Sunday, November 13, 2016

Chart of the Day: OPEC Price, Output, and Revenue

While doing some research for my book earlier this month, I came across an interesting graphic created by Dermot Gately in his paper "Lessons from the 1986 Oil Price Collapse." The chart provided a useful perspective on the equilibrium price of a barrel of oil during a period where OPEC sought to control the price by cutting production after it fell to lows in the 1970's. Revenue levels for the oil cartel declined to almost $50 billion endangering the health of many economies that relied on its natural resources for survival.  As more members began to feel the pain of tighter trade balances, more support for a supply cut forced the hand of the swing producer, Saudi Arabia. The price control worked until 1986 when prices crashed again.

From Gately's "Lessons from the 1986 Oil Price Collapse"

Gately's chart plots output, price, and revenue on a graphical space that can be pictured as a curve in three-dimensional space, but, for informational purposes, it relies on level curves to make its point. The display is also set up to reflect the structure of a standard supply and demand graph with price on the y-axis and output on the x-axis, and this allows us to theorize about an equilibrium if the data provides some structure to the behavior of the market. Because OPEC acts as a cartel with quasi-monopolistic powers, plotting its output alone is sufficient. 

At first glance, I noticed that the behavior of the OPEC output movement appeared cyclical from 1970 to 1986. With the exception of a kink in the late 1970's, the trend in the market appears to mirror a positive feedback loop in which price and OPEC output respond to each other's movement with revenue level accelerating the shifts. As prices grew from 1973 to 1974, OPEC kept output levels high to take advantage of higher revenue. In 1980, prices peaked after the global supply of oil had grown from the growth of production in North America and OPEC. In response, the cartel attempted to cut production to cushion the fall to a low in 1986. Prices would bottom out later that decade and, encouraged by low revenue levels, OPEC would add to output in anticipation of a higher equilibrium price. Saudi Arabia's data reflects the same kind of trend but with more inelastic output changes. From 1970-1973 and 1980-1985, the Middle Eastern nation had the most flexibility in its output policy. The years following the shifts in production were defined by dramatic moves in price suggesting that OPEC's swing producer had an enormous amount of control over the pricing mechanism. Although, is was still susceptible to the cyclical trend because its government relied on oil revenues to keep the country operating.

But 1986 is history, and if one reads more and more about the behavior of 20th century OPEC, it becomes quite predictable amidst the countless number of regional conflicts and price control tactics. Using the behavior in this period as a predictor of what should or could happen in the most recent oil glut of 2014-2015 has proven to be useless. This is most likely caused by the growth of non-OPEC supply, particularly the North American shale producers. Nevertheless, OPEC actions still have some effects on the markets, but, overall, the effects are muted. To investigate the fundamental picture, I recreated the chart above to track the movement of price and output in relation to revenue from 2000-2015 using Gately's style.

Based on price data from OPEC's Statistical Review adjusted for inflation and exchange rates and daily output figures from the Monthly Oil Market Reports, I was able to map the two series over some revenue isoquants calculated by multiplying price and output together. The behavior that is observed between 2000-2016 is very different from that of 1970-1986 with a circular figure turning into a curve that appears to trend linearly over time (as shown by the purple trendline). We have a gradual increase in OPEC output accompanied by a quasi-proportional increase in the price of oil up until 2008. The financial crisis occurs producing a slight deviation from the trend which reaches its peak, in both price and output, in 2012. Based on a linear regression analysis, we can develop a theoretical supply function that appears to define OPEC price policy from 2000-2012. So have we observed a deviation from the monopolistic behavior we saw in the previous graph? Not exactly.

The oil cartel is taking advantage of the inelastic qualities of petroleum demand to secure the best price for each barrel they produce. Because OPEC member nations need to reach these higher revenue levels to support the growing costs of government and higher rates of inflation in the 2000's, they seek to optimize policy to be as far right on the supply function as possible. In order to do this, OPEC made use of the regional conflict in Iraq and demand growth in emerging economies to achieve its goal, but there would be residual consequences. Remember how higher revenue levels would accelerate the trend in the opposite direction as producers seek to maximize output to reach even higher revenue levels? Well, the trend of price leading up to 2012 sparked a new set of producers to optimize and, in the end, flourish. North American shale producers reaching untapped reserves and pumping them quickly challenged OPEC for its market share causing the green line to drop to where the awkward looking 2015 data point falls. Here, the market has changed as OPEC's monopolistic powers are threatened by this surging source of output. This new competition can be modeled by a shifting of the purple supply curve so that to intersects the 2015 data point. The oil cartel now has less control over its revenue streams.

The new pricing mechanism in the current market will not allow a trend like that of the early 2000's to develop. For that reason, OPEC has been wary in trying to influence the market with an output freeze (or an outright cut). While that cut in the 1970's would have supported price, one in 2016 would be met by an increase in North American shale output. Saudi Arabia hinted at this shift in power when it announced a sale of 5 percent of Aramco stake in the U.S. markets with the goal of financing an investment fund that would reduce the country's reliance on fossil fuel income in the long run. Suddenly, OPEC looks useless despite calls for action by investors have suggested otherwise. At the moment, only a Saudi Arabian-Russian agreement looks to have any major effect on the price of oil, but based on economic circumstances in both countries, neither can risk a drop in output being negated by an increase in North American production. In the end, I see OPEC countries being forced to come to terms with a new oil market. After all, renewable energy is getting cheap, and there is clearly a global preference for those energy sources.  

Friday, November 4, 2016

Normalization Versus Rate Hike Policy

The steadfast Federal Reserve is at it again. After a meeting on November 2nd, the committee of ten concluded with the federal funds rate and the discount rate held steady at the status quo. In the release, they say that “the case for an increase in the federal funds rate has continued to strengthen,” but of course, confidence wasn’t strong enough for the economy to off of low-interest rate life support. Three hesitant words stuck out to in particular: the labor market is expected to “strengthen somewhat further,” economic activity well grow “at a moderate pace,” and market risks “appear roughly balanced.” To me, these filler words indicate that the Federal Reserve recognizes the signs of a cyclical peak and seeks to diffuse tension in an economy that is moving flatly. The S&P 500, Dow Jones Industrial Average, and Nasdaq indices are trending at all-time highs, valuations continue to rise, and economic numbers paint an ambivalent picture of the economy. It’s not hard to conclude that we’re reaching a cyclical top after considering the fact that a seven-year bull market has pushed us to this top.

During a bull market, central banks typically raise interest rates to keep in check a rising level of inflation, but the Great Recession lead to a recovery that suggested typical monetary policy should be abandoned. Instead, policies like global quantitative easing and cheap debt were held in place to support a recovery. A divergent strategy has forced the Federal Reserve, along with the rest of the world’s central banks, into uncharted waters where it elected to keep the status quo. Companies liked that, but weird things started happening with inflation. An oil price shock caused half the world to develop symptoms of deflation, and rate hikes in this scenario would only hurt world markets.
Needless to say, the Federal Reserve finds itself in a very “un-normal” position where it must protect investors from a bubble while also shielding the economy from deflationary pains. In order to do this, the FOMC committee has elected to move in the direction of a “normalization” policy. When I first heard this term from one of the Fed member’s speeches, I just assumed “normalization” meant “rate hike,” but there is a distinction between the two that the Fed has intentionally signaled. While both involve increasing interest rates, a rate hike policy has a bearish connotation that suggests an abrupt shift in rates while normalization implies a more neutral move towards a clear target indicated by the central bank.

The key driver of the use of “normalization” language is the lapse in the recovery of inflation after the Great Recession. The chart above shows how a series of three periods of quantitative easing lead to a decline in the inflation rate from 3.77% annually in 2011 to -0.20% in early 2015. The FOMC first signaled that inflation was not where it wanted to be in the release following the December 2012 meeting by saying, “Inflation has been running somewhat below the Committee’s long-run objective.” Ever since then, the issue of inflation has risen to the top of the Fed’s list of priorities and has consistently been the reason why rates were held low. “Normalization” is the “solution” to this problem of nagging deflationary pressures, and I say “solution” carefully because this policy only works if markets respond the right way.

As evidenced by USD and Treasury yield movements at the conclusion of an FOMC meeting, investors like to jump the gun when it comes to reacting to a monetary policy updates. Normalization seeks to avoid the volatility associated with these movements, so the Fed acts in an extremely slow manner. In fact, they will set medium-term plans for the next three year and purposely act slower than what they projected. For example, projections from the December 2015 meeting suggested that four rate hikes would be a plausible way to move forward in 2016. Seven out of eight meetings later, the Fed has yet to raise even rates even once. In doing this, the Federal Reserve is manipulating expectations so that investors trade like four rate hikes are in play. When the meetings actually do come around, expectations are gradually dropped and the markets perceive the lack of rate hikes as accommodative policy. When rates are increased in December 2016, the markets’ reaction shouldn’t be decisively bearish. “Rate hike” policy suggests that markets should expect a rise in interest rates, and the Federal Reserve will follow through on these intentions. This distinction is necessary if a 2 percent inflation target is to hold any legitimacy. Only through normalization policy could the Federal Reserve massage inflation rates to their liking; a clear rate hike agenda is deflationary and would yield different results.

An agenda that is contractionary on purpose would be very dangerous in the current global monetary condition where central banks across developed and emerging economies have failed to move in a coordinated manner. The BIS released the charts above showing how central banks have been forced to respond to local inflationary effects. In Europe and Japan, negative yields have been introduced to combat stagnate growth and deflation while developing countries like Brazil, Colombia, South Africa, and India have set rates higher to tame inflation rates above the respective bank’s inflation target. This environment differs drastically with the coordination that was required to repair the damage of the financial crisis. If the Federal Reserve chooses a “rate hike” policy which could upset measures being taken in countries troubled by deflation, it could send negative shockwaves in the foreign exchange and capital markets. Adopting “normalization” would put the Federal Reserve more in line with foreign central banks who are attempting their own forms of careful normalization, and consequently, would calm volatility in equity and bond markets that is being caused by shifting investor expectations.


The Federal Reserve has shown its preference for normalization policy by choosing the appropriate signaling and maintaining global monetary coordination. Going forward, the Fed will deviate farther from rate hike policy by ensuring that the differences in timing are evident. In May 2015, BBVA published some interesting research on timing differences in normalization and tightening (rate hike) policies. A comparison of “past tightening cycles” shows that the length of low rates and the expected length of tightening period is projected to surpass the five other cycles that have occurred in the past 35 years. According to basis point per month calculations, this cycle of “tightening” will occur 31 percent slower than the slowest cycle in 1999. These numbers were published in 2015, and since then, the actual rate of increase has been about 1.3 basis points per month. Even if the Federal Reserve had held to its policy projections in December 2015 (25 basis point increase in Dec 2015 and four 25 basis point increases in 2016), the basis point per month increase would be 6, significantly lower than what investors expected at the time of this paper’s publication.

With such a clear difference in the uptrends of these tightening cycles, it seems clear that the Federal Reserve is trying to implement a different policy framework. BBVA even identified this shift toward tightening suggesting that “’normalization’ is defined as an increase in the Fed funds rate at a point when monetary policy could be assessed as loose.” Even if Janet Yellen and her FOMC cohorts have successfully aligned expectations, coordination, and timing with a policy considered “normalizing,” can we be sure that it will work?

There’s really no way to tell. Markets only have one rate hike under their belt, and that instance led to a sell-off at the beginning of 2016 that threatened to turn into a full-on bear market. Expectations say another 25 basis point rate hike is in the cards for December, so will a similar reaction greet 2017? Once again, it’s a toss-up. One year ago oil prices were significantly more volatile, but the UK had not left the European Union. Growth rates in the United States appear to have stabilized with the most recent GDP figure of 2.9 percent surprising positively, but the Eurozone and Japan had sunk deeper into negative interest rates. The economy is no replica of what it was a year ago, but only a few structural shifts make it distinct.

As far as predictions go, I see a rate hike in December confirming the Federal Reserve’s commitment to “normalization” rather than “rate hike” policy. In that meeting, it will project another three or four 25 basis point rate hikes in 2017, but, like in 2016, that will be an overshoot of its actual path. If markets respond bearishly to the December hike (like this year), the Fed might squeeze in two 25 basis point but one is more likely. If the economy shows improvement and earnings season at the end of 2016 isn’t a total bust, we might see two to three rate hikes. However, the amount of rate hikes in 2017 will always be at least one less than what is projected. This is essential in case the FOMC committee needs to pull out a “bullish surprise” of holding out one meeting so as to avoid any contractionary moves.

Monday, October 10, 2016

Italy Industrial Production and Chaos Theory

Yes, I'm eating spaghetti today for lunch in honor of Italy's second straight month in a row of beating industrial production expectations. A positive trend in this industry will bode well for President Renzi's hope for the passing of his constitutional referendum to pass next week. In August, output rose 1.7 percent, a positive surprise over the -0.1 percent expected. In July, expectations were also beaten with a 0.7 percent jump. Such meager statistics are not trivial, for those who doubt my need for celebration, as any positive growth trend is critical in a world that has been deemed "low growth." This will be especially true for the ailing Italians who have been in perplexing economic and political positions for some time now. Renzi's cut in corporate taxes will hope to rectify business sentiment that has drifted with low growth. GDP of the ninth largest economy in the world has stagnated over the past four years with growth finally positive midway through 2014. But, in June of this year, GDP movement fell flat. So you'd understand why a spaghetti dinner is appropriate, and it might not be the only rejoicing meal either.

The STOXX 600, composed of major European stocks, posted healthy gains of about 0.7 percent today. The Italian stock exchange, with the largest overall increase out od European exchanges, led with gains of 1.38 percent gains. The short-term euphoria helped by good feelings in Italy was mostly caused by new highs in the crude oil market. WTI and Brent prices are both up about 3 percent on the news that Putin might actually cut production. Spaghetti? That news warrants an entire pan of lasagna. ENI's investors are certainly taking a slice as they watch their shares in the largest Italian oil and gas company grow by 2.33 percent. The stock is reversing a month-long downtrend in favor of a five-day gain of over 5 percent. This growth, not particularly driven by technicals, could continue in response to more catalysts, especially if a higher oil price remains in play.

But we didn't come all this way to talk about Italian energy stocks. After all, Total , BP, and Royal Dutch Shell account for most of the sector's movement in European stock indexes. The same could be said about Italy and its economic woes. The world, and really Europe for that matter, should be large enough to make up for weakness in a small branch of its hierarchy. At some level, this kind of compartmentalization helps us diversify and avoid risks that made the 2008 crisis so deadly, systemic risks. Already seen by the Greek example, debt-burdened countries see softer growth and political destabilization both of which lead to recession and financial collapse. These risks and uncertainties are relatively compartmentalized and only send small shockwaves to its closest trade partners. Italy is the next economy under the microscope and many see its weaknesses secular to the domestic system. Instead, analysts prefer to pick apart events like Brexit which appear to pose a larger systemic threat, but the impact may be overstated as the status quo is likely to remain.

Italy's debt to GDP ratio has risen by over 30 percent since the financial crisis struck in 2008 and the beginning of the low-interest rate environment. The proliferation of cheap corporate and sovereign debt bogged down major developed economies like Japan, Ireland, Portugal, and Italy which saw this credit growth as the only way to stimulate growth coming out of the Great Recession. Whether or not that is the case, risks within the economies aren't as compartmentalized like they should be. Instead, this risk has been transferred to the European banking sector. This year, headlines lamenting the performance of financial firms within the eurozone have caused investors to be wary in the bond and equity markets. The STOXX Europe Banks index is down over 25 percent year-to-date. But why have I jumped from an Italian debt crisis to weak European banks?

In chaos theory, the butterfly effect is summarized by the quote: "It has been said that something as small as the flutter of a butterfly's wing can ultimately cause a typhoon halfway across the world." The incredulity of such a claim is only overshadowed by the monstrosity of a chaotic system. In these systems, the initial condition means everything as a tiny tweak in that condition could translate to an amplified effect later on down the road. Financial systems are no different with millions of minds and trillions of dollars connected by a web, not unlike the spaghetti I eat. Economists and financial analysts can worry about macroeconomic events like Brexit and a shifting price of oil and make decent observations about the economy, but in chaotic systems, this analysis is often not good enough. And that's often the problem with financial interconnectedness, there are too many factors to begin with.

Recently, the weaknesses of Deutsche Bank and other European banks have been in the spotlight. Their profitability has run low and negative bond yields ultimately threaten the profit margins of the financial institutions that rely on them for safe assets. As a result, these institutions have fled to higher yield securities like corporate bonds and risky sovereign bonds. The web has been strung. Now these banks have left themselves exposed to riskier underlying assets in an environment where equity valuations are high and government debt is growing (especially in those countries with higher sovereign bond yields). The bank stocks may have supported their bottom line, but implicitly, their assets make it riskier. Although, this isn't exactly clear to the plain vanilla investor. In June, the IMF released a report on a stress test of the German financial sector. The analysis revealed that Deutsche Bank has heavy exposure in the sovereign bond market, and later on, the same paper suggested that the bank is one of the most "systemically important" institutions with regards to interconnectedness.

Through that channel, a weak Italy could explode into something bigger, helped by the size and complexity of Deutsche Bank's dealings. I do not suggest that a slow Italy will break the system, but by the tenets of chaos theory, lower sovereign bond valuations will create a weaker DB portfolio. Questions regarding the bank's financial health are systemically dangerous (as indicated by the IMF). So yes, celebrating a minor recovery in Italy is warranted. Similar celebrations would be appropriate for improvements in Portugal, Ireland, and Greece, all countries which, domestically, show compartmentalized weakness, but are often not considered to be a systemic threat. But, it is important to acknowledge chaos theory and recognize that even the smallest change can be relevant. If you're still unconvinced, rewind to 2008 and observe what a small increase in mortgage defaults

Tuesday, August 30, 2016

Preparing for September

Last week ended with another heavy statement from the Federal Reserve Chairwoman, Janet Yellen, addressing her fellow central bankers at an annual conference at Jackson Hole. Her words, "In light of the continued solid performance of the labor market and our outlook for economic activity and inflation, I believe the case for an increase in the federal funds rate has strengthened in recent months," were enough to inject a small dose of volatility into trading on Friday. Equities which had grown earlier in the day weakened in later trading, and the dollar jumped against foreign currencies.

from WSJ
Trading opened the week with Yellen's remarks in mind and a fresh batch of economic data in the morning. Income and inflation metrics met consensus estimates with earlier estimates revised slightly upward. Personal income and consumer spending inched upward in the last reported month showing signs that the economy has begun to stabilize, but a small increase will fuel pessimism surrounding third quarter results in a couple months. Consumer goods and services should be wary of a flat consumer consumption growth, and utilities will have the edge. Sluggish prices also fuel the slow growth trend that the Fed will reconsider in September. A "lower for longer" oil scenario translates to a limp PCE index which could discourage any hawkish action by the Federal Reserve during the next meeting. An inflation target of 2 percent looks very lofty when looking at yesterday's numbers. According to projections in June, PCE inflation should be at about 1.4 by the end of 2016, but the current reading of 0.8 suggests a pessimistic outlook. On the other hand, Core PCE is on target to meet the Fed's projections of 1.6. Most sections of the economy appear to be moving fine which supports Yellen's comments on Friday. Perhaps the most troubling numbers are personal income and consumer spending which appear stagnate. If more optimistic data supported a growing consumer, then a low rate of inflation wouldn't be as dangerous.

Inflation could be supported September when OPEC meets for the second time to consider an output freeze. In the last meeting, a sanctionless Iran ruined any hopes for a deal when it asserted that it needed to resume production to pre-sanction levels. After a couple months and a 600,000 increase in Iranian output, OPEC members will try again. Investors initially traded the news bullishly, but losses on Monday and Tuesday this week suggest that most don't think that a deal will go through. The pessimists have a good reason to doubt the chances as well; the current state of the oil market is bullish for countries and companies looking to produce more. OPEC's own monthly reports have set the scene perfectly with updated data.

  • Spot prices are significantly higher 

Every major crude oil spot price is trading higher over the past couple of months. Brent crude and the OPEC basket price have gains over $1,00 higher than WTI crude oil suggesting the international oil market may even be more balanced than the U.S. market despite the output freeze failure. The members' own price metric has grown the most according to a percentage calculation implying their situation may be improving faster. If an output freeze couldn't be negotiated at April 17th prices, then a deal in September will be unlikely especially considering an end-of-the-year target around and above $50 a barrel for Brent and WTI.

  • Oil consumption estimates and projections are bullish 

Monthly reports gauged global oil consumption as higher in August than in April. For the month of April, world growth in consumption was expected to be 1.2 million b/d for the 2016 year, but four months later, the same number came in 30,000 barrels higher at 1.22 million b/d. The increase is not enormous, but it asserts a positive outlook on the demand side which will bolster more production from OPEC members. The report upgraded demand estimates for North America, Europe, Africa, and India. The important players are India and Africa as they will be major sources of demand growth in the near future. On the other hand, Chinese demand was revised slightly lower along with Latin America which had the largest decline. A source of concern may be China's flat demand trend. The Asian giant is a neighbor to many OPEC members, and thus, has become their biggest consumer. A strong China is necessary for the cartel's survival. Oil product markets also looked to be heating up in some areas of the globe. In the United States, the product markets showed more demand which could bolster OPEC exports. Asian markets, though, appeared to weaken. This bearish concern may outweigh U.S. product demand strength in the long run.

Since the oil market is turning in their favor, participants at September's summit will be less likely to conclude with a deal negotiated. Yes, revenue streams are still pinched, but the small amount of breathing room that the market has allowed will send producers into a wild-goose chase for more market share. The competition could threaten the survival of the oil cartel, in the long run, a death that would shake the global economy to its core. With two important meetings in September (Fed and OPEC), the month has the potential to instantly shift the current market trend in either direction.

Thursday, August 25, 2016

Does Iranian Oil Still Matter?

With a crude oil rallying looking to end out a hot summer, investors will be focused on OPEC supply reactions that will develop over the next couple of months. At the end of last week, WTI contracts are trading up 9.16 percent over the past month posting a year-to-date gain of 11.04 percent, and Brent contracts are up 9.55 percent and 14.58 percent respectively. Worries that a glut still remains have subsided, and instead, investors have piled behind a rally off of all-time lows that were seen at the beginning of the year. Now, eyes are on producers to see how they will react to the higher prices.

The rally came after seven strong bullish trading sessions that were supported by reports of an OPEC output freeze in consideration and a surprise 2.5 million barrel draw on inventory last week. Prices jumped from lows near the $40's into territory well above both the 50-day and 200-day moving averages. Volume was not as strong, but the clear direction of the trend did not lack conviction. We're now at a bit of a resistance where bullish traders have backed off, and the bears have taken control. With relatively bland data coming from North American producers, investors should keep their eyes on production totals from their counterparts in the Middle East. Bolstered by a slightly mitigated glut, OPEC members from that region have continued to pump at higher levels hoping that an increase in fossil fuel consumption will make up the supply difference. Although, reports of a September output freeze in the cards has done enough to convolute the fundamental picture and any rational sentiment. The spotlight will, once again, be pointed towards OPEC's swing producers, Iran and Saudi Arabia, two nations which couldn't put aside their geopolitical difference to arrive at an agreement. In just under a month, the biggest oil producers in the world will come to the table once again, and the hopes for a freeze reside in the unstable relationship between Iran and Saudi Arabia.

The question that most people have going into the September meeting is whether Iran has enough pull to influence the proceedings. There's no doubt that Saudi Arabia remains in the saddle, but the Iranians have the most availability capacity as they continue to rebound from the sanctions that were just lifted at the beginning of the year. Since then, monthly production figures have grown almost 300,000 b/d which makes Iran's output the fastest growing in OPEC. This fact made an output freeze in April all but impossible despite Saudi Arabia's desires to come to an agreement. With Iranian production returning to pre-sanction levels, the nation's available capacity has shrunk. Thus, volatility in output figures should fall in tandem, making an output freeze deal more likely if other OPEC members can cooperate. Countries like Nigeria and Venezuela might show more resistance as their governments, like Iran's, are strapped for revenue and slightly higher oil prices would relieve some financial pressure if the output, at the very least, remained stable. But that shouldn't dim the outlook much, in the end, Saudi Arabia has most of the power. However, Iran will once again be in the spotlight as its fundamental position is brought into the foreground. Investors need to pay attention to updates on its oil output there in preparation for the upcoming OPEC meeting.

Unfortunately, statements from the Iranian government have suggested a dim outlook for the September meeting. The Wall Street Journal reported that Iran said "it doesn’t expect that its production will have risen to the levels the country" and "it needs to justify cooperation with its rivals." Officials say that production would have to breach the 4 million barrel a day level for they would consider cooperation. In reality, this output goal does not appear to be achievable in the near-term, and definitely not by September. Naturally, an output freeze should be counted out, but Saudi Arabia's sway should never be counted out. If a freeze is a necessity, the combined power of OPEC members without Iran would have enough production to influence the global markets. But in allowing Iran to successfully resist, the cartel is endangering its own existence through moral hazard. Nations in monetary distress would feel hard done by and be quick to nominate themselves for an exception. Estimates from suggest that Iran would need $70 billion in foreign capital to increase its production to its 2021 target of 4.8 million b/d. In the end, Iran's target bring low, steady growth in the long run, a plan that wouldn't be significantly interrupted with a short-term output freeze.

News of oil swaps between Iranian and Russian energy companies might also be disturbing to OPEC going into September. As the largest oil and gas producer in the world, Russia has the potential to undermine any production moves made by the oil cartel. According to Mehr News, the swaps could include a capacity of up to 150,000 barrels a day with the opportunity to increase natural gas trade by a third as well. The Iranian government implemented these plans in order to rehabilitate energy exports which had fallen during a period of trade sanctions. In the first five months of 2016, Iran's exports have grown by 1.4 million barrels a day with hopes of growing above 3.0 million barrels a day in the coming months. Growing exports don't necessarily mean more production, but it certainly means more oil, whether stored or pumped, will reach the markets. A joint deal with Russia will put pressure on other OPEC members to secure their own buyers. Market share has definitely become a real issue as China's growth begins to level off and U.S. oil is allowed to be exported. These concerns will be in the mind of minor and major OPEC members alike and might have enough sway to diminish hope of a freeze.

Iran's recent policy changes and production trends don't bode well for an output freeze in September which will be bearish for oil through the end of the year. North American production has started to stabilize to a less volatile equilibrium point which might do little to move energy futures in the latter half of the year. In fact, OPEC's meeting in September might be the last event for a major crude oil trend shift before the election in November. Speculation before the meeting next month will most likely boost oil, but investors shouldn't be fooled by this peak. If fundamentals are stable, oil will remain in the $40's through December barring any "black swan" event.

Tuesday, August 2, 2016

Oil is Going Down Again

After a rough first quarter for oil in 2016, spot price trading has shown reduced volatility compared to the past year and a half. Supply movements have been relatively unsurprising in North America and other oil exporting nations. After the failure of the output freeze, OPEC's role changed from market leader to a market reactor waiting on true supply data to affect commodity traders. For the WTI spot price, a range of $40 to $50 developed with hopes of an upward breakthrough during the bullish summer months. June and July have passed and a different trend has set in. In its July meeting, the Federal Reserve was faced, once again, with tanking crude oil spot prices weighing on inflation. Now, August has come and oil is looking to break through a floor of $40. The EIA has revised their WTI projections from $48 a barrel by the end of 2016 to $44 a barrel. So why has this summer been so tame?

Based on data from the past five years, crude oil prices tend to peak in the first two months of the summer with refineries operating at full capacity. In 2015 and 2016, we're seeing deviations from this trend. Last year, volatile pricing was caused by a trend of climbing domestic production which overcame refinery inputs. This year, domestic production is stabilizing if not falling, so increased refinery utilization should help demand and reduce supply, but the WTI spot price hasn't responded accordingly. The average difference between the price of the first and eighth week during the summer over the past five years was +$0.53, in 2016 it was -$4.56. This deviation has troubled analysts who expected more bullish sentiment to be coupled with shrinking output.

Falling input prices have translated to even lower regular and diesel gasoline prices during the
summer months. The 2016 trend deviates from the usual pattern of high gas prices due to more demand from the summer driving season. In fact, the 1st to 8th-week difference in 2016 is larger than the past five years. Why is that? There are two sides of the coin to consider, the supply and demand side of the pump. On the demand side, 2016 transportation consumption remains strong and is already outperforming the previous two years according to the EIA's Monthly Energy Review. Compared to the first four months of 2015, petroleum consumption this year is up over 200 billion Btu. Therefore, supply-side factors can be assumed to have made the biggest impact.

Record high crude oil stocks have been the most bearish factor weighing on the price of oil. Initially, firms hoped that inventories would start to recede with less domestic output in the beginning of the year, but that wasn't the case. As soon as analysts started to see a reversal in upward crude oil stockpile trends, domestic production stopped falling. Going into the summer months, oil companies were faced with a rebound in spot prices, but inventories that have never been seen before. Typically, investors can expect a strong draw on stockpiles over the summer months with refinery inputs at their highest, but this year may be different (as it was last year). In fact, supply estimates for the last week of July reported an increase in crude oil stockpiles, weighing on the bulls.

The truth is, downstream trends could be having a larger effect on supply issues than producers. In 2015, we saw crude inputs rise well above 2014 levels as crude stocks grew with the oil glut, but that phenomenon did not carry over to this year. Crude oil estimates for this year have been in line with last year's even though stockpile estimates were much higher. What does this mean? For the first time in years, the U.S. upstream sector is outrunning its downstream sector which, previously, required imports to satisfy the refinery input demand. This summer, fully utilized refining operations are over-supplied and this is causing prices to fall on the producers' side. A bearish summer will force price expectations for the winter even lower as the maintenance season reduces weekly crude oil inputs.

The flood on the input side of the refinery is causing drivers to be flooded with cheap gas. Weekly motor gas production estimates have reached five-year highs. U.S. firms have maxed out downstream operations because it has become significantly cheaper to operate with growing from the transportation sector. As a result, gas prices dropped the faster this summer than the all of the past five summers. After growing to about $2.30 per gallon, prices at the pump plummeted back towards $2.00 a gallon with the EIA only projecting a rebound to $2.16 by the end of the year. The Short Term Energy Outlook forecasted summer prices to average $2.25 a gallon. The maintenance season should help stabilize prices around $2.15, but high finished motor gasoline production will persist to the end of the year.

After a seasonality analysis of the first two months of the 2016 summer, here's what we can expect:

  • By the end of the summer, a smaller draw on inventories or possibly a surplus if production increases.
  • Crude oil inputs to remain in line with last year's summer peaks
  • Motor gasoline production to peak higher than last year or follow in line with transportation consumption to show modest growth
For energy traders following WTI and regular gas prices, these three points will prove to be bearish factors in August and the fall. Rotary rig counts for June show that U.S. producers are beginning to increase their drilling activities after adding 10 active rigs in that month. If you think that the supply picture is continuing to improve, that is not the case. In fact, firms who have cut unconventional costs will find it profitable to produce at prices as low as $40 a barrel. When the industry finds this is possible, the glut will reemerge and weigh on prices more permenantly.

Wednesday, July 27, 2016

What Solar Impulse Means to the Energy Sector

Today is a big day for solar energy as the world's first solar-powered airplane completed its circumnavigation of the globe. The journey marked the first time a plane has circled the globe without the need for fuel. Solar Impulse 2, the name of the craft that made the trip, was flown over 21,000 miles by two pilots rotating in the cockpit. After layovers in five different continents, the lightweight plane landed where it started in Abu Dhabi. Despite being wide than a Boeing 747, the solar-powered craft weighs only 5,000 pounds according to WIRED. Four 17.4-horsepower motors account for most of the weight, but when equipped with 17,000 photovoltaic panels, the machine becomes capable of flying at an average speed of about 47 mph. Yes, this plane is still painfully slow, but it introduces renewable energy potential to the air. The motors generated well over 10 MWh of energy an impressive feat that compares to some systems on the ground. Proving that energy can be successfully created in transit while propelling a weight through the air safely will boost the prospects for solar air cargo and even solar commercial flights.

Some big names in business flew behind the two pilots in their grueling journey that lasted well over 2 months. Google, the tech-savvy search engine, supported the project as an official partner. The firm helped promote the flight with the assortment of Google platforms such as Google+ and Google Earth. In fact, the pilots took part in an occasional Google Hangout as a way to generate buzz on social media. In addition to multimedia support, Google provided some financial backing. Nestle's research segment provided dietary support as they were responsible for feeding the pilots for the entirety of the journey. Covestro, one of the world's largest polymer companies, showed their support by designing and constructing the lightweight systems on the plane. The German energy giant, Siemens, used its engineering technology from its PLM Software branch to optimize the design of aircraft. Most of these companies stood to gain nothing from the completion of the historic feat, but individually, their contributions could be indications of their involvement in the future of solar flight. Covestro's interest, for example, might go beyond social responsibility as lightweight materials will be a necessity as this technology continues to develop. It is also interesting to note that three mission partners came from the booming renewable industries of China and India, two countries which will account for a major share of renewable energy growth in the future.

So where from here? Obviously, the only direction is up (literally). Like Wilbur and Orville's first flight at Kitty Hawk, Piccard and Borschberg's feat will revolutionize the aerospace industry and encourage developments in this renewable energy niche. The flight of the Solar Impulse 2 speaks especially to progress made in the quality of photovoltaic panels. The company that supplied the technology, SunPower Corp, has a lot to be proud of as the successful journey will become a milestone in its photovoltaic development going forward. Participation in this project should catapult the solar company to new opportunities in solar-powered aviation in the future. In the same way, Covestro's lightweight polymers will be invited to the party that is not too far away. Another interesting company to mention amidst the celebration of Solar Impulse 2's landing is Solar Flight Inc, headed by President Eric Raymond. The small firm has already introduced four solar powered airplanes to the public including its latest, the SUNSTAR. The aircraft, which came out almost two years ago, flies at high altitudes and can act as an unmanned drone or a piloted vehicle. The project demonstrates advances in weight efficiency and solar power capacity and leads to plans of an even more impressive craft.

solar electric airplane

The picture above is a rendering of a 6-seat solar transporter that Solar Flight has posted on its website. There is no signal as to whether the project has been started or how much progress has been made, but any kind of prototype or evidence of headway should interest any major names in the aerospace industry. Boeing, for example, has been fidgeting with its own interpretations of the fuel-free craft. GeekWire reports on some of the designs, all of which are limited to unmanned devices. Technology that has been developed by the team behind Solar Flight would be especially valuable to a big commercial name like Boeing. Speaking of the team behind Solar Flight, guess who shows up again...SunPower. It's clear that this company has its eyes on solar flight and may find partners in companies like Boeing, Facebook, and Google who are considering prototypes for solar commercial flights and free internet access to remote parts of the world (see The successful circumnavigation of globe in the Solar Impulse 2 is a feat that should be praised. In the solar power industry, it should be heralded as a great milestone that rivals the creation of the solar powered car. Investors should be keen to watch out for opportunities in this sector of the renewable energy industry. Something tells be SunPower is not finished creating solar-powered planes.

Thursday, July 21, 2016

The Global Economy in Charts: The Bank for International Settlements' Annual Report

In late June, the famed Bank for International Settlements produces their annual report for their financial year that ends at the end of March. The financial institution, based in Basel, Switzerland, is known for its international clientele and enduring history of excellent economic analysis. With 60 central banks included in its operations, the BIS has its hands in a group of nations that accounts for about 95 percent of the world's GDP. Hence, a report as extensive and in-depth as its annual publication is widely read and referenced among analysts. Its insights into monetary policy and the dynamics of the global economy are impressive. For that reason, I shall use the charts and graphs in the report to paint a picture of BIS's economic analysis as well as adding my own perspective along the way. Here is the global economy in charts.

All images and quotes can be found in this report.

"The global economy is not as weak as rhetoric suggests"

The media, analysts, and pundits covering economic news aren't told to sell lukewarm. Instead, public figures use extremes and decisive statements to polarize their arguments for the sake of joining the bulls or the bears. Too often, they ignore the average, a state that is the most probable. The BIS, though, successfully disables the extremes of both side with the statement, "the global economy is not as weak as rhetoric suggests." The report acknowledges the existence of weakness but admits that it might be more average than detrimental. The opening BIS statement is supported by these three charts which paint a picture of a stabilizing system that has just undergone a period of disequilibrium. GDP growth's variability reduced across countries, and now a trend of convergence is setting in. Unemployment in advanced economies (AEs) are finally regressing towards the mean while discontent in emerging economies (EMEs) have caused an uptick in recent jobless numbers. In the past six quarters, we've seen oil price fluctuations complicate economic growth in the post-crisis bull market, but those trepidations have largely calmed down. After peaks in 2015 and the first two months of 2016, the CBOE Volatility Index (VIX) is down over 30 percent this year. As fearful trading has subsided, investors with more confidence are buying back into the market. Suddenly, the Dow and S&P are setting new highs.

This interesting environment described by BIS's big picture diagnosis is best explained using the concepts of energy in physics. In mechanics, objects with mass always have energy. With movement and force, kinetic energy represents the amount of energy used to do work. For example, it takes kinetic energy to move a box from one location to the other, to start a car and drive across the country. But an object doesn't have to be moving to have energy. Potential energy is energy that an object with mass has based on its position. A ball on the top of a hill has potential energy because gravity can push it down the slope with the right catalyst. That picture of the ball might be an accurate image of the global economy at this moment. Volatility has slowed down, and a steady positive trend has taken over. Relative to stock movement in August 2015 and January 2016, markets have shown reduced kinetic energy, or volatility, which usually supports an optimistic environment. But, potential energy remains high. Stocks and bonds are tightly wound and give the impression that they could fall at any moment. The BIS points out a "risky trinity" that adds to this negative potential energy: "low productivity growth, global debt levels that are historically high, and narrow room for policy maneuver." BIS's opening statement should not be taken as assurance that weakness is gone; instead, investors should recognize this idyllic trading period as a short respite before the storm.

"...a highly visible and much-debated sign of this discomfort has been exceptionally and persistently low-interest rates"

Because the BIS has access to data and policy from over 60 central banks, its monetary commentary is some of the best in the game. In the low-interest rate environment, it has been quick to be critical of the loose policy that has whitewashed the capital markets in advanced and emerging economies. As the first chart demonstrates, policy rates in Japan, the euro area, and the United States (G3) have been forced into negative territory after adjusted for inflation. The central banks have maintained this policy in order to encourage investment in the equities markets and allow lending to occur at almost no cost to the borrower. As a result, households, governments, and businesses have stacked up on debt, and it has created unsustainable growth. The BIS condemns this trend saying, "debt has been acting as a political and social substitute for income growth for far too long." The global economy will not survive for long if market participants continue to support the imbalance of productivity and credit. Instead of a large-scale shifting of funds, the BIS encourages "an urgent rebalancing of policy to focus more on structural measures, on financial developments, and on the medium term." Policy changes seem easy enough, but complications could arise from the turbulent relationship between monetary and fiscal institutions as they often have before.

Another consequence of persistently low-interest rates is a topsy-turvy bond market with yields that discourage investment in that arena. The chart on the right catalogs some of the lowest yields in the world, and surprisingly, they have fallen below zero. Japan's yield has fallen to about -0.125 after its central bank began experiments with interest rates set at negative values. France, Denmark, and Sweden, the three lowest yields in the euro zone are results of low rates and heavy quantitative easing from Draghi's ECB. The BIS sees this as a signal that, "market participants look to the future with a degree of apprehension." Trust in monetary policy is quickly falling as inflation struggles to pick up and growth settles into a new, low "normal." The solution to global economic weakness will not come from the halls of major central banks, but instead, will be left to the whims of the crowd. Large-scale asset purchases have exhausted bond markets in advanced economies forcing money to chase riskier segments, a dynamic that would accelerate a crash if one were to come. In addition to this risk, unconventional adjustment of long-term interest rates will not be an option in the next downturn as they have already been flattened to dangerous levels.

"Global debt continues to rise and productivity growth to decline"

The above charts produced by the BIS go hand-in-hand with the four-part series just published on Black Gold Disease called Predicting a Crash. In it, I discussed the incredibly high levels of debt across every kind of economy. From 2007 to 2015, government, corporate, and household debt has been on a clear climb upward with AEs and EMEs all reporting debt that is over 150 percent of GDP. That growth might not be troubling if justified by a simultaneous increase in output, income, and consumption, but these characteristics of a healthy expansion are mostly absent. As evidenced by the chart on the left, labor productivity has remained below 2000-2005 levels even though a robust recovery after the financial crisis was supposed to take place. For that reason, these two issues are set as the first two pillars of BIS's "risky trinity." The truth is, employment supported by borrowed capital is not sustainable and has lead to a crowding out of growth that is sustainable. In the end, there will be a correction in one of these areas. Either productivity will see a robust recovery in the next few years, a positive growth scenario, or debt levels will be forced downwards, a catastrophic scenario that would lead to a crisis.

"The spotlight shone especially brightly on China, which for several years had been seen as the global growth engine"

The BIS identifies "the first episode of market turbulence" as the global sell-off in the third quarter of 2015 largely lead by weak Chinese fundamentals. Major market indices in China's equity markets revealed a relative trend of overvaluation as its people sought yield for its savings glut. The largest Asian nation is also known for its high savings rate which causes its domestic firms to be less reliant on domestic consumption. The chart on the right shows how prices and P/E valuations topped out in the middle of 2015. After the peaks, volatility set in as traders sold heavily before buying back into the trend. Currently, valuations are still higher than 2015 Q2 levels, but fundamentals such as manufacturing and GDP growth rate have stabilized countering uncertainty. Still, the BIS sees fragility in Chinese equities as the 2015 sell-off, "shook confidence in China’s ability to achieve a 'soft landing' scenario after years of rapid credit-fuelled growth." The Chinese government, which remains very exposed to debt in many advanced economies, might experience even more distress if a global credit crunch ensues. In the end, investors should never let their eyes stray far from this nation as its currency fluctuations (middle and left graph) and large demand have the power to sway the world's economy.

"The plunge in commodity prices weakened the economic prospects of commodity-exporting countries and of commodity-producing firms"

If there was one sector that lost in the 2015 year, it was energy. Since the second quarter of 2014, oil and gas firms have been grappling with the new trend of low oil prices. And while some institutions claimed that the fluctuations were temporary, Brent and WTI spot price movement is shaping up to reflect a lower-for-longer scenario. Oil and natural gas saw their prices drop by well over 50 percent, but they weren't alone. Metal and foodstuff saw similar debilitating movements on the futures markets, a cumulative effect that weighed on inflation. Deflationary pressures caused by these volatile commodity prices (middle chart) forced monetary institutions to be cautious in their policymaking, a sentiment not well received by market participants. We saw energy prices take a toll on market dynamics but they also played a role in an industrywide earnings loss. As illustrated by the graph on the right, energy stocks almost 50 percent in 2015 putting many of the weaker issuers in danger of bankruptcy. In fact, these companies played a large part in debt growth as, "their bonds
outstanding increased from $455 billion in 2006 to $1.4 trillion in 2014, or by 15% per year; and their syndicated loans rose from $600 billion to $1.6 trillion, 13% per year." The BIS and many other analysts blame this weak sector for the losses in the high yield sector, a segment of the market that is just now starting to rebound. Energy volatility has recently started to cool, and that will support investors looking to buy oil and gas producers at a cheaper price. But, oil prices don't appear to be increasing anytime soon. This could create imbalances in power among oil importing and oil exporting nations.

"The likelihood of divergent monetary policies between the United States, on the one hand, and the euro area and Japan, on the other, contributed to renewed dollar strength"

The BIS stresses monetary analysis in its report and provides excellent insight on how different policy affects each corner of the economy. In these charts, it looks at the performance of the dollar in relation to interest rate expectations in the euro zone, Japan, and the U.S. The Federal Reserve looked to be the most eager to raise rates as 2016 was once projected to have as many as five rate hikes occur. At the same time, the Bank of Japan and the ECD were both reluctant to raise rates in what they determined was a weak economic state. As the BIS comments, the diverse global economy experienced "uneven global momentum" as fluctuating commodity prices affected markets in different ways. This individualistic approach to cohesive monetary policy appears to have failed as the expansive setting that has been maintained since 2009 is failing to produce a positive effect. Investors are trading the uncertainty and division by flocking into the dollar, the currency in which most debt is denominated. This dynamic has weighed on the Federal Reserve's hopes for growth in foreign demand forcing them to be even more dovish. Investors have responded by selling more bonds and flattening the forward interest rate curve (right graph). Every meeting in the Fed, ECB, and the BOJ seems to be conducted on a tightrope as options are limited. The BIS cites this lack of flexibility as a problem that plagues economic stability and something that must be fixed if a crash is to be avoided.

The annual report of the Bank for International Settlements is a must-read document for investors who pay attention to macroeconomics. Its expertise on monetary policy and accessible charts allow investors the opportunity to discover many critical insights. The fragile state of the global economy demands an accurate analysis of the forces that underpin its movements, whether they be positive or negative. This publication provides many different perspectives looking at the problem of weakness in financial markets and could be the reason why you avoid losing big in the next crisis.

Friday, July 8, 2016

Predicting a Crash: Part Four

So far in our investigation, we've looked at the existing fundamental condition of the global economy to support the proposition that a crash is coming. Debt levels have continued to rise since the financial crisis in 2008, and companies and households continue to increase their leverage despite mini-crashes in August of 2015 and January of 2016. The declining health of corporate and governmental balance sheets has endangered the survivability of many national stock markets which are faced with the risk of crisis similar to the Greek debt crisis that happened a couple of years ago. These debt conditions are allowed to prevail because of the loose behavior of the world's central banks, namely the Federal Reserve, the European Central Bank, and the Bank of Japan. Cheap credit has encouraged a growth in business loans, mortgages, auto loans, and credit card use that has surpassed the levels seen in the years leading up to the financial crisis. The conditions just described are not necessarily indicative of a global crisis, but if a degrading fundamental position is paired with an overvalued asset market, a dangerous game of musical chairs ensues. In closing this investigation, we will look at and analyze some of the trends in stock evaluations that have developed in the seven-year bull market that followed the worst recession since the Great Depression. With any luck, the bystanding investor can use this investigation to develop an exit strategy before the storm hits.


Stocks act as the barometer of the economy measuring the fluctuations of business strength and individual sentiment on a daily, weekly, and yearly basis. Stock market patterns always react to a brewing recession and often lead economic downturns that are unexpected. One measure of overvaluation, and perhaps the most popular is the price-to-earnings ratio of the S&P 500 over time. The chart above shows the historical data for this measure. Upon observation one notices many peaks which are followed by consolidation periods that eventually lead to another peak. Another interesting observation is that overvaluation was not typically a problem until after the 1980's. While there is a smaller peak around the 1929 mark, the P/E valuation measure would have said very little about the market crash that led to the Great Depression. However, major peaks before market downturns in 2000, 2003, and 2009 have proven to be very accurate in describing overvaluation. After P/E ratings reached over 70 in 2009, they settled in the mid- to low-teens. From 2012 to now, S&P 500 growth has lead to a 63 percent increase in the corresponding P/E measure. These levels compare to those seen just before the tech bubble popped in 2000. So bubble territory is not out of the question. The truth is earnings have not grown as robustly as they were supposed to coming out of the recession. A slowdown in European growth and recent stagnation in the Chinese economy has jeopardized the expansion of many multinational firms that aggressively expanded after the financial crash even though the Federal Reserve support them with low-interest rates. In conjunction with encouraging business investment, the Fed also set out to bolster equity investment by dropping bond yields lower forcing money managers to look for alternate forms of high yield.

With a low-interest rate and low bond yields, investors can expect cheaper debt financing and higher earnings for the equities in which they invest. In any investing situation, such conditions allow for larger dividends and stock price appreciation. In the end, stock demand increases and the cycle feeds back into itself. Bubbles form in these conditions when market psychology gets overly positive and the crowd maintains a laser sharp focus on expansion. This kind of over-zealous attitude was (and still is) consistently encouraged by loose monetary policy and their own analysis which replicated the optimism that fueled the rise in stock prices. This mismanagement and dovish approach to recovery have resulted in the current trend of overvaluation, and any attitude or policy change to the contrary could knock down the house of cards that has been built. Central banks and other monetary institutions have a responsibility to summarize the current state of the economy, not push an agenda of stock market expansion. While investors will trade news events positively, they will also correctly price the current economic condition whether it is bad or good. In the end, unhealthy, unstable, or weak fundamental positions will be realized by the general investing public, and when this occurs, traders usually find things worse than what they expected.

Another interesting measure of overvaluation to observe is the growth rate of the S&P 500 index against the growth rate of the U.S. economy. The idea is to look for periods where the quarterly growth in the stock market superseded the economy it is supposed to represent. In the chart above, one can observe similarities in the years preceding major market crashes, Just before the mysterious 1987 crash, stock growth peaked well above GDP growth and fell successively until it reached almost zero at the turn of the decade. The introduction of the internet and the popularization of that mass communications technology caused great speculation to inflate the stocks of companies that listed on the market. Actual economic prosperity failed to reflect investment growth and the bubble popped. Stock market quarterly growth once again peaked just before the 2008 crisis. Notice that economic expansion seemed to match those levels hinting that there might not have been overvaluation. This may be true as the bubble that popped was in the housing market. Nevertheless, it was clear that the stock market had warmed up quickly in the quarters before the financial crisis. Following the crash, S&P 500 and U.S. GDP growth both tanked and soon recovered. The disparity between stock market growth and the growth of the economy soon formed and has remained through 2015. So if a crisis is brewing, when will it occur? The past three markers did not last very long which suggests it could be sooner than you think.

We've reached our final argument, and we must come to a conclusion about whether or not an asset bubble has formed on the stock market. On this article's day of publication, the Dow Jone Industrial Average grew to its highest level over 18,000 on news of an exceptionally strong jobs report. The appreciation appears real, supported by robust job market improvement because of the Federal Reserve's patient hand. All the while. FOMC governors and Chairwoman Janet Yellen are huddled, preparing a strategy for gradual monetary tightening. Knowing this could be the demise of the seven-year bull market, investors should heed the Fed's words and thoroughly investigated every Fed publication in the second half of 2016. The cues of the beginning of the next crisis will come from these prophetic words, and they are not to be underestimated. As long as companies are allowed to grow freely in a low-interest rate environment, speculation will be justified. But, demand for equities and the higher amounts of risk will soon dry up endangering accessibility to corporate finance. When this time comes, a crisis will be upon us, and views in hindsight will be the only perspectives left as stocks sell-off once again.

Friday, June 24, 2016

Fundamental Friday: 24 June 2016

Crude oil: Crude oil fundamentals are reacting bullishly to the spike in refining this summer. Domestic production fell 39,000 b/d to 8.677 million b/d approaching another significant milestone at 8.5 million b/d. Since the beginning of the year, U.S. producers have cut 542,000 b/d worth of production as the squeeze on supply continues despite the stabilization of oil prices. Crude oil stockpiles continued their decline as well. With a drop of about 900,000 barrels, last week stockpiles were reported at 1.225 billion barrels. For the year, stocks are up about 48 million barrels but have declined in the past two months at a rate of about 13 million barrels.

Refinery data spiked to new highs this week as upstream operations heat up with the temperatures. Refinery inputs grew by 190,000 b/d to 16.505 million b/d reaching a new peak for the year. So far, June averages are well above the earlier 2016 months. Compared to last year, this week's refinery inputs are just 27,000 b/d lower, on par with the season average. Utilization peaked this week as well jumping 1.1 percent to 91.3 percent. Utilization data, compared to what it was last year, is 2.7 percent lower hinting at higher refinery input to come later in the summer.

WTI and Brent spot prices traded turbulently this week with Brexit weighing at the end of the week. The declines on Friday helped solidify the $50 mark as a potential resistance going forward. WTI settled at $47.50, and Brent settled at $49.00.

Natural gas: Natural gas supply and demand trends extend the pattern that has developed in the past couple of months. Underground stockpiles of natural gas jumped 62 bcf to another new high of 3103 bcf. The rig count jumped at the highest rate in awhile, up 4 rigs to a total of 90 for this week. The growth in rig operation is most likely caused by an even stronger jump in demand. The EIA estimates a 0.3 bcf/d increase in supply for this week. The estimate for demand growth is 1.8 bcf/d completely offsetting and overwhelming the corresponding shifts in supply.

In the weekly report on natural gas fundamentals, the EIA discusses the pace at which the 2016 summer season is growing. Last week's peak above 3,000 bcf marked the earliest date at which this level was reached over the past 20 years. In 2012, supply reached this point by June but was still below 2016 fundamental data. Projections have the 2016 summer injection season ending with stockpiles just above 4,000 bcf, a point never reached before.

Henry Hub spot prices continued their impressive streak of gains despite losses on Friday. A 5-day gain of 0.84 percent adds on to three-month growth of 23.99 percent.

Gasoline: Gasoline supply data reflected the expectation of more consumption to come in the next two months. Finished motor gasoline production grew by 580,000 b/d to end at a six-week high of 10.289 million b/d. As a result, finished motor gasoline stockpiles grew as well adding just under 1.5 million barrels for a total of 25.016 million b/d last week. Component stocks fell by 800,000 barrels to 212.615 million barrels. These data confirm the expectation that higher consumption is imminent. Product supplied contradicted the assumed trend falling 830,000 b/d to 20.010 million b/d after a peak the week before.

Regular and diesel gas prices reversed this week after a long streak of gains. Regular gas fell by $0.046 to $2.353 per gallon with declines across all regions. Diesel gas prices fell as well down $0.005 to $2.426 per gallon with mixed data across the regions. The drop in prices may have been a reaction to higher product supply corresponding with flat demand.

Thursday, June 23, 2016

Predicting a Crash: Part Three

The next step in predicting a crisis is identifying the causes behind the growth of the global debt problem. The proliferation of credit, loans, and any other form of borrowing does not occur randomly. Individuals, businesses, and governments are all affected by the state of risk in the economy, the availability of capital in the current setting, and how costly this capital will be. The growth of mortgage-backed securities (MBS) during the prelude to the financial crisis was caused by the perception that these assets were low risk increasing the demand for their creation. As a result, the amount of residential mortgage debt skyrocketed. After the unraveling of the housing market in 2009 and 2010, a similar trajectory has developed leading up to today. In this episode of Predicting a Crash, we're going to look at how central banks in developed nations have encouraged the formation of a debt crisis with cheap capital and a bloated money supply.

Before visiting the current debt crisis that has encroached upon the economic safety of the next three years, it's important to review the effects that the 2008 crisis had on shaping the market conditions in the next eight years. The failure of the housing market caused panic and uncertainty to freeze the credit mechanism in the residential, corporate, and public sectors of the economy. Banks which had been more than willing to initiate home mortgages just a couple years ago were reluctant to lend to anyone. The commercial paper market, an outlet of credit used daily by financial institutions, became a quiet doldrum. Even governments found it difficult to convince lenders to loan at a reasonable rate. After the capital mechanisms at the base levels of the economy broke down, a recession hit, and the Federal Reserve was forced to move into action. Ben Bernanke and now Janet Yellen sought to counter the debilitating effects of the crash by lowering every kind of interest rate their Board of Governors could think of, starting with the Fed Funds rate. Through conventional and unconventional open market operations they found ways to cut the discount rate, rates for mortgages, rates for interbank lending, and many more lending rates that were responding to panic and fear. The lower interest rates and a Federal Reserve willing to pump money into the economy caused money supply growth to accelerate in the years after the recession. Companies and households that were affected by the economic downturn that followed were not wary of the building debt crisis that they were creating; instead, they focused on recovering.

For corporations, recovering meant taking advantage of newly available capital with interest rates that were at record low levels. The Federal Reserve, exemplifying the "lender of last resort" role discussed by Walter Bagehot in 1871, encouraged the flourishing trend of lending capital in the face of uncertainty with their own loans to AIG, GMC, Chrysler, and most of the leaders of the financial services sector. When the recession hit commercial and industrial loans peaked during the recession as the Fed's easy money encouraged emergency lending. Financials eventually improved and loans dipped. Around the beginning of 2011, we see a different trend set in. Interest rates were still at all time lows and the Federal Reserve was still trying to prop up the floundering economy. The commercial and industrial businesses saw an opportunity; they could take the cheap money and invest it into their operations which were producing returns that were worth well above the cost of the loan. The result, the past five years of low-interest rates have pushed commercial and industrial loans 29.4 percent above its peak in 2009. Meanwhile, corporate profits after tax have only increased 5.7 percent since 2010. This disparity between earnings and debt load has come to define this period of low-interest rates and signals a potential breakdown in the balance sheets of companies in every sector of the economy. The built up pressure might finally crash the system if circumstances were to change (like a sudden drop in profits or consumption, or an increase in interest rates).

The same situation arose in the major consumer credit markets. Low-interest rates among institutions allowed them to charge less for mortgages, car loans, personal loans, and credit card rates. This is a healthy scenario when a recession is threatened. The low cost of loans allows consumers to get back on their feet and enter the market with a smaller chance of default. Lower repayment fees also leave a more income available for consumption. This makes sense. The healthy response soon denigrated into a dangerous environment where debt was encouraged even after the recovery had taken place. In between 2011 and 2015, interest rates on new car loans, personal loans, and credit cards fell significantly even though the recession had been over for almost two years. Delinquencies successfully fell, but in its place, a growing debt burden subtly inched its Monthly growth rates suggest that consumer credit growth had reached levels comparable to the years leading up to the financial crisis, debt growth rates that had ultimately brought down an economy. The same could be said about the housing market and mortgages. The Mortgage Bankers Association revealed a trend in mortgage purchases that reflects the trend in the early 2000's. Estimates for 2016, 2017, and 2018 continue to follow that pattern.

The charts and data above reveal the Federal Reserve's era of loose money which encouraged consumers and businesses to add on to debt loads that were already high. The picture painted in the United States is mirrored by monetary policy in countries across the globe. Japan, a developed nation with one of the highest debt-to-GDP ratios, saw credit explode as its central bank dropped interest rates to zero. The mature Asian nation also flirted with the idea of negative interest rates, an unconventional method that would lead to the addition of even more corporate and consumer debt. The European Central Bank continues to keep their interest rates low as the economic leaders there try to coax growth despite an aging population. Along with cheap capital, the ECB head Mario Draghi have employed aggressive quantitative easing measures hoping to encourage investments by supporting asset prices. Both policies have allowed the development of a credit trend similar to the one in the U.S. and Japan. Because of the interconnectedness of the institutions to which the largest central banks lend, the debt crisis spread to small, emerging economies in tandem. New firms in countries like Brazil, Russia, and China could access these funds through the hands of foreign investors able to lend at lower interest rates because of the atmosphere created by the Federal Reserve, the Bank of Japan, the ECB, and the many other institutions implementing loose monetary policy in the past few years.

So we're starting to approach a verdict. As we have looked further into the weakness of the global economy and the pressure of debt, fingers start to point at monetary leaders for their irresponsible handling of interest rate trends. In hindsight, almost everyone will assert that rate hikes came too late, a statement that is quickly followed by the question, "When will they raise rates?" During economic expansion that typically follows a recession, monetary institutions are generally supposed to increase interest rates to cool down the recovery. That path was not taken. Now, debt loads and weak market fundamentals are waited to unravel when necessary rate hikes finally occur. The unfortunate scenario has monetary leaders choosing between higher interest rates and another recession or more low-interest rates and more debt. The former will be chosen; thus, a crash should be expected. If you're worried about credit markets now, be prepared for even more anxiety when "helium" stocks are discussed in the next installment of Predicting a Crash.