Slip Slidin’ Away

Slip Slidin’ Away

You Know The Nearer Your Destination

The More You’re Slip Slidin’ Away

Paul Simon

Well, now things are starting to get interesting. Contrary to most expectations, OPEC decided last week to maintain – or more accurately, continue ignoring – their current production target. OPEC members haven’t been sticking to their quotas and after their latest meeting I’d say the odds of them getting religion are pretty slim; most of the OPEC countries can’t afford to cut. And the Saudis, for whatever reason, don’t seem to care all that much. As I said a few weeks ago, lower oil prices hurt all the right people as far as they are concerned. Iran and Russia, ISIS (or whatever they’re being called this week) and last but not least, US shale companies.

What is most amazing to me is that anyone – and apparently a lot of anyones considering the 10% drop in prices Friday – thought the Saudis would back an OPEC production cut. OPEC has never had the control over energy prices that so many believe anyway and certainly now with US production rising via fracking, their control is that much less. A cut in production by OPEC would most likely have been offset by a continued rise in US and other non-OPEC production. At $100/barrel there aren’t many areas on the planet that aren’t profitable to drill. Cutting production now would just push OPEC closer to the day of complete irrelevance.

What is unclear at this point – at least to me – is whether the drop in oil prices is merely a matter of increased supply or whether the real culprit is lower demand due to a slowing global economy. Certainly, supply has risen and many are citing that as the main factor but a drop of nearly 40% in 5 months seems a bit much to blame on just increased supply; global production has not accelerated that much in recent months. So, some of the decline has to be a function of reduced demand. There is also the matter of the US dollar which has an inverse relationship to the price of oil in dollars but the dollar is up a mere 10% in that time so it isn’t all about the dollar either. The recent moves also revive memories – at least for me – of the rapid rise in the dollar and collapse in oil prices in 2008. I can’t help but think that at least some element of this is due to a reduction in liquidity. We know that a lot of the commodity trading operations at the big banks have been downsized and in some cases completely eliminated. And I suspect that the Fed’s tapering has tightened funding markets, especially outside the US.

I’ve been saying all year that the bond market is telling us something about the economy – US and global – and last week reinforced the trend we’ve been tracking all year. Treasury notes and bonds rallied. The 10 year note yield dropped below 2.2% and the 30 year bond dropped below 3% again. I’ve seen a number of commentators recently cite lower bond yields as a positive but that would seem to be a case of hope triumphing over experience. Big, rapid drops in long term rates in the past have preceded or coincided with growth scares – or recessions – and I don’t think this one will prove any different. Lower long term rates certainly don’t appear to be having a positive impact on the mortgage market; applications dropped again last week continuing a trend that has been in place since the word “taper” was first uttered.

Other areas of the markets seem to be speaking the same slowdown language. High yield bonds – junk bonds – have been underperforming all year and that accelerated last week. Part of the increase in spreads is no doubt due to the fact that energy is now 16% of the junk bond index, up from less than 5% a decade ago. The weak dollar and easy monetary policy during most of the last decade pushed a lot of investment into the commodity space and much of it was funded with debt. But the performance of regional bank stocks would seem to indicate that it isn’t all about oil and gas. Those shares have been underperforming the other financials and the S&P 500 all year. And finally, it isn’t just oil that is slipping lower; other commodities have been falling almost as hard as crude oil. Copper dropped over 5% last week and last I checked OPEC wasn’t operating any copper mines.

So who are the winners and losers from lower oil and commodity prices? Is it positive or negative for the US and global economy? It seems that everyone who manages to get booked on CNBC sees the drop in oil prices as a net positive but as I’ve said in the past, it is impossible to know in advance whether the US and/or global economy will gain or lose on net. In fact, it is hard to even pinpoint winners and losers among industries, at least in the short term. The transportation stocks have been on a tear on the simple belief that lower fuel prices are a big positive but it isn’t that easy. Did airlines hedge against a possible rise in prices at the beginning of the year (I know of at least one company that hedged their year’s fuel costs when crude was over $100)? If oil production falls in the shale areas, how much will that impact the railroads who have benefitted from the lack of pipeline access in so many of those areas? I’d expect to see some company or companies reporting big “hedging” losses in the coming months; it happens every time there is a big shift in commodity prices.

One area of the economy that might be in for some turbulence is the private equity industry. They have been prominent investors in energy the last few years and some of those deals are already looking like mistakes. KKR and Itochu led the biggest leveraged buyout in the oil and gas space with the takeover of Samson in 2012. Itochu wrote down part of that investment this past spring and that was before the big drop in oil prices. And if private equity has trouble with their shale investments, you can bet their bankers will too. Just this week, an article in the FT profiled an $850 million loan, led by Wells Fargo and Barclay’s, to fund the merger of Sabine and Forest Oil. The banks had intended to syndicate the loan but have found no buyers with oil prices dropping and the banks are probably sitting on some pretty hefty mark to market losses. The article also mentioned a loan to Apollo Group from UBS and Goldman to fund the purchase of Express Energy; it was supposed to be sold last week but has apparently been postponed. If oil prices keep dropping you can bet that these won’t be the last losses reported.

Side note: The first failure of a “too big to fail” bank is widely considered to be the bailout of Continental Illinois back in 1984. What isn’t well known is that the failure of CI was driven by the mid-80s oil bust. CI was brought down by loans originated by Penn Square, an Oklahoma bank that was lending to anyone with a pulse and an oil lease. Don’t think it can’t happen again.

One area of the market not affected by the commodity crash so far, outside of a few sectors, is the US stock market. In fact, the S&P 500 and Dow both set new all time highs last week. The idea that the drop in oil prices is positive for the US economy and therefore US stocks is widespread. It better be right because earnings estimates for the energy sector were dropping like a stone even before last week’s crude massacre. The materials sector is also seeing estimate cuts; between them materials and energy represent about 15% of the S&P 500.

I’ve said before and still believe that a stronger dollar and lower commodity prices are good for the US (and large parts, but not all, of the rest of the world) in the long run. I’ve also said that the transition to a stronger dollar will not be smooth. It takes time for investors and companies to reorient their investment plans from weak dollar investments (commodities, real estate) to strong dollar investments (more intellectual investments that increase productivity and growth). It appears we are about to find out how rocky that transition will be. With oil and gas representing about 1/3 of total capital spending in recent years (up from less than 15%), a drop in drilling activity could have an outsized impact on GDP growth. Will consumers who put less money in their gas tank go out and spend those dollars elsewhere? Part of the idea that lower fuel costs are a stimulus rests on the idea that consumers have a higher propensity to spend than oil companies. Considering that oil and gas companies have been spending like drunken sailors the last 5 years, I have my doubts about that.

Right now, the commodity and bond markets are pointing to weaker growth. That may or may not turn out to be true. The last time we had similar movements in junk bonds and commodities was in 2011 and that turned out to just be a growth scare. Maybe this time will work out the same but it could also be a sign that the US recovery is slip slidin’ away.

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For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@4kb.d43.myftpupload.com or   786-249-3773. You can also book an appointment using our contact form.