global Macro Strategist at NDR,  “Although Fed Chair Yellen cautioned against reading too much into the so called “dot plot,” we can’t get it out of our head that the median year-end values rose compared to three months ago.  The median year-end fed funds rate target of FOMC participants for 2015 is now 1.00%, up from 0.75%, while the year-end target for 2016 is 2.25%, up from 1.75%. This suggests the FOMC will begin hiking rates sooner and/or more aggressively than previously expected.”

Now the picture should be abundantly clear. Wednesday’s press conference, plus follow-on information, has revealed that the men and women of the US Federal Reserve are significantly less dovish than many anticipated (including me). Combine this cold-water dose of narrative sea-change with a slow growth global economy, and commodities are in danger. 

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Here's Why The Bulls Are Coming For The Aussie Dollar

The Aussie traded down below US89c last Friday night but opened the week more than half a cent higher on the back of Chinese data over the weekend.

That’s not much of a bounce from the recent lows, but over the past two days something has shifted. Strategists and traders are feeling it.

This morning the Aussie is above US91c and trading at its highest levels in more than two weeks. There is every chance that this rally confounds the Reserve Bank’s hope for a lower Aussie and the rally might extend into the 94-96 region over the next month.

Here’s what changed.

Global growth has stopped being hideously terrible – it’s not great but it has stopped falling.

In a note to clients yesterday, the ANZ Economics team wrote:

Our ANZ global lead indicators lifted strongly again in August with growth leadership passing to the developed economies, although China has stabilised. The key issue is whether momentum slides as in 2012 or whether the lift can be sustained into 2014.

This is the big change for the Aussie if the lead indicators of growth have picked up – or at least stopped falling. The ANZ goes on to say:

The sharp rise in our global lead indicator suggests that risk appetite will remain buoyant.

This is really important because now that the dark days of the GFC have passed the Aussie can resume its rightful place in global investment portfolios and traders mind’s as the world’s favourite punt.

That is, if growth is positive and or rising then buyers for the Aussie dollar start lining up.

Why?

Because Australia, and Canada to a certain extent, remain the only deep, liquid and developed markets which sell the “stuff” that drives global growth. Iron Ore, Coal – both types, Bauxite, Uranium, Copper, Gold, nickel and so on.

So traders understand that Australia is leveraged to global growth and when it’s positive they buy, when it’s negative they sell.

It’s why the Aussie fell to US0.5960c in the GFC and why, now even though Australian domestic growth looks weak, the buyers are back.

Oh and if you want to know about global growth the ANZ Leading Indicators pic up is stunning

Business Insider Australia

Greg McKenna is an active currency trader – but his trading is in hiatus at the moment

Read more: http://www.businessinsider.com.au/the-bulls-are-coming-for-the-aussie-dollar-heres-what-you-need-to-know-2013-9#ixzz2dvef3mqp

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