Thursday, December 31, 2015

Evaluating A Year In Oil

It's finally the end of the year, and oil producers across the globe sigh in relief as one of the worst years in crude oil trading finally closes. But as they turn around to face 2016, the shaky ground they tread provides little respite of the past 365 years. Losses for the WTI and Brent spot prices amount to about -38% and -43% on the last day of the year. Both petroleum benchmarks underperformed other commodities traded on that market with general losses for the year traced by a plunge of about -23% for the CRB basket index. Because of these drops, commodity-based corporations, like Glencore, saw major squeezes on their top lines as slashed prices put many firms in danger of default. Exploration and production companies tracked by the S&P Sector Select ETF saw a total yearly return of -37.5% compared to a general S&P yearly loss of about -0.8%. There's no question when it comes to deciding the losing sector of 2015, that is if investors found themselves with a long position. On the other hand, short selling energy stocks became the favorite hobby of the average trader which exaggerated losses of energy shares across the board. Valuations of those same companies became increasingly expensive as average PE ratios steadily increased throughout the year due to a deterioration of the revenue stream. To keep up, investment spending cuts were forced across the board, and some companies even shrunk their workforce. Exxon-Mobil's price-to-earnings ratio is expected to jump from its 2013-2014 number of 13.3x to an even 20x for the year of 2015. Sales for the oil major will have decreased almost -37% on the year with a -15.5% decrease in the net assets on the balance sheet. This trend will be evident throughout the oil and gas industry as fourth quarter and yearly reports begin to emerge in January.

This leads to the next problem facing oil corporations at the end of the year. How will they evaluate their assets and performance of this year to reorganize for success in the next year? These entities will see major haircuts to their size and power going into 2016, a year that will no doubt feature another bout for market share by the looming Saudis. Because companies evaluate their current reserves using a spot price based on the past year, those assets will see major devaluations even if they've seen no change from the previous year. For example, an untouched pocket of crude oil discovered in 2014 would have been valued at an average price of about $80 a barrel in 2015, but because WTI and Brent prices have plunged this year, those assets will now be priced around $50 a barrel. Thus, all of the implied wealth that was created when prices were supported by OPEC will disappear. At first, this sounds like a good thing as share prices may see a reduction in swelling that occurred during the energy boom caused by high oil prices. But then we have to remember that hundreds of millions, if not billions, of investor dollars have been invested on this conjectured wealth and could be lost like the popping of a mini-bubble in this sector. That not only heaps tons of bearish sentiment onto the energy market, but it eventually spills into other sectors that may be sensitive to the weakness. Low oil prices have also been blamed for a dramatic drop in inflation that has hurt wages and earnings across the country but failing to spark consumer spending. The economic dynamics just mentioned definitely do not line up and are causing major debates in the monetary and fiscal stages in how to fix it. The Federal Reserve will continue its goals of increasing the Federal Funds rate which has been linked to better overall commodity performance by intermarket analysis. At the same time, a drop in investment spending in the energy sector threatens the surging shale production that has caused such a glut.

So that moves us into the extraction statistics. For 2015, both American and OPEC producers increased their production with domestic oil and gas companies only beginning to pull back in the latter part of the year. During a December meeting, Saudi Arabia and Iran lead the member countries' output to new highs that was augmented by the relaxation of a 30 million barrel a day quota. In the same month, Iranian production increased 119,000 barrels to help total OPEC production jump 18,000 barrels. U.S. output remains steady at 9.18 million barrel a day for the month, barely down from the 9.5 million barrel a day peak. Various International Energy Agency reports have estimated an 800,000 barrel a day decrease in the coming year, but many analysts have already underestimated the power of cutting costs. Look at analysts this year. Rigzone cited a Reuter's survey that averaged 31 projections for the 2015 year. That result is almost $20 over the current price at $57.95 a barrel.

That's definitely one thing that took me by surprised as I constantly heard about the new analyst projection. Most, if not all, were completely off the mark with either hope of a steep recovery or fear of another plunge. With prices starting just around the $50 mark at the beginning of the year, the analysts appeared reasonable with a $8 increase projected for the next 12 months. Not crazy, but definitely positive and bullish. It's possible that the expertes guessed that spending cuts would lead to larger production cuts, and once again, they might have underestimated the power of technology in cutting costs. The shifts in market power might have also been underrepresented in the projections because of the power OPEC typically has. For 2016, similar predictions are being formed. Meanwhile, the future price curve continues to get flatter with only $5.00 separating the latest 2016 contract and the current spot price. These prices communicated by investors reflect the burgeoning bearish momentum that might continue into 2016, and it may flood onto the trading floor. As analysts gather their research once more, it will be interesting where they place their this time around.

Tuesday, December 22, 2015

Paranoia And A Change In Political Expectations

Merry Christmas! This trading week is cut short by the holidays as a lunch time closing bell is to be heard on Christmas Eve and no trading on Friday. Analysts begin to wrap up 2015 with their "year in review" articles. Retail stores hope for the last of the shoppers to trickle in and spend the extra cash they've been able to hold onto with low gas prices. The investing world as a whole looks forward to fourth quarter reports and 2016 projections. The joyous feelings appear to reverberate through the market today with all major market averages up attempting to put last week's slide behind them. Earlier in the day, both the Dow Jones Industrial Average and the S&P 500 saw large, early gains parsed down to 0.12% and 0.16% respectively. The midday drag shows just weak the crowd of sellers are in this current market. The same goes for crude oil. Larger losses were pared back to a drop of -0.20% on the price of WTI benchmarked crude oil. Major forces might be slowing down to revert back to the oscillating movement that defines periods of volatility. Until the end of 2016, waiting move will populate the trading floor as yearly earnings and economic indicators roll in. A more accentuated move of -1.46% is seen in the Euro STOXX 50 with the Spanish market plunging -3.42% as a reaction to austerity measures by the government. With the possibility of more piling debt in the European countries, tensions in the eurozone and the general European Union could be augmented in the coming year. On the other hand, Asian markets look to stabilize with gains as large as the Shanghai Composite jump of 1.77%. Long-term (10Y) treasury yields for the US, the UK, and Germany are up once again with uncertainty still lingering in the long-term. Feelings like those in the stable 1990's seem so surreal as we prepare to move into the latter half of the 2010's. Consumers and investors are not as confident as they used to be. Capital slowly shifts out of the sight of the public into a derivatives market that continues to operate almost under the radar. Every conversation is deluded with an analyst bringing that "meltdown" option even a bubble is clearly not evident. Perhaps this still plays into our investment decisions; it would surely explain a the slowdown in overall spending. In my opinion, economists should start paying more attention to the symptoms of the late 1930's which sent in through another recession after the stock bubble in 1929. Another thing that is often discounted as a real economic factor is the development of the next election in 2016. As Republican candidates continue to divide over certain issues and Trump's lead widens, conservative voters are continually being split away from a possible majority that could counter a Democratic force rallying around Clinton. As the election inches closer, business and firms will be preparing for the most likely outcome, another Democrat in office.

In match-ups with the leading candidates from both parties, polling numbers only have Cruz as capable of tying Clinton. Ted Cruz isn't even close to leading Trump on the Republican side. The shadow of another Democratic year, with chances of Bernie, has helped investment spending to slow. Increased taxes on the largest corporations would be another likely outcome with a Democratic victory as well as the possibility of government spending crowding out private capital. Financial institutions might also be under fire as ghosts of the financial crisis may be revisited with more Democratic leadership. Barack Obama's response to punishing the big banks for their irresponsible action has been tepid at best which has heated up support for Sanders' rhetoric. That's why we shouldn't be surprised that 2015 marked a record level of mergers and acquisitions with some of the largest mega-deals being approved. On top of that, IPOs for this year lagged behind their usual numbers. I think these two numbers are representations of the expectation of who will win the 2016 election, but it is in no way a prediction. Softer consumer consumption may also be a response to these expectations as well. In their opinions, investment and consumer spending drops aren't leaving holes in the growth of the economy, With prospects for higher wages and free college from either Bernie or Clinton, government expenditures are expected to fill in the gap. An increase in the savings rate can be traced to the expectation in changes of fiscal policy as well. The change in expectations that has occurred will negatively affect the business outlook for next year with small business start-ups and loans discouraged. Incentives for corporate growth and profits will be taken away, and government filler will be the prescribed solution.

Saturday, December 19, 2015

Painting Pictures Of Weakness

We saw earlier this a year in October when investors shocked seasonality trends and made October excessively bullish in nature. Energy and mining shares lead rallies that returned value lost in the August corrections. The winter months were approach with the same seasonality assumptions with a Santa Claus rally looming over the hopeful wallets of investors. Black Friday brought the first bad news with sales and traffic numbers down from last year. A drawing off of consumer confidence and consumption from earlier in the year weighed on the hopes of shoppers spending more on their gifts. December's rallies were finally dashed by energy pressure from OPEC acknowledgement and encouragement of their peak production still seeking to destroy shale producers. A quarter point rate hike seemed to be just subtitle to that the larger headline. In just two weeks from December 4th to the 18th, U.S. priced oil has dropped a stunning -15.46% with no signs of higher demand. At the same time, natural gas has fallen -18.98% in the same period has a warmer winter endangers demand for heating around the country. These two stats have weighed on energy shares which have created bearish undertones in the overall market. The uncertainty continues. The S&P 500 closes -1.78% lower as it approaches the 2,000 mark that had been crossed, both up and down, earlier in the year. The Dow Jones -2.10% slide also puts it near its significant 17,000 point level. Once again, stocks threaten to retract back to prices that reflect late August when a Chinese stock bubble popped and erased millions of dollars of wealth from major stock exchanges. Monetary institutions used that signal to boost stimulus for local economies with the Bank of Japan cutting rates and the ECB extending asset purchases to support corporate bond and equities prices in the eurozone. Meanwhile, Mario Draghi ambidextrously demands further austerity from debt-slumped eurozone economies in Portugal, Greece, and Italy. Solutions look far-fetched, and risks build up daily.

But there's no point in building up a pessimistic image because that fuels irrational investing that can exaggerate losses.

Let's look at some charts that tend to indicate the state of the market as a whole.

The common litmus test of the market of comparing the Dow Industrial and Dow Transports reports harrowing news for 2016. Looking back at late August, both averages fell to nearly equal levels with recoveries in the Transport Average (black) rallying past Industrials (blue). Typically, with transportation stocks leading, the markets perform better and show greater demand. With the rebound in these stocks more prolific, larger demand supplied the gains of the next couple months to replenish equities to their pre-August levels. It may also be worth noting the momentum and reversal indicators at both of the blue lines marking the corrections. RSI levels for August were very oversold and snapped back like a rubber band in October. Now, the same statistic is just under the midpoint. The MACD spread grew very large in just a week but also recovered in about two weeks. Currently, the MACD line continues its trend underneath its counterpart while gap widens.

Small-cap and large-cap differences describe trends with their unique reactions to weak markets. Smaller firms' shares typically respond first with their high levels of beta. These fast-moving stocks, when compared to their slower counterparts, can describe major trends before they actually happen. For example, the August correction was mildly predicted by the Russell 2000 (black) when it started to deviate from the S&P 500 (blue). That weakness halted after the turbulent losing sessions and both indices consolidated. Starting in October, though, a spread with the small-caps lagging began to widen. The current weakness has accentuated this trend with Russell losses being the more volatile and containing the most risk.

The last chart for today describes some of the fixed income choices that have been made over the past couple of months. As their labels indicated, GOVT (blue) follows a portfolio of Treasuries while JNK  (black) describes overall high yield trends.Their relationship has been rather complex through the beginning of the year with their performances not majorly impacted by the August correction. In early November, we start to see major trends emerge in both Treasuries and junk bonds; whether that is most associated with rate hikes or economic weakness, no one will ever really know. Demand for Treasuries explodes with its price rallying beyond both 50-day and 200-day averages. On the other hand, high yield bonds fall even further. With or without rate hikes, the atmosphere of the market has clearly gotten too risky for some of the most daring investors. Charts like this would discourage small business start-ups and inhibit spending from small institutions threatening to go bankrupt. One thing that is common during a recession is the tendency for consumers to retreat their spending back to large-cap producers. These are the ruts in which we have been forced into. Ruts that must be massaged out of the system in the next year. The further bearish action could bring equity values down to reasonable post-August correction levels. I would throw out 16,500 as a proposed support for the Dow. Energy will continue to weigh on stocks until the commodity problem is fixed, and that's just the truth. For those who found interest in my charts, feel free to use them for your own arguments or reports. My charts and graphs are always open for anyone's use. Check out my Flickr page for more images!

Thursday, December 17, 2015

A New Era?

After hours of deliberation, the FOMC committee emerged exhausted. It had been six hours since the beginning of what some called "the changing of an era in monetary policy." The governors now stood aside and below their public leader, Janet Yellen, as her dreary eyes blinked in front of the long-awaited press conference to announce a change in the Federal Funds rate of .25%. That's right, the price of money just recently increased from 0%-.25% to .25%-.50%, a move that left the financial sector groaning and the world, wary of overheating, applauding. In at least one article, the words "day of reckoning" were used to describe the fateful day as if they were just assembled to discuss plans for the necessary destruction of the all-powerful Ring. The Federal Reserve, known for its beaucratic leisure and quiet nature, was made out to be game-changing where suddenly Yellen has decided the fate of the economy. Arguments still exist for no rate hikes but quickly become swept away by the fervor of the new period of economics.A little gaudy, no? I, for one, am tired of the headlines this policy change has garnered as if the markets truly shifted the second the words "quarter point increase" came from Yellen's mouth. Investors, firms, and consumers had already adjusted their expectations to account for this transformation. This can be observed through the flattening of consumer spending and an increase in saving.

Years and years of ZIRP policy attempted to stimulate consumers to spend more so that GDP would grow more streneously. This occurred for a while after the financial crisis, but it soon began to slow down. Another characteristic of ZIRP policy is a decrease in the savings rate of the general population. Because savings accounts don't yield as much, consumers are less likely to put their money away because it has more value in their wallet. The relatively flat trend of savings rate growth has finally reversed to beat the previous peak of the beginning of this year. During that same period, consumer expenditure begins to soften depite its tendency to accelerate during the winter months. Are people spending less on Christmas? Or were rate hikes expected?

The same here can be said for corporate expenditures and savings. The buzzsaw movement that defines the monthly trend of capital expenditures with a negative trend showing a steady decline of the statistic over time. Firms tend to spend less when borrowing money gets more expensive or it's expected to get more expensive. Look at the drop in the beginning of 2014, here marks a new period where oscillation slowly drops off and highs get lower. During that same period, cash and cash equivalents of domestic firms begins its spike into 2015. The timing of these reversals show that expectations of firms had changed well before late this year. The analysis of these indicators could have helped the Federal Reserve notice that. Low inflation is a cause of these consumers and businesses that are adjusting for the increase in borrowing costs. If there's a reason to be surprised at the timing of this rate hike, it should be that it came so late. There's no need to pump up the importance of such a move in fancy headlines and boisterous calls of the end of an era. That end came about when expectations changed. Just look at the market's response to the move. Green numbers lead a positive rebound off of an unstable energy loss. Today, those numbers turned red as energy took back the headlines. What we should be looking forward to is how high will the interest rate hikes take the price of money? And finally, how to deal with low inflation?

Wednesday, December 16, 2015

Broken Pricing In The Oil Markets

Market headlines constantly pore over crude oil price, and how they've taken over the market. As if they had never missed a beat, OPEC's oil shenanigans came back to bite global stocks as they appear to mishandle their petroleum policies once more. The Saudis continue to push OPEC production despite all-time highs in the numbers. Member states of the cartel continue to gnaw at the heels of the Saudis while their wallets are drained by the low prices. But is OPEC and Saudi Arabia really to blame? Are the shale producers to blame? I don't think so. My hypothesis suggests a problem in the pricing mechanism where emotional investing has convoluted proper assessment of supply and demand fundamentals. In a previous article, a swift calculation was produced to show the imbalance in changes between supply and price, but the issue has become accelerated with the recent declines. Look at theses charts and notice the scales:

The dates correspond roughly to the length of the supply glut so far, about a year and a half of data. The scales were adjusted so that they most show 20% increases for each major grid line making the comparisons roughly similar. While the decline in supply is barely noticeable, the drop in WTI price is dramatic and has not let up its pace. These declines have been lead by numerous events like changes in rig utilization and reactions to a possible change in demand. Because of this, the process for determining price should be called into question. Every basic economics course discusses the role of prices in representing accurate supply and demand forces. As price increases, either the object has become more scarce and more desirable, or fewer people may desire it and inventories grow. Typically, the increases and decreases in the equilibrium when looking at the supply and demand model are relatively proportionate which has not been the case in the market for the past year. Hence, enormous amounts of uncertainty introduced a general downtrend in the market as analysts' predictions were always in such a wide range and often capricious. That left investors to do the job of finding the tops and bottoms of oil price when they had really never had that job before. Perhaps no one had realized the importance of OPEC when it came to stable pricing, but now, as the free market mechanism has become erratic and almost nauseating, the contributions from the cartel are almost missed. With power now in their hands, the price has adjusted to include smaller producers from a wide range of countries in the supply channel. My hypothesis is that without the experience and certainty of the investors in deciding how crude oil should be priced, correlations between supply (production) and demand (spot price) will be minuscule. These next hypothesis tests will be conducted in order to test my argument that correlations that should be there due to proportionate changes in supply and demand have either deteriorated or never existed in the first place. The first set of data will analyze weekly WTI spot price and weekly U.S. production over the past year and a half in order to make inferences about domestic connections. All data is from the Energy Information Administration on their official website.

The first thing to notice is the skewed distribution of the spot price data. Points beyond the dotted lines represent data that doesn't reflect the normal distribution. For spot price data, it's very evident that a right tail skew exists with a majority of the data between 60 and 40. This should be expected with the supply glut in effect, but if changes were proportionate like they should be, points should follow the red normal curve. It's important to keep this mind when looking at these tests. Next, we'll look at a scatterplot.

Here we have a comparison between production and spot price with the least squares line showing a negative correlation. Once again, one can observe the concentration of points in the range of $40-$60. Overall a correlation appears evident, but I wish to test the significance of the strength which could be significantly small. The line shows a lot of overpredicted and underpredicted points which represent times where the price should have been higher or lower. Data associated with higher production levels are especially messy and disoriented just like current crude oil trends. This shows the chaotic microcosm of an oversupplied market. Points on the more expensive spectrum, associated with OPEC control, are closer together with relatively smaller residuals. After a hypothesis test, we get a very small p-value that significantly rejects the possibility that there is not a connection. The data generates a linear regression line of:

So we are able to find a significant correlation between the two groups with a moderate strength of R=0.668. The strength is not perfect but relatively reflects what might be going on in the world of supply and demand. Looking at the slope, we observe that every $1.00 price decrease should correlate to a 12,400 barrel increase in production. As highlighted in my earlier article, that proportion seems crazy, but I fear comparisons cannot be made until we experience more from a free oil market. Looking at prices before the supply glut seems illegitimate because of OPEC control. Another argument supporting the untrustworthy nature of this model is that only 44.6% of the variability in production is explained by price. That means the model can only account for half the correlational effects which doesn't seem very strong. Nevertheless, there appears to be a correlation. For a second, though, I'd like to zoom in on the data that defines the smaller price ranges of $40-$60 which were shown to be chaotic. Notice the very weird correlation that emerges.

Wait, I thought we just established a positive correlation between these two variables? When narrowing down on 2015 data, the supply and demand curve inverts. While traditional economic theory can often be incorrect, a total inversion of the supply and demand curve seems irrational. Perhaps a more sensible explanation would be the large amount of bearish events that have caused price declines without consideration of output changes. This just furthers my argument for emotionally charged trading in the oil market.

What have we learned here today? The past year and a half, data I chose to represent the time period where OPEC control had deteriorated, shows a moderate correlation between WTI spot price and U.S. production. Residuals were evident, and data points in the lowest price range $40-$60 were the most chaotic. After zooming into the smaller range which spanned the weeks of 2015, we saw an odd inversion of the supply and demand curve which was clearly an irrational deviation of conventional economic calculation. There seems to be no doubt that the pricing mechanism is not operating like it should. While global production is certainly a confounding variable in these models, the effects are drastic. What does this information mean for the future? Let's extrapolate the $1.00 decrease with every 12,400 barrel a day which should be reversible if the correlation is relevant. As mentioned before, the IEA predicts an 800,000 barrel a day decrease of the next year. If U.S. production was to experience just half of the declines, then we could expect an increase of $32.26 in the price over the same time. With this change, WTI levels could be around $70 when not taking global oil output into account. The model seems fairly reasonable here, but still, the small amount of variability actually explained by the model calls into question its reliability. For final thoughts on predictions and validity, the law of averages may explain a stronger correlation despite higher variability. Because deviations from the average are relatively consistent, the average can still stand with both extremes pulling on it equalling. For predictions, it may not be crazy to forecast larger gains because emotionally charged buyers may irrationally skyrocket the price. The extrapolation mentioned above will never be fulfilled with perfect proportionate increases until the final value is reached; instead, erratic trading may affect exaggerated movements that eventually converge to ideal values. These are the types of outcomes I hope to see in a crude oil market that stabilizes and adjusts to its free-market status.

Sunday, December 13, 2015

Following The Leader

This upcoming week, the FOMC finally meets for the much-anticipated meeting where interest rates are expected to hop upwards. Their opening act was a terrifying slide in both equities and commodities, something that will speak loudly to dovish central bankers deliberating on the 16th. Weekly losses for some of the largest indices are those voices: the Dow Jones Industrial Average fell -3.26% and the S&P 500 dropped -3.79% over the past five trading sessions. With more bearish sentiment being activated, stocks are threatening to decline back to August correction levels. A truly harrowing prospect indeed. The Global Dow saw similar losses as well at -3.51% implying that weakness was not restricted to the U.S. Some of the most vulnerable parts of the economy revealed fragility that hadn't left. EEM, the GSCI index following major emerging market stocks lost -5.99% over the past week, almost twice the Dow Jones losses. The Russell 2000, monitoring volatile small-cap stocks, slide 5.05%. The accentuated movements of these sectors can be traced to their reactions to economic weakness that may still be a factor to consider. As a general rule of thumb, these stocks and indices may lead a broad trend because of their high beta. If their volatile patterns turn to a consistent downtrend, it may signal a move in more consistent markets. What, though, may be agitating these sectors? It is no secret really and hasn't been one this whole year. Commodity prices have been ravaged this year with losses of over 28% reported for CRB, a basket of core commodity' contracts. This week, their performance was even worse dropping -4.57% of its value. The shining star of the week, of course, was crude oil measured by both the Brent and WTI indices. On the week, the U.S. benchmark plunged a stunning -11.53%, and the international benchmark dropped -12.02%. Both reached yearly lows and approached prices that resemble the pain and sorrow of the financial crisis. Prices responded to the OPEC meeting last week, and pent up bearish emotions seemed to extend the losses. Losses from Exxon and Chevron, both contributors to the Dow Jones Industrial 30, painted major market averages red, and the color stuck. Broad-based declines appeared to be acknowledgements of the deflationary effects the supply glut will continue to have. Technically, this could be a point where oil and gas equities determine the movement of the overall market. We saw trends like this earlier in the year when crude oil really weighed on the market, and the trend could be back through the end of the year.

Some analysts are calling this the end of the 7-year bull market and could further be antagonized by a change in interest rate policy. These same analysts, though, were calling for the same thing just a couple months ago in August. It may be easy to assume that what comes way up must come way down, but that thinking can be dangerous. Gains in the past are sunk and have no major impact on the future, like a roulette game. Selling just because a "bull market" has been evident for too long is not a justified action. Instead, look above at what is really going on with the relationship to energy stocks. It has been a very common trend this year and should not be disregarded. Just as these equities are very sensitive to news, so the markets will be as well. Don't look for this trend to continue into 2016, though, because constant bad news from the oil and gas industry may soon be factored into pricing. When investors feel stock prices have been adjusted for these losses, trading will rely less on emotion in these areas. Nevertheless, a connection can be established between drastic movements in the energy sector and similar trends in the S&P 500. There is no doubt that investors have been playing Simon Says with oil and gas stocks because  the disparity in fundamentals may have been most evident there. Come FOMC meeting time, Yellen and her associates may decide that the trend
I have discussed has more relative economic implications than previously realized.

In the commodities market, crude oil is making dramatic moves that have pressed on the broad equities market. Analysis of the technical situation for WTI appears very bearish. The first thing to notice is a trendline spanning the previous three peaks on the chart. A bearish price channel can be drawn here as a continuation trend, but it seems more appropriate to show the most recent movement as a deviation from the trendline. Earliest this week, a low established in late August was broken with similar volume statistics shown by the Chaikin Money Flow indicator. The drops seem even stronger when noticing that bearish peaks have larger girth than their bullish counterpart. With the absence of smaller rebounds, the demand for the futures contract has fallen off a cliff with little hope of finding footing. Momentum and MACD crossover indicators show an equal amount of negativity surrounding the current trend. The RSI's signal that the security is oversold is less convincing than the last time that signal appeared, and the MACD line has already staged two bearish crossovers in the past couple of weeks. Prices through the end of the year will either oscillate at or below $40, continue to fall with more bad news, or increase at the sound of supply dwindling. Unfortunately for equities, the potential for major sentiment reversals is slim, and more losses may be on the horizon.

Thursday, December 10, 2015

Dead Stocks Walking

The day of reckoning is just under a week out, but markets don't seem to be focusing too much on the potential for interest rate changes during the FOMC meeting. Instead, all eyes rest on movements in the commodity market where oil has recently dropped to a 7 year low and other commodities continue their trend of low prices. WTI stooped to a low of $36.51 which mirrored levels that defined the global financial crisis. The international Brent benchmark fell to a low of $39.80, also a low for the years since 2008. On the whole, stocks are moving quite differently than their commodity counterparts as pared gains represent buying across most of the sectors. The S&P 500 is up 0.51% and the NASDAQ up 0.43%. The Dow Jones Industrial Average is up about 0.64% with gains from Exxon and Chevron leading the index. The Euro STOXX 50 also shows some growth at 0.22% for the day. As lagging in energy becomes the biggest financial issue, look for broad-based movements to follow the sentiment coming from that sector. The last four trading sessions have more or less mimicked energy investors. Two of the companies leading the small rebounds are Glencore traded on the London Stock Exchange and Chevron. Both companies reported significant restructuring maneuvers in order to fight the commodity rout. Glencore, dealing with metals, promised a large reduction in debt by the end of 2016 with a decrease in capital expenditures. Chevron, responding to new lows in oil, has introduced a 24% decrease in capital expenditures as it highlights paying its dividend as its first priority going into the next year. GLEN (LSE) is currently seeing an 8.27% increase in their stock price by about midday fighting a whopping -69.70% YTD performance, and CVX has jumped 2.70% in the same period, looking to reverse a YTD trend of -19.93%. If this isn't a hint to what commodity-based firms and energy companies should be doing, I don't know what is. Investors are looking to reward austerity measures in these industries as we have seen here today. Chevron has shown an impressive amount of intelligence when it comes in investor relations. They realize that traders will irrationally sell their stock at the sight of any bad news. In order to quell the negative sentiment, a proclamation of what the investors want to hear works every time. These capital expenditure cuts aren't set in stone; in reality, they provide a rebuttal to bearish investors that Chevron has a plan if low prices are sustained. In the situation that prices suddenly increase, they can easily reverse the changes they made with reason and new expectations for growth. In stock trading, it is important to recognize that buying and selling are not based on the present; instead, investors typically trade on their expectations. If a firm can adjust the expectations, it can improve the emotions in smaller investors looking to trade. At this point, smaller crowding can signal health and institutional buyers in the end. This process could prove to be useful for large- and some mid-cap stocks with the ability to be flexible in their cash flow statements and balance sheets. On the other hand, smaller ventures with higher debt may not be able to make such a change to entice investors. These small-cap projects with low levels of revenue and high start-up debt are named, by a Rigzone article, "zombies". Many of these entities face the real danger of defaulting on their loans if prices do not recover soon. Some of the names in the article include small firms like Comstock Resources, Goodrich Petroleum, and SandRidge Energy. And yes, there's a reason you've never heard of them because their production can almost meaningful to the grand scheme of things, sometimes as low as 10,000 barrels a day. With the absence of diversification in their plays, small-cap companies have no choice but to either produce profitably or sell their play to someone who can absorb the losses. Reuters has a great chart which describes some of those in danger. A high debt to EBITDA ratio can be dangerous as over-leveraged oil and gas projects cannot take on too much loss.

High Yield Bond ETF and WTI Crude Oil
This chart shows exactly why this trend exists. In blue, we have the all too familiar trend line showing the demise of oil prices, and consequently, the deterioration of amount of revenue from extracting the commodity. In black, an exchange traded fund following high yield bonds ironically labelled JNK is plotted in comparison. Although the categories they represent seem different, the year 2015 has brought them together. In the past six months or so, the two values have been moving together with general similar trends, but in November and December, the movements are almost the same. These "zombies" referenced above have most of their debt under this "junk bond" category where risk premiums are exceptionally high. In fact, the Rigzone article states that "at least 25 U.S. exploration and production companies are rated by Moody's at B3 or better." This rating signals a very speculative project with significant risk involved. There's no coincidence that WTI and JNK are moving together. Energy companies are leading this category of debt downwards and are in peril of crippling the small-cap group of a whole sector. In my opinion, larger corporations will start to eye these smaller plays turned "zombies" as price begins to stabilize. Once the larger corporations have saved themselves from danger, small-cap operations will be put up for sale like an auction. In the end, the supply glut is going to consolidate the oil and gas industry and turn out to be incredibly profitable for large-caps. While this may be what OPEC had wanted at first, shale technology will only get cheaper and more efficient. Depending on the advancement of climate change policy, the next five or ten years in the energy sector will be dominated by the largest cash flow statements and most adaptive capital structures.

Tuesday, December 8, 2015

Too Quick To Jump Off A Cliff

It appears most investors took more away from the OPEC meeting than expected. Once again I must take the time to explain that on Friday of last week, the member countries of the oil cartel met to discuss the possibility of price supports, but to the chagrin of the hurting resource economies, Saudi Arabia declined to even bring the topic to debate. Instead, they adjusted the official ceiling of production to meet their current known levels of daily supply additions. There was nothing new in these announcements. None of the countries declared augmentation of operations. Saudi Arabia did not even threaten to flood the earth with more of its cheap oil. The simple fact of acknowledging their current production levels sent the market into a tailspin, and when I say tailspin, I mean falling out of the sky in a blaze of glory. Major market averages are building on the losses of Monday with the Dow Jones Industrial Average down about -1.45% and the S&P 500 losing -1.18% over the past two days. The highs for these indices over the past two days are Mondy's opening price as bears totally outweigh the bulls and maybe even converting them. The largest contributors to Dow Jones losses were Chevron and Exxon-Mobil which both lost about -2.65%. A sample of oil equities shows the damage that has been done, the NYSE Arca index XOI has fallen -3.33% up to midday Tuesday. XNG, the sample of natural gas companies, fared almost as bad losing -2.92% in the same time period. -38.79%. This index is also being sold as a warmer winter is projected to diminish demand for heat. Year-to-date return on these equities has dropped to -19.8% with hopes of posting better results in 2016 sliding farther and farther as sentiment gets worse and worse. Looking at volume feed for SPDR Oil and Gas Exploration and Production (XOP) one can observe the reversal that occurred Monday, and was validated Tuesday. A -4.19% loss in the industry was accelerated by  a volume of 20.5 million. By midday on Tuesday, a tiny rebound is supported by 12 million in volume, a bearish drag of about 8 million. Comparing this major loss to losses of similar parity allows us to make judgements on how powerful this move was.

Data from WSJ
The above numbers chronicle some of the largest falls of the year for XOP, the ETF previously mentioned. Bolded are today's statistics compared with major losses that are similar as well as the crowd behind the rebound. No move this year has shown a difference in opinion quite like this one. First of all, the numbers supporting the loss were exceptionally higher, almost a third higher than the next most popular sell-off in November. While the events spurring these changes may have been different across each movement, investors have clearly denoted the power that OPEC still has in causing market swings. This reaction will only give them more hope and desire to try and affect the market more. Looking at the strength of rebounds, one can observe and conclude that today's attempt at making back lost ground was thinner than previous rallies hinting at the lasting effect of updated supply quota from the cartel. While showing that a huge difference occurred between losses and gains does not prove a permanent  downward price shift, it is certainly noteworthy when comparing against earlier performance. In my personal opinion, bears were too quick to sell here and may have gotten too emotional with they enormous losses realized in the WTI and Brent benchmarks as well as equities related to their movement. Even is supply problems have increased, energy companies are showing that improvement will allow them to succeed. This point has constantly been undermined by the capricious thoughts of a variable amount of barrels being brought onto the market sometime in the future. These austerity measures from firms are more clearly visible than theorizing about production from a Middle Eastern country, but uncertainty could definitely be part of the problem. Although I think that the "implied support" of $40 will hold up, short-term investors should definitely be aware of short selling opportunities that come from extreme reactions on the bear side. This seems like a more effective way of taking advantage of buzzsaws instead of buying low and holding on for dear life through the storm that is the oil and gas markets.

Friday, December 4, 2015

Rate Hikes And Iranian Oil

The end of the week has come and only two things seem more apparent than before: rate hikes appear to be almost guaranteed and oil prices continue to be extremely volatile. Trading for Friday shows positive movement as the S&P 500 and Dow Jones Industrial Average jump 1.83% and 2.00% at about midday. The Russell 2000, a measure of small-cap stocks, lags behind at 1.05% with stress over rate hikes more significant for them. Small cap performance has continued this trend of lagging since September 28th where, over the six past months, the S&P Small Cap 600 has fallen -2.53% versus the S&P 500's drop of -0.46%. A stronger dollar over the past couple of months has also been injurious to competitive advantage for smaller firms looking to do business internationally. After a peak on August 24th at about 1.16 USD per Euro, the support for stimulus programs from the European Central Bank has inspired a precipitous fall of -7.49% to 1.09 USD per Euro Friday. Nevertheless, the domestic economy continues to make its case for strength to the Fed as solid gains from all sectors but two (energy and industrials) reveal investor satisfaction from the jobs report. After a revision of 20,000 more jobs in October, the November report beat a consensus of 200,000 by 10,000 jobs. Payroll girth also increased by an expected 0.2% to stay on track for a 2.3% year-by-year increase. The unemployment rate remains unchanged at 5%, a comfortable level for an ideal stable economy; although, those adhering to strict business cycle logistics would predict more downside risks in favor of the traditional recurrent pattern. Despite wariness over growth of wages, investors have increased the possibility of rate hikes since a month ago. Probabilities of a quarter point increase in the Federal Funds rate have increased from 71.9% to 79.1% for the December meeting, and from 66.5% to 70.7% for the January meeting. Both recognize the chance of further downside risks that could be a result of sensitive investors still rubbed raw from the financial crisis, but these risks and investors should not be considered valid in the face of an overheating economy. Easy monetary policy (much like stimulus in Europe) has been stunted by its overuse and, if not corrected, could lead to soft spots in corporate and consumer expenditures structures. Cheap money has already resulted in a decrease of capital expenditures and an increase in consumption which had eliminated reasons for saving. In my opinion, the markets will react with more negativity to the rate hikes than if they had occurred sooner because of the "softness" in expenditures and the absence of adequate savings. Gradual interest rate increases will cause an influx of savings and a transfer of capital from equities to bonds which may limit growth projections for firms next year. The energy sector, on the other hand, may fare a bit better after supply glut problems have forced more rigorous corporate adjustments that will allow for more growth in 2016 (if prices cooperate with this narrative). The corporate adjustments include operating under less revenue and smaller margins, both of which may become a problem for companies in other sectors as a normalization of monetary policy occurs.

As the past week has been important for Federal Reserve watchers, oil and gas analysts were exposed to OPEC opinion at a meeting this week. Sentiment over potential decisions by Saudi Arabia and the rest of the member states was more mixed than ever as prices touched prices below the $40 lower bound. Member states continue to request price controls as their revenue streams are limited by their dependence on petroleum, and Iran reignites their oil infrastructure in order to enter the market. Production from the now sanctionless country could reach as high as 3.2 million barrels a day according to a Bloomberg article. On the OPEC website, production capability for the country is listed at 3.17 million barrels a day which is 10% of what OPEC members are already producing. Are these additions too much for the cartel? Actually, no. Instead of adjust production to its cap before last week's meeting (30 million bbls/day), Saudi Arabia established the current extraction rate of 31.7 million bbls/day as the new official quota even though it had already acted as an unofficial quota. As a result, supplies could jump more at the theoretical increase of the ceiling. If they could get away with producing a little bit more at 30 million bbl/day, who is going to stop them at producing a little bit over the new official quota of 31.7 million bbl/day. Member states that have previously wanted to curtail production will shift from a state of price protection to a competitive market share strategy which involves maxing out that production in order to compete for profits. Contrary to popular belief, I think the Saudis want their compatriots to think this way, discord within the cartel that melts into the larger plan of the Desert Kingdom. The International Energy Agency reported that oil demand and supply are currently offset by about 200,000 barrels a day in their Oil Market Report. They also cited the possibility of non-OPEC contributions dropping by 600,000 barrels. Moving into 2016, the oil and gas markets will no doubt see an increase in supply from Iran, but conclusions about the impact are overall very erratic. Reports coming from the country are already convoluted with conflict and deception in the region a very common thing, both economically and politically. This only adds to the struggle of other OPEC members, and investors trading the worldwide benchmarks. The ramifications of Iranian oil are difficult to quantify, but analysts continue to claim their addition as an obvious bearish factor. Indecision and opaque information have caused oil trading to become exceptionally volatile as a wide range of opinions populate investors and companies trading in the WTI and Brent markets. Buzzsaw movement is the result of these perspectives sparring each other over each piece of news. The real question traders should ask is how global supply and demand will be affected. After looking at data from the IEA, I have crafted some simple projections to consider for 2016.

Historical data and demand projections by IEA Oil Market Report
The chart above describes two possibilities that could characterize the flow of Iranian oil to the markets. The orange line describes IEA demand levels through the end of the next year. After a small dip in the beginning of 2016, demand is projected to beat 2015 levels. These calculations must take into account the global deflationary slowdown as well as tightening in the U.S. The green and yellow lines represent two scenarios, but both include a net 100,000 bbl/d increase over the next five quarters with non-OPEC sources projected to drop by 600,000 bbl/d by the IEA and OPEC members (except Iran) to grow by 700,000 bbl/d (number from Q215 to Q315 increase). In one scenario, Iranian oil reemerges on the market with 100% of their capability of 3.17 mbbl/d. This amount (minus the 1.3 mbbl/d already being produced by them) is divided evenly over the next five quarters to reach about 2 million bbl/d of oversupply shown by the yellow line. Clearly, the situation described above represents the nightmare that Iran could bring for the recovery of oil prices. Price projections would probably remain in the low $40's ceteris paribus. The second scenario highlighted by the green line has Iranian production reach about 60% of its potential capacity, or 1.9 mbbl/d, which would be an increase of about 600,000 bbl/d over the next five quarters. By the end of 2016, supplies would have only outgrown demand by 1 million, which is half of what was extrapolated in scenario one. Simplified results like these don't predict price and supply very well as much could happen on other production fronts and the IEA could be wrong on demand estimation, but this model, in particular, communicates how important Iranian oil can be in the macrocosm of global petroleum markets. As incomprehensible that Iranian policy can be, I would expect global volatility in oil prices to continue with high beta levels and a tendency to trade around the "implied support" discussed earlier. Remember, OPEC cannot control the new laissez-faire mechanism working in their market, but the large reserves and extraction capacity that defines them causes significant swings when finding accurate prices.

Tuesday, December 1, 2015

Oil and Gas Trends for 2016

And we're back! The Thanksgiving holiday winds down into the last month of the year with highlights of the Christmas season. The Federal Reserve also moves into territory for their next decision concerning interest rates in mid-December. Trading on Monday and Tuesday were both mostly flat with small losses at the beginning of the week bouncing to parsed gains on the second day of the week. Today, the S&P 500 trades up 15 points or 0.72%, the Dow Jones Industrial gains 132 points or 0.72%, and the NASDAQ up 33 points or 0.64% at about midday. The bounces seem a bit premature, though, as the ISM manufacturing index reveals a contraction (first in 36 months) in November. From October, the index fell 1.5 points to 48.6 points, new orders fell 4 points to 48.9 points, and production dropped 3.7 points to 49.2 points. The numbers look disparaging at first as one of the largest declines in the year, but looking at October's uncanny rally, November's numbers may be normalized with this in consideration. Perhaps investors are recognizing this disparity and continue to support the positive movement on the day. Around 10:00 a.m. an initial trough occurred with the introduction of the news, but upside hopes continue to define how traders act through the end of the year. Also moving downward were retail sales for Black Friday weekend and store traffic during that time. Although not an important observation, it may lend itself to an argument for diminishing consumer spending and could foreshadow something smaller over December. A WSJ report discussed both a drop in capital expenditures on the corporate side accompanied by stagnating consumer spending numbers. These kinds of reports have populated the equity and economic discussions in the latter half of the year with the August correction scaring a lot of money away from upside trend hopes. Even then, equity prices continue to be held up despite the cost of money rising, and for some, that may signal a bubble-like pattern. There will definitely be a small deviation from stocks as their return in the future is pared and bond yields begin to increase. The real question will be, from where will the capital exit and if there will be enough remaining to support the bullish market of about 7 years. On top of the worsening of the manufacturing index and an apparent outflow of capital in the markets, central bankers are coming to terms with the potential of "policy divergence" between the European Central Bank and the Federal Reserve. The two most powerful monetary institutions in the world might see opposite policy decisions as the Fed makes rate hikes a clear goal in mid-December and the ECB considers more easing this week. Investors will be looking at reactions from the dollar and euro relationship as well as export and import relationships between the two areas. Predictions are muddled by a historical eye casting a negative outlook on the prospects for divergence. In a time of global weakness, where all countries are feeling squeezed, harmony in policymaking could make the difference for confidence. But the eurozone continues to lag behind in equities markets with losses of -0.76% this Tuesday despite the possibility of more stimulus. Perhaps this is an investor response to the exhaustion of easy money policy and the irreversible fluctuations of the business cycle. In Europe where easing has been going on since the financial crisis in 2008, I refer back to my article on the complex relationship between employment and inflation. Particularly, the emphasis on the shifts of the Phillips curve due to changes in expectations should be considered as the culprit of limp monetary easing in the eurozone.

Bouncing from support to 50-day moving average
Where do oil and gas come into the big picture? Besides low oil prices being the main factor instigating the problem of lower inflation, energy firms have led the decreases in capital expenditures and overall business investments that typically lead to more growth. But, they've done this out of necessity, for the sake of their dividends and their share prices (well, what's left of them). Just last week, commodity traders traded WTI crude oil below the $40 level which had been a support over the past month or two. Near the end of last week and the beginning of this week, trading has bounced out of the brief foray into the $30's normalizing to the lower bound that had been established for a while. In today's trading session, WTI price settled -0.13% lower, but continues to maintain gains of about 6% for the week. Everytime spot prices for crude oil reach to the high $30's, a bullish recovery sends prices a dollar or two above $40. In the chart above, recoveries appear to be reaching for 50-day moving average levels as a provisional resistance point (shown by the blue circles). In my opinion, traders have anchored in their minds that $40 is the absolute support level for the price of WTI which is why the rebounds can be observed. Estimations and projections below this "implicit" support seem invalid to me for this reason. This could be attributed to the establishment of limit trades at $40 which would trigger buying and cashing of shorts in large groups. It may also be the mentality of the market, which has been formed under the iron grip of OPEC, that prices are not decided in a free market but instead are dictated by a cartel-like force. OPEC meetings and announcements still affect trading on and around the day of the event even though the member countries have lost a significant amount of market share. Countries who have been most hurt by low oil prices continue to believe in the price fixing system and continue to claim OPEC action against prices. It appears that the only country that has conceded the fact that oil markets are finally free is the largest petroleum producer in the world, Saudi-Arabia. Throughout the year, their petroleum experts have projected oil prices in the $30's, and the government officials refuse the calls for a quota on production. This puts U.S. oil and gas companies in the best position to flourish in the coming year. The same firms that have captured market share with the development of fracking are now cutting capital expenditures by millions in order to survive the glut. Something tells me their share prices are not determined by the prices of the commodities anymore.

WTI and equity deviations
It may have something to do with charts like these. The graphs above trace return from investments in WTI and S&P oil and gas ETFs over the past 60 trading days. From the beginning of the year and even before that, oil and gas companies were assumed to follow the prices of their respective commodities for appropriate valuation. This fact became well-accepted under market conditions determined by OPEC's massive market share and dictated a lot of price movement through 2014 and 2015. I think that is going to change in the end of 2015 and going into the new year. As quarter four begins to close in December, analysts and economists begin to muse about what 2016 will bring for the markets with interest rates beginning the gradual hike upward and a stronger dollar in the very near future. My prognosis for energy shares is that a deviation from their dependence on commodity prices will become evident as free market forces are realized in the sector. Firms have already seen the necessity of cutting costs in order to stay competitive, and investors are finally trading upon that fact as well. First evident at the end of October and the beginning of November, oil and gas equities have begun a deviation from WTI benchmark performance. While prices for crude oil have lost -9% in the past 60 trading sessions, S&P Oil and Gas Exploration (XOP) and S&P Oil and Gas Equipment (XES) have maintained gains of about 1% and 2%. This differs from movement in October which saw all three securities following each other. This pattern stands a good chance of continuing as oil and gas firms retain their objective of increasing competitive advantages in the industry while other sectors might not have the same incentives to do so. While employment in the sector has been hurt, necessary investment spending cuts have been paired with aggressive marketing and negotiating in order to preserve decent revenue levels. With futures contracts showing projections of higher prices in 2016, the sector could become a winner even as overall market predictions have been lukewarm. Long-term positions in solid mid- and large-cap stocks are the best ways to capitalize on this trend, but investors should buy now and buy low to establish the most price security in their equity choice.