QUESTION: Mr. Armstrong, I think I am starting to see the light you have been shining. Negative interest rates really are “completely insane”. I also now see that months after you wrote about central banks were trapped, others are now just starting to entertain the idea. Is this distinct difference in your views that eventually become adopted with time because you were a hedge fund manager?
ANSWER: I believe the answer is rather simple. How can anyone pretend to be analysts if they have never traded? It would be like a man writing a book explaining how it feels to give birth. You cannot analyze what you have never done. It is just impossible. Those who cannot teach and those who can just do. Negative interest rates are fueling deflation. People have less income to spend so how is this beneficial? The Fed always needed 2% inflation. The father of negative interest rates is Larry Summers. He teaches or has been in government. He is not a trader and is clueless about how markets function. I warned that this idea of negative interest rates was very dangerous.
Yes, I have warned that the central banks are trapped. Their QE policies have totally failed. There were numerous “analysts” without experience calling for hyperinflation, collapse of the dollar, yelling the Fed is increasing the money supply so buy gold. The inflation never appeared and gold declined. Their reasoning was so far off the mark exactly as people like Larry Summers. These people become trapped in their own logic it becomes irrational gibberish. They only see one side of the coin and ignore the rest.
Central banks have lost all ability to manage the economy even in theory thanks to this failed reasoning. They have bought-in the bonds and are unable to ever resell them again. If they reverse their policy of QE and negative interest rates, government debt explodes with insufficient buyers. If the central banks refuse to reverse this crazy policy of QE and negative interest rates they will see a massive capital flight from government to the private sector once the MAJORITY realize the central banks are incapable of any control.
The central banks have played a very dangerous game and lost. It appears we are facing the collapse of Social Security which began August 14th, 1935 (1935.619) because they stuffed with government debt and robbed the money for other things. Anyone else would go to prison for what politicians have done and prosecutors would never defend the people because they want to become famous politicians. We will probably see the end of this Social Security program by 2021.772 (October 9th, 2021), or about 89 weeks into the next business cycle. These people are completely incompetent to manage the economy and we are delusional to think people with no experience as a trader can run things. If you have never traded, you have no busy trying to “manipulate” society with you half-baked theories. So yes. The central banks are trapped. They have lost ALL power. It becomes just a matter of time as the clock ticks and everyone wakes up and say: OMG!
We have government addicted to borrowing and if rates rise, then everything will explode in their face. Western Civilization is finished as we know it just as Communism collapsed because we too subscribe to the theory of Marx that government is capable of managing the economy. Just listen to the candidates running for President. They are all preaching Marx. Vote for me and I will force the economy to do this. IMPOSSIBLE! We have debt which is unsustainable the further you move away from the United States which is the core economy such as emerging markets. Unfunded pensions destroyed the Roman Empire. We are collapsing in the very same manner and for the very same reason. We are finishing a very very very important report on the whole pension crisis issue worldwide.
This predatory exploitation is only possible if the central bank and state have partnered with financial Elites.
After decades of denial, the mainstream has finally conceded that rising income and wealth inequality is a problem–not just economically, but politically, for as we all know wealth buys political influence/favors, and as we’ll see below, the federal government enables and enforces most of the skims and scams that have made the rich richer and everyone else poorer.
Here’s the problem in graphic form: from 1947 to 1979, the family income of the top 1% actually expanded less that the bottom 99%. Since 1980, the income of the 1% rose 224% while the bottom 80% barely gained any income at all.
Globalization, i.e. offshoring of jobs, is often blamed for this disparity, but as I explained in “Free” Trade, Jobs and Income Inequality, the income of the top 10% broke away from the bottom 90% in the early 1980s, long before China’s emergence as an exporting power.
Indeed, by the time China entered the WTO, the top 10% in the U.S. had already left the bottom 90% in the dust.
The only possible explanation of this is the rise of financialization: financiers and financial corporations (broadly speaking, Wall Street, benefited enormously from neoliberal deregulation of the financial industry, and the conquest of once-low-risk sectors of the economy (such as mortgages) by the storm troopers of finance.
Financiers skim the profits and gains in wealth, and Main Street and the middle / working classes stagnate. Gordon Long and I discuss the ways financialization strip-mines the many to benefit the few in our latest conversation (with charts): Our “Lawnmower” Economy.
Many people confuse the wealth earned by people who actually create new products and services with the wealth skimmed by financiers. One is earned by creating new products, services and business models; financialized “lawnmowing” generates no new products/services, no new jobs and no improvements in productivity–the only engine that generates widespread wealth and prosperity.
Consider these favorite financier “lawnmowers”:
1. Buying a company, loading it with debt to cash out the buyers and then selling the divisions off: no new products/services, no new jobs and no improvements in productivity.
2. Borrowing billions of dollars in nearly free money via Federal Reserve easy credit and using the cash to buy back corporate shares, boosting the value of stock owned by insiders and management: no new products/services, no new jobs and no improvements in productivity.
3. Skimming money from the stock market with high-frequency trading (HFT): no new products/services, no new jobs and no improvements in productivity.
4. Borrowing billions for next to nothing and buying high-yielding bonds and investments in other countries (the carry trade): no new products/services, no new jobs and no improvements in productivity.
All of these are “lawnmower” operations, rentier skims enabled by the Federal Reserve, its too big to fail banker cronies, a complicit federal government and a toothless corporate media.
This is not classical capitalism; it is predatory exploitation being passed off as capitalism. This predatory exploitation is only possible if the central bank and state have partnered with financial Elites to strip-mine the many to benefit the few.
This has completely distorted the economy, markets, central bank policies, and the incentives presented to participants.
“A key empirical question in the inequality debate is to what extent rich people derive their wealth from “rents”, which is windfall income they did not produce, as opposed to activities creating true economic benefit.
Political scientists define “rent-seeking” as influencing government to get special privileges, such as subsidies or exclusive production licenses, to capture income and wealth produced by others.
However, Joseph Stiglitz counters that the very existence of extreme wealth is an indicator of rents.
Competition drives profit down, such that it might be impossible to become extremely rich without market failures. Every good business strategy seeks to exploit one market failure or the other in order to generate excess profit.
The bottom-line is that extreme wealth is not broad-based: it is disproportionately generated by a small portion of the economy.”
This small portion of the economy depends on the central bank and state for nearly free money, bail-outs, guarantees that profits are private but losses are shifted to the taxpaying public–all the skims and scams we’ve seen protected for seven long years by Democrats and Republicans alike.
Learn how our “Lawnmower Economy” works (with host Gordon Long; 26:21 minutes)
The S&P 500 closed today exactly where it first crossed in November 2014. In the interim, its been a roller-coaster of rips, dips, spills and thrills.
The thing is, however, this extended period of sideways churning has not materialized under a constant economic backdrop; it does not reflect a mere steady-state of dare-doing at the gaming tables.
Actually, earnings have been falling sharply and macroeconomic headwinds have been intensifying dramatically. So the level of risk in the financial system has been rocketing higher even as the stock averages have labored around the flat-line.
Thus, GAAP earnings of the S&P 500 in November 2014 were $106 per share on an LTM basis compared to $86.44today. So earnings are down by 18.5%, meaning that the broad market PE multiple has escalated from an already sporty 19.3Xback then to an outlandish 23.7Xtoday.
Always and everywhere, such persistent profit collapses have signaled recession just around the corner. And there are plenty of macro-economic data points signaling just that in the remainder of this article (here)
The pessimists are already talking about 3% inflation later this year if energy prices don’t retreat. Most likely, Federal Reserve monetary experimentation will inflict a new great inflation on the U.S., although this is much more likely to occur in the next business cycle rather than the current one. Before that, we’ll get the shock of an economic slowdown — or even recession — which will exert some pause. So many households are right to ask whether their main asset will insulate them from this shock whenever it occurs. The answer from economic science is no.
House prices perform best during the asset-price inflation phase of the monetary cycle. During that period, low or zero rates stimulate investors to search for yield, which many do, shedding their normal skepticism. The growth in irrationality across many marketplaces is why some economists describe set price inflation as a “disease.” Usually, the housing and commercial real estate markets become infected by this disease at some stage.
Real estate markets are certainly not shielded from irrational forces. “Speculative stories” about real estate flourish and quickly gain popularity — whether it’s the ever-growing housing shortage in metropolitan centers; illicit money pouring into the top end from all over the world and high prices rippling down to lower layers of the market; or bricks and mortar (and land), the ultimate safe haven when goods and services inflation ultimately accelerates.
That last story defies much economic experience to the contrary. By the time inflation shock emerges, home prices have already increased so much in real terms under asset-price inflation that they cannot keep up with goods and services inflation, and may even fall in nominal terms. One thinks of the tale of the gold price in the Paris black market during World War II: prices hit their peak just before the Germans entered the city in May 1940 and never returned.
Real estate is only a hedge against high inflation if it is bought early on in the preceding asset-price inflation period. We can generalize this lesson. The arrival of high inflation is an antidote to asset-price inflation. That is, if it has not already reached its late terminal stage when speculative temperatures are falling across an array of markets.
To understand how home prices in real terms behave under inflation shock we must realize how, in real terms, they are driven by expectations of future rents (actual, or as given to homeowners); the cost of capital; and the profit from carry trade. All of these drivers have been operating in the powerful asset-price inflation phase the U.S. and many foreign countries have been experiencing during recent years.
Together they have pushed up the S&P Case Shiller national home price index to almost 20% above its long-run trend (0.6% each year since 1998), having fallen slightly below at its trough in 2011, and having reached a peak 85% above in 2006.
The cost of equity is low, judging by high underlying price earnings ratios in the stock markets. Investors suffering from interest income famine are willing to put a higher price on future earnings, whether in the form of house rents or corporate profits, than they would do under monetary stability.
Leveraged owners of real estate can earn a handsome profit between rental income and interest paid, especially taking account of steady erosion of loan principal by inflation and tax deductions.
The arrival of high inflation would change all these calculations.
Cost of equity would rise as markets feared the denouement of recession, and reckoned with the new burden on economic prosperity. Long-term interest rates would climb starkly in nominal terms. Their equivalent in real terms would be highly volatile and unpredictable, albeit at first low in real terms (inflation-adjusted), meaning that carry trade income for leveraged owners would become elusive.
None of this is to suggest that a high inflation shock is likely in the second quarter. A sustained period of much stronger demand growth across an array of goods, services and labor markets would most likely have to occur first, and could be seen as early as the next cyclical upturn.
An economic miracle could bring a reprieve from inflation. But much more likely, the infernal inflation machine of expanding budget deficits and Fed experimentation will ultimately mow down any resistance in its way.
Several months ago, a chart produced by one of the Big Banks was presented to readers . It was supposed to be innocuous data on global wealth distribution, but instead portrayed a horrifying picture.
The focal point of the aforementioned article was that when it came to “the world’s poorest people,” the Corrupt West has now produced a greater percentage of severe poverty in its own populations than in India, and an equal percentage of such poverty as exists in Africa.
Stacked beside this, we see that when it comes to the richest-of-the-rich, the Corrupt West remains in a league of its own. Supposedly, we are living in “the New Normal,” where life is supposed to get increasingly harder and harder. So why does the New Normal never affect those on top?
Of course all of these extremely poor people being manufactured by our governments (as these regimes give away our jobs, destroy wages, and eviscerate our social programs) have to come from somewhere. Certainly they don’t come from the Wealthy Class.
Indeed, the chart above provides us with a crystal-clear view of where all these poor and very-poor people are coming from: the near-extinct Middle Class. In order to manufacture hundreds of millions of impoverished citizens in our nations, the Old World Order has had to engage in a campaign to end the Middle Class.
We are conditioned to consider economic “classes” within our own societies, but with the chart above, we’re given a global perspective. Where does the Middle Class exist today, globally? At the upper end, it exists in China, and to a lesser extent, in Latin America and other Asian nations. At the lower end of the Middle Class, we see such populations growing in India and even Africa.
Only in the West, and especially North America, is the Middle Class clearly an endangered species. Two incredibly important aspects of this subject are necessary to cover:
1) How and why has the One Bank chosen to perpetrate Middle Class genocide?
2) What are the consequences of the Death of the Middle Class?
Attempting to catalogue the nearly infinite number of ways in which the oligarchs of the One Bank have perpetrated their Middle Class genocide is impractical. Instead, discussion will be limited to the five most important programs responsible for the Death of the Middle Class: three of them relatively new, and two of them old.
a) Globalization
b) Union decimation/wage destruction
c) Small business decimation
d) Money-printing/inflation
e) Income taxation
Globalization was rammed down our throats in the name of “free trade,” the Holy Grail of charlatan economists . But, as previously explained, real free trade is a world of “comparative advantage” where all nations play by a fair-and-equal set of rules. Without those conditions, “free trade” can never exist.
The globalization that has been imposed upon us is, instead, a world of “competitive devaluation,” a corrupt, perpetual, suicidal race to the bottom. The oligarchs understood this, given that they are the perpetrators. The charlatan economists were too blinded by their own dogma to understand this. And, as always, the puppet politicians simply do what they are told.
Next on the list: union decimation and wage destruction are inseparable subjects, virtually the flip side of the same coin. “But wait,” shout the right-wing ideologues, “unions are corrupt, everyone knows that.”
Really? Corrupt compared to whom? Are they “corrupt” standing next to the bankers, who have stolen all our wealth ? Are they “corrupt” standing next to their Masters, the oligarchs who are hoarding all our stolen wealth ? Are they “corrupt” standing next to our politicians, who betrayed their own people to facilitate this economic pillaging? No, compared to any of those groups, unions (back when they still existed) were relative choir-boys.
When it comes to corruption, nobody plays the game as well as those on top. Compared to the Fat Cats, everyone else are rank amateurs. When unions were strong and plentiful, everyone had jobs. Almost everyone earned a livable wage (or better). Gee, weren’t those terrible times! Look how much better off we are now, without all those “corrupt unions.”
The other major new component in the deliberate, systemic slaughter of the Middle Class was and continues to be Small Business decimation. “Small business is the principal job-creator in every economy.” Any politician who ever got elected can tell you that.
If this is so, why do our corrupt governments funnel endless trillions of dollars of Corporate Welfare (our money) into the coffers of Big Business, while complaining there is nothing left to support Small Business? Why do our governments stack the deck in all of our regulations and bureaucracies, greasing the wheels for Big Business and strangling Small Business in their red tape?
Why do our governments refuse to enforce our anti-trust laws? One of the primary reasons for not allowing the corporations of Big Business to grow to an illegal size is because these monopolies and oligopolies make “competition” (meaning Small Business) impossible. One might as well try to start a small business on the Moon.
Then we have the oligarchs’ “old tricks” for stealing from the masses (and fattening themselves): banking and taxation. Of course, to the oligarchs, “banking” means stealing, and you steal by printing money. As many readers are already aware, “inflation” is money-printing – the increase (or inflation) of the supply of money.
“In the absence of the gold standard, there is no way to protect savings [i.e. wealth] from confiscation through inflation”
Remove the Golden Handcuffs , as central banker Paul Volcker bragged of doing in 1971, and then it’s just print-and-steal – until the whole fiat currency Ponzi scheme implodes.
Then of course we have income taxation: 100 years of systemic thievery. No matter what the form or structure, by its very nature every system of income taxation will:
i) Provide a free ride to those at the very, very top
ii) Be revenue-neutral to the remainder of the wealthy
iii) Relentlessly steal out of the pockets of everyone else (via over-taxation)
This is nothing more than a matter of applying simple arithmetic. However, many refuse to educate themselves on how they are being robbed in this manner, year after year, so no more will be said on the subject.
These were the primary prongs of the oligarchs’ campaign to exterminate the Middle Class. As always, skeptical readers will be asking “why?” The answer is most easily summarized via The Bankers’ Manifesto of 1892 . This document was presented to the U.S. Congress in 1907 by Republican congressman, and career prosecutor, Charles Lindbergh Sr.
It reads, in part:
The courts must be called to our aid, debts must be collected, bonds and mortgages foreclosed as rapidly as possible.
When through the process of law, the common people have lost their homes they will be more tractable and easily governed through the influence of the strong arm of government applied to a central power of imperial wealth under the control of the leading financiers [the oligarchs]. People without homes won’t quarrel with their leaders.
We have “the strong arm of government.” The oligarchs saw to that by bringing us their “War on Terror.” When it comes to throwing people out of their homes, and creating a population of serfs, that’s a two-part process.
Step 1 is to manufacture artificial housing bubbles across the Western world, and then crash those bubbles. However, this is only partially effective in turning Homeowners into Homeless. To truly succeed at this requires Step 2: exterminating the Middle Class. A Middle Class can survive a collapsing housing bubble, assuming they remained reasonably prudent. The Working Poor cannot.
Finally, after more than a century of scheming, the oligarchs have all of their pieces in place. In the U.S., they’ve even already built many gulags – to warehouse these former Middle Class homeowners – since a large percentage of those people are armed.
This brings us to one, final point: the consequences of the Death of the Middle Class. What happens when you destroy the foundation of a house? Just look.
As readers have been told on many previous occasions, the “velocity of money” is effectively the heartbeat of an economy. It is another way of representing the economics principle known as the Marginal Propensity to Consume, probably the most important principle of economics forgotten by charlatan economists.
The principle is a simple one, since it is half basic arithmetic and half common sense. Unfortunately, these are both skills beyond the grasp of charlatan economists. If you take all of the money out of the pockets of the People, and you stuff it all into the vaults of the wealthy (where it sits in idle hoards), then there is no “capital” for our capitalist economies – and these economiesstarve to death.
What is the response of the oligarchs to the relentless hollowing-out of our economies? They have ordered the puppet politicians to impose Austerity: taking even more money out of the pockets of the people. It is the equivalent to someone with anorexia going to a doctor, and the doctor imposing a severe diet on the patient (i.e. victim). The patient will not survive.
The Middle Class is dying. Unlike the oligarchs’ Big Banks, we are not “too big to fail.”Our jobs are gone. Our unions are gone. Our Middle Class wages are gone. Very soon, our homes will be gone. But don’t worry! It’s just the New Normal.
On the surface, the March jobs reported was better than expected… except for manufacturing workers. As shown in the chart below, in the past month, a disturbing 29,000 manufacturing jobs were lost. This was the single biggest monthly drop in the series going back to December 2009.
But not all is lost: as has been the case for virtually every month during the “recovery”, virtually every laid off manufacturing worker could find a job as a waiter: in March, the workers in the “Food services and drinking places” category, aka waiters, bartenders and minimum wage line cooks, rose again to a new record high of 11,307,000 workers, an increase of 25K in the month, offsetting virtually all lost manufacturing jobs.
This is how the two job series have looked since the start of 2015.
And here is the longer-term, going back to the start of the crisis in December 2007: please do not “peddle fiction” upon seeing this chart.
US Manufacturing Surveys Bounce Despite The Biggest Industry Job Losses In 7 Years
Following China’s miraculous PMI jump back into expansion, Markit reports US Manufacturing also rose to 51.5 in March (despite the biggest drop in manufacturing jobs since 2009). As Markit details, output growth is unchanged from February’s 28-month low, and prices charged decline amid further drop in input costs. ISM Manufacturing also jumpedfrom 49.5 to 51.8 – the first ‘expansion’ in 7 months. Finally, we note that ISM Prices Paid exploded higher (from 38.5 to 51.5) – the biggest jump since Aug 2012.
“V”-shaped recovery in ISM Manufacturing
All of which occurred as the manufacturing sector lost more jobs in March than at any time since 2009…
Every ISM Respondent thinks everything is awesome…
“Unemployment rate is low in our county, making it hard to find workers. We are understaffed and running lots of overtime.” (Plastics & Rubber Products)
“Business in telecom is booming. Fiber plant is at capacity.” (Chemical Products)
“Current trends remain steady. No issues with delivery or costs.” (Computer & Electronic Products) “Capital equipment sales are steady.” (Fabricated Metal Products)
“Requests for proposals for new equipment [are] very strong.” (Machinery)
“Government is spending again. Have received delivery orders.” (Transportation Equipment)
“Things are starting to pick up. Our business is seasonal and it is that time of year.” (Printing & Related Support Activities)
“Business conditions are stable, little change from last month.” (Miscellaneous Manufacturing)
“Incoming sales are improving.” (Furniture & Related Products)
“Our business is still going strong.” (Primary Metals)
But as Markit details, output growth is unchanged from February’s 28-month low, and prices charged decline amid further drop in input costs:
“March’s survey highlights sustained weakness across the US manufacturing sector, meaning that overall growth through the first quarter slowed to its lowest since late-2012. Subdued client spending patterns within the energy sector, ongoing pressure from the strong dollar, and general uncertainty about the business outlook were cited as factors weighing on new order flows in March.
“Meanwhile, price discounting strategies resulted in the first back-to-back drop in factory gate charges for around three-and-a-half years, suggesting another squeeze on margins despite lower materials costs across the manufacturing sector.“
So – to summarize, US manufacturing sector lost more jobs in March than at any time since 2009 BUT the managers that were surveyed by ISM and Markit proclaimed expansion is back and this puts all the pressure back on The Fed once again as more excuses are lost for hiking rates.
Yellen Says Caution in Raising Rates Is ‘Especially Warranted’ … Fed Chair makes case for go-slow changes with rate near zero … Janet Yellen said it is appropriate for U.S. central bankers to “proceed cautiously” in raising interest rates because the global economy presents heightened risks. The speech to the Economic Club of New York made a strong case for running the economy hot to push away from the zero boundary for the Federal Open Market Committee’s target rate. –Bloomberg
Janet Yellen was back at it yesterday, talking down the need for a rate hike.
She is comfortable with the economy running “hot.”
Say what?
After a year or more of explaining why rate hikes were necessary, up to four or more of them in 2016, Ms. Yellen has now begun speechifying about how rate hikes are not a good idea.
It’s enough to give you whiplash.
It sets the stage for increased stagflation in the US and increased price inflation in China. More in a moment.
Here’s the real story. At the last G20 meeting in February, secret agreements were made between the most powerful economies to lift both the US and Chinese economy.
The details of these deals have been leaked on the Internet over the past few weeks and supported by the actions of central bankers involved.
It is what The Daily Reckoning last week called “The most important financial development of 2016, with enormous implications for you and your portfolio.”
The Fed and other members of the G20, which met in February, intend to maintain the current Chinese system.
They want China to stay strong economically.
The antidote to China’s misery, according to the Keynsian-poisoned G20, is more yuan printing. More liquidity that will supposedly boost the Chinese economy.
As a further, formal yuan loosening would yield a negative impact felt round the world, other countries agreed to tighten instead.
This is why Mario Draghi suddenly announced that he was ceasing his much asserted loose-euro program. No one could figure out why but now it’s obvious.
Same thing in Japan, where central bank support for aggressive loosening has suddenly diminished.
The US situation is more complicated. The dollar’s strength is now seen as a negative by central bankers and thus efforts are underway to weaken the currency.
A weaker dollar and a weaker yen supposedly create the best scenario for a renewed economic resurgence worldwide.
The euro and the yen rose recently against the dollar after it became clear that their central banks had disavowed further loosening.
Now Janet Yellen is now coming up with numbers and statistics to justify backing away from further tightening.
None of these machinations are going to work in the long term. And even in the short term, such currency gamesmanship is questionable in the extreme, as the Daily Reckoning and other publications have pointed out when commenting on this latest development.
In China, a weaker yuan will create stronger price inflation. In the US, a weaker dollar will boost stagflation.
We’ve often made a further point: Everything central bankers do is counterproductive on purpose.
The real idea is to make people so miserable that they will accede to further plans for increased centralization of monetary and governmental authority.
Slow growth or no growth in Japan and Europe, supported by monetary tightening, are certainly misery-making.
Stagflation in the US and Canada is similarly misery-provoking, as is price-inflation in China.
Nothing is what it seems in the economic major leagues.
Central banks are actually mandated to act as a secret monopoly, supervised by the Bank for International Settlements and assisted by the International Monetary Fund.
Deceit is mandated. As with law enforcement, central bankers are instructed to lie and dissemble for the “greater good.”
It’s dangerous too.
The Fed along with other central banks have jammed tens of trillions into the global economy over the past seven years. Up to US$100 trillion or more.
They’ve been using Keynesian monetary theories to try to stimulate global growth.
It hasn’t worked of course because money is no substitute for human action. If people don’t want to invest, they won’t.
In the US, the combination of low growth and continual price inflation creates a combination called “stagflation.”
It appeared in its most serious form in the 1970s but it is a problem in the 2000s as well.
According to non-government sources like ShadowStats, Inflation is running between four and eight percent in the US while formal unemployment continues to affect an astonishing 90 million workers.
US consumers on average are said to be living from paycheck to paycheck (if they’ve even got one) with almost no savings.
Some 40 million or more are on foodstamps.
Many workers in the US are probably engaged in some kind of off-the-books work and are concealing revenue from taxation as well.
As US economic dysfunction continues and expands, people grow more alienated and angry. This is one big reason for the current political season with its surprising dislocation of the established political system.
But Yellen has made a deal with the rest of the G20 to goose the US economy, or at least to avoid the further shocks of another 25 basis point rate hike in the near future.
Take their decisions at face value, and these bankers are too smart for their own good.
Expanding US growth via monetary means has created asset bubbles in the US but not much real economic growth.
And piling more yuan on the fire in China is only going to make Chinese problems worse in the long term. More resources misdirected into empty cities and vacant skyscrapers – all to hold off the economic day of reckoning that will arrive nonetheless.
Conclusion: As we have suggested before, the reality for the US going forward is increased and significant stagflation. Low employment, high price inflation. On the bright side, this will push up the prices of precious metals and real estate. Consider appropriate action.
Money is leaving China in myriad ways, chasing after overseas assets in near-panic mode. So Anbang Insurance Group, after having already acquired the Waldorf Astoria in Manhattan a year ago for a record $1.95 billion from Hilton Worldwide Holdings, at the time majority-owned by Blackstone, and after having acquired office buildings in New York and Canada, has struck out again.
It agreed to acquire Strategic Hotels & Resorts from Blackstone for a $6.5 billion. The trick? According to Bloomberg’s “people with knowledge of the matter,” Anbang paid $450 million more than Blackstone had paid for it three months ago!
Other Chinese companies have pursued targets in the US, Canada, Europe, and elsewhere with similar disregard for price, after seven years of central-bank driven asset price inflation [read… Desperate “Dumb Money” from China Arrives in the US].
As exports of money from China is flourishing at a stunning pace, exports of goods are deteriorating at an equally stunning pace. February’s 25% plunge in exports was the 11th month of year-over-year declines in 12 months, as global demand for Chinese goods is waning.
And ocean freight rates – the amount it costs to ship containers from China to ports around the world – have plunged to historic lows.
The China Containerized Freight Index (CCFI), published weekly, tracks contractual and spot-market rates for shipping containers from major ports in China to 14 regions around the world. Unlike most Chinese government data, this index reflects the unvarnished reality of the shipping industry in a languishing global economy. For the latest reporting week, the index dropped 4.1% to 705.6, its lowest level ever.
It has plunged 34.4% from the already low levels in February last year and nearly 30% since its inception in 1998 when it was set at 1,000. This is what the ongoing collapse in shipping rates looks like:
The rates dropped for 12 of the 14 routes in the index. They rose in only one, to the Persian Gulf/Red Sea, perhaps in response to the lifting of the sanctions against Iran, and remained flat to Japan. Rates on all other routes dropped, including to Europe (-7.9%), the US West Coast (-3.5%), the US East Coast (-1.0%), or the worst drop, to the Mediterranean (-13.4%).
The Shanghai Containerized Freight Index (SCFI), which is much more volatile than the CCFI, tracks only spot-market rates (not contractual rates) of shipping containers from Shanghai to 15 destinations around the world. It had surged at the end of last year from record lows, as carriers had hoped that rate increases might stick this time and that the worst was over. But rates plunged again in the weeks since, including 6.8% during the last reporting week to 404.2, a new all-time low. The index is now down 62.3% from a year ago:
Rates were flat for three routes, but dropped for the other 12 routes, including to Europe, where rates plunged nearly 10% to a ludicrously low $211 per TEU (twenty-foot equivalent container unit). Rates to the US West Coast fell 8.4% to $810 per FEU (forty-foot equivalent container unit). Rates to the East Coast fell 5.2% to $1,710 per FEU. Rates to South America plunged 25.4%.
This crash in shipping rates is a result of two by now typical forces: rampant and still growing overcapacity and lackluster demand.
“Typical” because lackluster demand has been the hallmark of the global economy recently, and the problems of overcapacity have also been occurring in other sectors, including oil & gas and the commodities complex. Overcapacity from coal-mining to steel-making, much of it in state-controlled enterprises, has been dogging China for years and will continue to pose mega-problems well into the future. Overcapacity kills prices, then jobs, and then companies.
The ocean freight industry went on a multi-year binge buying the largest container ships the world has ever seen and smaller ones too. It was led by executives who believed in the central-bank dogma that radical monetary policy will actually stimulate the real economy, and they were trying to prepare for it. And it was made possible by central-bank-blinded yield-chasing investors and giddy bankers. As a result, after years of ballooning capacity, carriers added another 8% in 2015, even while demand for transporting containers across the oceans languished near the flat line, the worst performance since 2009.
“The market wants to do it’s sole job which is to establish fair market value. I am talking currencies, housing, crude oil, derivatives and the stock market. This will correct to fair market value. It’s a mathematical certainty, and it’s already begun.”
Financial analyst and trader Gregory Mannarino thinks the coming market crash will be especially bad for people not awake or prepared. Mannarino says, “This is going to get a lot worse. On an individual level, we have to understand what we have to do for ourselves and our families to get through this. No matter what is happening on the political front, there is no stopping what is coming. . . . We’re going back to a two-tier society. We are seeing it happen. The middle class is being systematically destroyed. We are going to have a feudal system of the haves and the have nots. People walking around blindly thinking it’s going to be okay are going to suffer the worst.”
Mannarino’s advice is to “Bet against this debt, and that means hold hard assets; also, become your own central bank. Their system has already failed and it’s coming apart.”
We grow up being taught a very specific set of principles.
One plus one equals two. I before E, except after C.
As we grow older, the principles become more complex.
Take economics for example.
The law of supply states that the quantity of a good supplied rises as the market price rises, and falls as the price falls. Conversely, the law of demand states that the quantity of a good demanded falls as the price rises, and vice versa.
These basic laws of supply and demand are the fundamental building blocks of how we arrive at a given price for a given product.
At least, that’s how it’s supposed to work.
But what if I told you that the principles you grew up learning is wrong?
With today’s “creative” financial instruments, much of what you learned no longer applies in the real world.
Especially when it comes to oil.
The Law of Oil
Long time readers of this Letter will have read many of my blogs regarding commodities manipulation.
With oil, price manipulation couldn’t be more obvious.
“…While agencies have found innovative ways to explain declining oil demand, the world has never consumed more oil.
In 2010, the world consumed a record 87.4 million barrels per day. This year (2014), the world is expected to consume a new record of 92.7 million barrels per day.
Global oil demand is still expected to climb to new highs.
If the price of oil is a true reflection of supply and demand, as the headlines tell us, it should reflect the discrepancy between supply and demand.
Since we know that demand is actually growing, that can’t be the reason for oil’s dramatic drop.
So does that mean it’s a supply issue? Did the world all of a sudden gain 40% more oil? Obviously not.
So no, the reason behind oil’s fall is not the causality of supply and demand.
The reason is manipulation. The question is why.
I go on to talk about the geopolitical reasons of why the price of oil is manipulated.
“On September 11, Saudi Arabia finally inked a deal with the U.S. to drop bombs on Syria.
But why?
Saudi Arabia possesses 18 per cent of the world’s proven petroleum reserves and ranks as the largest exporter of petroleum.
Syria is home to a pipeline route that can bring gas from the great Qatar natural gas fields into Europe, making billions of dollars for Saudi Arabia as the gas moves through while removing Russia’s energy stronghold on Europe.
Could the U.S. have persuaded Saudi Arabia, during their September 11 meeting, to lower the price of oil in order to hurt Russia, while stimulating the American economy?
… On October 1, 2014, shortly after the U.S. dropped bombs on Syria on September 26 as part of the September 11 agreement, Saudi Arabia announced it would be slashing prices to Asian nations in order to “compete” for crude market share. It also slashed prices to Europe and the United States.”
Following Saudi Arabia’s announcement, oil prices have plunged to a level not seen in more than five years.
Is it a “coincidence” that shortly after the Saudi Arabia-U.S. meeting on the coincidental date of 9-11, the two nations inked a deal to drop billions of dollars worth of bombs on Syria? Then just a few days later, Saudi Arabia announces a massive price cut to its oil.
Coincidence?
There are many other factors – and conspiracies – in oil price manipulation, such as geopolitical attacks on Russia and Iran, whose economies rely heavily on oil. Saudi Arabia is also flooding the market with oil – and I would suggest that it’s because they are rushing to trade their oil for weapons to lead an attack or beef up their defense against the next major power in the Middle East, Iran.
However, all of the reasons, strategies or theories of oil price manipulation could only make sense if they were allowed by these two major players: the regulators and the Big Banks.
How Oil is Priced
On any given day, if you were to look at the spot price of oil, you’d likely be looking at a quote from the NYMEX in New York or the ICE Futures in London. Together, these two institutions trade most of the oil that creates the global benchmark for oil prices via oil futures contracts on West Texas Intermediate (WTI) and North Sea Brent (Brent).
What you may not see, however, is who is trading this oil, and how it is being traded.
Up until 2006, the price of oil traded within reason. But all of a sudden, we saw these major price movements. Why?
“Until recently, U.S. energy futures were traded exclusively on regulated exchanges within the United States, like the NYMEX, which are subject to extensive oversight by the CFTC, including ongoing monitoring to detect and prevent price manipulation or fraud.
In recent years, however, there has been a tremendous growth in the trading of contracts that look and are structured just like futures contracts, but which are traded on unregulated OTC electronic markets. Because of their similarity to futures contracts they are often called ”futures look-a likes.”
The only practical difference between futures look-alike contracts and futures contracts is that the look-a likes are traded in unregulated markets whereas futures are traded on regulated exchanges.
The trading of energy commodities by large firms on OTC electronic exchanges was exempted from CFTC oversight by a provision inserted at the behest of Enron and other large energy traders into the Commodity Futures Modernization Act of 2000 in the waning hours of the 106th Congress.
The impact on market oversight has been substantial.
NYMEX traders, for example, are required to keep records of all trades and report large trades to the CFTC. These Large Trader Reports (LTR), together with daily trading data providing price and volume information, are the CFTC’s primary tools to gauge the extent of speculation in the markets and to detect, prevent, and prosecute price manipulation.
…In contrast to trades conducted on the NYMEX, traders on unregulated OTC electronic exchanges are not required to keep records or file Large Trader Reports with the CFTC, and these trades are exempt from routine CFTC oversight.
In contrast to trades conducted on regulated futures exchanges, there is no limit on the number of contracts a speculator may hold on an unregulated OTC electronic exchange, no monitoring of trading by the exchange itself, and no reporting of the amount of outstanding contracts (”open interest”) at the end of each day.
The CFTC’s ability to monitor the U.S. energy commodity markets was further eroded when, in January of this year (2006), the CFTC permitted the Intercontinental Exchange (ICE), the leading operator of electronic energy exchanges, to use its trading terminals in the United States for the trading of U.S. crude oil futures on the ICE futures exchange in London-called ”ICE Futures.”
Previously, the ICE Futures exchange in London had traded only in European energy commodities-Brent crude oil and United Kingdom natural gas. As a United Kingdom futures market, the ICE Futures exchange is regulated solely by the United Kingdom Financial Services rooority. In 1999, the London exchange obtained the CFTC’s permission to install computer terminals in the United States to permit traders here to trade European energy commodities through that exchange.
Then, in January of this year, ICE Futures in London began trading a futures contract for West Texas Intermediate (WTI) crude oil, a type of crude oil that is produced and delivered in the United States. ICE Futures also notified the CFTC that it would be permitting traders in the United States to use ICE terminals in the United States to trade its new WTI contract on the ICE Futures London exchange.
Beginning in April, ICE Futures similarly allowed traders in the United States to trade U.S. gasoline and heating oil futures on the ICE Futures exchange in London. Despite the use by U.S. traders of trading terminals within the United States to trade U.S. oil, gasoline, and heating oil futures contracts, the CFTC has not asserted any jurisdiction over the trading of these contracts.
Persons within the United States seeking to trade key U.S. energy commodities-U.S. crude oil, gasoline, and heating oil futures-now can avoid all U.S. market oversight or reporting requirements by routing their trades through the ICE Futures exchange in London instead of the NYMEX in New York.
As an increasing number of U.S. energy trades occurs on unregulated, OTC electronic exchanges or through foreign exchanges, the CFTC’s large trading reporting system becomes less and less accurate, the trading data becomes less and less useful, and its market oversight program becomes less comprehensive.
The absence of large trader information from the electronic exchanges makes it more difficult for the CFTC to monitor speculative activity and to detect and prevent price manipulation. The absence of this information not only obscures the CFTC’s view of that portion of the energy commodity markets, but it also degrades the quality of information that is reported.
A trader may take a position on an unregulated electronic exchange or on a foreign exchange that is either in addition to or opposite from the positions the trader has taken on the NYMEX, and thereby avoid and distort the large trader reporting system.
Not only can the CFTC be misled by these trading practices, but these trading practices could render the CFTC weekly publication of energy market trading data, intended to be used by the public, as incomplete and misleading.”
Simply put, any one can now speculate and avoid being tagged with illegal price. The more speculative trading that occurs, the less “real” price discovery via true supply and demand become.
With that in mind, you can now see how the big banks have gained control and cornered the oil market.
Continued from the Report:
“…Over the past few years, large financial institutions, hedge funds, pension funds, and other investment funds have been pouring billions of dollars into the energy commodities markets…to try to take advantage of price changes or to hedge against them.
Because much of this additional investment has come from financial institutions and investment funds that do not use the commodity as part of their business, it is defined as ”speculation” by the Commodity Futures Trading Commission (CFTC).
…Reports indicate that, in the past couple of years, some speculators have made tens and perhaps hundreds of millions of dollars in profits trading in energy commodities.
This speculative trading has occurred both on the regulated New York Mercantile Exchange (NYMEX) and on the over-the-counter (OTC) markets.
The large purchases of crude oil futures contracts by speculators have, in effect, created an additional demand for oil, driving up the price of oil to be delivered in the future in the same manner that additional demand for the immediate delivery of a physical barrel of oil drives up the price on the spot market.
As far as the market is concerned, the demand for a barrel of oil that results from the purchase of a futures contract by a speculator is just as real as the demand for a barrel that results from the purchase of a futures contract by a refiner or other user of petroleum.
Although it is difficult to quantify the effect of speculation on prices, there is substantial evidence that the large amount of speculation in the current market has significantly increased prices.
Several analysts have estimated that speculative purchases of oil futures have added as much as $20-$25 per barrel to the current price of crude oil, thereby pushing up the price of oil from $50 to approximately $70 per barrel.”
The biggest banks in the world, such as Goldman Sachs, Morgan Stanley, Citigroup, JP Morgan, are now also the biggest energy traders; together, they not only participate in oil trades, but also fund numerous hedge funds that trade in oil.
Knowing how easy it is to force the price of oil upwards, the same strategies can be done in reverse to force the price of oil down.
All it takes is for some media-conjured “report” to tell us that Saudi Arabia is flooding the market with oil, OPEC is lowering prices, or that China is slowing, for oil to collapse.
Traders would then go short oil, kicking algo-traders into high gear, and immediately sending oil down further. The fact that oil consumption is actually growing really doesn’t matter anymore.
In reality, oil price isn’t dictated by supply and demand – or OPEC, or Russia, or China – it is dictated by the Western financial institutions that trade it.
“For years, I have been talking about how the banks have taken control of our civilization.
…With oil prices are falling, economies around the world are beginning to feel the pain causing a huge wave of panic throughout the financial industry. That’s because the last time oil dropped like this – more than US$40 in less than six months – was during the financial crisis of 2008.
…Let’s look at the energy market to gain a better perspective.
The energy sector represents around 17-18 percent of the high-yield bond market valued at around $2 trillion.
Over the last few years, energy producers have raised more than a whopping half a trillion dollars in new bonds and loans with next to zero borrowing costs – courtesy of the Fed.
This low-borrowing cost environment, along with deregulation, has been the goose that laid the golden egg for every single energy producer. Because of this easy money, however, energy producers have become more leveraged than ever; leveraging themselves at much higher oil prices.
But with oil suddenly dropping so sharply, many of these energy producers are now at serious risk of going under.
In a recent report by Goldman Sachs, nearly $1 trillion of investments in future oil projects are at risk.
…It’s no wonder the costs of borrowing for energy producers have skyrocketed over the last six months.
…many of the companies are already on the brink of default, and unable to make even the interest payments on their loans.
…If oil continues in this low price environment, many producers will have a hard time meeting their debt obligations – meaning many of them could default on their loans. This alone will cause a wave of financial and corporate destruction. Not to mention the loss of hundreds of thousands of jobs across North America.”
You may be thinking, “if oil’s fall is causing a wave of financial disaster, why would the banks push the price of oil down? Wouldn’t they also suffer from the loss?”
Great question. But the banks never lose. Continued from my letter:
“If you control the world’s reserve currency, but slowly losing that status as a result of devaluation and competition from other nations (see When Nations Unite Against the West: The BRICS Development Bank), what would you do to protect yourself?
You buy assets. Because real hard assets protect you from monetary inflation.
With the banks now holding record amounts of highly leveraged paper from the Fed, why would they not use that paper to buy hard assets?
Bankers may be greedy, but they’re not stupid.
The price of hard physical assets is the true representation of inflation.
Therefore, if you control these hard assets in large quantities, you could also control their price.
This, in turn, means you can maintain control of your currency against monetary inflation.
And that is exactly what the banks have done.
The True World Power
Last month, the U.S. Senate’s Permanent Subcommittee on Investigations published a 403-page report on how Wall Street’s biggest banks, such as Goldman Sachs, Morgan Stanley, and JP Morgan, have gained ownership of a massive amount of commodities, food, and energy resources.
The report stated that “the current level of bank involvement with critical raw materials, power generation, and the food supply appears to be unprecedented in U.S. history.”
For example:
“…Until recently, Morgan Stanley controlled over 55 million barrels of oil storage capacity, 100 oil tankers, and 6,000 miles of pipeline. JPMorgan built a copper inventory that peaked at $2.7 billion, and, at one point, included at least 213,000 metric tons of copper, comprising nearly 60% of the available physical copper on the world’s premier copper trading exchange, the LME.
In 2012, Goldman owned 1.5 million metric tons of aluminum worth $3 billion, about 25% of the entire U.S. annual consumption. Goldman also owned warehouses which, in 2014, controlled 85% of the LME aluminum storage business in the United States.” – Wall Street Bank Involvement with Physical Commodities, United States Senate Permanent Subcommittee on Investigations
From pipelines to power plants, from agriculture to jet fuel, these too-big-to-fail banks have amassed – and may have manipulated the prices – of some of the world’s most important resources.
The above examples clearly show just how much influence the Big Banks have over our commodities through a “wide range of risky physical commodity activities which included, at times, producing, transporting, storing, processing, supplying, or trading energy, industrial metals, or agricultural commodities.”
With practically an unlimited supply of cheap capital from the Federal Reserve, the Big Banks have turned into much more than lenders and facilitators. They have become direct commerce competitors with an unfair monetary advantage: free money from the Fed.
Of course, that’s not their only advantage.
According to the report, the Big Banks are engaging in risky activities (such as ownership in power plants and coal mining), mixing banking and commerce, affecting prices, and gaining significant trading advantages.
Just think about how easily it would be for JP Morgan to manipulate the price of copper when they – at one point – controlled 60% of the available physical copper on the world’s premier copper trading exchange, the LME.
How easy would it be for Goldman to control the price of aluminum when they owned warehouses – at one point – that controlled 85% of the LME aluminum storage business in the United States?
And if they could so easily control such vast quantities of hard assets, how easy would it be for them to profit from going either short or long on these commodities?
Always a Winner
But if, for some reason, the bankers’ bets didn’t work out, they still wouldn’t lose.
That’s because these banks are holders of trillions of dollars in FDIC insured deposits.
In other words, if any of the banks’ pipelines rupture, power plants explode, oil tankers spill, or coal mines collapse, taxpayers may once again be on the hook for yet another too-big-to-fail bailout.
If you think that there’s no way that the government or the Fed would allow this to happen again after 2008, think again.
Via the Guardian:
“In a small provision in the budget bill, Congress agreed to allow banks to house their trading of swaps and derivatives alongside customer deposits, which are insured by the federal government against losses.
The budget move repeals a portion of the Dodd-Frank financial reform act and, some say, lays the groundwork for future bailouts of banks who make irresponsibly risky trades.”
Recall from my past letters where I said that the Fed wants to engulf you in their dollars. If yet another bailout is required, then the Fed would once again be the lender of last resort, and Americans will pile on the debt it owes to the Fed.
It’s no wonder that in the report, it actually notes that the Fed was the facilitator of this sprawl by the banks:
“Without the complementary orders and letters issued by the Federal Reserve, many of those physical commodity activities would not otherwise have been permissible ‘financial’ activities under federal banking law. By issuing those complementary orders, the Federal Reserve directly facilitated the expansion of financial holding companies into new physical commodity activities.”
The Big Banks have risked tons of cash lending and facilitating in oil business. But in reality they haven’t risked anything. They get free money from the Fed, and since they aren’t supposed to be directly involved in natural resources, they obtain control in other ways.
Remember, the big banks – and ultimately the Fed who controls them – are the ones who truly control the world. Their monetary actions are the cause of many of the world’s issues and have been used for many years to maintain control of other nations and the world’s resources.
But they can’t simply go into a country, put troops on the ground and take over. No, that would be inhumane.
“Currency manipulation allows developed countries to print and lend to other developing countries at will.
A rich nation might go into a developing nation and lend them millions of dollars to build bridges, schools, housing, and expand their military efforts. The rich nation convinces the developing nation that by borrowing money, their nation will grow and prosper.
However, these deals are often negotiated at a very specific and hefty cost; the lending nation might demand resources or military and political access. Of course, developing nations often take the loans, but never really have the chance to pay it back.
When the developing nations realize they can’t pay back the loans, they’re at the mercy of the lending nations.
The trick here is that the lending nations can print as much money as they want, and in turn, control the resources of developing nations. In other words, the loans come at a hefty cost to the borrower, but at no cost to the lender.”
This brings us back to oil.
We know that oil’s crash has put a heavy burden on many debt facilities that are associated with oil. We also know that the big banks are all heavily leveraged within the sector.
If that is the case, why are the big banks so calm?
The answer is simple.
Asset-Backed Lending
Most of the loans associated with oil are done through asset-backed loans, or reserve-based financing.
It means that the loans are backed by the underlying asset itself: the oil reserves.
So if the loans go south, guess who ends up with the oil?
According to Reuters, JP Morgan is the number one U.S. bank by assets. And despite its energy exposure assumed at only 1.6 percent of total loans, the bank could own reserves of up to $750 million!
“If oil reaches $30 a barrel – and here we are – and stayed there for, call it, 18 months, you could expect to see (JPMorgan’s) reserve builds of up to $750 million.”
No wonder the banks aren’t worried about a oil financial contagion – especially not Jamie Dimon, JP Morgan’s Chairman, CEO and President:
“…Remember, these are asset-backed loans, so a bankruptcy doesn’t necessarily mean your loan is bad.” – Jamie Dimon
As oil collapses and defaults arise, the banks have not only traded dollars for assets on the cheap, but gained massive oil reserves for pennies on the dollar to back the underlying contracts of the oil that they so heavily trade.
The argument to this would be that many emerging markets have laws in place that prevent their national resources from being turned over to foreign entities in the case of corporate defaults.
Which, of course, the U.S. and its banks have already prepared for.
“…If the Fed raises interest rates, many emerging market economies will suffer the consequence of debt defaults. Which, historically means that asset fire sales – often commodity-based assets such as oil and gas – are next.
Historically, if you wanted to seize the assets of another country, you would have to go to war and fight for territory. But today, there are other less bloody ways to do that.
Take, for example, Petrobras – a semi-public Brazilian multinational energy corporation.
…Brazil is in one of the worst debt positions in the world with much of its debt denominated in US dollars.
Earlier this year (2015), Petrobras announced that it is attempting to sell $58 billion of assets – an unprecedented number in the oil industry.
Guess who will likely be leading the sale of Petrobras assets? Yup, American banks.
“…JPMorgan would be tasked with wooing the largest number of bidders possible for the assets and then structure the sales.”
As history has shown, emerging market fire sales due to debt defaults are often won by the US or its allies. Thus far, it appears the Petrobras fire sale may be headed that way.
‘Brazilian state-run oil company Petróleo Brasileiro SA said Tuesday (September 22, 2015) it is closing a deal to sell natural-gas distribution assets to a local subsidiary of Japan’s Mitsui & Co.’
The combination of monetary policy and commodities manipulation allows Western banks and allies to accumulate hard assets at the expense of emerging markets. And this has been exactly the plan since day one.
As the Fed hints of raising rates, financial risks among emerging markets will continue to build. This will trigger a reappraisal of sovereign and corporate risks leading to big swings in capital flows.”
Not only are many of the big banks’ practices protected by government and Fed policies, but they’re also protected by the underlying asset itself. If things go south, the bank could end up owning a lot of oil reserves.
No wonder they’re not worried.
And since the banks ultimately control the price of oil anyway, it could easily bring the price back up when they’re ready.
Controlling the price of oil gives U.S. and its banks many advantages.
For example, the U.S. could tell the Iranians, the Saudis, or other OPEC nations, whose economies heavily rely on oil, “Hey, if you want higher oil prices, we can make that happen. But first, you have to do this…”
You see how much control the U.S., and its big banks, actually have?
At least, for now anyway.
Don’t think for one second that nations around the world don’t understand this.
Just ask Venezuela, and many of the other countries that have succumbed to the power of the U.S. Many of these countries are now turning to China because they feel they have been screwed.
The World Shift
The diversification away from the U.S. dollar is the first step in the uprising against the U.S. by other nations.
As the power of the U.S. dollar diminishes, through international currency swaps and loans, other trading platforms that control the price of commodities (such as the new Shanghai Oil Exchange) will become more prominent in global trade; thus, bringing some price equilibrium back to the market.
And this is happening much faster than you expect.
Chinese President Xi Jinping returned home Sunday after wrapping up a historic trip to Saudi Arabia, Egypt, and Iran with a broad consensus and 52 cooperation agreements set to deepen Beijing’s constructive engagement with the struggling yet promising region.
During Xi’s trip, China upgraded its relationship with both Saudi Arabia and Iran to a comprehensive strategic partnership and vowed to work together with Egypt to add more values to their comprehensive strategic partnership.
Regional organizations, including the Organization of Islamic Cooperation (OIC), the Cooperation Council for the Arab States of the Gulf (GCC) and the Arab League (AL), also applauded Xi’s visit and voiced their readiness to cement mutual trust and broaden win-win cooperation with China.
AL Secretary General Nabil al-Arabi said China has always stood with the developing world, adding that the Arab world is willing to work closely with China in political, economic as well as other sectors for mutual benefit.
The Belt and Road Initiative, an ambitious vision Xi put forward in 2013 to boost inter-connectivity and common development along the ancient land and maritime Silk Roads, has gained more support and popularity during Xi’s trip.
…Xi and leaders of the three nations agreed to align their countries’ development blueprints and pursue mutually beneficial cooperation under the framework of the Belt and Road Initiative, which comprises the Silk Road Economic Belt and the 21st Century Maritime Silk Road.
The initiative, reiterated the Chinese president, is by no means China’s solo, but a symphony of all countries along the routes, including half of the OIC members.
During Xi’s stay in Saudi Arabia, China, and the GCC resumed their free trade talks and “substantively concluded in principle the negotiations on trade in goods.” A comprehensive deal will be made within this year.”
In other words, the big power players in the Middle East – who produce the majority of the world’s oil – are now moving closer to cooperation with China, and away from the U.S.
As this progresses, it means the role of the U.S. dollar, and its value in world trade, will diminish.
And the big banks, which hold trillions of dollars in U.S. assets, aren’t concerned.
China’s slowdown, cash-strapped emerging markets, the negative interest rate contagion – news from the world economy has been almost uniformly negative for much of the past twelve months. The bright spot amid the gloom has been the relatively upbeat US economy, the strength of which finally convinced the Fed to nudge up interest rates last December. At that time, based on the available data, we concurred that a slow liftoff was the right course of action. But a growing number of macroeconomic reports issued since call that decision into question. From productivity to durable goods orders to real GDP growth, indications are that the pace of recovery is waning. Not enough to raise fears of an imminent recession, but enough to stoke the flames of negative sentiment currently afflicting risk asset markets around the world.
Mary Mary Quite Contrary, How Does Your Economy Grow?
Jobs Friday may be the headline event for macro data nerds, but in our opinion, Productivity Wednesday was the more significant event of the week. The Bureau of Labor Statistics release this past midweek showed that fourth quarter 2015 productivity declined by three percent (annualized) from the previous quarter. Now, productivity can be sporadic from quarter to quarter, but this week’s release is part of a larger trend of lackluster efficiency gains.
As measured by real GDP, an economy can only grow in three ways: population growth, increased labor force participation, or increased output per hour of labor – i.e. productivity. Unfortunately, none of these are trending positive. The chart below offers a snapshot of current labor, productivity and growth trends.
Labor force participation (upper right area of chart) has been in steep decline for the past five years – an outcome of both the jobs lost from the 2007-09 recession and the retirement of baby boomers from the workplace. This decline has helped keep the headline unemployment rate low (blue line in the bottom left chart) and also explains in part the anemic growth in hourly wages over this period. This trend is unlikely to reverse any time soon. If real GDP growth (bottom right chart) is to return to its pre-recession normal trend line, it will have to come from productivity gains. That is why the current trend in productivity (upper left chart) is of such concern.
Of Smartphones and Sewage
The last sustained productivity surge we experienced was in the late 1990s. It is attributed largely to the fruits of the Information Age – the period when the innovations in computing and automation of the previous decades translated into increased efficiencies in the workplace. From 1995 to 2000, quarterly productivity gains averaged 2.6 percent on an annual basis. The pace slackened in the first decade of the current century. In the first five years of this decade – from 2010 to the present – average quarterly productivity growth amounted to just 0.6 percent – more than three times slower than the gains of the late 1990s.
Is that all we can expect from the Smartphone Age? Or are we simply in the middle of an innovation gap – a period in between technological breakthroughs and the translation of those breakthroughs to actual results? It is possible that a new growth age is just around the corner, powered by artificial intelligence, virtual reality and the Internet of Things, among other inventions. It is also possible that the innovations of our day simply don’t pack the same punch as those of other ages. Economist Robert Gordon makes a version of this argument in his recent book, The Rise and Fall of American Growth. Gordon points to the extraordinary period of growth our country experienced from 1870 to 1970 – growth delivered largely thanks to the inventions of electricity and the internal combustion engine – and argues that this was a one-off anomaly that we should not expect to continue indefinitely. What would you rather live without – your Twitter feed and Uber app, or indoor plumbing?
We don’t necessarily agree with Gordon’s conclusion that nothing will ever again rival electricity and motorized transport as an economic growth driver. But we do believe that the growth equation is currently stuck, and the headline data we have seen so far this year do nothing to indicate its becoming unstuck. Long-term growth is not something that drives day-to-day fluctuations in asset prices. But its absence is a problem that is increasingly part of the conversation about where markets go from here. Stay tuned for more Productivity Wednesdays.
No one has called long-duration treasury yields better than Lacy Hunt at Hoisington Management. He says they are going lower. If the US is in or headed for recession then I believe he is correct.
“Debt only works if it generates an income to repay principle and interest.”
Research indicates that when public and private debt rises above 250% of GDP it has very serious effects on economic growth. There is no bit of evidence that indicates an indebtedness problem can be solved by taking on further debt.
One of the objectives of QE was to boost the stock market, on theory that an improved stock market will increase wealth and ultimately consumer spending. The other mechanism was that somehow by buying Government securities the Fed was in a position to cause the stock market to rise. But when the Fed buys government securities the process ends there. They can buy government securities and cause the banks to surrender one type of government asset for another government asset. There was no mechanism to explain why QE should boost the stock market, yet we saw that it did. The Fed gave a signal to decision makers that they were going to protect financial assets, in other words they incentivized decision makers to view financial assets as more valuable than real assets. So effectively these decision makers transferred funds that would have gone into the real economy into the financial economy, as a result the rate of growth was considerably smaller than expected.
“In essence the way in which it worked was by signaling that real assets were inferior to financial assets. The Fed, by going into an untested program of QE effectively ended up making things worse off.”
Flattening of the Yield Curve
“Monetary policies currently are asymmetric. If the Fed tried to do another round of QE and/or negative interest rates, the evidence is overwhelming that will not make things better. However if the Fed wishes to constrain economic activity, to tighten monetary conditions as they did in December; those mechanisms are still in place.”
They are more effective because the domestic and global economy is more heavily indebted than normal. The fact we are carrying abnormally high debt levels is the reason why small increases in interest rate channels through the economy more quickly.
If the Fed wishes to tighten which they did in December then sticking to the old traditional and tested methods is best. They contracted the monetary base which ultimately puts downward pressure on money and credit growth. As the Fed was telegraphing that they were going to raise the federal funds rate it had the effect of raising the intermediate yield but not the long term yields which caused the yield curve to flatten. It is a signal from the market place that the market believes the outlook is lower growth and lower inflation. When the Fed tightens it has a quick impact and when the Fed eases it has a negative impact.
The critical factor for the long bond is the inflationary environment. Last year was a disappointing year for the economy, moreover the economy ended on a very low note. There are outward manifestations of the weakening in economy activity. One impartial measure is what happened to commodity prices, which are of course influenced by supply and demand factors. But when there are broad declines in all the major indices it is an indication of a lack of demand. The Fed tightened monetary conditions into a weakening domestic global economy, in other words they hit it when it was already receding, which tends to further weaken the almost non-existent inflationary forces and for an investor increases the value.
Failure of Quantitative Easing
“If you do not have pricing power, it is an indication of rough times which is exactly what we have.”
The fact that the Fed made an ill-conceived move in December should not be surprising to economists. A detailed study was done of the Fed’s 4 yearly forecasts which they have been making since 2007. They have missed every single year.
That was another in a series of excellent interviews by Gordon Long. There’s much more in the interview. Give it a play.
Finally, lest anyone scream to high heavens, Lacy is obviously referring to price inflation, not monetary inflation which has been rampent.
From my standpoint, consumer price deflation may be again at hand. Asset deflation in equities, and junk bonds is a near given.
The Fed did not save the world as Ben Bernanke proclaimed. Instead, the Fed fostered a series of asset bubble boom-bust cycles with increasing amplitude over time.
The bottom is a long, long ways down in terms of time, or price, or both.
Earlier this week, before first JPM and then Wells Fargo revealed that not all is well when it comes to bank energy loan exposure, a small Tulsa-based lender, BOK Financial, said that its fourth-quarter earnings would miss analysts’ expectationsbecause its loan-loss provisions would be higher than expected as a result of a single unidentified energy-industry borrower. This is what the bank said:
“A single borrower reported steeper than expected production declines and higher lease operating expenses, leading to an impairment on the loan. In addition, as we noted at the start of the commodities downturn in late 2014, we expected credit migration in the energy portfolio throughout the cycle and an increased risk of loss if commodity prices did not recover to a normalized level within one year. As we are now into the second year of the downturn, during the fourth quarter we continued to see credit grade migration and increased impairment in our energy portfolio. The combination of factors necessitated a higher level of provision expense.”
Another bank, this time the far larger Regions Financial, said its fourth-quarter charge-offs jumped $18 million from the prior quarter to $78 million, largely because of problems with a single unspecified energy borrower. More than one-quarter of Regions’ energy loans were classified as “criticized” at the end of the fourth quarter.
It didn’t stop there and as the WSJ added, “It’s starting to spread” according to William Demchak, chief executive of PNC Financial Services Group Inc. on a conference call after the bank’s earnings were announced. Credit issues from low energy prices are affecting “anybody who was in the game as the oil boom started,” he said. PNC said charge-offs rose in the fourth quarter from the prior quarter but didn’t specify whether that was due to issues in its relatively small $2.6 billion oil-and-gas portfolio.
Then, on Friday, U.S. Bancorp disclosed the specific level of reserves it holds against its $3.2 billion energy portfolio for the first time. “The reason we did that is that oil is under $30” said Andrew Cecere, the bank’s chief operating officer. What else will Bancorp disclose if oil drops below $20… or $10?
It wasn’t just the small or regional banks either: as we first reported, on Thursday JPMorgan did something it hasn’t done in 22 quarter: its net loan loss reserve increased as a result of a jump in energy loss reserves. On the earnings call, Jamie Dimon said that while he is not worried about big oil companies, his bank has started to increase provisions against smaller energy firms.
Then yesterday it was the turn of the one bank everyone had been waiting for, the one which according to many has the greatest exposure toward energy: Wells Fargo. To be sure, in order not to spook its investors, among whom most famously one Warren Buffet can be found, for Wells it was mostly “roses”, although even Wells had no choice but to set aside $831 million for bad loans in the period, almost double the amount a year ago and the largest since the first quarter of 2013.
What was laughable is that the losses included $118 million from the bank’s oil and gas portfolio, an increase of $90 million from the third quarter. Why laughable? Because that $90 million in higher oil-and-gas loan losses was on a total of $17 billion in oil and gas loans, suggesting the bank has seen a roughly 0.5% impairment across its loan book in the past quarter.
How could this be? Needless to say, this struck us as very suspicious because it clearly suggests that something is going on for Wells (and all of its other peer banks), to rep and warrant a pristine balance sheet, at least until a “digital” moment arrives when just like BOK Financial, banks can no longer hide the accruing losses and has to charge them off, leading to a stock price collapse.
Which brings us to the focus of this post: earlier this week, before the start of bank earnings season, before BOK’s startling announcement, we reported we had heard of a rumor that Dallas Fed members had met with banks in Houston and explicitly “told them not to force energy bankruptcies” and to demand asset sales instead.
Rumor Houston office of Dallas Fed met with banks, told them not to force energy bankruptcies; demand asset sales instead
We can now make it official, because moments ago we got confirmation from a second source who reports that according to an energy analyst who had recently met Houston funds to give his 1H16e update, one of his clients indicated that his firm was invited to a lunch attended by the Dallas Fed, which had previously instructed lenders to open up their entire loan books for Fed oversight; the Fed was shocked by what it had found in the non-public facing records. The lunch was also confirmed by employees at a reputable Swiss investment bank operating in Houston.
This is what took place: the Dallas Fed met with the banks a week ago and effectively suspended mark-to-market on energy debts and as a result no impairments are being written down. Furthermore, as we reported earlier this week, the Fed indicated “under the table” that banks were to work with the energy companies on delivering without a markdown on worry that a backstop, or bail-in, was needed after reviewing loan losses which would exceed the current tier 1 capital tranches.
In other words, the Fed has advised banks to cover up major energy-related losses.
Why the reason for such unprecedented measures by the Dallas Fed? Our source notes that having run the numbers, it looks like at least 18% of some banks commercial loan book are impaired, and that’s based on just applying the 3Q marks for public debt to their syndicate sums.
In other words, the ridiculously low increase in loss provisions by the likes of Wells and JPM suggest two things: i) the real losses are vastly higher, and ii) it is the Fed’s involvement that is pressuring banks to not disclose the true state of their energy “books.”
Naturally, once this becomes public, the Fed risks a stampeded out of energy exposure because for the Fed to intervene in such a dramatic fashion it suggests that the US energy industry is on the verge of a subprime-like blow up.
Putting this all together, a source who wishes to remain anonymous, adds that equity has been levitating only because energy funds are confident the syndicates will remain in size to meet net working capital deficits. Which is a big gamble considering that as we first showed ten days ago, over the past several weeks banks have already quietly reduced their credit facility exposure to at least 25 deeply distressed (and soon to be even deeper distressed) names.
However, the big wildcard here is the Fed: what we do not know is whether as part of the Fed’s latest “intervention”, it has also promised to backstop bank loan losses. Keep in mind that according to Wolfe Research and many other prominent investors, as many as one-third of American oil-and-gas producers face bankruptcy and restructuring by mid-2017 unless oil rebounds dramatically from current levels.
However, the reflexive paradox embedded in this problem was laid out yesterday by Goldman who explainedthat oil could well soar from here but only if massive excess supply is first taken out of the market, aka the “inflection phase.” In other words, for oil prices to surge, there would have to be a default wave across the US shale space, which would mean massive energy loan book losses, which may or may not mean another Fed-funded bailout of US and international banks with exposure to shale.
What does it all mean? Here is the conclusion courtesy of our source:
If revolvers are not being marked anymore, then it’s basically early days of subprime when mbs payback schedules started to fall behind. My question for bank eps is if you issued terms in 2013 (2012 reserves) at 110/bbl, and redetermined that revolver in 2014 at 86, how can you be still in compliance with that same rating and estimate in 2016 (knowing 2015 ffo and shut ins have led to mechanically 40pc ffo decreases year over year and at least 20pc rebooting of pud and pdnp to 2p via suspended or cancelled programs). At what point in next 12 months does interest payments to that syndicate start to unmask the fact that tranch is never being recovered, which I think is what pva and mhr was all about.
Beyond just the immediate cash flow and stock price implications and fears that the situation with US energy is much more serious if it merits such an intimate involvement by the Fed, a far bigger question is why is the Fed once again in the a la carte bank bailout game, and how does it once again select which banks should mark their energy books to market (and suffer major losses), and which ones are allowed to squeeze by with fabricated marks and no impairment at all? Wasn’t the purpose behind Yellen’s rate hike to burst a bubble? Or is the Fed less than “macro prudential” when it realizes that pulling away the curtain on of the biggest bubbles it has created would result in another major financial crisis?
The Dallas Fed, whose new president Robert Steven Kaplan previouslyworked at Goldman Sachs for 22 years rising to the rank of vice chairman of investment banking, has not responded to our request for a comment as of this writing. ( source: ZeroHedge )
Fed Response
Over the weekend, we gave the Dallas Fed a chance to respond to a Zero Hedge story corroborated by at least two independent sources, in which we reported that Federal Reserve members had met with bank lenders with distressed loan exposure to the US oil and gas sector and, after parsing through the complete bank books, had advised banks to i) not urge creditor counterparties into default, ii) urge asset sales instead, and iii) ultimately suspend mark to market in various instances.
Moments ago the Dallas Fed, whose president since September 2015 is Robert Steven Kaplan, a former Goldman Sachs career banker who after 22 years at the bank rose to the rank of vice chairman of its investment bank group – an odd background for a regional Fed president – took the time away from its holiday schedule to respond to Zero Hedge.
We thank the Dallas Fed for their prompt attention to this important matter. After all, as one of our sources commented, “If revolvers are not being marked anymore, then it’s basically early days of subprime when MBS payback schedules started to fall behind.” Surely there is nothing that can grab the public’s attention more than a rerun of the mortgage crisis, especially if confirmed by the highest institution.
As such we understand the Dallas Fed’s desire to avoid a public reaction and preserve semantic neutrality by refuting “such guidance.”
That said, we fully stand by our story, and now that we have engaged the Dallas Fed we would like to ask several very important follow up questions, to probe deeper into a matter that is of significant public interest as well as to clear up any potential confusion as to just what “guidance” the Fed is referring to.
Has the Dallas Fed, or any other members and individuals of the Federal Reserve System, met with U.S. bank and other lender management teams in recent weeks/months and if so what was the purpose of such meetings?
Has the Dallas Fed, or any other members and individuals of the Federal Reserve System, requested that banks and other lenders present their internal energy loan books and loan marks for Fed inspection in recent weeks/months?
Has the Dallas Fed, or any other members and individuals of the Federal Reserve System, discussed options facing financial lenders, and other creditors, who have distressed credit exposure including but not limited to:
avoiding defaults on distressed debtor counter parties?
encouraging asset sales for distressed debtor counter parties?
advising banks to avoid the proper marking of loan exposure to market?
advising banks to mark loan exposure to a model framework, one created either by the creditors themselves or one presented by members of the Federal Reserve network?
avoiding the presentation of public filings with loan exposure marked to market values of counter party debt?
Was the Dallas Fed, or any other members and individuals of the Federal Reserve System, consulted before the January 15, 2016 Citigroup Q4 earnings call during which the bank refused to disclose to the public the full extent of its reserves related to its oil and gas loan exposure, as quoted from CFO John Gerspach:
“while we are taking what we believe to be the appropriate reserves for that, I’m just not prepared to give you a specific number right now as far as the amount of reserves that we have on that particular book of business. That’s just not something that we’ve traditionally done in the past.”
Furthermore, if the Dallas Fed, or any other members and individuals of the Federal Reserve system, were not consulted when Citigroup made the decision to withhold such relevant information on potential energy loan losses, does the Federal Reserve System believe that Citigroup is in compliance with its public disclosure requirements by withholding such information from its shareholders and the public?
If the Dallas Fed does not issue “such” guidance to banks, then what precisely guidance does the Dallas Fed issue to banks?
Since the Fed is an entity tasked with serving the public, and since it took the opportunity to reply in broad terms to our previous article, we are confident that Mr. Kaplan and his subordinates will promptly address these follow up concerns.
Finally, in light of this official refutation by the Dallas Fed, we are confident that disclosing the Fed’s internal meeting schedules is something the Fed will not object to, and we hereby request that Mr. Kaplan disclose all of his personal meetings with members of the U.S. and international financial system since coming to office, both through this article, and through a FOIA request we are submitting concurrently. (source: ZeroHedge)
Fed Scrambles as Oil ETN Premium Soars to New Highs
Over the weekend, Zero Hedge reported exclusively how the Dallas Fed is pulling strings behind the scenes to conceal the fallout from the oil market crash. By suspending mark-to-market on energy loans and distorting the accounting, they are postponing the inevitable as long as possible. The current situation is eerily reminiscent to the heyday of the mortgage market in 2007, when mortgage defaults started to pick up, and yet the credit default swaps that tracked them continued to decline, bringing losses to those brave enough to trade against the crowd.
Amidst the market chaos on Friday, a trader brought something strange to my attention. He asked me exactly what the hell was going on with this ETN he was watching. I took a closer look and was baffled. It took me awhile to put the pieces together. Then when I saw the story about mark-to-market being suspended, it all made sense.
Here is the daily premium for the last 6 months on the Barclays iPath ETN that tracks oil:
Initially, I thought this was merely a sign of retail desperation. As they faced devastating losses on their oil stocks, small investors turned to products like oil ETNs as they tried to grasp the elusive oil profits their financial adviser promised them a year ago. Oblivious to the cruel mechanics of ETNs, they piled in head first, in spite of the soaring premium to fair value. After all, Larry Fink is making the rounds to convince the small investor that ETFs are indeed safer than mutual funds. Because nothing says “safe” like buying an ETN that is 36% above its fair value.
Sure, there are differences between ETFs and ETNs, particularly regarding their solvency in the event of an issuer default, but the premium/discount problem plagues ETFs and ETNs alike. Nonetheless, widely trusted retail sources of investment information perpetuate the myth that ETNs do not have tracking errors.
I thought I had connected the dots on the Oil ETN story. It was just retail ignorance. Then I saw this comment from a Zero Hedge reader:
He had a point. On Friday, stocks were slammed, and the team known as 3:30 Ramp Capital was noticeably absent.
The current stock market decline began with transportation stocks and small capitalization stocks severely under-performing the market.
Weakness then spread to the energy complex and high-yield bonds.
Yield focused stocks were the next to fall, with Kinder Morgan being the most prominent example.
Stalwarts like Apple and Gilead lost their momentum with the August 2015 decline and never regained their mojo.
In 2016, a slow motion crash is occurring in the stock market, and the price action has finally impacted the leading FANG stocks.
“Hysteria is impossible without an audience. Panicking by yourself is the same as laughing alone in an empty room. You feel really silly.” – Chuck Palahniuk
“Life is ten percent what you experience and ninety percent how you respond to it.” – Dorothy M. Neddermeyer
Introduction:
The stock market decline has gained momentum in 2016, and much like a runaway train, the current decline will be hard to stop, until the persistent overvaluations plaguing the stock market over this current bull market are corrected.
The correction that has caused the average stock in the United States to correct over 25%, thus far, started as an innocuous move down in global equities, outside of the depression enveloping the downtrodden emerging markets and commodities stocks, and then spread from transportation stocks to market leaders like biotechnology companies. The first wave down culminated in a gut-wrenching August 2015 sell-off that saw the Dow Jones Industrial Average (NYSEARCA:DIA) fall 1000 points at the open on August 24th, 2015. The panic was quickly brushed aside, but not forgotten, as market leading stocks made new highs in the fall of 2015.
That optimism, has given way to the reality that global quantitative easing has not provided the boost that its biggest supporters claimed. Now, everything is falling in tandem, and there is not much hope with the Fed nearly out of bullets, other than perhaps lower energy prices, to spark a true recovery.
The financial markets have taken notice, and are repricing assets accordingly. Just like forays to the upside are not one way affairs, the move down will not be a one-way adjustment, and investors should be prepared for sharp counter-trend rallies, and the price action yesterday, Thursday, January 14th, 2016 is a perfect example. To close, with leading stocks now suffering sizable declines that suggest institutional liquidation, investors should have their respective defensive teams on the field, and be looking for opportunistic, out-of-favor investments that have already been discounted.
Thesis:
The market correction is gaining steam and will not be completed until leading stocks and market capitalization indexes correct materially.
Small-Caps & Transports Led The Downturn:
While U.S. stocks have outperformed international markets since 2011, 2014 and 2015 saw the development of material divergences. Specifically, smaller capitalization stocks, measured by the Russell 2000 Index, and represented by the iShares Russell 2000 ETF (NYSEARCA:IWM), began under performing in 2014. Importantly, small-caps went on to make a new high in 2015, but their negative divergence all the way back in 2014, planted the seeds for the current decline, as illustrated in the chart below.
Building on the negative divergences, transportation stocks began severely under performing the broader markets in 2015. To illustrate this, I have used the charts of two leading transportation stocks, American Airlines (NASDAQ:AAL) and Union Pacific Corporation (NYSE:UNP), which are depicted below. For the record, I have taken a fundamental interest in both companies as I believe they are leading operators in their industries.
The Next Dominoes – Oil Prices & High Yield Bonds:
Oil prices, as measured by the United States Oil Fund (NYSEARCA:USO) in the chart below, were actually one of the first shoes to drop, even prior to small-cap stocks, starting a sizable move down in June of 2014.
Industry stalwart Chevron Corporation (NYSE:CVX) peaked in July of 2014, and despite tremendous volatility since then, has been in a confirmed downtrend.
As the energy complex fell apart with declining oil prices, high-yield bonds, as measured by the iShares iBoxx High Yield Corporate Bond Fund (NYSEARCA:HYG), and by the SPDR Barclays High Yield Bond ETF (NYSEARCA:JNK), made material new lows.
Yield Focused Stocks Take It On The Chin
As the energy downturn intensified, many companies that had focused on providing attractive yields, to their yield starved investors, saw their business models questioned at best, and implode at worst. The most prominent example was shares of Kinder Morgan (NYSE:KMI).
The fallout did not stop with KMI, as many MLP s and other yield oriented stocks continue to see declines as 2015 has rolled into 2016. Williams Companies (NYSE:WMB) has been especially hard hit, showing extreme volatility over the past several weeks.
Leading GARP Stocks Never Recovered:
Even though I have been bearish on the markets for some time, I was not sure if the markets would melt-up or meltdown in December of 2015, as I articulated in a Seeking Alpha article at the time.
In hindsight, the under performance of growth-at-a-reasonable-price stocks, like Apple (NASDAQ:AAPL) and Gilead Sciences (NASDAQ:GILD), which had struggled ever since the August 2015 sell-off, should have been an ominous sign.
FANG Stocks, The Last Shoe To Drop:
Even as many divergences developed in the financial markets over the last year, many leading stocks made substantial new highs in the fall of 2015, led by the FANG stocks. Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), Netflix (NASDAQ:NFLX), and Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL), along with NASDAQ stalwarts Microsoft (NASDAQ:MSFT) and Starbucks (NASDAQ:SBUX), attracted global capital as growth became an increasingly scarce commodity. The last two weeks have challenged the assumption that these companies are a safe-haven, immune from declines impacting the rest of the stock market, as the following charts show.
The PowerShares QQQ ETF (NASDAQ:QQQ), which is designed to track the performance of the NASDAQ 100 Index, and counts five of the world’s ten largest market capitalization companies among its largest holdings, Apple, Alphabet, Microsoft, Amazon, and Facebook, has outperformed the S&P 500 Index, as measured by the SPDRs S&P 500 ETF (NYSEARCA:SPY), for a majority of the current bull market, with a notable exception being the last week of 2015, and the first two weeks of 2016. Wholesale, sustained selling is now starting to grip the markets.
Conclusion – The Market Downturn Is Gaining Momentum:
The developing market correction is gaining momentum. Like an avalanche coming down a mountain, it is impacting everything it touches, and no sectors or companies, even the previously exalted FANG stocks, are immune from its reaches. Investors should have their respective defensive teams on the field, while looking for opportunities in undervalued, out-of-favor assets, as many stocks have been in their own bear markets for years.
Some of the richest people in the US, including billionaires Warren Buffett and Sam Zell, have made millions from trailer parks at the expense of the country’s poorest people. Seeing their success, ordinary people from across the country are now trying to follow in their footsteps and become trailer park millionaires.
Rising interest rates are a negative for real estate.
Gold and oil are still dropping.
Company earnings are not beating expectations.
So, where do we begin?
The economy has been firing on all eight cylinders for several years now. So long, in fact, that many do not or cannot accept the fact that all good things must come to an end. Since the 2008 recession, the only negative that has remained constant is the continuing dilemma of the “underemployed”.
Let me digress for a while and delve into the real issues I see as storm clouds on the horizon. Below are the top five storms I see brewing:
Real estate
Subprime auto loans
Falling commodity prices
Stalling equity markets and corporate earnings
Unpaid student loan debt
1. Real Estate
Just this past week there was an article detailing data from the National Association of Realtors (NAR), disclosing that existing home sales dropped 10.5% on an annual basis to 3.76 million units. This was the sharpest decline in over five years. The blame for the drop was tied to new required regulations for home buyers. What is perplexing about this excuse is NAR economist Lawrence Yun’s comments. The article cited Yun as saying that:
“most of November’s decline was likely due to regulations that came into effect in October aimed at simplifying paperwork for home purchasing. Yun said it appeared lenders and closing companies were being cautious about using the new mandated paperwork.”
Here is what I do not understand. How can simplifying paperwork make lenders “more cautious about using… the new mandated paperwork”?
Also noted was the fact that median home prices increased 6.3% in November to $220,300. This comes as interest rates are on the cusp of finally rising, thus putting pressure (albeit minor) on monthly mortgage rate payments. This has the very real possibility of pricing out investors whose eligibility for financing was borderline to begin with.
2. Subprime auto loans
Casey Research has a terrific article that sums up the problems in the subprime auto market. I strongly suggest that you read the article. Just a few of the highlights of the article are the following points:
The value of U.S. car loans now tops $1 trillion for the first time ever. This means the car loan market is 47% larger than all U.S. credit card debt combined.
According to the Federal Reserve Bank of New York, lenders have approved 96.7% of car loan applicants this year. In 2013, they only approved 89.7% of loan applicants.
It’s also never been cheaper to borrow. In 2007, the average rate for an auto loan was 7.8%. Today, it’s only 4.1%.
For combined Q2 2015 and Q3 2015, 64% of all new auto loans were classified as subprime.
The average loan term for a new car loan is 67 months. For a used car, the average loan term is 62 months. Both are records.
The only logical conclusion that can be derived is that the finances of the average American are still so weak that they will do anything/everything to get a car. Regardless of the rate, or risks associated with it.
3. Falling commodity prices
Remember $100 crude oil prices? Or $1,700 gold prices? Or $100 ton iron ore prices? They are all distant faded memories. Currently, oil is $36 a barrel, gold is $1,070 an ounce, and iron ore is $42 a ton. Commodity stocks from Cliffs Natural Resources (NYSE:CLF) to Peabody Energy (NYSE:BTU) (both of which I have written articles about) are struggling to pay off debt and keep their operations running due to the declines in commodity prices. Just this past week, Cliffs announced that it sold its coal operations to streamline its business and strengthen its balance sheet while waiting for the iron ore business to stabilize and or strengthen. Similarly, oil producers and metals mining/exploration companies are either going out of business or curtailing their operations at an ever increasing pace.
For 2016, Citi’s predictions commodity by commodity can be found here. Its outlook calls for 30% plus returns from natural gas and oil. Where are these predictions coming from? The backdrop of huge 2015 losses obviously produced a low base from which to begin 2016, but the overwhelming consensus is for oil and natural gas to be stable during 2016. This is clearly a case of Citi sticking its neck out with a prediction that will garnish plenty of attention. Give it credit for not sticking with the herd mentality on this one.
4. Stalling equity markets and corporate earnings
Historically, the equities markets have produced stellar returns. According to an article from geeksonfinace.com, the average return in equities markets from 1926 to 2010 was 9.8%. For 2015, the markets are struggling to erase negative returns. Interestingly, the Barron’s round table consensus group predicted a nearly 10% rise in equity prices in 2015 (which obviously did not materialize) and also repeated that bullish prediction for 2016 by anticipating an 8% return in the S&P. So what happened in 2015? Corporate earnings were not as robust as expected. Commodity prices put pressure on margins of commodity producing companies. Furthermore, there are headwinds from external market forces that are also weighing on the equities markets. As referenced by this article which appeared on Business Insider, equities markets are on the precipice of doing something they have not done since 1939: see negative returns during a pre-election year. Per the article, on average, the DJIA gains 10.4% during pre-election years. With less than one week to go in 2015, the DJIA is currently negative by 1.5%
5. Unpaid student loan debt
Once again, we have stumbled upon an excellent Bloomberg article discussing unpaid student loan debt. The main takeaway from the article is the fact that “about 3 million parents have $71 billion in loans, contributing to more than $1.2 trillion in federal education debt. As of May 2014, half of the balance was in deferment, racking up interest at annual rates as high as 7.9 percent.” The rate was as low as 1.8 percent just four years ago. It is key to note that this is debt that parents have taken out for the education of their children and does not include loans for their own college education.
The Institute for College Access & Success released a detailed 36 page analysis of what the class of 2014 faces regarding student debt. Some highlights:
69% of college seniors who graduated from public and private non-profit colleges in 2014 had student loan debt.
Average debt at graduation rose 56 percent, from $18,550 to $28,950, more than double the rate of inflation (25%) over this 10-year period.
Conclusion
So, what does this all mean?
To look at any one or two of the above categories and see their potential to stymie the economy, one would be smart to be cautious. To look at all five, one needs to contemplate the very real possibility of these creating the beginnings of another downturn in the economy. I strongly suggest a cautious and conservative investment outlook for 2016. While the risk one takes should always be based on your own risk tolerance levels, they should also be balanced by the very real possibility of a slowing economy which may also include deflation. Best of health and trading to all in 2016!
The Federal Reserve did it — raised the target federal funds rate a quarter point, its first boost in nearly a decade. That does not, however, mean that the average rate on the 30-year fixed mortgage will be a quarter point higher when we all wake up on Thursday. That’s not how mortgage rates work.
Mortgage rates follow the yields on mortgage-backed securities. These bonds track the yield on the U.S. 10-year Treasury. The bond market is still sorting itself out right now, and yields could end up higher or lower by the end of the week.
The bigger deal for mortgage rates is not the Fed’s headline move, but five paragraphs lower in its statement:
“The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way.”
When U.S. financial markets crashed in 2008, the Federal Reserve began buying billions of dollars worth of agency mortgage-backed securities (loans backed by Fannie Mae, Freddie Mac and Ginnie Mae). As part of the so-called “taper” in 2013, it gradually stopped using new money to buy MBS but continued to reinvest money it made from the bonds it had into more, newer bonds.
“In other words, all the income they receive from all that MBS they bought is going right back into buying more MBS,” wrote Matthew Graham, chief operating officer of Mortgage News Daily. “Over the past few cycles, that’s been $24-$26 billion a month — a staggering amount that accounts for nearly every newly originated MBS.”
At some point, the Fed will have to stop that and let the private market back into mortgage land, but so far that hasn’t happened. Mortgage finance reform is basically on the back-burner until we get a new president and a new Congress. As long as the Fed is the mortgage market’s sugar daddy, rates won’t move much higher.
“Also important is the continued popularity of US Treasury investments around the world, which puts downward pressure on Treasury rates, specifically the 10-year bond rate, which is the benchmark for MBS/mortgage pricing,” said Guy Cecala, CEO of Inside Mortgage Finance. “Both are much more significant than any small hike in the Fed rate.”
Still, consumers are likely going to be freaked out, especially young consumers, if mortgage rates inch up even slightly. That is because apparently they don’t understand just how low rates are. Sixty-seven percent of prospective home buyers surveyed by Berkshire Hathaway HomeServices, a network of real estate brokerages, categorized the level of today’s mortgage rates as “average” or “high.”
The current rate of 4 percent on the 30-year fixed is less than 1 percentage point higher than its record low. Fun fact, in the early 1980s, the rate was around 18 percent.
Jeffrey Gundlach of DoubleLine Capital just wrapped up his latest webcast updating investors on his Total Return Fund and outlining his views on the markets and the economy.
The first slide gave us the title of his presentation: “Tick, Tick, Tick …”
Overall, Gundlach had a pretty downbeat view on how the Fed’s seemingly dead set path on raising interest rates would play out.
Gundlach expects the Fed will raise rates next week (probably!) but said that once interest rates start going up, everything changes for the market.
Time and again, Gundlach emphasized that sooner than most people expect, once the Fed raises rates for the first time we’ll quickly move to talking about the next rate hike.
As for specific assets, Gundlach was pretty downbeat on the junk bond markets and commodities, and thinks that if the Fed believe it has anything like an “all clear” signal to raise rates, it is mistaken.
Here’s our full rundown and live notes taken during the call:
Gundlach said that the title, as you’d expect, is a reference to the markets waiting for the Federal Reserve’s next meeting, set for December 15-16.
Right now, markets are basically expecting the Fed to raise rates for the first time in nine years.
Here’s Gundlach’s first section, with the board game “Kaboom” on it:
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Gundlach says that the Fed “philosophically” wants to raise interest rates and will use “selectively back-tested evidence” to justify an increase in rates.
Gundlach said that 100% of economists believe the Fed will raise rates and with the Bloomberg WIRP reading — which measures market expectations for interest rates — building in around an 80% chance of rates things look quite good for the Fed to move next week.
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Gundlach said that while US markets look okay, there are plenty of markets that are “falling apart.” He adds that what the Fed does from here is entirely dependent on what markets do.
The increase in 3-month LIBOR is noted by Gundlach as a clear signal that markets are expecting the Fed to raise interest rates. Gundlach adds that he will be on CNBC about an hour before the Fed rate decision next Wednesday.
Gundlach notes that cumulative GDP since the last rate hike is about the same as past rate cycles but the pace of growth has been considerably slower than ahead of prior cycles because of how long we’ve had interest rates at 0%.
Gundlach next cites the Atlanta Fed’s GDPNow, says that DoubleLine watches this measure:
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The ISM survey is a “disaster” Gundlach says.
Gundlach can’t understand why there is such a divide between central bank plans in the US and Europe, given that markets were hugely disappointed by a lack of a major increase in European QE last week while the markets expect the Fed will raise rates next week.
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If the Fed hikes in December follow the patterns elsewhere, Gundlach thinks the Fed could looks like the Swedish Riksbank.
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And the infamous chart of all central banks that haven’t made it far off the lower bound.
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Gundlach again cites the decline in profit margins as a recession indicator, says it is still his favorite chart and one to look at if you want to stay up at night worrying.
Gundlach said that while there are a number of excuses for why the drop in profit margins this time is because of, say, energy, he doesn’t like analysis that leaves out the bad things. “I’d love to do a client review where the only thing I talk about is the stuff that went up,” Gundlach said.
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On the junk bond front, Gundlach cites the performance of the “JNK” ETF which is down 6% this year, including the coupon.
Gundlach said that looking at high-yield spreads, it would be “unthinkable” to raise interest rates in this environment.
Looking at leveraged loans, which are floating rates, Gundlach notes these assets are down about 13% in just a few months. The S&P 100 leveraged loan index is down 10% over that period.
“This is a little bit disconcerting, that we’re talking about raising interest rates with corporate credit tanking,” Gundlach said.
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Gundlach now wants to talk about the “debt bomb,” something he says he hasn’t talked about it a long time.
“The trap door falls out from underneath us in the years to come,” Gundlach said.
In Gundlach’s view, this “greatly underestimates” the extent of the problem.
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“I have a sneaking suspicion that defense spending could explode higher when a new administration takes office in about a year,” Gundlach said.
“I think the 2020 presidential election will be about what’s going on with the federal deficit,” Gundlach said.
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Gundlach now shifting gears to look at the rest of the world.
“I think the only word for this is ‘depression.'”
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Gundlach calls commodities, “The widow-maker.”
Down 43% in a little over a year. Cites massive declines in copper and lumber, among other things.
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“It’s real simple: oil production is too high,” Gundlach said.
Gundlach calls this the “chart of the day” and wonders how you’ll get balance in the oil market with inventories up at these levels.
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Gundlach talking about buying oil and junk bonds and says now, as he did a few months ago, “I don’t like to buy things that go down everyday.”
GUNDLACH: ‘It’s a different world when the Fed is raising interest rates’
Jeffrey Gundlach, CEO and CIO of DoubleLine Capital
Jeffrey Gundlach, CEO and CIO of DoubleLine Funds, has a simple warning for the young money managers who haven’t yet been through a rate-hike cycle from the Federal Reserve: It’s a new world.
In his latest webcast updating investors on his DoubleLine Total Return bond fund on Tuesday night, Gundlach, the so-called Bond King, said that he’s seen surveys indicating two-thirds of money managers now haven’t been through a rate-hiking cycle.
And these folks are in for a surprise.
“I’m sure many people on the call have never seen the Fed raise rates,” Gundlach said. “And I’ve got a simple message for you: It’s a different world when the Fed is raising interest rates. Everybody needs to unwind trades at the same time, and it is a completely different environment for the market.”
Currently, markets widely expect the Fed will raise rates when it announces its latest policy decision on Wednesday. The Fed has had rates pegged near 0% since December 2008, and hasn’t actually raised rates since June 2006.
According to data from Bloomberg cited by Gundlach on Tuesday, markets are pricing in about an 80% chance the Fed raises rates on Wednesday. Gundlach added that at least one survey he saw recently had 100% of economists calling for a Fed rate hike.
The overall tone of Gundlach’s call indicated that while he believes it’s likely the Fed does pull the trigger, the “all clear” the Fed seems to think it has from markets and the economy to begin tightening financial conditions is not, in fact, in place.
In his presentation, Gundlach cited two financial readings that were particularly troubling: junk bonds and leveraged loans.
Junk bonds, as measured by the “JNK” exchange-traded fund which tracks that asset class, is down about 6% this year, including the coupon — or regular interest payment paid to the fund by the bonds in the portfolio.
Overall, Gundlach thinks it is “unthinkable” that the Fed would want to raise rates with junk bonds behaving this way.Doubleline Capital
Meanwhile, leveraged loan indexes — which tracks debt taken on by the lowest-quality corporate borrowers — have collapsed in the last few months, indicating real stress in corporate credit markets.
“This is a little bit disconcerting,” Gundlach said, “that we’re talking about raising interest rates with corporate credit tanking.”
On Tuesday, West Texas Intermediate crude oil, the US benchmark, fell below $37 a barrel for the first time in over six years.
The implication with Gundlach’s December 2014 call is that not only would there be financial stress with oil at $40 a barrel, but geopolitical tensions as well.
Gundlach noted that while junk bonds and leveraged loans are a reflection of the stress in oil and commodity markets, this doesn’t mean these impacts can just be netted out, as some seem quick to do. These are the factors markets are taking their lead from.
It doesn’t seem like much of a reach to say that when compared to this time a year ago, the global geopolitical situation is more uncertain. Or as Gundlach said simply on Tuesday: “Oil’s below $40 and we’ve got problems.”
• No empire has ever prospered or endured by weakening its currency.
• Those who argue the Fed can’t possibly raise rates in a weakening domestic economy have forgotten the one absolutely critical mission of the Fed in the Imperial Project is maintaining U.S. dollar hegemony.
• In essence, the Fed must raise rates to strengthen the U.S. dollar ((USD)) and keep commodities such as oil cheap for American consumers.
• Another critical element of U.S. hegemony is to be the dumping ground for exports of our trading partners.
• If stocks are the tail of the bond dog, the foreign exchange market is the dog’s owner.
• No empire has ever prospered or endured by weakening its currency.
Now that the Fed isn’t feeding the baby QE, it’s throwing a tantrum. A great many insightful commentators have made the case for why the Fed shouldn’t raise rates this month – or indeed, any other month. The basic idea is that the Fed blew it by waiting until the economy is weakening to raise rates. More specifically, former Fed Chair Ben Bernanke – self-hailed as a “hero that saved the global economy” – blew it by keeping rates at zero and overfeeding the stock market bubble baby with quantitative easing (QE).
On the other side of the ledger, is the argument that the Fed must raise rates to maintain its rapidly thinning credibility. I have made both of these arguments: that the Bernanke Fed blew it big time, and that the Fed has to raise rates lest its credibility as the caretaker not just of the stock market but of the real economy implodes.
But there is another even more persuasive reason why the Fed must raise rates. It may appear to fall into the devil’s advocate camp at first, but if we consider the Fed’s action through the lens of Triffin’s Paradox, which I have covered numerous times, then it makes sense.
The core of Triffin’s Paradox is that the issuer of a reserve currency must serve two quite different sets of users: the domestic economy, and the international economy.
Those who argue the Fed can’t possibly raise rates in a weakening domestic economy have forgotten the one absolutely critical mission of the Fed in the Imperial Project is maintaining U.S. dollar hegemony.
No nation ever achieved global hegemony by weakening its currency. Hegemony requires a strong currency, for the ultimate arbitrage is trading fiat currency that has been created out of thin air for real commodities and goods.
Generating currency out of thin air and trading it for tangible goods is the definition of hegemony. Is there any greater magic power than that?
In essence, the Fed must raise rates to strengthen the U.S. dollar (USD) and keep commodities such as oil cheap for American consumers. The most direct way to keep commodities cheap is to strengthen one’s currency, which makes commodities extracted in other nations cheaper by raising the purchasing power of the domestic economy on the global stage.
Another critical element of U.S. hegemony is to be the dumping ground for exports of our trading partners. By strengthening the dollar, the Fed increases the purchasing power of everyone who holds USD. This lowers the cost of goods imported from nations with weakening currencies, who are more than willing to trade their commodities and goods for fiat USD.
But in this case, perception and signaling are more important than the actual rates: By signaling a sea change in U.S. rates, the Fed will make the USD even more attractive as a reserve currency and U.S.-denominated assets more attractive to those holding weakening currencies.
What better way to keep bond yields low and stock valuations high than insuring a flow of capital into U.S.-denominated assets?
If stocks are the tail of the bond dog, the foreign exchange market is the dog’s owner. Despite its recent thumping (due to being the most over loved, crowded trade out there), the USD is trading in a range defined by multi-year highs.
The Fed’s balance sheet reveals its basic strategy going forward: maintain its holdings of Treasury bonds and mortgage-backed securities (MBS) while playing around in the repo market in an attempt to manipulate rates higher.
Whether or not the Fed actually manages to raise rates in the real world is less important than maintaining USD hegemony. No empire has ever prospered or endured by weakening its currency.
The Fed Funds Futures say a December 2015 rate raise is a near sure thing at 74%.
Many major currencies are down substantially against the USD in the last 1-2 years. This is hurting exports. It is costing jobs.
A raise of the Fed Funds rate will lead to a further appreciation of the USD. That hurt exports more; and it will cost the US more jobs.
A raise of the Fed Funds rate will also lead to an automatic cut to the GDP’s of Third World and Emerging Market nations, which are calculated in USD’s.
There will likely be a nasty downward economic spiral effect that no one wants in Third World countries, Emerging Market countries, and in the US.
The Fed Funds Futures, which are largely based on statements from the Fed Presidents/Governors, are at 74% for a December 2015 raise as of November 26, 2015. This is up from 50% at the end of October 2015. If the Fed does raise the Fed Funds rate, will the raise have a positive effect or a negative one? Let’s examine a few data points.
First raising the Fed Funds rate will cause the value of the USD to go up relative to other currencies. It is expected that a Fed Funds rate raise will cause a rise in US Treasury yields. This means US Treasury bond values will go down at least in the near term. In the near term, this will cost investors money. However, the new higher yield Treasury notes and bonds will be more attractive to investors. This will increase the demand for them. That is the one positive. The US is currently in danger that demand may flag if a lot of countries decide to sell US Treasuries instead of buying them. The Chinese say they are selling so that they can defend the yuan. Their US Treasury bond sales will put upward pressure on the yields. That will in turn put upward pressure on the value of the USD relative to other currencies.
So far the Chinese have sold US Treasuries (“to defend the yuan”); but they have largely bought back later. Chinese US Treasuries holdings were $1.2391T as of January 2015. They were $1.258T as of September 2015. However, if China decided to just sell, there would be significant upward pressure on the US Treasury yields and on the USD. That would make China’s and other countries products that much cheaper in the US. It would make US exports that much more expensive. It would mean more US jobs lost to competing foreign products.
To better assess what may or may not happen on a Fed Funds rate raise, it is appropriate to look at the values of the USD (no current QE) versus the yen and the euro which have major easing in progress. Further it is appropriate to look at the behavior of the yen against the euro, where both parties are currently easing.
The chart below shows the performance of the euro against the USD over the last two years.
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The chart below shows the performance of the Japanese yen against the USD over the last two years.
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As readers can see both charts are similar. In each case the BOJ or the ECB started talking seriously about a huge QE plan in the summer or early fall of 2014. Meanwhile the US was in the process of ending its QE program. It did this in October 2014. The results of this combination of events on the values of the two foreign currencies relative to the USD are evident. The value of the USD went substantially upward against both currencies.
The chart below shows the performance of the euro against the Japanese yen over the last two years.
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As readers can see the yen has depreciated versus the euro; but that depreciation has been less than the depreciation of the yen against the USD and the euro against the USD. Further the amount of Japanese QE relative to its GDP is a much higher at roughly 15%+ per year than the large ECB QE program that amounts to only about 3%+ per year of effectively “printed money”. The depreciation of the yen versus the euro is the result that one would expect based on the relative amounts of QE. Of course, some of the strength of the yen is due to the reasonable health of the Japanese economy. It is not just due to QE amount considerations. The actual picture is a complex one; and readers should not try to over simplify it. However, they can generally predict/assume trends based on the macro moves by the BOJ, the ECB, and the US Fed.
The chart below shows the relative growth rates of the various central banks’ assets.
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As readers can see, this chart makes it appear that Japan is in trouble relative to the other countries. When this situation will explode (implode) into a severe recession for Japan is open to question. That is not the theme of this article, so I will not speculate here. Still it is good to be aware of the relative situation. Japan is clearly monetizing its debts relative to the other major currencies. That likely means effective losses in terms of “real” assets for the other countries. It means Japan is practicing mercantilism against its major competitors to a huge degree. Do the US and other economies want to allow this to continue unabated? Theoretically that means they are allowing Japanese workers to take their jobs unfairly.
I will not try to include the Chinese yuan in the above description, since it has not been completely free floating. Therefore the data would be distorted. However, the yuan was allowed to fall against other major currencies by the PBOC in the summer of 2015. In essence China is participating in the major QE program that many of the world’s central banks seem to be employing. It has also been steadily “easing” its main borrowing rate for more than a year now from 6.0% before November 23, 2014 to 4.35% after its latest cut October 23, 2015. It has employed other easing measures too. I have omitted them for simplicity’s sake. Many think China will continue to cut rates in 2016 and beyond as the Chinese economy continues to slow.
All of these countries are helping their exports via mercantilism by effectively devaluing their currencies against the USD. The table below shows the trade data for US-China trade for 2015.
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As readers can see in the table above the US trade deficit popped up in the summer about the time China devalued the yuan. Some of this pop was probably seasonal; but a good part of it was almost certainly not seasonal. This means the US is and will be losing more jobs in the future to China (and perhaps other countries), if the US does not act to correct/reverse this situation.
The US Total Trade Deficit has also been going up. ⦁ For January-September 2013, the deficit was -$365.3B. ⦁ For January-September 2014, the deficit was -$380.0B. ⦁ For January-September 2015, the deficit was -$394.9B.
The US Total Trade Deficit has clearly been trending upward. The lack of QE by the US for the last year plus and the massive QE by the US’ major trade partners is making the situation worse. The consequently much higher USD has been making the situation worse. The roughly -$30B increase in the US Total Trade Deficit for the first nine months of the year from 2013 to 2015 means the US has been paying US workers -$30B less than it would have if the level of the deficit had remained the same. If the deficit had gone down, US workers would have benefited even more.
If you take Cisco Systems (NASDAQ:CSCO) as an example, it had trailing twelve month revenue of $49.6B as of its Q3 2015 earnings report. That supported about 72,000 jobs. CSCO tends to pay well, so those would be considered “good” jobs. Adjusting for three fourths of the year and three fifths of the amount of money (revenue), this amounts to roughly -57,000 well paying jobs that the US doesn’t have due to the extra deficit. If I then used the multiplier effect from the US Department of Commerce for Industrial Machinery and Equipment jobs of 9.87, that would translate into over -500,000 jobs lost. Using that logic the total trade deficit may account for more than -5 million jobs lost. Do US citizens really want to see their jobs go to foreign countries? Do US citizens want to slowly “sell off the US”? How many have seen the Chinese buying their houses in California?
The US Fed is planning to make that situation worse. A raise of the Fed Funds rate will lead directly to a raise in the yield on US Treasuries. It will lead directly to a stronger USD. That will translate into an even higher US trade deficit. That will mean more US jobs lost. Who thinks that will be good for the US economy? Who thinks the rate of growth of the US trade deficit is already too high? When you consider that oil prices are about half what they were a year and a half ago, you would think that the US Trade Deficit should not even be climbing. Yet it has, unabated. That bodes very ill for the US economy for when oil prices start to rise again. The extra level of non-oil imports will not disappear when oil prices come back. Instead the Total Trade Deficit will likely spike upward as oil prices double or more. Ouch! That may mean an instant recession, if we are not already there by then. Does the US Fed want to make the already bad situation worse?
Consider also that other countries use the USD as a secondary currency, especially South American and Latin American countries. Their GDP’s are computed in USD’s. Those currencies have already shown weakness in recent years. One of the worse is Argentina. It has lost almost -60% of its value versus the USD over the last five years (see chart below).
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The big drop in January 2014 was when the government devalued its currency from 6 pesos to the USD to 8 pesos to the USD. If the Fed causes the USD to go up in value, that will lead to an automatic decrease in the Argentine GDP in USD terms. Effectively that will lead to an automatic cut in pay for Argentine workers, who are usually paid in pesos. It will cause a more rapid devaluation of the Argentine peso due to the then increased scarcity of USD’s with which to buy imports, etc. Remember also that a lot of goods are bought with USDs in Argentina because no one has any faith in the long term value of the Argentine peso. Therefore a lot of Argentine retail and other trade is done with USD’s. The Fed will immediately make Argentinians poorer. Labor will be cheaper. The cost of Argentine exports will likely go down. The US goods will then have even more trouble competing with cheaper Argentine goods. That will in turn hurt the US economy. Will that then cause a further raise to the US Treasury yields in order to make them more attractive to buyers? There is that possibility of a nasty spiral in rates upward that will be hard to stop. Further the higher rates will increase the US Budget Deficit. Higher taxes to combat that would slow the US economy further. Ouch! The Argentine scenario will likely play out in every South American and Latin American country (and many other countries around the world). Is this what the Fed really wants to accomplish? Christine Lagarde (head of the IMF) has been begging them not to do this. Too many Third World and Emerging Market economies are already in serious trouble.
Of course, there is the argument that the US has to avoid inflation; but how can the US be in danger of that when commodities prices are so low? For October export prices ex-agriculture and import prices ex-oil were both down -0.3%. The Core PPI was down -0.3%. Industrial Production was down -0.2%. The Core CPI was only up + 0.2%. The Core PCE Prices for October were unchanged at 0.0%. Isn’t that supposed to be one of the Fed’s favorite inflation gauges? Personal Spending was only up +0.1%, although Personal Income was up +0.4%. I just don’t see the inflation the Fed seems to be talking about. Perhaps when oil prices start to rise again, it will be time to raise rates. However, when there are so many arguments against raising rates, why would the Fed want to do so early? It might send the US economy into a recession. It would only increase the rate of rise of the US Trade Deficit and the US Budget Deficit. It would only hurt Third World and Emerging Market economies.
Of course, there is the supposedly full employment argument. However, the article, “20+ Reasons The Fed Won’t RaiseEven After The Strong October Jobs Number” contains a section (near the end of the article) that explains that the US employment rate is actually 10.8% relatively to the level of employment in 2008 (before the Great Recession). The US has not come close to recovering from the Great Recession in terms of jobs; and for the US Fed or the US government to pretend that such a recovery has occurred is a deception of US citizens. I am not talking about the U6 number for people who are only partially employed. If I were, the unemployment number would be roughly 15%. I am merely adding in all of the people who had jobs in 2008, who are no longer “in the work force” because they have stopped “looking for jobs” (and therefore not in the unemployment number calculation). The unemployment number the government and the Fed are citing is a farce if you are talking about the 2008 employment level; and people should recognize this. The Fed should also be recognizing this when they are making decisions based on the unemployment level. Political posturing by Democrats (Obama et al) to improve the Democratic performance in the 2016 elections will only have a negative impact on the US economy. There is no “full employment” at the moment.
We all know that the jobs numbers are usually good due to the Christmas season. Some say those jobs don’t count because they are all part time. However, a lot of businesses hire full time temporarily. Think of all of those warehouse jobs for e-commerce. Do you think they want to train more people to work part time? Or do you think they want to train fewer people to work perhaps even more than full time? Confusion costs money. It slows things down. Fewer new people is often the most efficient way to go. A lot of the new jobs for the Christmas season are an illusion. They will disappear come late January 2016. Basing a Fed Funds rate raise on Christmas season hiring is again a mistake that will cost the US jobs in the longer term. If the Fed does this, it will be saying that the US economy exists in a US vacuum. It will be saying that the US economy is unaffected by the economies of the rest of the world. Remember the latest IMF calculation for the world economic outlook for FY2015 was cut in October 2015 to +3.1% GDP Growth. This is -0.2% below the IMF’s July 2015 estimate and -0.3% below FY2014. If the world economic growth outlook is falling, is it at all reasonable to think that US economic growth will be so high as to cause significant inflation? Is it instead more reasonable to think that a higher Fed Funds rate, higher Treasury yields, and a more highly valued USD will cause the US economy to slow further as would be the normal expectation? Does the Fed want to cause STAGFLATION?
If the Fed goes through with their plan to raise rates in December 2015, they will be committing the Sin Of Pride. That same sin is at least partially responsible for the US losing so many of its jobs to overseas competitors over the last 50 years. One could more logically argue that the Fed should be instituting its own QE program in order to combat the further lost of US jobs to the mercantilist behaviors of its trade partners. The only reason not to do this is that it believes growing its balance sheet will be unhealthy in the long run. However, the “Total Central Bank Assets (as a % of GDP)” chart above shows that the US is lagging both the ECB and the BOJ in the growth of its balance sheet. In other words our major competitors are monetizing their debts at a faster rate than we are. You could argue that someone finally has to stop this trend. However, the logical first step should be not adding to the central banks’ asset growth. Reversing the trend should not be attempted until the other major central banks have stopped easing measures. Otherwise the US Fed is simply committing the SIN OF PRIDE; and as the saying goes, “Pride goeth before a fall”. There are a lot of truisms in the Bible (Proverbs). It is filled with the wisdom of the ages; and even the Fed can benefit from its lessons. Let’s hope they do.
The moon was a waning crescent sliver Sept. 9 when a man emerged from an oil tanker, sidled up to a well outside Cotulla, Texas, and siphoned off almost 200 barrels. Then, he drove two hours to a town where he sold his load on the black market for $10 a barrel, about a quarter of what West Texas Intermediate currently fetches.
“This is like a drug organization,” said Mike Peters, global security manager of San Antonio-based Lewis Energy Group, who recounted the heist at a Texas legislative hearing. “You’ve got your mules that go out to steal the oil in trucks, you’ve got the next level of organization that’s actually taking the oil in, and you’ve got a gathering site — it’s always a criminal organization that’s involved with this.”
From raw crude sucked from wells to expensive machinery that disappears out the back door, drillers from Texas to Colorado are struggling to stop theft that has only worsened amid the industry’s biggest slowdown in a generation. Losses reached almost $1 billion in 2013 and likely have grown since, according to estimates from the Energy Security Council, an industry trade group in Houston. The situation has been fostered by idled trucks, abandoned drilling sites and tens of thousands of lost jobs.
“You’ve got unemployed oilfield workers that unfortunately are resorting to stealing,” said John Chamberlain, executive director of the Energy Security Council.
In Texas, unemployment insurance claims from energy workers more than doubled over the past year to about 110,000, according to the Workforce Commission. In North Dakota, average weekly wages in the Bakken oil patch decreased nearly 10 percent in the first quarter of 2015, compared with the previous quarter, according to the Federal Reserve Bank of Minneapolis.
With dismissals hitting every corner of the industry, security guards hired during boom times are receiving pink slips. That’s leaving sites unprotected.
“There are a lot less eyes out there for security,” said John Esquivel, an analyst at security consulting firm Butchko Inc. in Tomball, Texas, and a former chief executive of the U.S. Border Patrol in Laredo. “The drilling activity may be quieter, but I don’t think criminal activity is.”
Special Charges
States are trying to get a handle on the theft, which can include anything from drill bits that can fetch thousands on the resale market, to copper wiring that can be melted down, to the crude itself. Texas lawmakers met earlier this month in Austin to craft a bill that would increase penalties related to the crime. A similar measure passed both houses of the legislature this year, but Republican Governor Greg Abbott vetoed it, saying it was “overly broad.” Lawmakers, at the urging of industry, are hoping to revive it next legislative session.
In Oklahoma, law-enforcement officers recently teamed with the Federal Bureau of Investigation to intensify their effort. In North Dakota, the FBI earlier this year opened an office in the heart of oil country to combat crimes including theft, drug trafficking and prostitution.
The lull in drilling has given oil companies more time to scrutinize their operations — and their losses.
During booms “they are moving at such a rapid pace there’s not a lot of auditing and inventorying going on,” said Gary Painter, sheriff in Midland County, Texas, in the oil-rich Permian Basin. “Whenever it slows down, they start looking for stuff and find out it never got delivered or it got delivered and it’s gone.”
Oil theft is as old as Spindletop, the East Texas oilfield that spewed black gold in 1901 and began the modern oil era. In the early 1900s, Texas Rangers were often deployed to carry out “town taming” in oil fields rife with roughnecks, prostitutes, gamblers and thieves. In 1932, 18 men were indicted for their role in a Mexia ring that included prominent politicians and executives and resulted in the theft of 1 million barrels.
The allure of ill-gotten oil money remains strong.
In April, the Weld County Sheriff’s office in Colorado recovered almost $300,000 worth of stolen drill bits. In January, a Texas man pleaded guilty to stealing three truckloads of oil worth nearly $60,000 after an investigation by the FBI and local law-enforcement officers. Robert Butler, a sergeant at the Texas Attorney General’s Office whose primary job is to investigate oil theft, said in the legislative hearing that he is investigating a case of 470,000 barrels stolen and sold over the past three years worth about $40 million.
In Texas, oilfield theft has become entangled with Mexican drug trafficking, as the state’s newest and biggest production area, the Eagle Ford Shale region, lies along traditional smuggling routes. That’s thrust oil workers in the middle of cartel activity, and made it even more difficult to track stolen goods across the U.S.-Mexico border, said Esquivel, the retired Border Patrol agent.
Trickling Away
Oil thieves are a slippery bunch. Criminals sand off serial numbers of stolen goods to evade detection or melt them for scrap. Tracking raw crude is even trickier, since tracing it to its originating well is almost impossible once it’s mixed with other oil. Many companies fail to report the crime, making it difficult for investigators to trace the origins of stolen goods.
Many of the crimes are inside jobs, with thieves doubling as gate guards, tank drivers or well servicers. Last year, a federal grand jury indicted three Texas men in connection with the theft of $1.5 million worth of oil from their employers, including Houston’s Anadarko Petroleum Corp.
“Your average person wouldn’t know the value of a drill bit or a piece of tubing or a gas meter,” said Chamberlain. “It’d be like breaking into a jewelry store; unless you know what’s valuable, you wouldn’t know what to steal.”
The federal government has piled up debt since the latest budget deal was signed into law, tacking $462 billion onto the national credit card since Nov. 2 as the Treasury Department replenished its funds and began another round of borrowing to take it all the way into 2017.
A staggering $339 billion in total debt was added on just the first day after President Obama signed the budget agreement — the single largest hike in history.
The debt has continued to rise, albeit more slowly, in the days since, putting the president on track to come close to the $20 trillion mark by the time he leaves office in January 2017.
Meanwhile, the early deficit numbers for fiscal year 2016, which began Oct. 1, are already looking more grim.
The government ran a deficit of $136 billion last month, up 12 percent compared with the previous October, as spending ballooned and taxes remained nearly flat. It was the worst October since 2010, when the government was still spending on the stimulus and was on pace for a deficit of more than $1 trillion that year.
The Treasury Department did not respond to a request for comment on the debt spike, but analysts said it wasn’t unexpected.
“It’s not going to keep rising at that pace. It’s like putting a cap on a geyser. It was being held at an artificially low pace,” said Robert L. Bixby, executive director of the Concord Coalition, which pushes for policymakers to control debt and deficits. “It’ll increase at a more traditional level from this point on.”
Despite the massive spread of red ink, the government has been getting away with small debt service payments because of historically low interest rates over the past several years.
But as rates rise, so will those payments — from about $220 billion a year now to $755 billion a year in a decade.
The size of the debt has begun to take a starring role in the 2016 presidential campaigns. In the Republican debate Tuesday, Fox Business Network prodded candidates on their plans.
Sen. Rand Paul of Kentucky poked fellow candidate Sen. Marco Rubio for a tax and defense spending plan that Mr. Paul said would hike deficits by $1 trillion.
“As we go further and further into debt, we become less and less safe. This is the most important thing we’re going to talk about tonight,” Mr. Paul said. “Can you be for unlimited military spending, and say, ‘Oh, I’m going to make the country safe?’ No, we need a safe country, but, you know, we spend more on our military than the next 10 countries combined.”
Mr. Rubio said defense comes first.
“We can’t even have an economy if we’re not safe,” he said.
Ohio Gov. John Kasich, who as chairman of the House Budget Committee in the late 1990s helped write the deals that produced four years of surpluses, said he has plans to do it again — including a freeze on non-defense discretionary spending.
But it was just such a freeze that Congress rejected this year, forcing the budget deal that allowed for unlimited borrowing for another 16 months.
Mr. Bixby said Congress should use those months to work on long-term fixes rather than preparing for another knock-down fight over the debt limit.
“The way to keep the debt from going up is to change the policies producing the debt,” he said.
The government began bumping up against the debt limit in March and was borrowing from other funds — using “extraordinary measures” — to keep from breaching the $18.1 trillion level. Treasury Secretary Jacob Lew was able to stretch that borrowing through the end of October, when Congress passed a debt holiday lasting into March 2017, allowing him to borrow as much as needed to keep the federal government operating.
The first move was to replenish all of the funds depleted under the “extraordinary measures,” which is what sent debt skyrocketing on Nov. 2.
Such spikes are normal. In 2013, when a debt deal was reached, the government added $328 billion to its borrowing in one day. After the August 2011 debt deal, the amount rose $238 billion in one day.
But the Nov. 2 spike topped them all, at $339 billion in one day.
Of that, about $199 billion is public debt, which is money borrowed from outside sources, and $140 billion is borrowing from within government accounts.
As of Monday, the gross total debt stood at $18.6 trillion, with $13.4 trillion of that public debt borrowed from the outside.
When Mr. Obama took office in 2009, total debt stood at $10.6 trillion.
If investors in stocks of home builders are wondering why they are losing money Thursday despite such upbeat new home sales data, traders of lumber futures may be smugly thinking: “Told you so.”
New home sales for Augustjumped more than expected to the highest level since February 2008. But the SPDR S&P Home builders exchange-traded fund XHB, +0.17% fell 0.5% in afternoon trade Thursday, and was down as much as 2.1% earlier in the session. The home builder-sector tracker (XHB) has lost 2.8% this week, and slumped 8.8% since it hit an 8 1/2-year high on Aug. 19.
FactSet Pullback in home builder stocks may be just the beginning
Some chart watchers might say, that’s easy.
Tom McClellan, publisher of the investment newsletter McClellan Market Report, said his research suggests lumber prices seem to foretell, about 12 months in advance, changes in the rate of new home sales. “That is important because lumber has been falling rapidly this year, which suggests a corresponding drop in new home sales in store over the next 12 months,” McClellan wrote in a recent report to clients.
Based on that assessment, home builder stocks appear to be well overdue for a bigger selloff.
Continuous lumber futures LBX5, -0.09% declined 0.1% Thursday to the lowest level in nearly four years, as they have tumbled 34% so far this year.
Selloff in lumber prices may suggest home builder stocks are overdue for bigger decline
What’s worse, McClellan said this week that recent data in the Commitment of Traders Report, published by the Commodity Futures Trading Commission, regarding the recent activity of commercial traders—the so-called “smart money”–suggests log prices are likely to see a further big drop over the next couple of months.
“And that is another sign of economic troubles about to befall not only the lumber market but also the rest of the economy,” McClellan said.
The Shanghai stock exchange, which has been creating global stock market convulsions while trimming 39 percent off its value since June, will be closed for the next two days. The Chinese holiday started on Thursday in Beijing with a big parade and show of military might to commemorate the 70th anniversary of V-Day and the defeat of Japan in World War II.
The massive military pageantry and display of weaponry was widely seen as a move by President Xi Jinping to reassert his authoritarian rule in the wake of a sputtering domestic economy, $5 trillion in value shaved off the stock market in a matter of months, and the need to devalue the country’s currency on August 11 in a bid to boost exports.
Tragically, what has received far less attention than melting China stocks is the mass arrests of dissidents, human rights activists, attorneys and religious leaders. More recently, the government has begun to “detain” journalists and finance executives in an apparent attempt to scapegoat them for the stock market’s selloff.
The mass arrests began in July, the same time the China stock market started to crater in earnest. Last evening, the Financial Times had this to say about the disappearance of Li Yifei, a prominent hedge fund chief at Man Group China.
“The whereabouts of Ms Li remained unclear on Wednesday. Her husband, Wang Chaoyong, told the Financial Times that her meetings with financial market authorities in Beijing had concluded, and ‘she will take a break for a while.’ ”
Bloomberg Business had previously reported that Li Yifei was being held by the police as part of a larger roundup of persons they wanted to interview regarding the stock market rout.
The reaction to these authoritarian sweeps has worsened the stock market situation in China. Volume on the Shanghai market, according to the Financial Times, has skidded from $200 billion on the heaviest days in June to just $66 billion this past Tuesday.
On Tuesday afternoon, a Wall Street Journal reporter was interviewed by phone from Beijing on the business channel, CNBC. He said “waves” of arrests were taking place. That interview followed an article in the Wall Street Journal on Monday, which appeared with no byline (perhaps for the safety of the Beijing-based reporter) that shed more light on the arrests:
“Chinese police on the weekend began rounding up the usual suspects, which in this case are journalists, brokers and analysts who have been reporting stock-market news. Naturally, the culprits soon confessed their non-crimes on national television. A reporter for the financial publication Caijing was shown on China Central Television on Monday admitting that he had written an article with ‘great negative impact on the market.’ His offense was reporting that authorities might scale back official share-buying, which is what they soon did. On Sunday China’s Ministry of Public Security announced the arrest of nearly 200 people for spreading rumors about stocks and other incidents.”
Also on Tuesday, David Saperstein, the U.S. Ambassador-at-large for religious freedom, publicly demanded that China release attorney Zhang Kai and religious leaders who had been swept up by the government the very day before Saperstein had been scheduled to meet with them. In an interview with the Associated Press, Saperstein called the state actions “outrageous,” particularly since he had been invited to China to observe religious freedom in the country.
Christianity is growing rapidly in some regions of China and strong religious leaders or movements are seen as a threat to communist party rule. Religious leaders had been protesting the state’s removal of crosses from the tops of churches.
On July 22, the New York Times reported that over 200 human rights lawyers and their associates had been detained. Using the same humiliating tactic as used recently against the financial journalist, The Times reports that some of the “lawyers have been paraded on television making humiliating confessions or portrayed as rabble-rousing thugs.” One of the lawyers who was later released, Zhang Lei, told The Times: “This feels like the biggest attack we’ve ever experienced. It looks like they’re acting by the law, but hardly any of the lawyers who disappeared have been allowed to see their own lawyers. Over 200 brought in for questioning and warnings — I’ve never seen anything like it before.”
U.S. Ambassador to the United Nations, Samantha Power, is also demanding the release of female prisoners in China, including Wang Yu, who was arrested with her husband in July.
According to a detailed interview that Wang Yu gave the Guardian prior to her detention and disappearance on July 9, people are being arrested, grabbed off the street, sent to mental hospitals or detention centers. She said: ‘You could disappear at any time.’
As a documentary made by the Guardian shows, one of Wang Yu’s cases involved the alleged rape of six underage girls by the headmaster of their school. Wang Yu took the case and organized a protest, handing out literature on child protection laws to pedestrians and people passing by in automobiles.
Parents of the young girls who had originally consented to their legal representation soon withdrew the consent, saying they were being monitored by the government and had been told not to speak to journalists or lawyers. Wang Yu said that cases like this are happening every minute and everywhere in China.
Yesterday, the Mail & Guardian reported that Wang Yu’s whereabouts remain a mystery.
On August 18, Reuters reported that Chinese government officials “had arrested about 15,000 people for crimes that ‘jeopardized Internet security,’ as the government moves to tighten controls on the Internet.”
Against this horrific backdrop, China’s authoritarian President Xi Jinping is slated to visit the United States late this month for a meeting with President Obama and state dinner at the White House. According to the Washington Post’s David Nakamura, a bipartisan group of 10 senators sent President Obama a letter in August calling on him to raise the issue of human rights abuses when Xi visits. The Post published the following excerpt from the letter:
“We expect that China’s recent actions in the East and South China Seas, economic and trade issues, climate change, as well as the recent cyber-attacks, will figure prominently in your discussions. While these issues deserve a full and robust exchange of views, so too do human rights. Under President Xi, there has been an extraordinary assault on rule of law and civil society in China.”
Given the delicacy with which President Obama is likely to broach this subject with Xi, a mass demonstration outside of the White House by human rights activists and lawyers in this country during the White House visit might send a more powerful message. Last year, U.S. consumers and businesses purchased $466.8 billion in goods from China. Should these human rights abuses continue, China should be made aware that consumers in the U.S. know how to check labels for country of origin.
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In a securities-based loan, the customer pledges all or part of a portfolio of stocks, bonds, mutual funds and/or other securities as collateral. But unlike traditional margin loans, in which the client uses the credit to buy more securities, the borrowing is for other purchases such as real estate, a boat or education.
The result was “dangerously high margin balances,” said Jeff Sica, president at Morristown, N.J.-based Circle Squared Alternative Investments, which oversees $1.5 billion of mostly alternative investments. He said the products became “the vehicle of choice for investors looking to get cash for anything.” Mr. Sica and others say the products were aggressively marketed to investors by banks and brokerages.
Today’s article from the Wall Street Journal on investors taking out large loans backed by portfolios of stocks and bonds is one of the most concerning and troubling finance/economics related articles I have read all year.
Many of you will already be aware of this practice, but many of you will not. In a nutshell, brokers are permitting investors to take out loans of as much as 40% of the value from a portfolio of equities, and up to a terrifying 80% from a bond portfolio. The interest rates are often minuscule, as low as 2%, and since many of these clients are wealthy, the loans are often used to purchase boats and real estate.
At the height of last cycle’s credit insanity, we saw average Americans take out large home loans in order to do renovations, take vacations, etc. While we know how that turned out, there was at least some sense to it. These people obviously didn’t want liquidate their primary residence in order to do these things they couldn’t actually afford, so they borrowed against it.
In the case of these financial assets loans, the investors could easily liquidate parts of their portfolio in order to buy their boats or houses. This is what a normal, functioning sane financial system would look like. Rather, these clients are so starry eyed with financial markets, they can’t bring themselves to sell a single bond or share in order to purchase a luxury item, or second home. Of course, Wall Street is encouraging this behavior, since they can then earn the same amount of fees managing financial assets, while at the same time earning money from the loan taken out against them.
I don’t even want to contemplate the deflationary impact that this practice will have once the cycle turns in earnest. Devastating momentum liquidation is the only thing that comes to mind.
So when you hear about margin loans against stocks, it’s not just to buy more stocks. It’s also to buy “pretty much everything…”
Loans backed by investment portfolios have become a booming business for Wall Street brokerages. Now the bill is coming due—for both the banks and their clients.
Among the largest firms, Morgan Stanley had $25.3 billion in securities-based loans outstanding as of June 30, up 37% from a year earlier. Bank of America, which owns brokerage firm Merrill Lynch, had $38.6 billion in such loans outstanding as of the end of June, up 14.2% from the same period last year. And Wells Fargo & Co. said last month that its wealth unit saw average loans, including these loans and traditional margin loans, jump 16% to $59.3 billion from last year.
In a securities-based loan, the customer pledges all or part of a portfolio of stocks, bonds, mutual funds and/or other securities as collateral. But unlike traditional margin loans, in which the client uses the credit to buy more securities, the borrowing is for other purchases such as real estate, a boat or education.
Securities-based loans surged in the years after the financial crisis as banks retreated from home-equity and other consumer loans. Amid a years long bull market for stocks, the loans offered something for everyone in the equation: Clients kept their portfolios intact, financial advisers continued getting fees based on those assets and banks collected interest revenue from the loans.
This is the reason Wall Street loves these things. You earn on both sides, while making the financial system much more vulnerable. Ring a bell?
The result was “dangerously high margin balances,” said Jeff Sica, president at Morristown, N.J.-based Circle Squared Alternative Investments, which oversees $1.5 billion of mostly alternative investments. He said the products became “the vehicle of choice for investors looking to get cash for anything.” Mr. Sica and others say the products were aggressively marketed to investors by banks and brokerages.
Even before Wednesday’s rally, some banks said they were seeing few margin calls because most portfolios haven’t fallen below key thresholds in relation to loan values.
“When the markets decline, margin calls will rise,” said Shannon Stemm, an analyst at Edward Jones, adding that it is “difficult to quantify” at what point widespread margin calls would occur.
Bank of America’s clients through Merrill Lynch and U.S. Trust are experiencing margin calls, but the numbers vary day to day, according to spokesman for the bank. He added the bank allows Merrill Lynch and U.S. Trust clients to pledge investments in lieu of down payments for mortgages.
Clients may be able to borrow only 40% or less of the value of concentrated stock positions or as much as 80% of a bond portfolio. Interest rates for these loans are relatively low—from about 2% annually on large loans secured by multi million-dollar accounts to around 5% on loans less than $100,000.
80% against a bond portfolio. Yes you read that right. Think about how crazy this is with China now selling treasuries, and U.S. government bonds likely near the end of an almost four decades bull market.
About 18 months ago, he took out a $93,000 loan through Neuberger Berman, collateralized by about $260,000 worth of stocks and bonds, and used the proceeds to buy his share in a three-unit investment property in the Bushwick section of Brooklyn, N.Y. He says that his portfolio, up about 3% since he took out the loan, would need to fall 25% before he would worry about a margin call.
Regulators earlier this year had stepped up their scrutiny of these loans due to their growing popularity at brokerages. The Financial Industry Regulatory Authority put securities-based loans on its so-called watch list for 2015 to get clarity on how securities-based loans are marketed and the risk the loans may pose to clients.
“We’re paying careful attention to this area,” said Susan Axelrod,head of regulatory affairs for Finra.
I think the window for “paying close attention” closed several years ago.
Perhaps it’s all the talk about across-the-board debt forgiveness or maybe the total amount of outstanding student debt has simply grown so large ($1.3 trillion) that even those with no conception of how much money that actually is realize that it’s simply never going to paid back so there’s no point worrying about, but whatever the case, the general level of concern regarding America’s student debt bubble doesn’t seem to be at all commensurate with the size of the problem.
And it’s not just the sheer size of the debt pile that’s worrisome. There’s also the knock-on effects, such as delayed household formation and the attendant downward pressure on the home ownership rate, and of course hyperinflation in the rental market.
Of course one reason no one is panicking – yet – is that the severity of the problem is masked by artificially suppressed delinquency rates. As we’ve documented in excruciating detail, if one excludes loans in deferment and forbearance from the numerator in the delinquency calculation, but includes those loans in the denominator then the delinquency rate will be deceptively low. In any event, as WSJ reports, even if one looks at something very simple like, say, the number of borrowers who haven’t made a payment in a year, the picture is not pretty and it’s getting worse all the time. Here’s more:
Nearly seven million Americans have gone at least a year without making a payment on their federal student loans, a staggering level of default that highlights how student debt continues to burden households despite an improving labor market.
As of July, 6.9 million Americans with student loans hadn’t sent a payment to the government in at least 360 days, quarterly data from the Education Department showed this week. That was up 6%, or 400,000 borrowers, from a year earlier.
The figures translate into about 17% of all borrowers with federal loans being severely delinquent—and that share would be even higher if borrowers currently in school were excluded. Additionally, millions of other borrowers who haven’t hit the 360-day threshold that the government defines as a default are months behind on their payments.
Each new crop of students is experiencing the same problems” with repaying, said Mark Kantrowitz, a higher-education expert and publisher of the information website Edvisors.com. “The entire situation isn’t getting better.”
The development carries big implications for borrowers, taxpayers and the economy. Economists have warned of student-debt defaults damaging borrowers’ credit standing, which would hurt their ability to borrow for things like cars and homes. That in turn would hamper the economy, which relies heavily on consumer purchases for economic activity. Delinquencies also drain government revenues, which are used to make future loans.
Education Secretary Arne Duncan said declines [in some categories of delinquencies] resulted from rising participation in income-based repayment plans, which lower borrowers’ monthly bills by tying payments to their incomes. Enrollment in the plans surged 56% over the past year among direct-loan borrowers.
The administration has urgently promoted the plans, mainly through emails to borrowers, over the past two years in an effort to stem defaults. The plans set payments as 10% or 15% of their discretionary income, defined as adjusted gross income minus 150% the federal poverty level.
The plans carry risks, though, for both borrowers and the government. Many borrowers’ payments aren’t enough to cover the interest on their debt, allowing their balances to grow and threatening to trap them under debt for years.
At the same time, the government could be left forgiving huge amounts of debt if borrowers stay in the plans. The government forgives balances after 10, 20 or 25 years of on-time payments, depending on the plan.
But aside from the fact that these plans will cost taxpayers an estimated $39 billion over the next decade – and that’s just counting those expected to enroll in plans going forward and ignoring the $200 billion or so in loans already enrolled in an IBR plan – the most absurd thing about Duncan’s claim is that, as we’ve shown, IBR programs don’t drive down delinquency rates, they just change the meaning of the term “payment”:
See how that works? If you can’t afford to pay, just tell the Department of Education and they’ll enroll you in an IBR plan where your “payments” can be $0 and you won’t be counted as delinquent.
So we suppose we should retract the statement we made above. You are correct Mr. Duncan, these plans are actually very effective at bringing down delinquencies and the method is remarkably straightforward: the government just stopped counting delinquent borrowers as delinquent.
Wealthy, very nervous foreigners yanking their money out of their countries while they still can and pouring it into US residential real estate, paying cash, and driving up home prices – that’s the meme. But it’s more than a meme as political and economic risks in key countries surge.
And home prices are being driven up. The median price of all types of homes in July, as the National Association of Realtors (NAR) sees it, jumped 5.6% from a year ago to $234,000, now 1.7% above the totally crazy June 2006 peak of the prior bubble that blew up in such splendid manner. But you can’t even buy a toolshed for that in trophy cities like San Francisco, where the median house price has reached $1.3 million.
And the role of foreign buyers?
[N]ever have so many Chinese quietly moved so much money out of the country at such a fast pace. Nowhere is that Sino capital flight more prevalent than into the US residential real estate market, where billions are rapidly pouring into the American Dream. From New York to Los Angeles, China’s nouveau riche are going on a housing shopping spree.
“For economic and political reasons, Chinese investors want to protect their wealth by diversifying their assets by buying US real estate,” William Yu, an economist at UCLA Anderson Forecast, told RealtyTrac. “The best place for China’s smart money to invest is the United States.”
In the 12-month period ending March 2015, buyers from China have for the first time ever surpassed Canadians as the top foreign buyers, plowing $28.6 billion into US homes, at an average price of $831,800, according to the NAR. In dollar terms, Chinese buyers accounted for 27.5% of the $104 billion that foreign buyers spent on US homes. It spawned a whole industry of specialized Chinese-American brokers.
Political and economic instability in China along with the anti-corruption drive have been growing concerns for wealthy Chinese, Yu said. “China’s real estate market has peaked already. Their housing bubble has popped.”
So they’re hedging their bets to protect their wealth. And more than their wealth….
“China’s economic elites have one foot out the door, and they are ready to flee en masse if the system really begins to crumble,” explained David Shambaugh Professor at George Washington University in Washington, D.C.
China has capital controls in place to prevent this sort of thing for the average guy. But Yu said there are ways for well-connected Chinese to transfer money to the US, particularly those with business relationships in Hong Kong or Taiwan.
But in the overall and immense US housing market, foreign buying isn’t exactly huge. According to NAR, foreign buyers acquired 209,000 homes over the 12-month period, or 4% of existing home sales. But foreign buyers go for the expensive stuff, and in dollar terms, their purchases amounted to 8% of existing home sales.
In most states, offshore money accounts for only 3% or less of total homes sales. But in four states it’s significant: Florida (21%), California (16%), Texas (8%), and Arizona (5%). And in some trophy cities in these states, the percentages are huge.
“On the residential side, Chinese buyers are looking for very specific things,” Alan Lu, owner of ALTC Realty in Alhambra, California, told RealtyTrac. “They are looking for grand houses with large footprints. And they want lots of upgrades. It’s a must. They also like new homes.”
Among California cities that are hot with Chinese investors: Alhambra, Arcadia, Irvine, Monterey Park, San Francisco, San Marino, and in recent years Orange County, “a once heavily white middle-class suburb that is now 40% Asian and becoming increasingly expensive,” according to RealtyTrac:
Buyers from China, including investors from Hong Kong and Taiwan, are driving up prices and fueling new construction in Southern California areas such as Arcadia, a city of 57,000 people with top-notch schools, a large Chinese immigrant community, and a constellation of Chinese businesses.
For example, at a new Irvine, California development Stonegate, where homes are priced at over $1 million, upwards of 80% of the buyers in the new Arcadia development are overseas Chinese, according to Bloomberg….
Similar dynamics are playing out in New York.
“In Manhattan, we estimate that 15% of all transactions are to foreign buyers,” Jonathan Miller, president of New York real estate appraisal firm Miller Samuel Inc., told RealtyTrac. “Luxury real estate is the new global currency,” he said. “Foreigners are putting their cash into a hard asset.” And they see US real estate as “global safe haven.”
And then there’s Florida, where offshore money accounts for 25% of all real estate sales, twice as high as in California, according to a join report by the Florida Realtors and NAR. In 2014, foreigners gobbled up 26,500 properties for $8 billion. Based on data by the Miami Downtown Development Authority, offshore money powered 90% of residential real estate sales in downtown Miami.
In other places it isn’t quite that high….
“About 70% of our buyers are foreign, but recently there’s definitely been a slowdown in the international buyer market,” explained Lisa Miller, owner of Keller Williams Elite Realty in Aventura, Florida. “We still have a large amount of Latin American buyers, but the Russian buyers have dropped off,” she said, pointing at the fiasco in the Ukraine, the plunging ruble, and the sanctions on Russia.
But there’s a little problem:
“We have an enormous amount of condo inventory in South Florida,” Miller said. “We have 357 condo towers either going up or planned in South Florida. We have a ton of condo inventory.”
Brazilians are among the top buyers in South Florida’s luxury condo market. “Brazilians like the water,” explained Giovanni Freitas, a broker associate with The Keyes Company in Miami. “They love to shop. They want high-end properties. They also buy the most expensive properties. And they love brand-name products.”
Capital flight accounts for 80% of his Brazilian business, he said; Brazilians are fretting over the economy at home and the left-leaning policies of President Dilma Rousseff. Miami Beach is a magnet for them. For instance, according to NBC, they own nearly half of the condos at the W South Beach.
Other nationalities, including Canadian snowbirds, play a role as well. Even the Japanese. They’re increasingly worried about their government’s dedication to resolving its insurmountable debt problem by crushing the yen. Miyuki Fujiwara, an agent with the Keyes Company in Miami, told RealtyTrac: “Many of my Japanese customers buy two or three condo units at a time.”
Could that shiny new car you just financed with a big dealer loan or lease put a damper on your ability to refinance your mortgage or move to a different house? Could your growing debt — for autos, student loans and credit cards — make it tougher to come up with all the monthly payments you owe? Absolutely.
And some mortgage and credit analysts are beginning to cast a wary eye on the prodigious amounts of debt American homeowners are piling up. New research from Black Knight Financial Services, an analytics and technology company focused on the mortgage industry, reveals that homeowners’ non-mortgage debt has hit its highest level in 10 years.
New debt taken on to finance autos accounted for 81 percent of the increase — a direct consequence of booming car sales and attractive loan deals. The average transaction price of a new car or pickup truck in April was $33,560, according to Kelley Blue Book researchers.
Student-loan debt is also contributing to strains on owners’ budgets. Balances are up more than 55 percent since 2006.Credit-card debt is another factor, but it has not mushroomed like auto and student loans have. Nonetheless, homeowners carrying balances on their cards owe an average $8,684, according to Black Knight data.The jump in non-mortgage debt is especially noteworthy among owners with Federal Housing Administration and Veterans Affairs home loans. These borrowers — who typically have lower credit scores and make minimal down payments (as little as 3.5 percent for FHA, zero for VA) — now carry non-mortgage debt loads that average $29,415. By contrast, borrowers using conventional Fannie Mae and Freddie Mac financing have significantly lower debt loads — an average $22,414 — but typically have much higher credit scores and have made larger down payments.
Is there reason for concern? Bruce McClary, vice president at the National Foundation for Credit Counseling, thinks there could be if the pattern continues.
Some people have lost sight of the ground rules for responsible credit and are “pushing the boundaries,” he said.
Auto costs — monthly loan payments plus fuel and maintenance — shouldn’t exceed
15 to 20 percent of household income, he said. Yet some people who already have debt-strained budgets are buying new cars with easy-to-obtain dealer financing that knocks them well beyond prudent guidelines.
According to a recent study by credit bureau Equifax, total outstanding balances for auto loans and leases surged by
10.5 percent during the past 12 months. Of all auto loans originated through April, 23.5 percent were made to consumers with subprime credit scores.
Ben Graboske, senior vice president for data and analytics at Black Knight Financial Services, cautions that although rising debt loads might look ominous, there is no evidence that more borrowers are missing mortgage payments or heading for default. Thanks to rising home-equity holdings and improvements in employment, 30-day delinquencies on mortgages are just 2.3 percent, he said, the same level as they were in 2005, before the housing crisis. Even FHA delinquencies are relatively low at 4.53 percent.
But Graboske agrees that other consequences of high debt totals could limit homeowners’ financial options: They “are going to have less wiggle room” in refinancing their current mortgages or obtaining a new mortgage to buy another house.
Why?
Because debt-to-income ratios are a crucial part of mortgage underwriting and are stricter and less flexible than they were a decade ago. The more auto, student-loan and credit-card debt you have along with other recurring expenses such as alimony and child support, the tougher it will be to refinance or get a new home loan.
If your total monthly debt for mortgage and other obligations exceeds 45 percent of your monthly income, lenders who sell their mortgages to giant investors Fannie Mae and Freddie Mac could reject your application for a refinancing or new mortgage, absent strong compensating factors such as exceptional credit scores and substantial cash or investments in reserve. FHA is more flexible but generally doesn’t want to see debt levels above 50 percent.
Bottom line: Before signing up for a hefty loan on a new car, take a hard, sober look at the effect it will have on your debt-to-income ratio. When it comes to what Graboske calls your mortgage wiggle room, less debt, not more, might be the way to go.
Read more inThe Columbus Dispatchwhere author Kenneth R. Harney covers housing issues on Capitol Hill for the Washington Post Writers Group. kenharney@earthlink.net
The “Revenue Recession” is alive and well, at least when it comes to the 30 companies of the Dow Jones Industrial Average.
Every month we look at what brokerage analysts have in their financial models in terms of expected sales growth for the Dow constituents. This year hasn’t been pretty, with Q1 down an average of 0.8% from last year and Q2 to be down 3.5% (WMT and HD still need to report to finish out the quarter). The hits keep coming in Q3, down an expected 4.0% (1.4% less energy) and Q4 down 1.8% (flat less energy).
The good news is that if markets discount 2 quarters ahead, we should be through the rough patch because Q1 2015 analyst numbers call for 1.9% sales growth, with or without the energy names of the Dow. The bad news is that analysts tend to be too optimistic: back in Q3 last year they thought Q2 2015 would be +2%, and that didn’t work out too well.
Overall, the lack of revenue growth combined with full equity valuations (unless you think +17x is cheap) is all you need to know about the current market churn. And why it will likely continue.
The most successful guy I’ve ever worked for – and he has the billions to prove it – had the simplest mantra: “Don’t make things harder than they have to be”. In the spirit of that sentiment, consider a simple question: which Dow stocks have done the best and worst this year, and why? Here’s the answer:
The three best performing names are UnitedHealth (+19.3%), Visa (+18.2%) and Disney (14.2%).
The worst three names are Dupont (-28.3%), Chevron (-23.5%) and Wal-Mart (-16.0%).
Now, consider the old market aphorism that “Markets discount two quarters ahead” (remember, we’re keeping this simple). What are analysts expecting for revenue growth in Q3 and Q4 that might have encouraged investors to reprice these stocks higher in the first 7 months of the year?
For the three best performing stocks, analysts expect second half revenues to climb an average of 14.1% versus last year.
And for the worst three? How about -22.1%. Don’t make things harder than they have to be.
That, in a nutshell, is why we look at the expected revenue growth for the 30 companies of the Dow every month. Even though earnings and interest rates ultimately drive asset prices, revenues are the headwaters of the cash flow stream. They also have the benefit of being easier for an analyst to quality control than earnings. Not easy, mind you – just easier. Units, price and mix are the only three drivers of revenues you have to worry about. When those increase profitably the rest of the income statement – including the bottom line – tends to take care of itself.
By both performance and revenue growth measures, 2015 has been tough on the Dow. It is the only one of the three major U.S. “Indexes” to be down on the year, with a 2.3% decline versus +1.2% for the S&P 500 and +6.3% for the NASDAQ. Ten names out of the 30 are lower by 10% or more, or a full 33%. By comparison, we count 107 stocks in the S&P 500 that are lower by 10% or greater, or only 21% of that index.
Looking at the average revenue growth for the Dow names tells a large part of the story, for the last time the Average enjoyed positive top line momentum was Q3 2014 and the next time brokerage analysts expect actual growth isn’t until Q1 2016. The two largest problems are well understood: declining oil and other commodity prices along with an increase in the value of the dollar. For a brief period there was some hope that declining energy company revenues would migrate to other companies’ top lines as consumers spent their energy savings elsewhere. That, of course, didn’t quite work out.
Still, we are at the crosswords of what could be a turn back to positive growth in 2016. Here’s how Street analysts currently expect that to play out:
At the moment, Wall Street analysts that cover the companies of the Dow expect Q3 2015 to be the trough quarter for revenue growth for the year. On average, they expect the typical Dow name to print a 4.0% decline in revenues versus last year. Exclude financials, and the comp gets a little worse: 4.4%. Take out the 2 energy names, and the expected comp is still negative to the tune of 1.5%.
Things get a little better in Q4, presumably because we start to anniversary the declines in oil prices as well as the strength of the dollar. These both began to kick in during Q4 2014, and as the old Wall Street adage goes “Don’t sweat a bad quarter – it just makes next year’s comp that much easier”. That’s why analysts are looking for an average of -1.8% revenue comps for Q4, and essentially flat (-0.01%) when you take out the Dow’s energy names.
Go all the way out to Q1 2016, and analysts expect revenue growth to finally turn positive: 1.9% versus Q1 2015, whether you’re talking about the whole Average or excluding the energy names. Better still, analysts are showing expected revenue growth for all of 2016 at 4.1%. OK, that’s probably overly optimistic unless the dollar weakens next year. But after 2015, even 1-3% growth would be welcome.
We’re still keeping it simple, so let’s wrap up. What ails the Dow names also hamstrings the U.S. equity market as whole. We need better revenue growth than the negative comps we’ve talked about here or the flattish top line progressions of the S&P 500 to get stocks moving again. The third quarter seems unlikely to provide much relief. On a more optimistic note, our chances improve in Q4 and even more so in Q1 2016. Until we see the U.S. economy accelerate and/or the dollar weaken and/or oil prices stabilize, the chance that investors will pay even higher multiples for stagnant earnings appears remote. That’s a recipe for more volatility – potentially a lot more.
West Texas Intermediate crude oil is at a 6-year low of $43 a barrel.
And back in December 2014, “Bond King” Jeff Gundlach had a serious warning for the world if oil prices got to $40 a barrel.
“I hope it does not go to $40,” Gundlach said in a presentation, “because then something is very, very wrong with the world, not just the economy. The geopolitical consequences could be — to put it bluntly — terrifying.”
Writing in The Telegraph last week, Ambrose Evans-Pritchard noted that with Brent crude oil prices — the international benchmark — below $50 a barrel, only Norway’s government is bringing in enough revenue to balance their budget this year.
And so in addition to the potential global instability created by low oil prices, Gundlach added that, “If oil falls to around $40 a barrel then I think the yield on ten year Treasury note is going to 1%.” The 10-year note, for its part, closed near 2.14% on Tuesday.
On December 9, 2014, WTI was trading near $65 a barrel and Gundlach said oil looked like it was going lower, quipping that oil would find a bottom when it starts going up.
WTI eventually bottomed at $43 in mid-March and spend most all of the spring and early summer trading near $60.
On Tuesday, WTI hit a fresh 6-year low, plunging more than 4% and trading below $43 a barrel.
In the last month, crude and the entire commodity complex have rolled over again as the market battles oversupply and a Chinese economy that is slowing.
And all this as the Federal Reserve makes noise about raising interest rates, having some in the market asking if these external factors — what the Fed would call “exogenous” factors — will stop the Fed from changing its interest rate policy for the first time in over almost 7 years.
In an afternoon email, Russ Certo, a rate strategist at Brean Capital, highlighted Gundlach’s comments and said that the linkages between the run-up, and now collapse, in commodity prices since the financial crisis have made, quite simply, for an extremely complex market environment right now.
“There is a global de-leveraging occurring in front of our eyes,” Certo wrote. “And, I suppose, the smart folks will determine the exact causes and translate what that means for FUTURE investment thesis. Today it may not matter other than accurately anticipating a myriad of global price movements in relation to each other.”
Examining the reasons to buy a house today may give us some idea where the housing market is heading in the future.
There are three reasons to buy a house:
Reason 1 – Utility
A house (any dwelling) is a shelter. It provides enjoyment, a home to raise one’s family, or just a place to watch that big screen TV. Utility is not quantifiable and it differs from household to household.
Reason 2 – Savings
If financed, a mortgage is a way of saving something every month until the mortgage is paid in full. If paid for, the savings come in the form of “owners’ equivalent rent”, which is what the census bureau uses to measure inflation in housing.
Reason 3 – Asset appreciation
At 5% appreciation per year, a $100k house today will be worth $412k in 30 years. Even a more modest 3% appreciation would result in better than a double.
Why Not to Buy a House Today
Based on the reasons above, it appears to be a slam dunk decision. Why would anyone not want to buy a house? There are three obstacles:
Obstacle 1 – Affordability
Housing, as a percentage of household income, is too expensive. A decade of ill-conceived government intervention and Federal Reserve accommodations prevented natural economic forces from driving house prices to equilibrium. As a result, not only is entry difficult, but many are struggling and are stuck in dire housing traps. Corelogic estimated that as of the 1st quarter of 2015, 10.2% of mortgages are still under water while 9.7 million households have less than 20% equity.
Obstacle 2 – High Risk
Say you are young couple that purchased a home two years ago, using minimal down financing. The wife is now pregnant and the husband has an excellent career opportunity in another city. The couple has insufficient savings and the house has not appreciated enough to facilitate a sale, which results in negative equity after selling expenses. The house can become a trap that diminishes a life time of income stream.
Obstacle 3 – “Dead zones”
Say you live in the middle of the country, in Kane County Illinois. For the privilege of living there, you pay 3% in property taxes. That is like adding 3% to a mortgage that never gets paid down. Your property would have to appreciate 3% per year just to break even. By the way, “appreciation” is unheard of in Kane County, good times or bad. There are many Kane Counties in the US. Real estate in these counties should be named something else and should not be co-mingled with other housing statistics. Employment is continuing to trend away from these areas. What is going to happen to real estate in these markets?
The Kane County court house: where real estate goes to vegetate
The factors listed above are nothing new. They provide some perspective as to where are are heading. Looking at each of the reasons and obstacles, they are all trending negatively.
The country is spending too much on housing, a luxury that is made possible by irresponsible Fed policies. 50% debt to income ratios are just insane and Ms. Yellen has the gall to call mortgage lending restrictive. Can we not see what is happening to Greece?
Mortgage backed securities held by the Federal Reserve System, a non-market central economic planning institution that is the chief instigator of house price inflation. Still growing, in spite of QE having officially ended – via Saint Louis Federal Reserve Research, click to enlarge.
Real estate is an investment that matures over time. The first few years are the toughest, until equity can be built up. With appreciation slowing, not to mention the possibility of depreciation, it is taking much longer to reach financial safety. The current base is weak, with too high a percentage of low equity and no equity ownership. The stress of a recession, or just a few years of a flat market, can impact the economy beyond expectations. The risks that might have been negligible once upon a time are much higher today. Many who purchased ten years ago are still living with the consequences of that ill-timed decision today.
By stepping back and looking at the big picture, we can see that real estate should be correcting and trending down. The reasons why our grandparents bought their homes have changed. Government intervention cannot last forever. It will change from accommodation to devastation, when they finally run out of ideas.
Conclusion
In summary, my working life had its origins in real estate and I am not trying to bite the hand that fed me. However, the reality is that the circumstances that prevailed when I entered the market are non-existent today. I seriously doubt that I would chose real estate as a career, or as an investment avenue, if I were starting over. As for buying a house, I would consider it more of a luxury as opposed to an investment, and one has to be prepared for the possibility of it being a depreciating asset, especially if one decides to move.
New York City, Los Angeles, Honolulu: They’re all places you would think would be popular destinations for Americans. So it might come as a surprise that these are among the cities U.S. residents are fleeing in droves.
The map below shows the 20 metropolitan areas that lost the greatest share of local people to other parts of the country between July 2013 and July 2014, according to a Bloomberg News analysis of U.S. Census Bureau data. The New York City area ranked 2nd, losing about a net 163,000 U.S. residents, closely followed by a couple surrounding suburbs in Connecticut. Honolulu ranked fourth and Los Angeles ranked 14th. The Bloomberg calculations looked at the 100 most populous U.S. metropolitan areas.
Interestingly, these are also the cities with some of the highest net inflows of people from outside the country. That gives many of these cities a steadily growing population, despite the net exodus of people moving within the U.S.
So what’s going on here? Michael Stoll, a professor of public policy and urban planning at the University of California Los Angeles, has an idea. Soaring home prices are pushing local residents out and scaring away potential new ones from other parts of the country, he said. (Everyone knows how unaffordable the Manhattan area has become.)
And as Americans leave, people from abroad move in to these bustling cities to fill the vacant low-skilled jobs. They are able to do so by living in what Stoll calls “creative housing arrangements” in which they pack six to eight individuals, or two to four families, into one apartment or home. It’s an arrangement that most Americans just aren’t willing to pursue, and even many immigrants decide it’s not for them as time goes by, he said.
In addition, the growing demand for high-skilled workers, especially in the technology industry, brought foreigners who possess those skills to the U.S. They are compensated appropriately and can afford to live in these high-cost areas, just like Americans who hold similar positions. One example is Washington, D.C., which had a lot of people from abroad arriving to soak up jobs in the growing tech-hub, Stoll said.
Other areas weren’t so lucky. Take some of the Rust Belt cities that experienced fast drops in their American populations, like Cleveland, Dayton and Toledo, even though they are relatively inexpensive places to live. These cities didn’t get enough international migrants to make up for the those who left, a reflection of the fact that locals were probably leaving out of a lack of jobs.
This is part of a multiple-decade trend of the U.S. population moving away from these manufacturing hubs to areas in the Sun Belt and the Pacific Northwest, Stoll said. Retiring baby boomers are also leaving the Northeast and migrating to more affordable places with better climates.
This explains why the majority of metropolitan areas in Florida and Texas, as well as west-coast cities like Portland, had an influx of people.
El Paso, Texas, the city that residents fled from at the fastest pace, also saw a surprisingly small number of foreigners settling in given how close it is to Mexico.
“A lot of young, reasonably educated people are having a hard time finding work there,” Stoll said. “They’re not staying in town after they graduate,” leaving for the faster-growing economies of neighboring metro areas like Dallas and Austin, he said.
Methodology: Bloomberg ranked 100 of the most populous U.S. metropolitan areas based on their net domestic migration rates, from July 1, 2013 to July 1, 2014, as a percentage of total population as of July 2013. Domestic migration refers to people moving within the country (e.g. someone moving from New York City to San Francisco). A negative rate indicates more people leaving than coming in. International migration refers to a local resident leaving for a foreign country or someone from outside the U.S. moving into the U.S.
WASHINGTON (AP) — Americans bought homes in June at the fastest rate in over eight years, pushing prices to record highs as buyer demand has eclipsed the availability of houses on the market.
The National Association of Realtors said Wednesday that sales of existing homes climbed 3.2 percent last month to a seasonally adjusted annual rate of 5.49 million, the highest rate since February 2007. Sales have jumped 9.6 percent over the past 12 months, while the number of listings has risen just 0.4 percent.
Median home prices climbed 6.5 percent over the past 12 months to $236,400, the highest level reported by the Realtors not adjusted for inflation.
Home-buying has recently surged as more buyers are flooding into the real estate market. Robust hiring over the past 21 months and an economic recovery now in its sixth year have enabled more Americans to set aside money for a down payment. But the rising demand has failed to draw more sellers into the market, causing tight inventories and escalating prices that could cap sales growth.
“The recent pace can’t be sustained, but it points clearly to upside potential,” said Ian Shepherdson, chief economist at Pantheon Macroeconomics.
A mere five months’ supply of homes was on the market in June, compared to 5.5 months a year ago and an average of six months in a healthy market.
Some markets are barely adding any listings. The condominium market in Massachusetts contains just 1.8 months’ supply, according to a Federal Reserve report this month. The majority of real estate agents in the Atlanta Fed region – which ranges from Alabama to Florida- said that inventories were flat or falling over the past year.
Some of the recent sales burst appears to come from the prospect of low mortgage rates beginning to rise as the Federal Reserve considers raising a key interest rate from its near-zero level later this year. That possibility is prompting buyers to finalize sales before higher rates make borrowing costs prohibitively expensive, noted Daren Blomquist, a vice president at RealtyTrac, a housing analytics firm.
The premiums that the Federal Housing Administration charges to insure mortgages are also lower this year, further fueling buying activity, Blomquist said.
It’s also possible that home buyers are checking the market for listings more aggressively, making it possible for them to act fast with offers despite the lack of new inventory.
“Buyers can more quickly be alerted of new listings and also more conveniently access real estate data to help them pre-search a potential purchase before they even step foot in the property,” Blomquist said. “That may mean we don’t need such a large supply of inventory to feed growing sales.”
Properties typically sold last month in 34 days, the shortest time since the Realtors began tracking the figure in May 2011. There were fewer all-cash, individual investor and distressed home sales in the market, as more traditional buyers have returned.
Sales improved in all four geographical regions: Northeast, Midwest, South and West.
Still, the limited supplies could eventually prove to be a drag on sales growth in the coming months.
Ever rising home values are stretching the budgets of first-time buyers and owners looking to upgrade. As homes become less affordable, the current demand will likely taper off.
Home prices have increased nearly four times faster than wages, as average hourly earnings have risen just 2 percent over the past 12 months to $24.95 an hour, according to the Labor Department.
Some buyers are also bristling at the few available options on the market. Tony Smith, a Charlotte, North Carolina real estate broker, said some renters shopping for homes are now choosing instead to re-sign their leases and wait until a better selection of properties comes onto the market.
New construction has yet to satisfy rising demand, as builders are increasingly focused on the growing rental market.
Approved building permits rose increased 7.4 percent to an annual rate of 1.34 million in June, the highest level since July 2007, the Commerce Department said last week. Almost all of the gains came for apartment complexes, while permits for houses last month rose only 0.9 percent.
The share of Americans owning homes has fallen this year to a seasonally adjusted 63.8 percent, the lowest level since 1989.
Real estate had until recently lagged much of the six-year rebound from the recession, hobbled by the wave of foreclosures that came after the burst housing bubble.
But the job market found new traction in early 2014. Employers added 3.1 million jobs last year and are on pace to add 2.5 million jobs this year. As millions more Americans have found work, their new paychecks are increasingly going to housing, both in terms of renting and owning.
Low mortgage rates have also helped, although rates are now starting to climb to levels that could slow buying activity.
Average 30-year fixed rates were 4.09 percent last week, according to the mortgage giant Freddie Mac. The average has risen from a 52-week low of 3.59 percent.
A job seeker yawns as he waits in front of the training offices of Local Union 46, a union representing metallic lathers and reinforcing iron workers, in the Queens borough of New York.
WASHINGTON (AP) — Even after another month of strong hiring in June and a sinking unemployment rate, the U.S. job market just isn’t what it used to be.
Pay is sluggish. Many part-timers can’t find full-time work. And a diminished share of Americans either have a job or are looking for one.
Yet in the face of global and demographic shifts, this may be what a nearly healthy U.S. job market now looks like.
An aging population is sending an outsize proportion of Americans into retirement. Many younger adults, bruised by the Great Recession, are postponing work to remain in school to try to become more marketable. Global competition and the increasing automation of many jobs are holding down pay.
Many economists think these trends will persist for years despite steady job growth. It helps explain why the Federal Reserve is widely expected to start raising interest rates from record lows later this year even though many job measures remain far below their pre-recession peaks.
“The Fed may recognize that this is a new labor-market normal, and it will begin to normalize monetary policy,” said Patrick O’Keefe, an economist at accounting and consulting firm CohnReznick.
Thursday’s monthly jobs report from the government showed that employers added a solid 223,000 jobs in June and that the unemployment rate fell to 5.3 percent from 5.5 percent in May. Even so, the generally improving job market still bears traits that have long been regarded as weaknesses. Among them:
— A shrunken labor force.
The unemployment rate didn’t fall in June because more people were hired. The rate fell solely because the number of people who had become dispirited and stopped looking for work far exceeded the number who found jobs.
The percentage of Americans in the workforce — defined as those who either have a job or are actively seeking one — dropped to 62.6 percent, a 38-year low, from 62.9 percent. (The figure was 66 percent when the recession began in 2007.) Fewer job holders typically means weaker growth for the economy. The growth of the labor force slowed to just 0.3 percent in 2014, compared with 1.1 percent in 2007.
“It is highly unlikely that we are going to see our (workforce) participation rate move anywhere near where it was in 2007,” O’Keefe says.
This marks a striking reversal. The share of Americans in the workforce had been steadily climbing through early 2000, and a big reason was that more women began working. But that influx plateaued in the late 1990s and has drifted downward since.
— The retirement of the vast baby boom generation.
The aging population is restraining the growth of the workforce. The pace of retirements accelerated in 2008, when the oldest boomers turned 62, when workers can start claiming some Social Security benefits. Economists estimate that retirements account for about half the decline in the share of Americans in the workforce since 2000.
From that perspective, the nation as a whole is beginning to resemble retirement havens such as Florida. Just 59.3 percent of Floridians are in the workforce.
— Younger workers are starting their careers later.
Employers are demanding college degrees and even postgraduate degrees for a higher proportion of jobs. Mindful of this trend, teens and young people in their 20’s are still reading textbooks when previous generations were punching time clocks.
The recession “basically told everybody that they need an education to get better jobs,” says John Silvia, chief economist at Wells Fargo. “So how would young people respond? They stayed in school.”
Fewer than 39 percent of 18- and 19-year-olds are employed, down from 56 percent in 2000. For people ages 20 to 24, the proportion has fallen to 64 percent from 72 percent.
— The number of part-timers who would prefer full-time work remains high.
About 6.5 million workers are working part time but want full-time jobs, up from 4.6 million before the recession began. This is partly a reflection of tepid economic growth. But economists also point to long-term factors: Industries such as hotels and restaurants that hire many part-timers are driving an increasing share of job growth, researchers at the Federal Reserve Bank of San Francisco have found.
As more young adults put off working, some employers are turning to older workers to fill part-time jobs. Older workers are more likely to want full-time work, raising the level of so-called involuntary part-time employment.
Many economists also point to the Obama administration’s health care reforms for increasing part-time employment. The law requires companies with more than 100 employees to provide health insurance to those who work more than 30 hours.
Michael Feroli, an economist at JPMorgan Chase, says this could account for as much as one-third of the increase in part-time jobs.
— Weak pay growth.
The average hourly U.S. wage was flat in June at $24.95 and has risen just 2 percent over the past year. The stagnant June figure dispelled hopes that strong job growth in May heralded a trend of steadily rising incomes.
In theory, steady hiring is supposed to reduce the number of qualified workers who are still seeking jobs. And a tight supply of workers tends to force wages up.
Yet a host of factors have complicated that theory. U.S. workers are competing against lower-paid foreigners. And automation has threatened everyone from assembly line workers to executive secretaries.
Still, economists at Goldman Sachs forecast that average hourly pay will grow at an annual pace of about 3.5 percent by the end of 2016. That is a healthy pace. But it will have taken much longer to reach than in previous recoveries.
Crude oil prices closed down 4% yesterday, breaking through a 2-month support level at $57/barrel, after an EIA report showed an unexpected build in inventories.
I argue that the domestic supply/demand balance has not improved and is just as bearish now as it was last winter when oil was in free fall.
Based on my analysis of supply/demand data presented in this article, I believe crude oil has further to fall.
My trading strategy, including holdings, price targets, and entry/exit points are discussed in detail.
After trading tightly range-bound between $58/barrel and $61/barrel since mid-April, crude oil finally broke down yesterday, after an EIA Petroleum report showed that crude oil inventories increased more than expected. The commodity slid 4.2% – its largest single-day loss since April 8 – to a 9-week low closing price of $56.92/barrel. The commodity is down 6.6% since recording a peak of $61/barrel one week ago on Tuesday. Further weighing on prices were unclear reports of a draft of an Iranian nuclear deal that would relax sanctions and permit a resumption of exports, as well as continued fears over Greece’s exit from the eurozone. This article will discuss yesterday’s EIA inventory report and use this data to support my argument that crude oil supply and demand remain just as unbalanced presently as when oil was trading at $45 per share, justifying my continued bearish position on the commodity.
In yesterday’s Petroleum Report for the week ending June 26, the EIA announced that crude oil inventories increased by 2.4 million barrels, versus the analyst consensus for a 2-million barrel storage withdrawal. The storage build was also markedly bearish compared to last week’s 4.9 million barrel withdrawal, last year’s 3.2 million barrel withdrawal and the 5-year average 4.1 million barrel withdrawal. It was the first storage injection in 9 weeks since the week ending April 24. Storage injections during the final week of June are highly unusual, and last week’s build was the first storage injection during the last week of June since the week ending June 29, 2007, and only the third this millennium.
At 480 million barrels, total crude oil storage is 90 million barrels above the five-year average inventory level and 80 million barrels above last year’s level, versus a 84 and 75 million barrel surplus last week, respectively. The increase in crude oil surplus is a sharp departure from the past two months which had seen surpluses, versus the five-year average decline in 8 of the past 9 weeks from a peak of over 113 million barrels. Figure 1 below shows the storage surplus versus the five-year average and 2014 over the past year.
(click to enlarge)
Figure 1: Crude oil storage surplus versus 2014 and the 5-year average showing an increase in the surplus after several weeks of decline. [Source: Chart is my own, data from the EIA.]
What happened over the past week that led to such an abrupt change in crude oil supply/demand balance?
Not much, I argue. And that is the problem.
There are three components of US supply/demand balance – domestic production, demand (measured by refinery inputs), and imports.
Domestic production was largely unchanged last week, declining by 9,000 barrels per day, from 9.604 million barrels per day the previous week to 9.595 million barrels last week. Domestic production remains at record highs, despite an oil rig count that has fallen 60% since October. Production is up 1.2 million barrels year-over-year.
Crude oil demand was likewise flat week-over-week, declining a negligible 1,000 barrels per day last week to 16.531 million barrels per day. Demand is up 313,000 barrels per day year-over-year. Note that this is well shy of the 1.2 million barrel per day year-over-year increase in production. As a result, the purely domestic supply/demand picture – demand minus US production – is markedly loose compared to last year. Figure 2 below compares the purely domestic supply/demand picture for 2015 versus 2014.
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Figure 2: Purely domestic crude oil supply/demand balance equal to demand minus domestic production. Supply/demand remains loose to 2014 and has been flat over the past 2 months, indicating minimal tightening of the market. [Source: Chart is my own, data from the EIA.]
Note that last year at this time, demand exceeded domestic production by 7.8 million barrels per day, while last week, this spread was just 6.9 million barrels. Further, despite all of the hullabaloo over record demand and declining domestic production, this spread is sitting near the 2015-to-date average of 6.6 million barrels, and has been essentially flat since late April.
It is the third component of the US supply/demand picture – imports – that drove last week’s bearish storage build and had been masking the persistent supply/demand mismatch shown above in Figure 2 that allowed crude oil to rally more than 30% off the March lows. Imports increased by 748,000 barrels per day last week to 7.513 million barrels per day. It was the largest week-over-week increase since the week ending April 3rd and the largest daily average since the week of April 17th. Nevertheless, the 7.5 million barrel per day tally was a mere 170,000 barrels per day above the 1-year average import level. Figure 3 below plots crude oil imports versus the 1-year average over the last 12 months.
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Figure 3: Crude oil imports versus the 1-year average. After 2 months well below the 1-year average, crude oil demand rebounded last week. [Source: Chart is my own, data from the EIA.]
Note that after hovering in the 6.75-7.25 million barrel per day range since late April, last week’s imports were merely a return to the baseline. Furthermore, imports have room to go even higher. Figure 4 below shows the week-over-week change and the departure from 2015-to-date average imports by country.
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Figure 4: Crude oil imports by nation with week-over-week and departure versus the 2015 average included. While imports from Canada rebounded last week, large deficits versus the 2015 average remain in Canada, Saudi Arabia, and Mexico. [Source: Chart is my own, data from the EIA.]
Note that the second-largest weekly increase in imports last week came from our biggest oil trading partner, Canada, where imports increased by 142,000 barrels per day. However, thanks to persistent wildfires in Alberta’s prolific oil sands, imports are still 187,000 barrels per day below their 2015 average. As these wildfires have largely diminished, I expect Canadian imports will continue to increase, from 2.8 million barrels per day last week back to their 3.0 million barrel per day 2015 average in coming weeks. An even more impressive departure versus the 2015 average was seen in Saudi Arabia, where imports remained flat at 700,000 barrels per day last week, more than 250,000 barrels below their 2015 average of 992,000 barrels per day. Saudi Arabia is a country whose rig count is at record highs and which is spearheading the effort to destroy the US shale oil industry, so I expect these imports will recover rapidly over the next month. Finally, our third-largest trading partner, Mexico, saw its imports slide 290,000 barrels per day last week, and currently sit 215,000 barrels per day below its 2015 average – likely another short-term anomaly. Were just these three countries to have had their imports at 2015 baseline levels, last week’s storage build would have been a massive 7.1 million barrels. The gains seen in Venezuela, Kuwait, and other smaller trading partners that sent tallies above their 2015 averages may be at least partially attributable to a surge in Gulf Coast imports following delays caused by Tropical Storm Bill, and therefore, may decline in coming weeks. However, I expect the net change in imports to be upwards over the next month, putting further pressure on the supply/demand balance.
My rationale for emphasizing imports compared to US production and demand is that I believe that they have been artificially creating the appearance of a tightening supply/demand balance. Thanks to wildfires in Canada, Tropical Storm Bill interrupting shipments in the Gulf of Mexico, and unrest in the Middle East, imports during April, May, and early June (as shown in Figure 3) were depressed below the five-year average. This correlated strongly with a transition to storage withdrawals that helped to fuel the back-end of crude oil’s 30% rally from the March low of $43/barrel to $61/barrel. Figure 5 below compares crude oil weekly storage injections/withdrawals to imports.
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Figure 5: Crude oil storage changes versus imports. There is a strong correlation between storage withdrawals between May and late June and a decline in imports. Storage injections resumed last week, following a surge in imports. This supports imports being the major driver of the domestic supply/demand balance over the past few months. [Source: Chart is my own, data from the EIA.]
During this same period (as shown in Figure 2), domestic production and demand remained relatively unchanged. As a result, I firmly believe that the decline in imports hoodwinked many investors into thinking that the supply/demand balance was permanently tightening, due either to increasing demand from cheap oil or declining production from the declining rig count, when it was really a temporary drop in imports. Now that imports have returned to a baseline level, this “masking” of the supply/demand balance has been lifted, and the result was a bearish injection similar to those seen during oil’s springtime free fall – but during a time when the market expects withdrawals. It is therefore unsurprising that oil retreated to the tune of 4% yesterday.
What I believe to be even more concerning is that there is little room to go higher on the demand front. Refinery utilization – the percentage of US refinery capacity that is being utilized to convert crude oil to gasoline and other finished products – was at 95.0% last week. This is the highest refinery utilization during the final week of June over the last 10 years. Figure 6 below shows refinery utilization for the last week of June from 2006 to the present.
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Figure 6: Refinery utilization during the final week of June for the past 10 years showing that, at 95%, 2015’s utilization is the highest of the decade. [Source: Chart is my own, data from the EIA.]
Furthermore, the maximum refinery utilization during any week in the last 10 years was 95.4%, recorded several times, most recently last December. As a result, at 95.0% refinery, utilization is nearly at its maximum capacity. The fact that we saw a 2.4 million barrel storage injection, with demand near its maximal level pulling hard at crude oil inventories and with imports still with room to run higher, suggests to me that oil still has room to fall.
Oil’s 4% decline to under $57/barrel represented a major breakdown not only from a fundamental level, as discussed above, but from a technical level. During the 44-day period from April 29 to June 30, crude oil had traded within a tight $4.17 range between $61.43/barrel and $57.26/barrel, the narrowest range since March 2004. Oil broke out of that range yesterday. Figure 7 plots the price of crude oil over the last 3 months, showing the rally, range-bound action, and the breakdown yesterday.
(click to enlarge)
Figure 7: Crude oil prices over the last 2 months showing range-bound trading largely between $58/barrel and $61/barrel. followed by a breakdown yesterday. [Source: Chart is my own, data from the EIA.]
Now that oil has fallen below its 2-month support level, I would not be surprised if more investors head for the exits.
I continue to hold three positions betting on a continued downtrend in crude oil prices. I own a 10% short position in the popular United States Oil ETF (NYSEARCA:USO) – increased from 5% last week – a large 15% short position in the leveraged VelocityShares 3x Long Crude Oil ETN (NYSEARCA:UWTI), and a 5% short position in the Market Vectors Russia ETF (NYSEARCA:RSX). The latter provides short exposure to an oil-driven economy, as well as the turmoil encompassing Europe. The short UWTI position is a higher-risk play on leverage-induced decay due to choppy trading. USO, of course, is a safer direct play on declining oil prices.
Should oil drop to $55/barrel – which has long been my short-term price target – I will begin to aggressively cover my UWTI short position to protect profits in a highly volatile trade, which is currently up 20% and would likely be pushing 35% if oil reaches $55/barrel. I will likewise plan to close out my RSX short around the same level to lock in profits, should the European crisis appear to be resolving.
However, I plan to hold USO for the foreseeable future. Following yesterday’s decline, contango in the oil futures market is again rising, with the 4-month spread up to $1.21, or 2.2%, after bottoming out at $0.86 last week. Should oil continue to fall, the contango will likely widen further, and I could easily see contango-generated returns topping 5% on a position held through the Fall. I feel USO is a safer, less volatile long-term hold than UWTI (despite the fact that UWTI triples the contango-generated gains and also benefits from leverage-induced decay). My price target to close out my USO position is currently $50/barrel. Factors that would likely cause me to cover sooner would include any socioeconomic forces that look like they would suppress imports for an extended period, or if US production (finally) begins declining in a meaningful way. As a result, my “stop” is a fundamental stop, and I do not have a specific stop price. Should oil rally in the face of the current bearish fundamentals, I will even consider adding to my USO short position up to 15%. If I had no crude oil short exposure, I would be reluctant to open a position here with oil down 7% in a week. Rather, I would wait for a bounce before initiating any position.
In conclusion, I believe that US crude oil demand and production remain in a stable, bearish pattern. Instead, the fundamental supply/demand picture is, and has been, dictated by fluctuations in crude oil imports. I do not believe that the underlying fundamental picture has changed since March, and that a return to baseline import levels last week following months of temporary suppression unmasked this persistent supply/demand imbalance. With crude oil demand unlikely to go higher with refineries near peak capacity, domestic production stable, and crude oil imports with room to go even higher, particularly from Canada and Saudi Arabia, I expect continued weakness in crude oil in the months to come. Once the summer driving season fades and demand declines, I would not be surprised to see the domestic oil surplus climb back above 100 million barrels over the next 1-3 months. Further exacerbating bearish sentiment are the possible resumption of Iranian exports and continued anxiety over Greece and the eurozone, although I believe these fears to be secondary to the ongoing domestic storage glut. My 1-3 month price target is $55/barrel, with a potential to drop as low as $50/barrel during this time. As a result, I plan to hold my large basket of crude oil short positions in USO, UWTI, and RSX.
Additional disclosure: As noted in the article, I am also short RSX and UWTI.
“Today is Day 1 of Year 7 of the ‘recovery’, and yet economists everywhere proclaims 3% growth is just around the corner,” rages Jim Bianco as he addresses what ‘bugs him’, exclaiming “that ship has sailed.” Bianco and Santelli go on to slay Keynesian big government dragons and the incessant bullshit from officials like Jack Lew who opine on Greece and other potential systemic risks as being a non-event – “what is priced in is that everything will work itself out at the 11th hour,” leaving a huge asymmetric risk.
The fall in U.S. rigs drilling for oil quickened a bit this week, data showed on Friday, suggesting a recent slowdown in the decline in drilling was temporary, after slumping oil prices caused energy companies to idle half the country’s rigs since October.
Drillers idled 31 oil rigs this week, leaving 703 rigs active, after taking 26 and 42 rigs out of service in the previous two weeks, oil services firm Baker Hughes Inc said in its closely watched report.
With the oil rig decline this week, the number of active rigs has fallen for a record 20 weeks in a row to the lowest since 2010, according to Baker Hughes data going back to 1987. Since the number of oil rigs peaked at 1,609 in October, energy producers have responded quickly to the steep 60 percent drop in oil prices since last summer by cutting spending, eliminating jobs and idling rigs.
After its precipitous drop since October, the U.S. oil rig count is nearing a pivotal level that experts say could dent production, bolster prices and even coax oil companies back to the well pad in the coming months.
Pioneer Natural Resources Co, a top oil producer in the Permian Basin of West Texas, said this week it will start adding rigs in June as long as market conditions are favorable. U.S. crude futures this week climbed to over $58 a barrel, the highest level this year, as a Saudi-led coalition continued bombings in Yemen.
That was up 38 percent from a six-year low near $42 set in mid March on oversupply concerns and lackluster demand, in part on expectations the lower rig count will start reducing U.S. oil output.
After rising mostly steadily since 2009, U.S. oil production has stalled near 9.4 million barrels a day since early March, the highest level since the early 1970s, according to government data.
The Permian Basin in West Texas and eastern New Mexico, the nation’s biggest and fastest-growing shale oil basin, lost the most oil rigs, down 13 to 242, the lowest on record, according to data going back to 2011.
Texas was the state with the biggest rig decline, down 19 to 392, the least since 2009. In Canada, active oil rigs fell by four to 16, the lowest since 2009.U.S. natural gas rigs, meanwhile, climbed by eight to 225, the same as two weeks ago.
“Come down to Houston,” William Snyder, leader of the Deloitte Corporate Restructuring Group, told Reuters. “You’ll see there is just a stream of consultants and bankruptcy attorneys running around this town.”
But it’s not just in Houston or in the oil patch. It’s in retail, healthcare, mining, finance…. Bankruptcies are suddenly booming, after years of drought.
In the first quarter, 26 publicly traded corporations filed for bankruptcy, up from 11 at the same time last year, Reuters reported. Six of these companies listed assets of over $1 billion, the most since Financial-Crisis year 2009. In total, they listed $34 billion in assets, the second highest for a first quarter since before the financial crisis, behind only the record $102 billion in 2009.
The largest bankruptcy was the casino operating company of Caesars Entertainment that has been unprofitable for five years. It’s among the zombies of Corporate America, kept moving with new money from investors that had been driven to near insanity by the Fed’s six-plus years of interest rate repression.
Next in line were Doral Financial, security services outfit Altegrity, RadioShack, and Allied Nevada Gold. The first oil-and-gas company showed up in sixth place, Quicksilver Resources [Investors Crushed as US Natural Gas Drillers Blow Up].
Among the largest 15 sinners on the list, based on Bankruptcydata.com, are six oil-and-gas related companies. But mostly in the lower half. So far, larger energy companies are still hanging on by their teeth.
This isn’t the list of a single troubled sector that ran out of luck. This isn’t a single issue, such as the oil-price collapse. This is the list of a broader phenomenon: too much debt across a struggling economy. And now the reckoning has started.
So maybe the first-quarter surge of bankruptcies was a statistical hiccup; and for the rest of the year, bankruptcies will once again become a rarity.
Wishful thinking? The list only contains publicly traded companies that have already filed. But the energy sector, for example, is full of companies that are owned by PE firms, such as money-losing natural gas driller Samson Resources. It warned in March that it might have to use bankruptcy to restructure its crushing debt.
Similar troubles are building up in other sectors with companies owned by PE firms. As a business model, PE firms strip equity out of the companies they buy, load them up with debt, and often pay special dividends out the back door to themselves. These companies are prime candidates for bankruptcy.
Restructuring specialists are licking their chops. Reality is setting in after years of drought when the Fed’s flood of money kept every company afloat no matter how badly it was leaking. These folks are paid to renegotiate debt covenants, obtain forbearance agreements from lenders, renegotiate loans, etc. At some point, they’ll try to “restructure” the debts.
“There is a ton of activity under the water,” explained Jon Garcia, founder of McKinsey Recovery & Transformation Services.
Just on Wednesday, gun maker Colt Defense, which is invoking a prepackaged Chapter 11 filing, proposed to exchange its $250 million of 8.75% unsecured notes due 2017 for new 10% junior-lien notes due in 2023, according to S&P Capital IQ/LCD. But at a pro rata of 35 cents on the dollar!
Equity holders are out of luck. The haircut would “address key issues relating to Colt’s viability as a going concern,” the filing said. It would allow the company “to attract new financing in the years to come.” Always fresh money!
Also on Wednesday, Walter Energy announced that it would skip the interest payment due on its first-lien notes. In early March, when news emerged that it had hired legal counsel to explore restructuring options, these first-lien notes plunged to 64.5 cents on the dollar and its shares became a penny stock.
None of them has shown up in bankruptcy statistics yet. They’re part of the “activity under water,” as Garcia put it.
But these Colt Defense and Walter Energy notes are part of the “distressed bonds” whose values have collapsed and whose yields have spiked in a sign that investors consider them likely to default. These distressed bonds, according to Bank of America Merrill Lynch index data, have more than doubled year over year to $121 billion.
The actual default rate, which lags behind the rise in distressed debt levels, is beginning to tick up. Yet it’s still relatively low thanks to the Fed’s ongoing easy-money policies where new money constantly comes forward to bail out old money.
But once push comes to shove, equity owners get wiped out. Creditors at the lower end of the hierarchy lose much or all of their capital. Senior creditors end up with much of the assets. And the company emerges with a much smaller debt burden.
It’s a cleansing process, and for many existing investors a total wipeout. But the Fed, in its infinite wisdom, wanted to create paper wealth and take credit for the subsequent “wealth effect.” Hence, with its policies, it has deactivated that process for years.
Instead, these companies were able to pile even more debt on their zombie balance sheets, and just kept going. It temporarily protected the illusory paper wealth of shareholders and creditors. It allowed PE firms to systematically strip cash out of their portfolio companies before the very eyes of their willing lenders. And it prevented, or rather delayed, essential creative destruction for years.
But now reality is re-inserting itself edgewise into the game. QE has ended in the US. Commodity prices have plunged. Consumers are strung out and have trouble splurging. China is slowing. Miracles aren’t happening. Lenders are getting a teeny-weeny bit antsy. And risk, which everyone thought the Fed had eradicated, is gradually rearing its ugly head again. We’re shocked and appalled.
Fed’s Dudley Warns about Wave of Municipal Bankruptcies
The Fed is doing workshops on municipal bankruptcies now.
It has been a persistent ugly list of municipal bankruptcies: Detroit, MI; Vallejo, San Bernardino, Stockton, and Mammoth Lakes, CA; Jefferson County, AL. Harrisburg, PA; Central Falls, RI; Boise County, ID.
There are many more aspirants for that list, including cities bigger than Detroit. Detroit was the test case for shedding debt. If bankruptcy worked in Detroit, it might work in Chicago. Illinois Gov. Bruce Rauner wants to make Chapter 9 bankruptcies legal for cities in his state, which is facing its own mega-problems.
“Bankruptcy law exists for a reason; it’s allowed in business so that businesses can get back on their feet and prosper again by restructuring their debts,” Rauner said. “It’s very important for governments to be able to do that, too.”
His plan for sparing Illinois that fate is to cut state assistance to municipalities, which doesn’t sit well with officials at these municipalities. Chicago Mayor Rahm Emanuel’s office countered that balancing the state budget on the backs of the local governments is itself a “bankrupt” idea.
Puerto Rico doesn’t even have access to a legal framework like bankruptcy to reduce its debts, but it won’t be able to service them. It owes $73 billion to bondholders, about $20,000 per-capita – more than any of the 50 states. If you own a muni bond fund, you’re probably a creditor. Bond-fund managers use its higher-yielding debt to goose their performance. But now some sort of default and debt relieve is in the works. The US Treasury Department is involved too.
“People before debt,” the people in Puerto Rico demand. It’s going to be expensive for bondholders.
That’s the ugly drumbeat in the background of New York Fed President William Dudley’s speech today at the New York Fed’s evocatively named workshop, “Chapter 9 and Alternatives for Distressed Municipalities and States.”
So they’re doing workshops on municipal bankruptcies now….
“We at the New York Fed are committed to playing a role in ensuring the stability of this important sector,” he said, referring to the sordid finances of state and local governments. But he wasn’t talking about future bailouts by the Fed. He was issuing a warning to municipalities and their creditors about “the emerging fiscal stresses in the sector.”
It’s a big sector. State and local governments employ about 20 million people – “nearly one in seven American workers.” The sector accounts for about $2 trillion, or 11%, of US GDP. And its services like public safety, education, health, water, sewer, and transportation, are “absolutely fundamental to support private sector economic activity.”
The problem is how all this and other budget items have gotten funded. There are about $3.5 trillion in municipal bonds outstanding. So Dudley makes a crucial distinction:
When governments invest in long-lived capital goods like water and sewer systems, as well as roads and bridges, it makes sense to finance these assets with debt. Debt financing ensures that future residents, who benefit from the services these investments produce, are also required to help pay for them. This principle supports the efficient provision of these long-lived assets.
“Unfortunately,” he said, governments borrow to “cover operating deficits. This kind of debt has a very different character than debt issued to finance infrastructure.” It’s “equivalent to asking future taxpayers to help finance today’s public services.”
In theory, 49 states require a balanced budget every year, but it’s easy enough to “find ways to ‘get around’ balanced budget requirements” and cover operating expenses with borrowed money, he said, including the widespread practice of “pushing the cost of current employment services into the future” by underfunding pensions and retiree healthcare benefits for current public employees.
The total mountain of unfunded liabilities remains murky, but estimates for unfunded pension liabilities alone “range up to several trillion dollars.” With these unfunded liabilities, employees are the creditors. That would be on top of the $3.5 trillion in official debt, where bondholders are the creditors.
And eventually, high debt levels and the provision of services clash as in Detroit and Stockton, he said, and render public sector finances “unsustainable.”
But cutting services to the bone to be able to service the ballooning debt entails a problem: citizens can vote with their feet and move elsewhere, thus reducing the tax base and economic activity further. To forestall that, municipalities may alter their priorities and favor the provision of services over debt payments. “This may occur well before the point that debt service capacity appears to be fully exhausted,” he said.
In other words, the prioritization of cash flows to debt service may not be sustainable beyond a certain point. While these particular bankruptcy filings [by Detroit and Stockton] have captured a considerable amount of attention, and rightly so, they may foreshadow more widespread problems than what might be implied by current bond ratings.
That was easy to miss: foreshadow more widespread problems than what might be implied by current bond ratings. Dudley in essence said that current bond ratings – and therefore current bond prices and yields – don’t reflect the ugly reality of state and municipal financial conditions.
It was a warning for states and municipalities to get their financial house in order “before any problems grow to the point where bankruptcy becomes the only viable option.”
It was a warning for public employees and retirees – in their role as creditors – to not rely on promises made by their governments concerning pensions and retiree healthcare benefits.
And it was a warning for municipal bondholders that their portfolios were packed with risky, but low-yielding securities that might end up being renegotiated in bankruptcy court, along with claims by public employees and what’s left of their pension funds. And it was a blunt warning not to trust the ratings that our infamous ratings agencies stamp on these municipal bonds.
Some states are worse than others. Even with capital gains taxes from the booming stock market and startup scene raining down on my beloved and crazy state of California, it ranks as America’s 7th worst “Sinkhole State,” where taxpayers shoulder the largest burden of state debt.
Consumer demand for housing has dropped to its lowest recorded level due to reduced confidence in financial security and income raises, a new survey from Fannie Mae says.
The government-sponsored enterprise’s March national housing survey found that 41% of Americans expect their financial situation to improve over the next year, and 22% said their income had increased substantially over the last year.
Most importantly, the percentage of respondents who said they planned to buy a home dropped five basis points to 60%, an all-time survey low.
“We’ve seen modest improvement in total compensation resulting from a strengthened labor market,” Fannie Mae chief economist Doug Duncan said in a release.
“However, income growth perceptions and personal financial expectations both eased off of recent highs, consistent with Friday’s weak jobs report. Simultaneously, the share of consumers expecting to buy on their next move has declined. Meanwhile, the wait for housing expansion continues.”
Oil prices caused one-third of the job cuts that U.S.-based companies announced in the first quarter, according to a new report.March was the fourth month in a row to record a year-over-year increase in job cuts, Chicago-based outplacement consultancy Challenger, Gray & Christmas Inc. reports. And 47,610 of the 140,214 job cuts announced between January and March were directly attributed to falling oil prices.Not surprisingly, the energy sector accounted for 37,811 of the job cuts — up a staggering 3,900 percent from the same quarter a year earlier, when 940 energy jobs were cut.However, U.S. energy firms only announced 1,279 job cuts in March, down about 92 percent from the 16,339 announced in February and down nearly 94 percent from the 20,193 announced in January.The trend held true in Houston, where several energy employers announced job cuts in January and February, while fewer cuts were announced in March.Overall job-cut announcements are declining, as well. U.S. employers announced 36,594 job cuts in March, down 27.6 percent from the 50,579 announced in February and down 31 percent from the 53,041 announced in January. In December, 32,640 job cuts were announced.“Without these oil related cuts, we could have been looking one of lowest quarters for job-cutting since the mid-90s when three-month tallies totaled fewer than 100,000. However, the drop in the price of oil has taken a significant toll on oil field services, energy providers, pipelines, and related manufacturing this year,” John Challenger, CEO of Challenger, Gray & Christmas, said in a statement.
The U.S. Oil Boom Is Moving To A Level Not Seen In 45 Years
SAN FRANCISCO (MarketWatch) — U.S. oil production is on track to reach an annual all-time high by September of this year, according to Rystad Energy.If production does indeed top out, then supply levels may soon hit a peak as well. That, in turn, could lead to shrinking supplies.The oil-and-gas consulting-services firm estimates an average 2015 output of 9.65 million barrels a day will be reached in five months — topping the previous peak annual reading of 9.64 million barrels a day in 1970.Coincidentally, the nation’s crude inventories stand at a record 471.4 million barrels, based on data from U.S. Energy Information Administration, also going back to the 1970s.The staggering pace of production from shale drilling and hydraulic fracturing have been blamed for the 46% drop in crude prices CLK5, -1.08% last year. But reaching so-called peak production may translate into a return to higher oil prices as supplies begin to thin.
Rystad Energy’s estimate includes crude oil and lease condensate (liquid hydrocarbons that enter the crude-oil stream after production), and assumes an average price of $55 for West Texas Intermediate crude oil. May WTI crude settled at $49.14 a barrel on Friday.The forecast peak production level in September is also dependent on horizontal oil rig counts for Bakken, Eagle Ford and Permian shale plays stabilizing at 400 rigs, notes Per Magnus Nysveen, senior partner and head of analysis at Rystad.Of course, in this case, hitting peak production isn’t assured.“Some will be debating whether the U.S. has reached its peak production for the current boom, without addressing the question of what level will U.S. production climb to in any future booms,” said Charles Perry, head of energy consultant Perry Management. “So one might also say U.S. peak production is a moving target.”James Williams, an energy economist at WTRG Economics, said that by his calculations, peak production may have already happened or may occur this month, since the market has seen a decline in North Dakota production, with Texas expected to follow.
The number of rigs exploring for oil and natural gas in the Permian Basin decreased five this week to 285, according to the weekly rotary rig count released Thursday by Houston-based oilfield services company Baker Hughes.
The North American rig count was released a day early this week because of the Good Friday holiday, according to the Baker Hughes website.
District 8 — which includes Midland and Ector counties — shed four rigs, bringing the total to 180. The district’s rig count is down 42.68 percent on the year. The Permian Basin is down 46.23 percent.
At this time last year, the Permian Basin had 524 rigs.
TEXAS
Texas’ count fell six this week, leaving 456 rigs statewide.
In other major Texas basins, there were 137 rigs in the Eagle Ford, unchanged; 29 in the Haynesville, down three; 23 in the Granite Wash, down one; and six in the Barnett, unchanged.
Texas had 877 rigs a year ago this week.
UNITED STATES
The number of rigs in the U.S. decreased 20 this week, bringing the nationwide total to 1,028.
There were 802 oil rigs, down 11; 222 natural gas rigs, down 11; and four rigs listed as miscellaneous, up two.
By trajectory, there were 136 vertical rigs, down eight; 799 horizontal rigs, down 13; and 93 directional rigs, up one. The last time the horizontal rig count fell below 800 was the week ending June 4, 2010, when Baker Hughes reported 798 rigs.
There were 993 rigs on land, down 17; four in inland waters, unchanged; and 31 offshore, down three. There were 29 rigs in the Gulf of Mexico, down four.
The U.S. had 1,818 rigs at this time last year.
TOP 5s
The top five states by rig count this week were Texas; Oklahoma with 129, down four; North Dakota with 90, down six; Louisiana with 67, down five; and New Mexico with 51, unchanged.
The top five rig counts by basin were the Permian; the Eagle Ford; the Williston with 91, down six; the Marcellus with 70, unchanged; and the Cana Woodford and Mississippian with 40 each. The Mississippian idled three rigs, while the Cana Woodford was unchanged. The Cana Woodford shale play is located in central Oklahoma.
CANADA AND NORTH AMERICA
The number of rigs operating in Canada fell 20 this week to 100. There were 20 oil rigs, up two; 80 natural gas rigs, down 22; and zero rigs listed as miscellaneous, unchanged.
The last time Canada’s rig count dipped below 100 was the week ending May 29, 2009, when 90 rigs were reported.
Canada had 235 rigs at this time last year.
The total number of rigs in the North America region fell 40 this week to 1,128. North America had 2,083 rigs a year ago this week.
Back in early 2007, just as the first cracks of the bursting housing and credit bubble were becoming visible, one of the primary harbingers of impending doom was banks slowly but surely yanking availability (aka “dry powder”) under secured revolving credit facilities to companies across America. This also was the first snowflake in what would ultimately become the lack of liquidity avalanche that swept away Lehman and AIG and unleashed the biggest bailout of capitalism in history. Back then, analysts had a pet name for banks calling CFOs and telling them “so sorry, but your secured credit availability has been cut by 50%, 75% or worse” – revolver raids.Well, the infamous revolver raids are back. And unlike 7 years ago when they initially focused on retail companies as a result of the collapse in consumption burdened by trillions in debt, it should come as no surprise this time the sector hit first and foremost is energy, whose “borrowing availability” just went poof as a result of the very much collapse in oil prices.
As Bloomberg reports, “lenders are preparing to cut the credit lines to a group of junk-rated shale oil companies by as much as 30 percent in the coming days, dealing another blow as they struggle with a slump in crude prices, according to people familiar with the matter.
Sabine Oil & Gas Corp. became one of the first companies to warn investors that it faces a cash shortage from a reduced credit line, saying Tuesday that it raises “substantial doubt” about the company’s ability to continue as a going concern.
It’s going to get worse: “About 10 firms are having trouble finding backup financing, said the people familiar with the matter, who asked not to be named because the information hasn’t been announced.”
Why now? Bloomberg explains that “April is a crucial month for the industry because it’s when lenders are due to recalculate the value of properties that energy companies staked as loan collateral. With those assets in decline along with oil prices, banks are preparing to cut the amount they’re willing to lend. And that will only squeeze companies’ ability to produce more oil.
Those loans are typically reset in April and October based on the average price of oil over the previous 12 months. That measure has dropped to about $80, down from $99 when credit lines were last reset.
That represents billions of dollars in reduced funding for dozens of companies that relied on debt to fund drilling operations in U.S. shale basins, according to data compiled by Bloomberg.
“If they can’t drill, they can’t make money,” said Kristen Campana, a New York-based partner in Bracewell & Giuliani LLP’s finance and financial restructuring groups. “It’s a downward spiral.”
As warned here months ago, now that shale companies having exhausted their ZIRP reserves which are largely unsecured funding, it means that once the secured capital crunch arrives – as it now has – it is truly game over, and it is just a matter of months if not weeks before the current stakeholders hand over the keys to the building, or oil well as the case may be, over to either the secured lenders or bondholders.
The good news is that unlike almost a decade ago, this time the news of impending corporate doom will come nearly in real time: “Publicly traded firms are required to disclose such news to investors within four business days, under U.S. Securities and Exchange Commission rules. Some of the companies facing liquidity shortfalls will also disclose that they have fully drawn down their revolving credit lines like Sabine, according to one of the people.”
Speaking of Sabine, its day of reckoning has arrived
Sabine, the Houston-based exploration and production company that merged with Forest Oil Corp. last year, told investors Tuesday that it’s at risk of defaulting on $2 billion of loans and other debt if its banks don’t grant a waiver.
Another company is Samson Resource, which said in a filing on Tuesday that it might have to file for a Chapter 11 bankruptcy protection if the company is unable to refinance its debt obligations. And unless oil soars in the coming days, it won’t.
Its borrowing base may be reduced due to weak oil and gas prices, requiring the company to repay a portion of its credit line, according to a regulatory filing on Tuesday. That could “result in an event of default,” Tulsa, Oklahoma-based Samson said in the filing.
Indicatively, Samson Resources, which was acquired in a $7.2-billion deal in 2011 by a team of investors led by KKR & Co, had a total debt of $3.9 billion as of Dec. 31. It is unlikely that its sponsors will agree to throw in more good money after bad in hopes of delaying the inevitable.
The revolver raids explain the surge in equity and bond issuance seen in recent weeks:
Many producers have been raising money in recent weeks in anticipation of the credit squeeze, selling shares or raising longer-term debt in the form of junk bonds or loans.
Energy companies issued more than $11 billion in stock in the first quarter, more than 10 times the amount from the first three months of last year, Bloomberg data show. That’s the fastest pace in more than a decade.
Breitburn Energy Partners LP announced a $1 billion deal with EIG Global Energy Partners earlier this week to help repay borrowings on its credit line. EIG, an energy-focused private equity investor in Washington, agreed to buy $350 million of Breitburn’s convertible preferred equity and $650 million of notes, Breitburn said in a March 29 statement.
Unfortunately, absent an increase in the all important price of oil, at this point any incremental dollar thrown at US shale companies is a dollar that will never be repaid.
The shale oil revolutionaries are retreating in disarray, and cheap foreign oil may banish them to the margins of the market.
As oil and natural gas move into a period of low prices, new data shows that North American drillers may not have the wherewithal to keep producing shale wells, which make up 90 percent of new drilling. In fact, if prices remain low for years to come, which is a real possibility, then investors may never see a return on the money spent to drill shale wells in the first place.
The full cost of producing oil and natural gas at a representative sample of U.S. companies, including capital spent to build the company and buy assets, is about $80 per barrel of oil equivalent, according to a study from the Bureau of Economic Geology’s Center for Energy Economics at the University of Texas.
The analysis of 2014 corporate financial data from 15 of the top publicly traded producers, which I got an exclusive look at before it’s published this week, determined that companies will have a hard time recovering the capital spent that year and maintaining production unless prices rise above $80 a barrel.
The price for West Texas Intermediate has spent most of the year below $50 a barrel.
Low prices, though, won’t mean that producers will shut in existing wells. Many of these same companies can keep pumping to keep cash coming into the company, and they can still collect a 10 percent return above the well’s operating costs at $50 a barrel of oil. They just won’t make enough money to invest in new wells or recover the capital already spent.
This harsh reality of what it will take to keep the shale revolution going shows how vulnerable it is to competition from cheap overseas oil.
“Everyone walks around thinking that they know how much this stuff costs because they see published information on what people spend to just drill wells,” explained Michelle Foss, who leads the Houston-based research center. “That is not what it takes for a company to build these businesses, to recover your capital and to make money.” The bureau was founded in 1909 and functions as the state geological agency.
Low oil prices will also exacerbate the economic impact of low natural gas prices. For years natural gas has kept flowing despite prices below $4 for a million British thermal units because about 50 percent of wells produced both gas and liquids, such as crude oil and condensate.
True natural gas costs
High oil prices have helped companies subsidize natural gas wells, but lower oil prices mean natural gas wells that don’t produce liquids will need to stand on their own economics.
The center’s analysis found that among the sample companies focused primarily on gas, prices will need to top $6 a million BTUs just to cover full costs and rise above $12 a million BTUs to recover the capital expended to develop the wells.
“We have important resources, but people have to be realistic about the challenges of developing them,” Foss told me. “There will have to be higher prices.”
Everyone predicts prices will rise again. The only questions are how quickly and to what price. Some experts predict WTI prices will reach $70 a barrel by the end of 2015, while others see $60. The soonest most expect to see $80 a barrel oil is in 2017. Saudi Arabian officials have said they believe the price has stabilized and don’t see oil returning to $100 a barrel for the next five years.
High prices and shale
The Saudi opinion is particularly important because that nation can produce oil cheaper than any other country and can produce more oil than any other country. As the informal leader of the Organization of the Petroleum Exporting Countries, Saudi Arabia kept the price of oil inside a band between $80 and $100 a barrel for years. Now, the Saudis appear ready to keep the price low.
That’s because high prices inspired the shale revolution, where American companies figured out how to economically drill horizontally into tight rocks and then hydraulically fracture them to release oil and natural gas. Since OPEC countries rely on high oil prices to finance their governments, everyone assumed OPEC would cut production and keep revenues high.
Arab leaders, though, were more concerned about holding on to market share and allowed prices to fall below levels that make most shale wells economic. Foss, who recently returned from meetings in the United Arab Emirates, said OPEC is unlikely to change course because developing countries are seeking alternatives to oil and reducing demand.
“The Saudis and their partners see pressures on oil use everywhere they look, and what they want is their production, in particular their share of the global supply pie, to be as competitive as it can be to ensure they’ve got revenue coming into the kingdom for future generations,” she said.
OPEC is afraid rich countries like the U.S. are losing their addiction to oil, and by lowering prices hope to keep us hooked. And OPEC has plenty of product.
“There’s 9 million barrels a day in current and potential production capacity in Iraq and Iran that is tied up by political conflicts, and if you sort that out enough, that’s a flood of cheap oil onto the market,” Foss said.
On the losing end
If prices remain low, the big losers will be the bond holders and shareholders of indebted, small and medium-size companies that drill primarily in North America. Since these companies are not getting high enough prices to pay off capital expenditures through higher share prices or interest payments , they are in serious trouble.
The inability of Denver-based Whiting Petroleum to sell itself is an example. The board of the North Dakota-focused company was forced to issue new shares, reducing the company’s value by 20 percent, and take on more expensive debt. Quicksilver Resources, based in Fort Worth, filed for Chapter 11 bankruptcy on March 17 because it couldn’t make the interest payments on its debt and no one was willing to invest more capital.
Until one of these companies is bought, we won’t know the true value of the shale producers at the current oil and natural gas prices.
But as more data reaches the market, there is a real danger that these companies are worth even less than investors fear, even though they may have high-quality assets.
We’ve been saying for quite some time now that the US equity market’s seemingly inexorable (until this week) tendency to rise to new highs in the absence of the Fed’s guiding hand is almost certainly in large part attributable to the fact that in a world where you are literally guaranteed to lose money if you invest in safe haven assets such as negative-yielding German bunds, corporations can and will take advantage of the situation by issuing debt and using the proceeds to buy back stock, thus underwriting the rally in US equities. Here’s what we said after stocks turned in their best month in three years in February:
It also explains why, in the absence of the Fed, stocks continue to rise as if QE was still taking place: simply said, bondholders – starved for any yield in an increasingly NIRP world – have taken the place of the Federal Reserve, and are willing to throw any money at companies who promise even the tiniest of returns over Treasuries, oblivious if all the proceeds will be used immediately to buyback stock, thus pushing equity prices even higher, but benefiting not only shareholders but management teams who equity-linked compensation has likewise never been higher.
If you need further proof that this is precisely what is going on in US markets, consider the following from Citi:
Companies are rapidly re-leveraging…
…and the proceeds sure aren’t being invested in future productivity, but rather in buy backs and dividends… …and Citi says all that debt issued by struggling oil producers may prove dangerous given that “default risk in the energy space has jumped [and considering] the energy sector now accounts for 18% of the market”… …and ratings agencies are behind the curve… We’ll leave you with the following:
To be sure, this theater of financial engineering – because stocks are not going up on any resemblance of fundamental reasons but simply due to expanding balance sheet leverage – will continue only until it can no longer continue.
Oil production continues to eclipse record highs on a weekly basis despite the oil rig count declining 49% since October.
A single oil-well declines exponentially up to 75% in its first year of production. However, in a process known as Convolution, older wells buffer the rapid decline from new rigs.
This article provides a comprehensive analysis of principles behind oil drilling and production, applies it to the current crude oil climate, and predicts future production, rig counts, and oil price.
Based on my analysis, I remain short-term bearish but long-term bullish on the commodity. My trading strategy based on this analysis is discussed in detail.
On Friday, March 20, Baker Hughes (NYSE:BHI) reported that the crude oil rig count had fallen an additional 41 rigs to 825 active rigs. This was the 15th straight week and 25th out of 26 weeks that the rig count has declined. Active oil rigs are now at the lowest level since the week ending March 18th, 2011 and total drilling rigs (oil + natural gas) are the fewest since October 2009. Overall, the oil rig count is down 49% in the 23 weeks since peaking in October. Nevertheless, in its weekly Petroleum Report, the EIA announced last Wednesday that domestic oil production set yet another record high of 9.42 million barrels per day. Since the rig count peaked the week of October 10, 2014 and began its subsequent collapse, oil production has climbed 460,000 barrels per day, or 5.2%. This continued increase in production in the face of a plummeting rig count has confounded journalists, flummoxed investors, and inflated supplies to record highs leading to a continued slump in oil prices.
The two main questions on traders’ minds are 1) why is oil production still at record highs five months after the rig count started dropping? And 2) when, if at all, will oil production begin to fall and how far will it fall? This article provides a comprehensive analysis of the principles behind the relationship between oil drilling and production, applies it to the current crude oil climate, and predicts where both production and the rig count will go in the coming year.
Before we discuss the real-world oil production and drilling situation – an extremely complex picture with over 1 million rigs producing oil – let’s look at a simple, hypothetical situation. The first key point is that once an oil well is drilled, its production is not constant. In fact, production not only begins to decline almost immediately, it does so in an exponential fashion. After analyzing production curves from multiple wells, I will be estimating weekly oil production from a single oil well by the following equation:
Equation 1:
Daily Oil Production From Single Well = (Initial Daily Production)/(1+ (Week # from start of production*K)
Where K is a constant equal to 0.06
When graphed using a well that initially produces 1000 barrels of oil per week this equation is represented by Figure 1 below:
Figure 1: Crude oil production curve of single, hypothetical well showing exponential decay.
There are two take home points to note from this chart. First, initial decay is very rapid, with weekly production declining by about 75% after 1 year. Second, after the initial rapid decay, production declines much slower and becomes approximately linear with decay rates of 5-10% per year. Although this graph ends after 2 years or 104 weeks, production continues slowly and steadily beyond 5 years.
Figure 1 represents production from a single well. What happens when we add multiple wells over a period of time? The process by which multiple functions – in this case, oil wells – are added over time is known as Convolution. As noted before, even after an oil well has been active for many years, it is still producing a small volume of oil, a fraction of its initial output. However, there are a LOT of these old, low-output rigs – over 1.1 million in fact. When the number of drilling rigs decreases – thus reducing the number of new wells that come into the service – the old, stable wells plus the production from the declining number of new wells is initially enough to buffer the decline in rig count and net output will continue to rise.
Let’s illustrate this with a simple example. Imagine a new oil field monopolized with a single company that owns 30 oil rigs. The company adds five new rigs each month. Each rig is able to drill 1 new well per month. After six months, the company has deployed all of its rigs to the field. Unfortunately, shortly thereafter the company encounters financial difficulties and is forced to withdraw rigs at a rate of 5 per month until zero remain drilling. Figure 2 below compares active drilling rigs and total wells in this field.
Figure 2: Rig count and total well count of hypothetical oil field
Note that after the rig count peaks and begins to decline, total wells continue to increase before ultimately peaking at 180, where it remains for the remainder of the 20-month period.
Each well initially produces 200 barrels of oil per day and declines according to Equation 1 and the chart in Figure 1. Figure 3 below shows total oil field production overlaid with the total rig count of the field.
Figure 3: Oil Production from hypothetical oil field illustrating how crude oil production can continue to climb despite a sharp reduction in the rig count due to convolution.
Oil production initially climbs rapidly as more rigs are added to the field, reaching 500,000 barrels per month by the time the rig count peaks after 6 months. However, even though the rig count declines to zero six months later, total production continues to increase and peaks at 770,000 barrels per month in month 10 – 4 months after the rig count peaked. Production then begins to decline, but slowly. Even by month 20 after the rig count has been at zero for eight months, production has only declined by 33%.
This is obviously a simply, insular example, but it illustrates several important points. First, there is a delay between when the rig count peaks and when production begins to decline as the combination of old, accumulated oil wells and the continued addition of new wells by the declining rigs is sufficient to coast production higher initially. Second, even when production begins to decline, it is blunted, with production declining a fraction of the actual reduction in rig count. For those interested, the Following Article delves into these principles further and provides useful insight.
Let’s now apply these principles to actual domestic oil production. Before we can set up the model, there are three baseline metrics that need to be established: 1) Rate that rigs drill a well, 2) Time between initial spudding of a well and when it begins production, and 3) Initial production rate of new oil wells.
The EIA has released well counts on a quarterly basis for the past two years. Their data shows that the ratio of new wells to rigs has increased slowly from around 4.75 per quarter in 2012 to 5.3 per quarter in 2014. This equates to about 0.4 wells per week per rig presently. For the model, I used a linear reduction in drilling efficiency with drilling rates down to 0.3 wells per week per rig in 2006.
It takes 15-30 days to drill a new oil well. Once the hole is dug, the well must be completed. It typically takes another week for the rig to be removed and new equipment to be set up. A further week is devoted to hydraulic fracturing. Initial flow back and priming of production takes place over the next 3-4 days. Over the final week, the well is primed for continuous production including installation of tank batteries, the pump jack, and assorted power connections. The well is then connected to the pipeline and permanent production begins. Thus, it takes roughly two months from initial spudding of the well to when it begins production. However, once a well is completed it does not always begin to produce immediately and may not do so for up to six months.
Initial oil production rates have increased markedly over the past decade as drilling technology has improved. The EIA released the chart shown below in Figure 4 showing yearly initial production rates in the Eagleford Shale.
Figure 4: Yearly production rates in Eagleford Shale Formation showing rapidly increased initial rates of production 2009-2014. (Source:EIA)
Initial rates increased from less than 50 barrels per day (or 350 per week) in 2009 to nearly 400 barrels per day (or 2800 per week) in 2014. Note that the decay rate has also increased such that by 2-3 years, all wells are approaching the same output despite the significant differences in increased production. This is a relatively new oil formation and older formations produced more oil initially prior to 2010. For my model, I assumed initial production of 2625 barrels of oil per well per week in 2014-2015 with initial production declining to 1400 barrels per well per week in 2006.
Using this data and the methodology discussed in the example above, a modeled projection of U.S. oil production is created dating back to 2006. This data is shown in Figure 5 below and is compared to actual oil production, calculated on a weekly basis. My preferred unit of time is 1 week as this is the frequency that both the rig count and oil production numbers are released.
Figure 5: Projected oil production based on my model vs. observed crude oil production vs. Baker Hughes Rig Count [Sources: Baker Hughes, EIA]
Overall, this model accurately projects oil production based on active drilling rigs. Between 2006 and 2015, the average error was 88,000 barrels per day, or 1.2%. Over the past six months, this error has averaged just 44,000 barrels per day. The model correctly shows production continuing to increase despite the sharp reduction in active drilling rigs. It is interesting to note that the largest deviation between projected oil production and observed production occurred in late 2009 and early 2010, or shortly after the rig count bottomed out from the previous oil price collapse. The model predicted that oil production would decline somewhat while actual production actually just leveled off before beginning a new rally once the rig count rebounded later in 2010.
This model can be used to project how oil production might behave heading into the future. To do so, we must make assumptions about how the rig count might behave heading into the future. First, let’s pretend that the rig count stays unchanged at 825 active oil rigs for the next 1 year. Figure 6 below projects crude oil production to 1 year.
Figure 6:Projected oil production based the rig count remaining unchanged at 825 [Sources: Baker Hughes, EIA]
Using this projection, crude oil production will peak during the week ending April 10 at 9.51 million barrels per day and then begin declining. By next March 2016, production will have declined to 8.68 million barrels per day, down 9.5% from the projected peak. Again, this goes to show the buffering capacity of older rigs, given that a sustained 50% reduction in the rig count results in a comparatively small <10% decrease in output.
Two qualifying notes are necessary. This model shows a relatively short period of time between production plateauing and production beginning its decline. 1) Given that this model assumes all completed wells are producing oil within 3 months of spudding, it is certainly possible that the production curve may flatten out for a longer period of time due to additional completed wells that have been idle are slowly hooked up to pipelines over the next several months. 2) This model also makes the assumption that all rigs produce oil equally. If rigs drilling less-productive oil fields have been selectively retired while those drilling richer fields have remained active, the rate of decline will similarly be slower and less than projected.
The most recent historical comparison to the events currently unfolding took place in 2008-2009 following the collapse of oil from record highs during the great recession from a high of $146/barrel to near $30/barrel. The rig count during that event was likewise slashed by 50% before rapidly recovering when prices rebounded. However, this is not an apples-to-apples comparison since drilling technology has changed substantially – decline rates are much more rapid, initial production is nearly double that in 2008, etc – and inferences cannot necessarily be made about the future of production. However, let’s assume that the current rig count follows a similar trend. If so, the rig count will slow its descent and bottom out in roughly six weeks near 760-780. If the rig count follows the trend seen in 2009, the count will then rapidly rise and will reach 1330 by this time next year. Production will again peak during the week of April 10, before declining. Production will bottom out in late October near 8.9 million barrels per day, down just 6.3% from its peak before again increasing late in the year.
However, the decline in oil in 2008-2009 was based more on the combination of a bubble bursting and a slumping economy than fundamental forces while the current slump is predicated on a supply/demand mismatch. I expect this will keep prices and rigs down significantly longer than in 2008-2009. Let’s amplify the 2008-2009 rig count curve and project instead that rigs bottom out near 730-750 and that the rate of recovery is roughly half that of 2008-2009 with total rigs at just 950 this time next year. Using this model, production will continue to slowly decline through the New Year and flatten out near 8.7 million barrels per day by March 2016, down 8.4% from the peak. I believe that this is a more realistic model for crude oil production. This projection is shown below in Figure 7.
Figure 7:Projected oil production based on 2008-2009 rig count [Sources: Baker Hughes, EIA]
What does this mean for the supply/demand situation? As I have discussed in my previous articles, crude oil supply and demand are severely mismatched. This has led to oil inventories skyrocketing to a record high of 458 million barrels, a huge 98.7 million barrels above the five-year mean for March. Applying the projected production curve shown in Figure 7 to crude oil storage yields some surprising results. Even with just an 8.7% reduction in supply, the inventory surplus will narrow markedly. These results are shown below in Figure 8, which compares the five-year average storage level and current and projected storage levels. Note: These projections assume that total imports will remain flat and that total demand will follow the five-year average.
Figure 8: Projected crude oil storage based on projected oil production data vs. 5-year average [Source: EIA]
While the rig count continues to climb and then plateaus, I expect that the storage surplus will continue to widen with total inventories approaching 500 million barrels by early May. However, as production drops off, the inventory surplus begins to decline. By the last week of 2015, total supply has declined by 4.7 million barrels per week and projected inventory levels cross the five-year average for the first time since October 2014. Should the rig count begin the slow rise that is projected, by March of 2016, total storage levels will be 50 million barrels BELOW the five-year average. Even if the two qualifying statements discussed above verify or the rig count rises more rapidly than projected, I expect that, based on the drop in rig count already, crude oil inventories will be at or below average this time next year.
What does this mean for crude oil prices? There is a chicken and egg situation going on here. This article makes references to the rebound in rig count after bottoming out in the next month or two. This, of course, is predicated on a rise in price to make drilling again profitable. Without a rally, the count will continue to fall or, at the very least NOT rise, putting further pressure on supply and down-shifting the projected production curve further, making it more likely that prices will THEN rally. Until they finally do. One way or another, I do not see how crude oil can remain priced at under $45/barrel for longer than a few months. Something has to give. Drilling technology is simply not yet to the point where this is a profitable price range for the majority of companies.
Given that these projections show production increasing through early April, I would not be surprised to see continued short-term pressure on oil prices. As I discussed in My Article Last Week, storage at Cushing, the closely watched oil pipeline hub, continues to fill rapidly and threatens to reach capacity by early May. I would welcome such an event, as crude oil would likely drop under $40/barrel presenting an even better buying opportunity. I therefore maintain a short-term bearish, long-term bullish stance on oil.
My favorite way to play a rally in oil is to short the VelocityShares 3x Inverse Crude Oil ETN (NYSEARCA:DWTI) to gain long exposure. This takes advantage of leverage-induced decay to at least partially negate the impact of contango on the ETF. The United States Oil ETF USO), on the other hand, is intended to track 1x the price of oil and leaves an investor directly exposed to contango, which is now 15% over the next six months. The same applies to the VelocityShares 3x Long Crude Oil ETN (NYSEARCA:UWTI), except that exposure to contango is now tripled to 45%.
The advantage to USO is in its safety. A short position in DWTI theoretically leaves an investor open to infinite losses should the price of oil continue to drop. Further, shares must be borrowed to short, which can cost 3-5% annually depending on the broker. And if, once a trader has a position, these shares are no longer available, the position can be forcibly closed at an inopportune time. A slightly less risky position would be the ProShares UltraShort Bloomberg Crude Oil ETF (NYSEARCA:SCO) that is more liquid and less volatile.
For this reason, I started a small position in USO on Thursday at $16.05 when oil erased its post-Fed Remarks gains from Wednesday. This position is equal to just 2% of my portfolio. I will add to my USO position once oil breaks $45/barrel and then again should the commodity break $42/barrel for a total exposure of 6% of my portfolio. Should oil continue to decline to under $40/barrel, I will begin to sell short DWTI at what I assume to be a safer entry point until 10% of my portfolio is allocated to oil ETFs.
Should oil rebound, I will look to take profits. Once the rig count bottoms, I will begin taking profits once oil reaches $50/barrel. I will selectively sell USO initially. I prefer to close out the position most exposed to contango initially in the event that oil reverses and I would otherwise be stuck holding it for an extended period of time. I will then close out DWTI if and when crude oil again reaches $60/barrel. While I believe that oil may ultimately see higher prices, I am concerned at the speed at which rigs may be re-deployed once drilling again becomes profitable. I believe that this will keep oil under $70/barrel for the foreseeable future and will look to exit prior to this level.
In conclusion, an oil production model based on 9 years of domestic production and rig count data is used to project oil production for the past 1 year. This model suggests that oil will bottom around the week ending April 10. However, this is just a modeled projection and the actual peak in production will depend on nuances in drilling discussed above. Nevertheless, I believe that the peak in oil production will represent a significant psychological inflection point and that crude oil is poised for a rally once production begins to roll over.
On the face of it, the oil price appears to be stabilizing. What a precarious balance it is, however.
Behind the facade of stability, the re-balancing triggered by the price collapse has yet to run its course, and it might be overly optimistic to expect it to proceed smoothly. Steep drops in the US rig count have been a key driver of the price rebound. Yet US supply so far shows precious little sign of slowing down. Quite to the contrary, it continues to defy expectations.
So said the International Energy Agency in its Oil Market Report on Friday. West Texas Intermediate plunged over 4% to $45 a barrel.
The boom in US oil production will continue “to defy expectations” and wreak havoc on the price of oil until the power behind the boom dries up: money borrowed from yield-chasing investors driven to near insanity by the Fed’s interest rate repression. But that money isn’t drying up yet – except at the margins.
Companies have raked in 14% more money from high-grade bond sales so far this year than over the same period in 2014, according to LCD. And in 2014 at this time, they were 27% ahead of the same period in 2013. You get the idea.
Even energy companies got to top off their money reservoirs. Among high-grade issuers over just the last few days were BP Capital, Valero Energy, Sempra Energy, Noble, and Helmerich & Payne. They’re all furiously bringing in liquidity before it gets more expensive.
In the junk-bond market, bond-fund managers are chasing yield with gusto. Last week alone, pro-forma junk bond issuance “ballooned to $16.48 billion, the largest weekly tally in two years,” the LCD HY Weekly reported. Year-to-date, $79.2 billion in junk bonds have been sold, 36% more than in the same period last year.
But despite this drunken investor enthusiasm, the bottom of the energy sector – junk-rated smaller companies – is falling out.
Standard & Poor’s rates 170 bond issuers that are engaged in oil and gas exploration & production, oil field services, and contract drilling. Of them, 81% are junk rated – many of them deep junk. The oil bust is now picking off the smaller junk-rated companies, one after the other, three of them so far in March.
On March 3, offshore oil-and-gas contractor CalDive that in 2013 still had 1,550 employees filed for bankruptcy. It’s focused on maintaining offshore production platforms. But some projects were suspended last year, and lenders shut off the spigot.
On March 8, Dune Energy filed for bankruptcy in Austin, TX, after its merger with Eos Petro collapsed. It listed $144 million in debt. Dune said that it received $10 million Debtor in Possession financing, on the condition that the company puts itself up for auction.
On March 9, BPZ Resources traipsed to the courthouse in Houston to file for bankruptcy, four days after I’d written about its travails; it had skipped a $60 million payment to its bondholders [read… “Default Monday”: Oil & Gas Companies Face Their Creditors].
And more companies are “in the pipeline to be restructured,” LCD reported. They all face the same issues: low oil and gas prices, newly skittish bond investors, and banks that have their eyes riveted on the revolving lines of credit with which these companies fund their capital expenditures. Being forever cash-flow negative, these companies periodically issue bonds and use the proceeds to pay down their revolver when it approaches the limit. In many cases, the bank uses the value of the company’s oil and gas reserves to determine that limit.
If the prices of oil and gas are high, those reserves have a high value. It those prices plunge, the borrowing base for their revolving lines of credit plunges. S&P Capital IQ explained it this way in its report, “Waiting for the Spring… Will it Recoil”:
Typically, banks do their credit facility redeterminations in April and November with one random redetermination if needed. With oil prices plummeting, we expect banks to lower their price decks, which will then lead to lower reserves and thus, reduced borrowing-base availability.
April is coming up soon. These companies would then have to issue bonds to pay down their credit lines. But with bond fund managers losing their appetite for junk-rated oil & gas bonds, and with shares nearly worthless, these companies are blocked from the capital markets and can neither pay back the banks nor fund their cash-flow negative operations. For many companies, according to S&P Capital IQ, these redeterminations of their credit facilities could lead to a “liquidity death spiral.”
Alan Holtz, Managing Director in AlixPartners’ Turnaround and Restructuring group told LCD in an interview:
We are already starting to see companies that on the one hand are trying to work out their operational problems and are looking for financing or a way out through the capital markets, while on the other hand are preparing for the events of contingency planning or bankruptcy.
Look at BPZ Resources. It wasn’t able to raise more money and ended up filing for bankruptcy. “I think that is going to be a pattern for many other companies out there as well,” Holtz said.
When it trickled out on Tuesday that Hercules Offshore, which I last wrote about on March 3, had retained Lazard to explore options for its capital structure, its bonds plunged as low as 28 cents on the dollar. By Friday, its stock closed at $0.41 a share.
When Midstates Petroleum announced that it had hired an interim CEO and put a restructuring specialist on its board of directors, its bonds got knocked down, and its shares plummeted 33% during the week, closing at $0.77 a share on Friday.
When news emerged that Walter Energy hired legal counsel Paul Weiss to explore restructuring options, its first-lien notes – whose investors thought they’d see a reasonable recovery in case of bankruptcy – dropped to 64.5 cents on the dollar by Thursday. Its stock plunged 63% during the week to close at $0.33 a share on Friday.
Numerous other oil and gas companies are heading down that path as the oil bust is working its way from smaller more vulnerable companies to larger ones. In the process, stockholders get wiped out. Bondholders get to fight with other creditors over the scraps. But restructuring firms are licking their chops, after a Fed-induced dry spell that had lasted for years.
Investors Crushed as US Natural Gas Drillers Blow Up
The Fed speaks, the dollar crashes. The dollar was ripe. The entire world had been bullish on it. Down nearly 3% against the euro, before recovering some. The biggest drop since March 2009. Everything else jumped. Stocks, Treasuries, gold, even oil.
West Texas Intermediate had been experiencing its biggest weekly plunge since January, trading at just above $42 a barrel, a new low in the current oil bust. When the Fed released its magic words, WTI soared to $45.34 a barrel before re-sagging some. Even natural gas rose 1.8%. Energy related bonds had been drowning in red ink; they too rose when oil roared higher. It was one heck of a party.
But it was too late for some players mired in the oil and gas bust where the series of Chapter 11 bankruptcy filings continues. Next in line was Quicksilver Resources.
It had focused on producing natural gas. Natural gas was where the fracking boom got started. Fracking has a special characteristic. After a well is fracked, it produces a terrific surge of hydrocarbons during first few months, and particularly on the first day. Many drillers used the first-day production numbers, which some of them enhanced in various ways, in their investor materials. Investors drooled and threw more money at these companies that then drilled this money into the ground.
But the impressive initial production soon declines sharply. Two years later, only a fraction is coming out of the ground. So these companies had to drill more just to cover up the decline rates, and in order to drill more, they needed to borrow more money, and it triggered a junk-rated energy boom on Wall Street.
At the time, the price of natural gas was soaring. It hit $13 per million Btu at the Henry Hub in June 2008. About 1,600 rigs were drilling for gas. It was the game in town. And Wall Street firms were greasing it with other people’s money. Production soared. And the US became the largest gas producer in the world.
But then the price began to plunge. It recovered a little after the Financial Crisis but re-plunged during the gas “glut.” By April 2012, natural gas had crashed 85% from June 2008, to $1.92/mmBtu. With the exception of a few short periods, it has remained below $4/mmBtu – trading at $2.91/mmBtu today.
Throughout, gas drillers had to go back to Wall Street to borrow more money to feed the fracking orgy. They were cash-flow negative. They lost money on wells that produced mostly dry gas. Yet they kept up the charade. They aced investor presentations with fancy charts. They raved about new technologies that were performing miracles and bringing down costs. The theme was that they would make their investors rich at these gas prices.
The saving grace was that oil and natural-gas liquids, which were selling for much higher prices, also occur in many shale plays along with dry gas. So drillers began to emphasize that they were drilling for liquids, not dry gas, and they tried to switch production to liquids-rich plays. In that vein, Quicksilver ventured into the oil-rich Permian Basin in Texas. But it was too little, too late for the amount of borrowed money it had already burned through over the years by fracking for gas below cost.
During the terrible years of 2011 and 2012, drillers began reclassifying gas rigs as rigs drilling for oil. It was a judgement call, since most wells produce both. The gas rig count plummeted further, and the oil rig count skyrocketed by about the same amount. But gas production has continued to rise since, even as the gas rig count has continued to drop. On Friday, the rig count was down to 257 gas rigs, the lowest since March 1993, down 84% from its peak in 2008.
Quicksilver’s bankruptcy is a consequence of this fracking environment. It listed $2.35 billion in debts. That’s what is left from its borrowing binge that covered its negative cash flows. It listed only $1.21 billion in assets. The rest has gone up in smoke.
Its shares are worthless. Stockholders got wiped out. Creditors get to fight over the scraps.
Its leveraged loan was holding up better: the $625 million covenant-lite second-lien term loan traded at 56 cents on the dollar this morning, according to S&P Capital IQ LCD. But its junk bonds have gotten eviscerated over time. Its 9.125% senior notes due 2019 traded at 17.6 cents on the dollar; its 7.125% subordinated notes due 2016 traded at around 2 cents on the dollar.
Among its creditors, according to the Star Telegram: the Wilmington Trust National Association ($361.6 million), Delaware Trust Co. ($332.6 million), US Bank National Association ($312.7 million), and several pipeline companies, including Oasis Pipeline and Energy Transfer Fuel.
Last year, it hired restructuring advisers. On February 17, it announced that it would not make a $13.6 million interest payment on its senior notes and invoked the possibility of filing for Chapter 11. It said it would use its 30-day grace period to haggle with its creditors over the “company’s options.”
Now, those 30 days are up. But there were no other “viable options,” the company said in the statement. Its Canadian subsidiary was not included in the bankruptcy filing; it reached a forbearance agreement with its first lien secured lenders and has some breathing room until June 16.
Quicksilver isn’t alone in its travails. Samson Resources and other natural gas drillers are stuck neck-deep in the same frack mud.
A group of private equity firms, led by KKR, had acquired Samson in 2011 for $7.2 billion. Since then, Samson has lost $3 billion. It too hired restructuring advisers to deal with its $3.75 billion in debt. On March 2, Moody’s downgraded Samson to Caa3, pointing at “chronically low natural gas prices,” “suddenly weaker crude oil prices,” the “stressed liquidity position,” and delays in asset sales. It invoked the possibility of “a debt restructuring” and “a high risk of default.”
But maybe not just yet. The New York Post reported today that, according to sources, a JPMorgan-led group, which holds a $1 billion revolving line of credit, is granting Samson a waiver for an expected covenant breach. This would avert default for the moment. Under the deal, the group will reduce the size of the revolver. Last year, the same JPMorgan-led group already reduced the credit line from $1.8 billion to $1 billion and waived a covenant breach.
By curtailing access to funding, they’re driving Samson deeper into what S&P Capital IQ called the “liquidity death spiral.” According to the New York Post’s sources, in August the company has to make an interest payment to its more junior creditors, “and may run out of money later this year.”
Industry soothsayers claimed vociferously over the years that natural gas drillers can make money at these prices due to new technologies and efficiencies. They said this to attract more money. But Quicksilver along with Samson Resources and others are proof that these drillers had been drilling below the cost of production for years. And they’d been bleeding every step along the way. A business model that lasts only as long as new investors are willing to bail out old investors.
But it was the crash in the price of “liquids” that made investors finally squeamish, and they began to look beyond the hype. In doing so, they’re triggering the very bloodletting amongst each other that ever more new money had delayed for years. Only now, it’s a lot more expensive for them than it would have been three years ago. While the companies will get through it in restructured form, investors get crushed.
HOUSTON – It’s official: The shale oil boom is starting to waver.
And, in a way, it may have souped-up rigs and more efficient drilling technologies to thank for that.
Crude production at three major U.S. shale oil fields is projected to fall this month for the first time in six years, the U.S. Energy Information Administration said Tuesday.
It’s one of the first signs that idling hundreds of drilling rigs and billions of dollars in corporate cutbacks are starting to crimp the nation’s surging oil patch.
But it also shows that drilling technology and techniques have advanced to the point that productivity gains may be negligible in some shale plays where horizontal drilling and hydraulic fracturing have been used together for the past several years.
Because some plays are already full of souped-up horizontal rigs, oil companies don’t have as many options to become more efficient and stem production losses, as they did in the 2008-2009 downturn, the EIA said.
The EIA’s monthly drilling productivity report indicates that rapid production declines from older wells in three shale plays are starting to overtake new output, as oil companies drill fewer wells.
In the recession six years ago, the falling rig count didn’t lead to declining production because new technologies boosted how fast rigs could drill wells.
But now that oil firms have figured out how to drill much more efficiently, “it is not clear that productivity gains will offset rig count declines to the same degree as in 2008-09,” the EIA said.
Overall, U.S. oil production is set to increase slightly from March to April to 5.6 million barrels a day in six major fields, according to the EIA.
But output is falling in the Eagle Ford Shale in South Texas, North Dakota’s Bakken Shale and the Niobrara Shale in Colorado, Wyoming, Nebraska and Kansas.
In those three fields, net production is expected to drop by a combined 24,000 barrels a day.
The losses were masked by production gains in the Permian Basin in West Texas and other regions.
Efficiency improvements are still emerging in the Permian, faster than in other oil fields because the region was largely a vertical-drilling zone as recently as December 2013, the EIA said.
Net crude output in the Bakken is expected to decline by 8,000 barrels a day from March to April. In the Eagle Ford, it’s slated to fall by 10,000 barrels a day. And in the Niobrara, production will dip by roughly 5,000 barrels a day.
But daily crude output jumped by 21,000 barrels in the Permian and by 3,000 barrels in the Utica Shale in Ohio and Pennsylvania.
“People need to kinda settle in for a while.” That’s what Exxon Mobil CEO Rex Tillerson said about the low price of oil at the company’s investor conference. “I see a lot of supply out there.”
So Exxon is going to do its darnedest to add to this supply: 16 new production projects will start pumping oil and gas through 2017. Production will rise from 4 million barrels per day to 4.3 million. But it will spend less money to get there, largely because suppliers have had to cut their prices.
That’s the global oil story. In the US, a similar scenario is playing out. Drillers are laying some people off, not massive numbers yet. Like Exxon, they’re shoving big price cuts down the throats of their suppliers. They’re cutting back on drilling by idling the least efficient rigs in the least productive plays – and they’re not kidding about that.
In the latest week, they idled a 64 rigs drilling for oil, according to Baker Hughes, which publishes the data every Friday. Only 922 rigs were still active, down 42.7% from October, when they’d peaked. Within 21 weeks, they’ve taken out 687 rigs, the most terrific, vertigo-inducing oil-rig nose dive in the data series, and possibly in history:
As Exxon and other drillers are overeager to explain: just because we’re cutting capex, and just because the rig count plunges, doesn’t mean our production is going down. And it may not for a long time. Drillers, loaded up with debt, must have the cash flow from production to survive.
But with demand languishing, US crude oil inventories are building up further. Excluding the Strategic Petroleum Reserve, crude oil stocks rose by another 10.3 million barrels to 444.4 million barrels as of March 4, the highest level in the data series going back to 1982, according to the Energy Information Administration. Crude oil stocks were 22% (80.6 million barrels) higher than at the same time last year.
“When you have that much storage out there, it takes a long time to work that off,” said BP CEO Bob Dudley, possibly with one eye on this chart:
So now there is a lot of discussion when exactly storage facilities will be full, or nearly full, or full in some regions. In theory, once overproduction hits used-up storage capacity, the price of oil will plummet to whatever level short sellers envision in their wildest dreams. Because: what are you going to do with all this oil coming out of the ground with no place to go?
A couple of days ago, the EIA estimated that crude oil stock levels nationwide on February 20 (when they were a lot lower than today) used up 60% of the “working storage capacity,” up from 48% last year at that time. It varied by region:
Capacity is about 67% full in Cushing, Oklahoma (the delivery point for West Texas Intermediate futures contracts), compared with 50% at this point last year. Working capacity in Cushing alone is about 71 million barrels, or … about 14% of the national total.
As of September 2014, storage capacity in the US was 521 million barrels. So if weekly increases amount to an average of 6 million barrels, it would take about 13 weeks to fill the 77 million barrels of remaining capacity. Then all kinds of operational issues would arise. Along with a dizzying plunge in price.
In early 2012, when natural gas hit a decade low of $1.92 per million Btu, they predicted the same: storage would be full, and excess production would have to be flared, that is burned, because there would be no takers, and what else are you going to do with it? So its price would drop to zero.
They actually proffered that, and the media picked it up, and regular folks began shorting natural gas like crazy and got burned themselves, because it didn’t take long for the price to jump 50% and then 100%.
Oil is a different animal. The driving season will start soon. American SUVs and pickups are designed to burn fuel in prodigious quantities. People will be eager to drive them a little more, now that gas is cheaper, and they’ll get busy shortly and fix that inventory problem, at least for this year. But if production continues to rise at this rate, all bets are off for next year.
Natural gas, though it refused to go to zero, nevertheless got re-crushed, and the price remains below the cost of production at most wells. Drilling activity has dwindled. Drillers idled 12 gas rigs in the latest week. Now only 268 rigs are drilling for gas, the lowest since April 1993, and down 83.4% from its peak in 2008! This is what the natural gas fracking boom-and-bust cycle looks like:
Yet production has continued to rise. Over the last 12 months, it soared about 9%, which is why the price got re-crushed.
Producing gas at a loss year after year has consequences. For the longest time, drillers were able to paper over their losses on natural gas wells with a variety of means and go back to the big trough and feed on more money that investors were throwing at them, because money is what fracking drills into the ground.
But that trough is no longer being refilled for some companies. And they’re running out. “Restructuring” and “bankruptcy” are suddenly the operative terms.
Debt funded the fracking boom. Now oil and gas prices have collapsed, and so has the ability to service that debt. The oil bust of the 1980s took down 700 banks, including 9 of the 10 largest in Texas. But this time, it’s different. This time, bondholders are on the hook.
And these bonds – they’re called “junk bonds” for a reason – are already cracking. Busts start with small companies and proceed to larger ones. “Bankruptcy” and “restructuring” are the terms that wipe out stockholders and leave bondholders and other creditors to tussle over the scraps.
Early January, WBH Energy, a fracking outfit in Texas, kicked off the series by filing for bankruptcy protection. It listed assets and liabilities of $10 million to $50 million. Small fry.
A week later, GASFRAC filed for bankruptcy in Alberta, where it’s based, and in Texas – under Chapter 15 for cross-border bankruptcies. Not long ago, it was a highly touted IPO, whose “waterless fracking” technology would change a parched world. Instead of water, the system pumps liquid propane gel (similar to Napalm) into the ground; much of it can be recaptured, in theory.
Ironically, it went bankrupt for other reasons: operating losses, “reduced industry activity,” the inability to find a buyer that would have paid enough to bail out its creditors, and “limited access to capital markets.” The endless source of money without which fracking doesn’t work had dried up.
On February 17, Quicksilver Resources announced that it would not make a $13.6 million interest payment on its senior notes due in 2019. It invoked the possibility of filing for Chapter 11 bankruptcy to “restructure its capital structure.” Stockholders don’t have much to lose; the stock is already worthless. The question is what the creditors will get.
It has hired Houlihan Lokey Capital, Deloitte Transactions and Business Analytics, “and other advisors.” During its 30-day grace period before this turns into an outright default, it will haggle with its creditors over the “company’s options.”
On February 27, Hercules Offshore had its share-price target slashed to zero, from $4 a share, at Deutsche Bank, which finally downgraded the stock to “sell.” If you wait till Deutsche Bank tells you to sell, you’re ruined!
When I wrote about Hercules on October 15, HERO was trading at $1.47 a share, down 81% since July. Those who followed the hype to “buy the most hated stocks” that day lost another 44% by the time I wrote about it on January 16, when HERO was at $0.82 a share. Wednesday, shares closed at $0.60.
Deutsche Bank was right, if late. HERO is headed for zero (what a trip to have a stock symbol that rhymes with zero). It’s going to restructure its junk debt. Stockholders will end up holding the bag.
On Monday, due to “chronically low natural gas prices exacerbated by suddenly weaker crude oil prices,” Moody’s downgraded gas-driller Samson Resources, to Caa3, invoking “a high risk of default.”
It was the second time in three months that Moody’s downgraded the company. The tempo is picking up. Moody’s:
The company’s stressed liquidity position, delays in reaching agreements on potential asset sales and its retention of restructuring advisors increases the possibility that the company may pursue a debt restructuring that Moody’s would view as a default.
Moody’s was late to the party. On February 26, it was leaked that Samson had hired restructuring advisers Kirkland & Ellis and Blackstone’s restructuring group to figure out how to deal with its $3.75 billion in debt. A group of private equity firms, led by KKR, had acquired Samson in 2011 for $7.2 billion. Since then, Samson has lost $3 billion. KKR has written down its equity investment to 5 cents on the dollar.
This is no longer small fry.
Also on Monday, oil-and-gas exploration and production company BPZ Resources announced that it would not pay $62 million in principal and interest on convertible notes that were due on March 1. It will use its grace period of 10 days on the principal and of 30 days on the interest to figure out how to approach the rest of its existence. It invoked Chapter 11 bankruptcy as one of the options.
If it fails to make the payments within the grace period, it would also automatically be in default of its 2017 convertible bonds, which would push the default to $229 million.
BPZ tried to refinance the 2015 convertible notes in October and get some extra cash. Fracking devours prodigious amounts of cash. But there’d been no takers for the $150 million offering. Even bond fund managers, driven to sheer madness by the Fed’s policies, had lost their appetite. And its stock is worthless.
Also on Monday – it was “default Monday” or something – American Eagle Energy announced that it would not make a $9.8 million interest payment on $175 million in bonds due that day. It will use its 30-day grace period to hash out its future with its creditors. And it hired two additional advisory firms.
One thing we know already: after years in the desert, restructuring advisers are licking their chops.
The company has $13.6 million in negative working capital, only $25.9 million in cash, and its $60 million revolving credit line has been maxed out.
But here is the thing: the company sold these bonds last August! And this was supposed to be its first interest payment.
That’s what a real credit bubble looks like. In the Fed’s environment of near-zero yield on reasonable investments, bond fund managers are roving the land chasing whatever yield they can discern. And they’re holding their nose while they pick up this stuff to jam it into bond funds that other folks have in their retirement portfolio.
Not even a single interest payment!
Borrowed money fueled the fracking boom. The old money has been drilled into the ground. The new money is starting to dry up. Fracked wells, due to their horrendous decline rates, produce most of their oil and gas over the first two years. And if prices are low during that time, producers will never recuperate their investment in those wells, even if prices shoot up afterwards. And they’ll never be able to pay off the debt from the cash flow of those wells. A chilling scenario that creditors were blind to before, but are now increasingly forced to contemplate.
According to the payroll jobs report today (March 6) the economy created 295,000 new jobs in February, dropping the rate of unemployment to 5.5%. However, the BLS also reported that the labor force participation rate fell and the number of people not in the labor force rose by 354,000.
In other words, the unemployment rate dropped because the labor force shrunk.
If the economy was in recovery, the labor force would be growing and the labor force participation rate would be rising.
The 295,000 claimed new jobs are highly suspect. For example, the report claims 32,000 new retail jobs, but the Census Bureau reports that retail sales declined in December and January. Why would retailers experiencing declining sales hire more employees?
Construction spending declined 1.1% in January, but the payroll jobs report says 29,000 construction jobs were added in February.
There is no sign in the payroll jobs report of the large lay-offs by IBM and Hewlett Packard.
These and other inconsistencies do not inspire confidence.
By ignoring the inconsistencies the financial press does not inspire confidence.
Let’s now look at where the BLS says the payroll jobs are.
All of the goods producing jobs are accounted for by the 29,000 claimed construction jobs. The remaining 259,000 new jobs–90%–of the total–are service sector jobs. Three categories account for 70% of these jobs. Wholesale and retail trade, transportation and utilities account. for 62,000 of the jobs. Education and health services account for 54,000 of which ambulatory health care services accounts for 19,900. Leisure and hospitality account for 66,000 jobs of which waitresses and bartenders account for 58,700 jobs.
These are the domestic service jobs of a turd world country.
John Williams (shadowstats.com) reports: “As of February, the level of full-time employment still was 1.0 million shy of its pre-recession peak.”
Paul Craig Roberts was Assistant Secretary of the Treasury for Economic Policy and associate editor of the Wall Street Journal. He was columnist for Business Week, Scripps Howard News Service, and Creators Syndicate. He has had many university appointments. His internet columns have attracted a worldwide following. His latest book, The Failure of Laissez Faire Capitalism and Economic Dissolution of the West is now available.
43% of adults would prefer homes bigger than where they currently live, but attitudes differ by age. Baby boomers would prefer to upsize rather than downsize by only a small margin, while the gap among millennials is much wider, with GenXers falling in between. Would-be downsizers outnumber upsizers only among households living in the largest homes.
Last year, we found that Baby Boomers were especially unlikely to live in multi-unit housing. At the same time, we noted that the share of seniors living in multi-unit housing rather than single-family homes has been shrinking for decades. These findings got us thinking about how the generations vary in house-size preference. So we surveyed over 2000 people at the end of last year to figure out if boomers have different house-size preferences than their younger counterparts. And that led us to ask: What size homes do Americans really want?
Most Americans are not living in the size home they want
As a whole, Americans are living in a world of mismatch – only 40% of our respondents said they are living in the size home that’s ideal. Furthermore, over 43% answered that the size of their ideal residence is somewhat or much larger than their current digs. Only 16% told us that their ideal residence is smaller than their existing home. However, these overall figures mask what is going on within different generations.
It’s natural to think that baby boomers are the generation most likely to downsize. After all, their nests are emptying and they may move when they retire. As it turns out though, more boomers would prefer to live in a larger home than a smaller one: 21% said their ideal residence is smaller than their current home, while 26% wanted a larger home – a 5-percentage-point difference. Clearly, boomers don’t feel a massive yearn to downsize. On the contrary, just over half (53%) said they’re already living in their ideally sized home. Nonetheless, members of this generation are more likely to want to downsize than millennials and GenXers.
In fact, those younger generations want some elbow room. First, the millennials. They’re looking to move on up by a big margin: just over 60% told us their ideal residence is larger than where they live now – the largest proportion among the generations in our sample. By contrast, only a little over 13% of millennials said they’d rather have a smaller home than their existing one – which is also the smallest among the generations in our sample. The results are clear: millennials are much more likely to want to upsize than downsize.
The next generation up the ladder, the GenXers, are hitting their peak earning years and many in this group may be in a position to trade up. Many aren’t living in their ideally sized home. Just 38% said where they live now is dream sized. Nearly a majority (48%) said their dream home is larger, while only 14% of GenXers would rather have a smaller home. This is the generation that bore the brunt of the foreclosure crisis. So, some of this mismatch could be because a significant number of GenXers lost homes during the housing bust and may now be living in smaller-than-desired quarters. But a much more probable reason is that many GenXers are in their peak child-rearing years. With kids bouncing off the walls, the place may be feeling a tad crowded.
Even the groups that seem ripe for downsizing don’t want smaller homes
Of course, age doesn’t tell the whole story about why people might want to downsize. It could be that certain kinds of households, – such as those without children, and living in the suburbs or in affordable areas – might be more likely to live in larger homes than they need. But our survey shows that households in these categories are about twice as likely to want a larger than a smaller home. For those with kids especially, the desire to upsize is strong: 39% preferred a larger home versus 18% who liked a smaller home. For those living in the suburbs, the disparity is even greater – 42% to 16%. And even among those living in the most affordable zip codes, where ideally-sized homes might be within the budgets of households, 40% of our respondents preferred larger homes versus 20% who said smaller.
Are all households more likely to upsize than downsize?
At this point you might be asking, “Are there any types of households that want to downsize?” The answer is yes. But only one kind of household falls into this category – those living in homes larger than 3,200 square feet. Of this group, 26% wanted to downsize versus 25% that wanted to upsize – a slight difference. But, when we looked overall at survey responses based on the size of current residence, households wanting a larger home kicked up as current home size went down. We can see this clearly when we divide households into six groups based on the size of the home they’re living in now. Among households living in 2,600-3,200 square foot homes, 37% prefer a larger home versus 16% a smaller home; in 2,000–2,600 square foot homes, its 34% to 18%; 38% to 18% in 1,400–2,000 square foot homes; 55% to 13% in 800–1,400 square foot homes; and 66% to 13% in homes less than 800 square feet. This makes intuitive sense. Those living in the biggest homes are most likely to have gotten a home larger than their ideal size. And those in the smallest homes are probably the ones feeling most squeezed.
The responses to our survey show significantly more demand for larger homes than for smaller ones. But the reality, of course, is that households must make tradeoffs between things like accessibility, amenities, and affordability when choosing what size homes to get. The “ideal” sized home for most Americans may be larger than where they’re living now. But that spacious dream home may not be practical. As result, the mismatch between what Americans say they want and what best suits their circumstances may persist.
The chart below showing the annual increase, or rather, decrease in US factory orders which have now declined for 6 months in a row (so no one can’t blame either the west coast port strike or the weather) pretty much speaks for itself, and also which way the US “recovery” (whose GDP is about to crash to the 1.2% where the Atlanta Fed is modeling it, or even lower is headed.
As the St Louis Fed so kindly reminds us, the two previous times US manufacturing orders declined at this rate on an unadjusted (or adjusted) basis, the US economy was already in a recession.
And now, time for consensus to be shocked once again when the Fed yanks the rug from under the feet of the rite-hike-istas.
Stephen Schwarzman, CEO and co-founder of Blackstone Group, the world’s largest private-equity firm with $290 billion in assets under management, made $690 million for 2014 via a mix of dividends, compensation, and fund payouts, according to a regulatory filing. A 50% raise from last year.
The PE firm’s subsidiary Invitation Homes, doped with nearly free money the Fed’s policies have made available to Wall Street, has become America’s number one mega-landlord in the span of three years by buying up 46,000 vacant single-family homes in 14 metro areas, initially at a rate of $100 million per week, now reduced to $35 million per week.
As of September 30, Invitation Homes had $8.7 billion worth of homes on its balance sheet, followed by American Homes 4 Rent ($5.5 billion), Colony Financial ($3.4 billion), and Waypoint ($2.6 billion). Those are the top four. Countless smaller investors also jumped into the fray. Together they scooped up several hundred thousand single-family houses.
A “bet on America,” is what Schwarzman called the splurge two years ago.
The bet was to buy vacant homes out of foreclosure, outbidding potential homeowners who’d actually live in them, but who were hobbled by their need for mortgages in cash-only auctions. The PE firms were initially focused only on a handful of cities. Each wave of these concentrated purchases ratcheted up the prices of all other homes through the multiplier effect.
Homeowners at the time loved it as the price of their home re-soared. The effect rippled across the country and added about $7 trillion to homeowners’ wealth since 2011, doubling equity to $14 trillion.
But it pulled the rug out from under first-time buyers. Now, only the ludicrously low Fed-engineered interest rates allow regular people – the lucky ones – to buy a home at all. The rest are renting, in a world where rents are ballooning and wages are stagnating.
Thanks to the ratchet effect, whereby each PE firm helped drive up prices for the others, the top four landlords booked a 23% gain on equity so far, with Invitation Homes alone showing $523 million in gains, according to RealtyTrac. The “bet on America” has been an awesome ride.
But now what? PE firms need to exit their investments. It’s their business model. With home prices in certain markets exceeding the crazy bubble prices of 2006, it’s a great time to cash out. RealtyTrac VP Daren Blomquist told American Banker that small batches of investor-owned properties have already started to show up in the listings, and some investors might be preparing for larger liquidations.
“It is a very big concern for real estate professionals,” he said. “They are asking what the impact will be if investors liquidate directly onto the market.”
But larger firms might not dump these houses on the market unless they have to. American Banker reported that Blackstone will likely cash out of Invitation Homes by spinning it off to the public, according to “bankers close to the Industry.”
After less than two years in this business, Ellington Management Group exited by selling its portfolio of 900 houses to American Homes 4 Rent for a 26% premium over cost, after giving up on its earlier idea of an IPO. In July, Beazer Pre-Owned Rental Homes had exited the business by selling its 1,300 houses to American Homes 4 Rent, at the time still flush with cash from its IPO a year earlier.
Such portfolio sales maintain the homes as rentals. But smaller firms are more likely to cash out by putting their houses on the market, Blomquist said. And they have already started the process.
Now the industry is fretting that liquidations by investors could unravel the easy Fed-engineered gains of the last few years. Sure, it would help first-time buyers and perhaps put a halt to the plunging home ownership rates in the US [The American Dream Dissipates at Record Pace].
But the industry wants prices to rise. Period.
When large landlords start putting thousands of homes up for sale, it could get messy. It would leave tenants scrambling to find alternatives, and some might get stranded. A forest of for-sale signs would re-pop up in the very neighborhoods that these landlords had targeted during the buying binge. Each wave of selling would have the reverse ratchet effect. And the industry’s dream of forever rising prices would be threatened.
“What kind of impact will these large investors have on our communities?” wondered Rep. Mark Takano, D-California, in an email to American Banker. He represents Riverside in the Inland Empire, east of Los Angeles. During the housing bust, home prices in the area plunged. But recently, they have re-soared to where Fitch now considers Riverside the third-most overvalued metropolitan area in the US. So Takano fretted that “large sell-offs by investors will weaken our housing recovery in the very same communities, like mine, that were decimated by the sub prime mortgage crisis.”
PE firms have tried to exit via IPOs – which kept these houses in the rental market.
Silver Bay Realty Trust went public in December 2012 at $18.50 a share. On Friday, shares closed at $16.16, down 12.6% from their IPO price.
American Residential Properties went public in May 2013 at $21 a share, a price not seen since. “Although people look at this as a new industry, there’s really nothing new about renting single-family homes,” CEO Stephen Schmitz told Bloomberg at the time. “What’s new is that it’s being aggregated, we’re introducing professional management and we’re raising institutional capital.” Shares closed at $17.34 on Friday, down 17.4% from their IPO price.
American Homes 4 Rent went public in August 2013 at $16 a share. On Friday, shares closed at $16.69, barely above their IPO price. These performances occurred during a euphoric stock market!
So exiting this “bet on America,” as Schwarzman had put it so eloquently, by selling overpriced shares to the public is getting complicated. No doubt, Blackstone, as omnipotent as it is, will be able to pull off the IPO of Invitation Homes, regardless of what kind of bath investors end up taking on it.
Lesser firms might not be so lucky. If they can’t find a buyer like American Homes 4 Rent that is publicly traded and doesn’t mind overpaying, they’ll have to exit by selling their houses into the market.
But there’s a difference between homeowners who live in their homes and investors: when homeowners sell, they usually buy another home to live in. Investors cash out of the market. This is what the industry dreads. Investors were quick to jump in and inflated prices. But if they liquidate their holdings at these high prices, regular folks might not materialize in large enough numbers to buy tens of thousands of perhaps run-down single-family homes. And then, getting out of the “bet on America” would turn into a real mess.
The Chicago Business Barometer plunged 13.6 points to 45.8 in February, the lowest level since July 2009 and the first time in contraction since April 2013. The sharp fall in business activity in February came as Production, New Orders, Order Backlogs and Employment all suffered double digit losses, leaving them below the 50 level which separates contraction from expansion.
New Orders suffered the largest monthly decline on record, leaving them at the lowest since June 2009. Lower order intake and output levels led to a double digit decline in Employment which last month increased markedly to a 14-month high.
Disinflationary pressures were still in evidence in February, although the slight bounce back in energy costs pushed Prices Paid to the highest since December – although still below the breakeven 50 level. Some purchasers cited weakness in some metals prices including copper and brass, but others said suppliers were slow to pass along lower prices to customers.
Commenting on the Chicago Report, Philip Uglow, Chief Economist of MNI Indicators said, “It’s difficult to reconcile the very sharp drop in the Barometer with the recent firm tone of the survey. There’s some evidence to point to special factors such as the port strike and the weather, although we’ll need to see the March data to get a better picture of underlying growth.“
Blame it on the Ports
Everyone was quick to blame this on the ports and bad weather.
But the LA port issue has been festering for months. Weren’t economists aware of the ports? Of bad weather?
China has long frustrated the hard-landing watchers – or any-landing watchers, for that matter – who’ve diligently put two and two together and rationally expected to be right. They see the supply glut in housing, after years of malinvestment. They see that unoccupied homes are considered a highly leveraged investment that speculators own like others own stocks, whose prices soar forever, as if by state mandate, but that regular people can’t afford to live in.
Hard-landing watchers know this can’t go on forever. Given that housing adds 15% to China’s GDP, when this housing bubble pops, the hard-landing watchers will finally be right.
Home-price inflation in China peaked 13 months ago. Since then, it has been a tough slog.
Earlier this month, the housing news from China’s National Bureau of Statistics gave observers the willies once again. New home prices in January had dropped in 69 of 70 cities by an average of 5.1% from prior year, the largest drop in the new data series going back to 2011, and beating the prior record, December’s year-over-year decline of 4.3%. It was the fifth month in a row of annual home price declines, and the ninth month in a row of monthly declines, the longest series on record.
Even in prime cities like Beijing and Shanghai, home prices dropped at an accelerating rate from December, 3.2% and 4.2% respectively.
For second-hand residential buildings, house prices fell in 67 of 70 cities over the past 12 months, topped by Mudanjiang, where they plunged nearly 14%.
True to form, the stimulus machinery has been cranked up, with the People’s Bank of China cutting reserve requirements for major banks in January, after cutting its interest rate in November. A sign that it thinks the situation is getting urgent.
So how bad is this housing bust – if this is what it turns out to be – compared to the housing bust in the US that was one of the triggers in the Global Financial Crisis?
Thomson Reuters overlaid the home price changes of the US housing bust with those of the Chinese housing bust, and found this:
The US entered recession around two years after house price inflation had peaked. After nine months of recession, Lehman Brothers collapsed. As our chart illustrates, house price inflation in China has slowed from its peak in January 2014 at least as rapidly as it did in the US.
Note the crashing orange line on the left: year-over-year home-price changes in China, out-crashing (declining at a steeper rate than) the home-price changes in the US at the time….
The hard-landing watchers are now wondering whether the Chinese stimulus machinery can actually accomplish anything at all, given that a tsunami of global stimulus – from negative interest rates to big bouts of QE – is already sloshing through the globalized system. And look what it is accomplishing: Stocks and bonds are soaring, commodities – a demand gauge – are crashing, and real economies are languishing.
Besides, they argue, propping up the value of unoccupied and often unfinished investment properties that most Chinese can’t even afford to live in might look good on paper, but it won’t solve the problem. And building even more of these units props up GDP nicely in the short term, and therefore it’s still being done on a massive scale, but it just makes the supply glut worse.
Sooner or later, the hard-landing watchers expect to be right. They know how to add two and two together. And they’re already smelling the sweet scent of being right this time, which, alas, they have smelled many times before.
But it does make you wonder what the China housing crash might trigger when it blooms into full maturity, considering the US housing crash helped trigger of the Global Financial Crisis. It might be a hard landing for more than just China. And ironically, it might occur during, despite, or because of the greatest stimulus wave the world has ever seen.
Stocks, of course, have been oblivious to all this and have been on a tear, not only in China, but just about everywhere except Greece. But what happens to highly valued stock markets when they collide with a recession? They crash.
What to Expect When This Stock Market Meets a Recession
Last week I had a fascinating conversation with Neile Wolfe, of Wells Fargo Advisors, LLC., about high equity valuations and what happens when they collide with a recession.
Here is my monthly update that shows the average of the four valuation indicators: Robert Shiller’s cyclically adjusted price-to-earnings ratio (CAPE), Ed Easterling’s Crestmont P/E, James Tobin’s Q Ratio, and my own monthly regression analysis of the S&P 500:
Based on the underlying data in the chart above, Neile made some cogent observations about the historical relationships between equity valuations, recessions and market prices:
High valuations lead to large stock market declines during recessions.
During secular bull markets, modest overvaluation does not produce large stock market declines.
During secular bear markets, modest overvaluation still produces large stock market declines.
Here is a table that highlights some of the key points. The rows are sorted by the valuation column.
Beginning with the market peak before the epic Crash of 1929, there have been fourteen recessions as defined by the National Bureau of Economic Research (NBER). The table above l ists the recessions, the recession lengths, the valuation (as documented in the chart illustration above), the peak-to-trough changes in market price and GDP. The market price is based on the S&P Composite, an academic splicing of the S&P 500, which dates from 1957 and the S&P 90 for the earlier years (more on that splice here).
I’ve included a row for our current valuation, through the end of January, to assist us in making an assessment of potential risk of a near-term recession. The valuation that preceded the Tech Bubble tops the list and was associated with a 49.1% decline in the S&P 500. The largest decline, of course, was associated with the 43-month recession that began in 1929.
Note: Our current market valuation puts us between the two.
Here’s an interesting calculation not included in the table: Of the nine market declines associated with recessions that started with valuations above the mean, the average decline was -42.8%. Of the four declines that began with valuations below the mean, the average was -19.9% (and that doesn’t factor in the 1945 outlier recession associated with a market gain).
What are the Implications of Overvaluation for Portfolio Management?
Neile and I discussed his thoughts on the data in this table with respect to portfolio management. I came away with some key implications:
The S&P 500 is likely to decline severely during the next recession, and future index returns over the next 7 to 10 years are likely to be low.
Given this scenario, over the next 7 to 10 years a buy and hold strategy may not meet the return assumptions that many investors have for their portfolio.
Asset allocation in general and tactical asset allocation specifically are going to be THE important determinant of portfolio return during this time frame. Just buying and holding the S&P 500 is likely be disappointing.
Some market commentators argue that high long-term valuations (e.g., Shiller’s CAPE) no longer matter because accounting standards have changed and the stock market is still going up. However, the impact of elevated valuations — when it really matters — is expressed when the business cycle peaks and the next recession rolls around. Elevated valuations do not take a toll on portfolios so long as the economy is in expansion.
How Long Can Periods of Overvaluations Last?
Equity markets can stay at lofty valuation levels for a very long time. Consider the chart posted above. There are 1369 months in the series with only 58 months of valuations more than two Standard Deviations (STD) above the mean. They are:
September 1929 (i.e., only one month above 2 STDs prior to the Crash of 1929)
Fifty-one months during the Tech bubble (that’s over FOUR YEARS)
Six of the last seven months have been above 2 STDs
The Fed should reject its inclination to raise rates, according to Jeffrey Gundlach. It’s rare that he agrees with Larry Summers, but in this case the two believe that the fundamentals in the U.S. economy do not justify higher interest rates.
Gundlach, the founder and chief investment officer of Los Angeles-based Doubleline Capital, spoke to investors in a conference call on February 17. The call was focused on the release of the new DoubleLine Long Duration Fund, but Gundlach also discussed a number of developments in the economy and the bond market.
Signals of an impending rate increase have come from comments by Fed governors that the word “patient” should be dropped from the Fed meeting notes, according to Gundlach. That word has taken on special significance, he explained, since Janet Yellen attached a two-month time horizon to it.
“If they drop that word,” Gundlach said, “it would be a strong signal that rates would rise in the following two months.”
The Fed seems “philosophically” inclined to raise rates, Gundlach said, even though the fundamentals do not justify such a move. Strong disinflationary pressure coming from the collapse in oil prices should caution the Fed against raising rates, he said.
Gundlach was asked about comments by Gary Shilling that oil prices might go as low at $10/barrel. “We better all hope we don’t get $10,” he said, “because something very deflationary would be happening in this world.” If that is the case, Gundlach said investors should flock to long-term Treasury bonds.
“I’d like to think that the world is not in that kind of deflationary precipice,” he said.
Oil will break below its previous $44 low, Gundlach said. But he did not put a price target on oil.
Gundlach warned that by mid-year, if the Fed does raise rates, “the sinister side of low oil may raise its head.” At that time, lack of hiring or layoffs in the fracking industry could cripple the economy, according to Gundlach.
In the short term, Gundlach said that the recent rise in interest rates is a signal that the “huge deflationary scare” –which was partly because of Greece – has dissipated. Investors should monitor Spanish and Italian yields, he said. If they remain low, it is a signal that Greece is not leaving the Eurozone or that, if it does, “it is not a big deal.”
This is the war on success that our government is waging. They are almost trying to make the economy worse by putting companies out of business. To Quote Jim Clifton of Gallup:
Our leadership keeps thinking that the answer to economic growth and ultimately job creation is more innovation, and we continue to invest billions in it. But an innovation is worthless until an entrepreneur creates a business model for it and turns that innovative idea in something customers will buy. Because we have misdiagnosed the cause and effect of economic growth, we have misdiagnosed the cause and effect of job creation.
For the first time in 35 years, American business deaths now outnumber business births.
Let’s get one thing clear: This economy is never truly coming back unless we reverse the birth and death trends of American businesses. It is catastrophic to be dead wrong on the biggest issue of the last 50 years — the issue of where jobs come from…when small and medium-sized businesses are dying faster than they’re being born, so is free enterprise.
And when free enterprise dies, America dies with it.
Current government regulations imposed by the Bureau of Land Management are harming energy production and holding back the U.S. economy, a new study reveals.
“While federally owned lands are also full of energy potential, a bureaucratic regulatory regime has mismanaged land use for decades,” write The Heritage Foundation’s Katie Tubb and Nicolas Loris.
The report focuses on the Federal Lands Freedom Act, introduced by Rep. Diane Black, R-Tenn., and Sen. James Inhofe, R-Okla. It is designed to empower states to regain control of their lands from the federal government in order to pursue their own energy goals. That is a challenge in an oil-rich state like Colorado.
“We need to streamline the process as there are very real consequences to poor [or nonexistent] management,” Tubb, a Heritage research associate, told The Daily Signal.
“Empowering the states is the best solution. The people who benefit have a say and can share in the benefits. If there are consequences, they can address them locally with state and local governments that are much more responsive to elections and budgets than the federal government.”
Emphasizing the need to streamline the process, Tubb pointed to the findings in the new report.
“The Bureau of Land Management estimates that it took an average of 227 days simply to complete a drill application,” Tubb said.
That’s more than the average of 154 days in 2005 and more than seven times the state average of 30 days, according to the report.
The report blames this increase in the application process on the drop in drilling on federal lands.
“Since 2009,” Tubb and Loris write, “oil production on federal lands has fallen by nine percent, even as production on state and private lands has increased by 61 percent over the same period.”
Despite almost “43 percent of crude oil coming from federal lands,” government-owned lands have seen a 13-point drop in oil production, from 36 percent to 23 percent.
The report also examines the recent oil-related job boom.
“Job creation in the oil and gas industry bucked the slow economic recovery and grew by 40 percent from 2007 to 2012, in comparison to one percent in the private sector over the same period,” according to the report.
That boom has had a big impact on jobs.
“Energy-abundant states like Colorado and Alaska would stand to benefit tremendously. We’ve seen oil and natural gas production increase substantially in Colorado over the past eight years, bringing jobs and economic activity to the state,” said Loris, an economist who is Heritage’s Herbert and Joyce Morgan fellow.
Tubb cautioned that any change will happen slowly. “The federal government likely will not release the land that easily.”
Loris agreed, noting the long-running debate about the Arctic National Wildlife Refuge.
“It was no surprise that the Alaskan delegation was up in arms when the administration proposed to permanently put ANWR off limits to energy exploration,” Loris told The Daily Signal. “Many in the Alaskan delegation and Alaskan natives, including village of Kaktovik—the only town in the coastal plain of ANWR, support energy development.”
“We are putting power to the people,” Tubb concluded.
The Baltic Dry Index, usually referred to as the BDI, is making historical lows in recent weeks, almost every week.
The index is a composition of four sub-indexes that follow shipping freight rates. Each of the four sub-indexes follows a different ship size category and the BDI mixes them all together to get a sense of global shipping freight rates.
The index follows dry bulk shipping rates, which represent the trade of various raw materials: iron, cement, copper, etc.
The main argument for looking at the Baltic Dry Index as an economic indicator is that end demand for those raw materials is tightly tied to economic activity. If demand for those raw materials is weak, one of the first places that will be evident is in shipping prices.
The supply of ships is not very flexible, so changes to the index are more likely to be caused by changes in demand.
Let’s first look at the three cases where the Baltic Dry Index predicted a stock market crash, as well as a recession.
1986 – The Baltic Dry Index Hits Its first All-time Low.
In late 1986, the newly formed BDI (which replaced an older index) hit its first all-time low.
Other than predicting the late 80s-early 90s recession itself, the index was a precursor to the 1987 stock market crash.
(click to enlarge)
1999 – The Baltic Dry Index Takes a Dive
In 1999, the BDI hit a 12-year low. After a short recovery, it almost hit that low point again two years later. The index was predicting the recession of the early 2000s and the dot-com market crash.
(click to enlarge)
2008 – The Sharpest Decline in The History of the BDI
In 2008, the BDI almost hit its all-time low from 1986 in a free fall from around 11,000 points to around 780.
(click to enlarge)
You already know what happened next. The 2008 stock market crash and a long recession that many parts of the global economy is still trying to get out of.
Is It Real Causation?
One of the pitfalls that affects many investors is to confuse correlation and causation. Just because two metrics seem to behave in a certain relationship, doesn’t tell us if A caused B or vice versa.
When trying to navigate your portfolio ahead, correctly making the distinction between causation and correlation is crucial.
Without doing so, you can find yourself selling when there is no reason to, or buying when you should be selling.
So let’s think critically about the BDI.
Is it the BDI itself that predicts stock market crashes? Is it a magical omen of things to come?
My view is that no. The BDI is not sufficient to determine if a stock market crash is coming or not. That said, the index does tells us many important things about the global economy.
Each and every time the BDI hit its lows, it predicted a real-world recession. That is no surprise as the index follows a fundamental precursor, which is shipping rates. It’s very intuitive; as manufacturers see demand for end products start to slow down, they start to wind-down production and inventory, which immediately affects their orders for raw materials.
Manufacturers are the ultimate indicator to follow, because they are the ones that see end demand most closely and have the best sense of where it’s going.
But does an economic slowdown necessarily bring about a full-blown market crash?
Only if the stock market valuation is not reflecting that coming economic downturn. When these two conditions align, chances are a sharp market correction is around the corner.
2010-2015 – The BDI Hits All-time Low, Again
In recent weeks, the BDI has hit an all-time low that is even lower than the 1986 low point. That comes after a few years of depressed prices.
(click to enlarge)
Source: Bloomberg
What does that tell us?
The global economy, excluding the U.S., is still struggling. Numerous signs for that are the strengthening dollar, the crisis in Russia and Eastern Europe, a slowdown in China, and new uncertainties concerning Greece.
The U.S. is almost the sole bright spot in the landscape of the global economy, although it’s starting to be affected by the global turmoil. A strong dollar hits exporters and lower oil prices hit the American oil industry hard.
Looking at stock prices, we are at the peak of a 6-year long bull market, although earnings seem to be at all-time highs as well.
What the BDI might tell us is that the disconnect between the global economy’s struggle and great American business performance across the board might be coming to an end.
More than that, China could be a significant reason for why the index has taken such a dive, as serious slowdowns on the real-estate market in China and tremendous real estate inventory accumulation are disrupting the imports of steel, cement and other raw materials.
Conclusion
The BDI tells us that a global economic slowdown is well underway. The source of that downturn seems to be outside of the U.S., and is more concentrated in China and the E.U.
The performance of the U.S. economy can’t be disconnected from the global economy for too long.
The BDI is a precursor for recessions, not stock market crashes. It’s not a sufficient condition to base a decision upon, but it’s one you can’t afford to ignore.
Going forward, this is a time to make sure you know the companies you invest in inside and out, and make sure end demand for their products is bound for continued growth and success despite overall headwinds.
The intervention by the world’s central banks has resulted in today’s bizarro financial markets, where “bad news is good” because it may lead to more (sorry, moar) thin-air stimulus to goose asset prices even higher.
The result is a world addicted to debt and the phony stimulus now essential to sustaining it. In the process, a tremendous wealth gap has been created, one still expanding at an exponential rate.
History is very clear what happens with dangerous imbalances like this. They correct painfully. Through class warfare. Through currency crises. Through wealth destruction.
Is that really the path we want? Because we’re for sure headed for it.
OPEC is supposedly out to beat, or at least curtail the growth of American shale oil production.
For a host of reasons, especially the much shorter capex cycle for shale, they will not succeed unless they are willing to accept permanent low oil prices.
But, permanent low oil prices will do too much damage to OPEC economies for this to be a credible threat.
We’re sure by now you are familiar with the main narrative behind the oil price crash. First, while oil production outside of North America is basically stagnant since 2005.
The shale revolution has dramatically increased supply in America.
(click to enlarge)
The resulting oversupply has threatened OPEC and the de-facto leader Saudi Arabia has chosen a confrontational strategy not to make way for the new kid on the block, but instead trying to crush, or at least contain it. Can they achieve this aim, provided it indeed is their aim?
Breakeven price At first, one is inclined to say yes, for the simple reason that Saudi (and most OPEC) oil is significantly cheaper to get out of the ground.
(click to enlarge)
This suggests that all OPEC has to do is to keep output high and sooner or later the oversupply will work itself off the market, and expensive oil is more likely to see cutbacks than cheaper oil, although this critically depends on incentives facing individual producers.
Capex decline It is therefore no wonder that we’ve seen significant declines in rig counts and numerous companies have announced considerable capex declines. While this needs time to work out into supply cutbacks, these will eventually come.
For instance BP (NYSE:BP) cutting capex from $22.9B in 2014 to $20B in 2015, or Conoco (NYSE:COP) reducing expenditures by more than 30% to $11.5B this year on drilling projects from Colorado to Indonesia. There are even companies, like SandRidge (NYSE:SD), that are shutting 75% of their rigs.
Leverage It is often argued that the significant leverage of many American shale companies could accelerate the decline, although it doesn’t necessarily have to be like that.
While many leveraged companies will make sharp cutbacks in spending, which has a relatively rapid effect on production (see below), others have strong incentives to generate as much income as possible, so they might keep producing.
Even the companies that go belly up under a weight of leverage will be forced to relinquish their licenses or sell them off at pennies to the dollar, significantly lowering the fixed cost for new producers to take their place.
Hedging Many shale companies have actually hedged much of their production, so they are shielded from much of the downside (at a cost) at least for some time. And they keep doing this:
Rather than wait for their price insurance to run out, many companies are racing to revamp their policies, cashing in well-placed hedges to increase the number of future barrels hedged, according to industry consultants, bankers and analysts familiar with the deals. [Reuters]
Economics Being expensive is not necessarily a sufficient reason for being first in line for production cuts. For instance, we know that oil from the Canadian tar sands is at the high end of cost, but simple economics can explain why production cuts are unlikely for quite some time to come.
The tar sands involve a much higher fraction as fixed cost:
Oil-sands projects are multibillion-dollar investments made upfront to allow many years of output, unlike competing U.S. shale wells that require constant injections of capital. It’s future expansion that’s at risk. “Once you start a project it’s like a freight train: you can’t stop it,” said Laura Lau, a Toronto-based portfolio manager at Brompton Funds. Current oil prices will have producers considering “whether they want to sanction a new one.” [Worldoil]
So, once these up-front costs are made, these are basically sunk, and production will only decline if price falls below marginal cost. As long as the oil price stays above that, companies can still recoup part of their fixed (sunk) cost and they have no incentive to cut back production.
But, of course, you have tar sand companies that have not yet invested all required up-front capital and new capex expenditures will be discouraged with low oil prices. So, there is still the usual economic upward sloping supply curve operative here.
Swing producer The funny thing is American shale oil is at the opposite end of this fixed (and sunk) cost universe, apart from acquiring the licenses. As wells have steep decline curves, production needs constant injection of capital for developing new wells.
Production can therefore be wound down pretty quickly should the economics require, and it can also be wound back up relatively quickly, which we think is enough reason why American shale is becoming the new (passive) swing producer. This has very important implications:
The relevant oil price to look at isn’t necessarily the spot price, but the 12-24 months future price, the time frame between capex and production.
OPEC will not only need to produce a low oil price today, that price needs to be low for a prolonged period of time in order to see cutbacks in production of American shale oil. Basically, OPEC needs the present oil price to continue indefinitely, as soon as it allows the price to rise again, shale oil capex will rebound and production will increase fairly soon afterwards.
So basically, shale is the proverbial toy duck which OPEC needs to submerge in the bathtub, but as soon as it releases the pressure, the duck will emerge again.
Declining cost curves The shale revolution caught many by surprise, especially the speed of the increase in production. While technology and learning curves are still improving, witness how production cost curves have been pushed out in the last years:
There is little reason this advancement will come to a sudden halt, even if capex is winding down. In fact, some observers are arguing that producers shift production from marginal fields to fields with better production economics, and the relatively steep production decline curves allow them to make this shift pretty rapidly.
Others point out that even the rapid decline in rig count will not have an immediate impact on production, as the proportion of horizontal wells and platforms where multiple wells are drilled from the same location are increasing, all of which is increasing output per rig.
Another shift that is going on is to re-frack existing wells, instead of new wells. The first is significantly cheaper:
Beset by falling prices, the oil industry is looking at about 50,000 existing wells in the U.S. that may be candidates for a second wave of fracking, using techniques that didn’t exist when they were first drilled. New wells can cost as much as $8 million, while re-fracking costs about $2 million, significant savings when the price of crude is hovering close to $50 a barrel, according to Halliburton Co., the world’s biggest provider of hydraulic fracturing services. [Bloomberg]
Production cuts will take time The hedging and shift to fields with better economics is only a few of the reasons why so far there has been little in the way of actual production cuts in American shale production, the overall oil market still remains close to record oversupply. The International Energy Agency (IEA) argues:
It is not unusual in a market correction for such a gap to emerge between market expectations and current trends. Such is the cyclical nature of the oil market that the full physical impact of demand and supply responses can take months, if not years, to be felt [CNBC].
In fact, the IEA also has explicit expectations for American shale oil itself:
The United States will remain the world’s top source of oil supply growth up to 2020, even after the recent collapse in prices, the International Energy Agency said, defying expectations of a more dramatic slowdown in shale growth [Yahoo].
OPEC vulnerable itself Basically, the picture we’re painting above is that American shale will be remarkably resilient. Yes, individual companies will struggle, sharp cutbacks in capex are already underway, and some companies will go under, but the basic fact is that as quick as capex and production can fall, they can rise as quickly again when the oil price recovers.
How much of OPEC can the storm of the oil price crash, very much remains to be seen. There is pain all around, which isn’t surprising as one considers that most OPEC countries have budgeted for much higher oil prices for their public finances.
(click to enlarge) You’ll notice that these prices are all significantly, sometimes dramatically, higher than what’s needed to balance their budgets. Now, many of these countries also have very generous energy subsidies on domestic oil use, supposedly to share the benefits of their resource wealth (and/or provide industry with a cost advantage).
So, there is a buffer as these subsidies can be wound down relatively painless. Some of these countries also have other buffers, like sovereign wealth funds or foreign currency reserves. And there is often no immediate reason for public budgets to be balanced.
But to suggest, as this article is doing, that OPEC is winning the war is short-sighted.
Conclusion While doing damage to individual American shale oil producers and limiting its expansion, the simple reality is that for a host of reasons discussed above, OPEC can’t beat American shale oil production unless it is willing to accept $40 oil indefinitely. While some OPEC countries might still produce profitably at these levels, the damage to all OPEC economies will be immense, so, we can’t really see this as a realistic scenario in any way.
February 4th, 2015: Crude oil had rallied 20% in three days, with West Texas Intermediate jumping $9 a barrel since Friday morning, from $44.51 a barrel to $53.56 at its peak on Tuesday. “Bull market” was what we read Tuesday night. The trigger had been the Baker Hughes report of active rigs drilling for oil in the US, which had plummeted by the most ever during the latest week. It caused a bout of short covering that accelerated the gains. It was a truly phenomenal rally!
But the weekly rig count hasn’t dropped nearly enough to make a dent into production. It’s down 24% from its peak in October. During the last oil bust, it had dropped 60%. It’s way too soon to tell what impact it will have because for now, production of oil is still rising.
And that phenomenal three-day 20% rally imploded today when it came in contact with another reality: rising production, slack demand, and soaring crude oil inventories in the US.
The Energy Information Administration reported that these inventories (excluding the Strategic Petroleum Reserve) rose by another 6.3 million barrels last week to 413.1 million barrels – the highest level in the weekly data going back to 1982. Note the increasingly scary upward trajectory that is making a mockery of the 5-year range and seasonal fluctuations:
And there is still no respite in sight.
Oil production in the US is still increasing and now runs at a multi-decade high of 9.2 million barrels a day. But demand for petroleum products, such as gasoline, dropped last week, according to the EIA, and so gasoline inventories jumped by 2.3 million barrels. Disappointed analysts, who’d hoped for a drop of 300,000 barrels, blamed the winter weather in the East that had kept people from driving (though in California, the weather has been gorgeous). And inventories of distillate, such as heating oil and diesel, rose by 1.8 million barrels. Analysts had hoped for a drop of 2.2 million barrels.
In response to this ugly data, WTI plunged $4.50 per barrel, or 8.5%, to $48.54 as I’m writing this. It gave up half of the phenomenal three-day rally in a single day.
In our experience, oil markets rarely exhibit V-shaped recoveries and we would be surprised if an oversupply situation as severe as the current one was resolved this soon. In fact, our balances indicate the absolute oversupply is set to become more severe heading into 2Q15.
Those hoping for a quick end to the oil glut in the US, and elsewhere in the world, may be disappointed because there is another principle at work – and that principle has already kicked in.
As the price has crashed, oil companies aren’t going to just exit the industry. Producing oil is what they do, and they’re not going to switch to selling diapers online. They’re going to continue to produce oil, and in order to survive in this brutal pricing environment, they have to adjust in a myriad ways.
“Efficiency and innovation, when price falls, it accelerates, because necessity is the mother of invention,” Michael Masters, CEO of Masters Capital Management, explained to FT Alphaville on Monday, in the middle of the three-day rally. “Even if the investment only spits out quarters, or even nickels, you don’t turn it off.”
Crude has been overvalued for over five years, he said. “Whenever the return on capital is in the high double digits, that’s not sustainable in nature.” And the industry has gotten fat during those years.
Now, the fat is getting trimmed off. To survive, companies are cutting operating costs and capital expenditures, and they’re shifting the remaining funds to the most productive plays, and they’re pushing 20% or even 30% price concessions on their suppliers, and the damage spreads in all directions, but they’ll keep producing oil, maybe more of it than before, but more efficiently.
This is where American firms excel: using ingenuity to survive. The exploration and production sector has been through this before. And those whose debts overwhelm them – and there will be a slew of them – will default and restructure, wiping out stockholders and perhaps junior debt holders, and those who hold the senior debt will own the company, minus much of the debt. The groundwork is already being done, as private equity firms and hedge funds offer credit to teetering oil companies at exorbitant rates, with an eye on the assets in case of default.
And these restructured companies will continue to produce oil, even if the price drops further.
So Masters said that, “in our view, production will not decrease but increase,” and that increased production “will be around a lot longer than people are forecasting right now.”
After the industry goes through its adjustment process, focused on running highly efficient operations, it can still scrape by with oil at $45 a barrel, he estimated, which would keep production flowing and the glut intact. And the market has to appreciate that possibility.
Rigs Down By 21% Since Start Of 2015 Permian Basin loses 37 rigs first week in February
The number of rigs exploring for oil and natural gas in the Permian Basin fell 37 this week to 417, according to the weekly rotary rig count released Friday by Houston-based oilfield service company Baker Hughes.
This week’s count marked the ninth-consecutive decrease for the Permian Basin. The last time Baker Hughes reported a positive rig-count change was Dec. 5, when 568 rigs were reported. Since then, the Permian Basin has shed 151 rigs, a decrease of 26.58 percent.
For the year, the Permian Basin has shed 113 rigs, or 21.32 percent.
In District 8, which includes Midland and Ector counties, the rig count fell 19 this week to 256. District 8 has shed 58 rigs, 18.47 percent, this year.
Texas lost 41 rigs this week for a statewide total of 654. The Lone Star State has 186 fewer rigs since the beginning of the year, a decrease of 22.14 percent.
In other major Texas basins, there were 168 rigs in the Eagle Ford, down 10; 43 in the Haynesville, unchanged; 39 in the Granite Wash, down one; and 19 in the Barnett, unchanged.
The Haynesville shale is the only major play in Texas to have added rigs this year. The East Texas play started 2015 with 40 rigs.
At this time last year, there were 483 rigs in the Permian Basin and 845 in Texas.
In the U.S., there were 1,456 rigs this week, a decrease of 87. There were 1,140 oil rigs, down 83; 314 natural gas rigs, down five; and two rigs listed as miscellaneous, up one.
By trajectory, there were 233 vertical drilling rigs, down two; 1,088 horizontal drilling rigs, down 80; and 135 directional drilling rigs, down five.
The top five states by rig count this week were Texas; Oklahoma with 176, down seven; North Dakota with 132, down 11; Louisiana with 107, down one; and New Mexico with 78, down nine.
The top five basins were the Permian; the Eagle Ford; the Williston with 137, down 11; the Marcellus with 71, down four; and the Mississippian with 53, down one.
In the U.S., there were 1,397 rigs on land, down 85; nine in inland waters, down three; and 50 offshore, up one. There were 48 rigs in the Gulf of Mexico, up one.
Canada’s rig count fell 13 this week to 381. There were 184 oil rigs, down 16; 197 natural gas rigs, up three; and zero rigs listed as miscellaneous, unchanged. Canada had 621 rigs a year ago this week, a difference of 240 rigs compared to this week’s count.
The number of rigs exploring for oil and natural gas in the North America region, which includes the U.S. and Canada, fell 100 this week to 1,837. There were 2,392 rigs in North America last year.
Rigs worldwide
On Friday, Baker Hughes released its monthly international rig count for January. The worldwide total was 3,309 rigs. The U.S. ended January with 1,683 rigs, just more than half of all rigs worldwide.
The following are January’s rig counts by region, with the top three nations in each region in parentheses:
Economic conditions are ripe for real estate trusts with short-term leases to improve, while longer lease duration REIT types will advance at a reduced rate.
A presentation that suggests storage REITs are expensive and as such, other short-term lease property sectors are more desirable.
A review of 5 U.S. REITs set to outperform, specifically in the apartment and hotel spaces.
“Strength does not come from winning. Your struggles develop your strengths. When you go through hardships and decide not to surrender, that is strength.”– Arnold Schwarzenegger
One of the most popular long-term holdings for income investors involves the real estate market. While single-property investments carry returns through a landlord-type management system, whether personally attained or through a management company, REITs (real estate investment trusts) offer professionally managed real estate portfolios that operate property, manage an ideal portfolio and use leverage to grow.
An investor with an after-debt market value of $1 MM in a personal real estate book could offer between one and several properties depending on market value, as well as income which investors call the “nut.” While is well known, these mom-and-pop type investors could fare much better in terms of growth and reduced risk to trade their entire real estate portfolio (save their own home) for a slice of several multi-million and billion-dollar, professionally managed REITs that pay dividends.
With the U.S. economy expanding and rates set to rise, major implications signal that the environment exists now to favor REITs with short-term leases, especially in terms of single-family and longer-term lease holdings in the real estate market.
The U.S. REIT Market Sub-Sectors
The REIT market is heavily divided into several sub-sectors, such as hotels, apartments and healthcare. While there are non-traditional categories as well, such as resource, mortgage (mREITs) and structural REITs (such as cell phone towers, golf courses, etc…), this article focuses on what is known as traditional, equity REITs (eREITs).
The following map is a guide to discovering the wonderful world of REITs.
REIT Categories Set To Outperform Today
When it comes to REIT diversification, most investors classify their REIT portfolio in a traditional sense and avoid the non-traditional areas such as resource and mREITs. Income investors who do use mREITs to boost portfolio yield would be smart to categorize them as dividend stocks, as they do not generally own real estate.
Today the U.S. economy is fascinating investors as it continues to grow in the face of global turbulence, albeit at a slower post-recessionary recovery rate than normal. While this fact has caused concern, the economic trade-off is potentially very lucrative: slower long-term growth versus higher short-term growth followed by a recession.
In times of recession, short-term leases are not generally favorable as there is a general decline in demand for real estate. Those with long-term leases in stable sectors would be preferred, as companies such as Wal-Mart Stores, Inc. (NYSE:WMT) and other stable, long-term leaseholders would continue to operate.
In times of economic improvement, short-term leases are favored as there is a general uptick in demand for real estate. More people are working in upturns, which increases the supply of those looking to spend on all sorts of goods and services, of which real estate benefits.
Where Is The U.S. Economy Headed?
In looking at the U.S. unemployment rate, the clear trend is that more workers are entering the workforce (source:BLS) and that this trend will continue into 2015 with an estimated year-end unemployment rate of 5.2-5.3% (source:FOMC).
In addition to a trend of higher U.S. employment, U.S. GDP growth is also expected to continue to trend higher in 2015. The real GDP growth of 2.4% in 2014 is expected to increase to a range of 2.6% to 3.0% according to the Fed (central tendency), while Goldman Sachs (NYSE:GS) anticipates 3.1% growth on the heels of world GDP growth of 3.4%.
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In addition to favorable U.S. macroeconomic conditions, the U.S. dollar has trended higher in terms of both the U.S. dollar index versus leading currencies as well as in terms of emerging market and commodity nation currencies.
Termed currency risk, the flight to U.S. dollars increases the value of U.S. assets in terms of other global currencies while promoting the U.S. in terms of lowered-borrowing costs and an increase in investment demand.
All of these circumstances favor the U.S. real estate market and as such, the conditions for short-term lease operators in diversified publicly traded REITs are favorable for success.
5 Short-Term Lease REITs Set To Outperform
There are a few short-term lease operator types that may do well, which includes the residential, storage and hotel categories of the traditional REIT class.
While the self-storage outlook remains bright as this property sector has a short duration and a lower economic sensitivity to the business cycle, the aggregate sector valuation is high and the accompanying yields are relatively low with modest growth prospects.
In addition to the high valuations and low yields, the top U.S. storage REITs have increased on average 26% in the past six months. The following charts include Public Storage (NYSE:PSA), Extra Space Storage Inc. (NYSE:EXR), Cube Smart (NYSE:CUBE), and Sovran Self Storage Inc. (NYSE:SSS).
These companies are all large players in the self-storage segment of the traditional, equity REIT class.
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There has been a huge run-up in the self-storage REITs over the past six months, with annualized returns of 52.89% on an equal-weighted average. When compared to the U.S. traditional equity REIT market as represented by the Vanguard REIT ETF (NYSEARCA:VNQ), self-storage has significantly outperformed.
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In looking at the average yield in the self-storage property sector versus the VNQ, self-storage is more expensive.
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With the apartment and hotel sectors, there are companies that offer above-average yields while taking advantage of the short lease-durations that should outperform in conjunction with U.S. economic growth.
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To refocus on the lease durations, hotels are able to raise prices very quickly, while apartment landlords may increase rents after a year. Also, to note, the barriers to entry are constrained in a construction/approval cycle of two years for hotels and 1 to 1.5 years for the hotel and apartment landlords, respectively. Finally, the economic sensitivity is highest here, which equates to a faster uptick in demand during economic booms.
Hotel & Apartment Landlords To Outperform
The larger REITs in any property sector are generally more expensive versus smaller peers, which equates to a lower dividend and much larger acquisitions or developments needed (relative to smaller peers) to move the growth needle.
As seen by the average annualized six-month return of the five hotel and apartment REITs selected for this portfolio versus the VNQ, there hasn’t been such a dramatic over-performance versus the traditional equity REIT index.
In terms of yield, the group here easily outperforms the VNQ as well, with an average yield of 4.89%, versus 3.35% for VNQ. This represents 46% more income for investors of this select REIT portfolio versus the VNQ.
Camden is the top under $10 billion apartment community landlord that focuses on high-growth markets in the sun-belt states.
Camden’s Diversified Portfolio As Of 11/5/14
The company recently announced a raise to their quarterly dividend by 6.1% and as such, their 5-year CAGR (compound annual growth rate) of their dividend is an impressive 9.24%.
The company also has $1 billion in development projects that are currently in construction and has $684 million in the pipeline for future development. Using the midpoint of 2015 FFO guidance of $4.46 per share and a share price of $76.99, the company has a FWD P/FFO ratio of 17.26, or a FWD FFO yield of 5.8%.
Mid-America Apartment Communities is slightly smaller than CPT with a market capitalization of $5.92 billion versus CPT’s $6.83 billion. MAA is also a takeover candidate, as the company is valued at much less than CPT (16.1x 2014 FFO versus CPT 18.3x 2014 FFO) but has a very similar and overlapping portfolio.
MAA raised their dividend 5.5% this year and over the past five years, the company has a dividend CAGR of 4.6%.
APTS is a new player to the U.S. REIT market; however, it is only valued at 9.69x 2014 FFO and is run by John Williams, the founder of Post Properties Inc. (NYSE:PPS), a $3.3 billion apartment landlord and developer.
APTS Property Map
The company recently traded at $10.05 per share, just above the 2011 IPO price of $10. Regarding the dividend, the quarterly payout was raised 9.4% in December 2014.
From their first December payout of $0.125 in 2011 to the recent December 2014 payout of $0.175 (due to short operating history), the company has a three-year dividend CAGR of 11.87%, which is higher than both CPT and MAA’s 5-year CAGR.
Chatham is a small-cap hotel operator that has shown significant growth over the past year. They have converted the dividend to monthly distributions, which is sure to appease income investors. Since going public in 2010, the dividend has increased by an average of 11.38% per year.
Chatham is an owner of the business/family segment of the hotel properties. Name brands include Residence at Marriott, Courtyard by Marriott, Homewood Suites by Hilton, Hyatt Place and Hampton Inn. While diversified, the company has a major interest in Silicon Valley, CA, home of several major U.S. technology companies.
The company just financed a secondary offering that raised ~$120 million in gross proceeds, which surely will help fuel future growth in same-store sales as well as property acquisitions.
Hospitality Properties Trust is the owner of hotels as well as travel centers throughout the U.S. They own mid-tier hotels in a similar fashion to Chatham, including similarly branded properties such as Courtyard by Marriott and Residence Inn by Marriott.
HPTProperty Map
With gas prices down and the economy up, both car travel and commercial trucking should have strong demand this year. As such, the travel center aspect of the business should do well.
The company offers a high-yield of ~6% currently, however the five-year dividend CAGR is less impressive at 1.72%. Investors should look at this company to operate in more of a bond-like fashion, with limited dividend increases and a slow increase in the value of the stock.
Conclusion
While many investors have suffered losses from the energy sector as well as many foreign holdings over the past year, one can only look forward to succeed. With the economic conditions ripe for short lease-duration U.S. REITs to advance, the potential return within this area of investment is too alluring to ignore.
When considering hotels, apartments and storage, storage looks expensive with a huge recent run-up while hotels and apartments look appealing. Rather than surrender to index investing, smart investors may choose to strengthen their portfolio with hotel and apartment REITs that are positioned today for continued growth and above-average dividend distributions.
“Unprecedented deflation are pushing rates down. However, investors are holding 1/3 outstanding shares of ETF | TLT short: Betting that rates will go up.”
In a totally unexpected move, the Bank of Canada cut the overnight interest rate by 25 basis points on Wednesday. This of course should make you wonder what the Bank of Canada knows that the rest of us don’t! I mean usually the Bank indicates a bias towards cutting interest rates, but this was just out of the blue. It signals that the oil shock on the economy is going to be a lot more significant than anyone expected.
The Canadian dollar dropped vs. the US dollar thanks to the surprise move. Gold and silver prices climbed on safe-haven demand. Canadian bond yields plunged. As per Bloomberg: “’It’s a big shock,’ David Doyle, a strategist at Macquarie Capital Markets, said by phone from Toronto. “They’re going to try to provide the necessary medicine here for the soft landing from slowing debt growth, from slowing investment in the oil sands, and I think they thought it needed some stimulus here.”
No one probably stands to hurt more from plunging oil prices than Alberta.
Energy companies have started cutting capital expenditure, and this means job losses, which means a slowing housing market. In fact, plunging oil prices have seen home sales in Calgary tumble 37% in the first half of January, compared to a year earlier. Prices dropped 1.5%. And active listings soared by nearly 65%.
As you can see in the chart below, while you may have thought Toronto was a hot housing market these past several years, you’d be wrong. It was Calgary. What’s the most worrisome about this is that everyone thinks Canada’s mortgages are different than what caused the US housing market to blow up. Well, not exactly. See, mortgage standards vary by province, and things in Alberta don’t look good.
There are two types of mortgages Alberta can issue: recourse and non-recourse. In a recourse mortgage, the bank can cease your house, sell it, and you will still owe the remaining balance of your mortgage. In a non-recourse mortgage, the bank can seize your house, and you the borrower can walk away. If the asset doesn’t sell for at least what you owe, then the bank has to absorb the loss.
Below is a chart, courtesy of RBC Capital Markets, which outlines that 35% of all Alberta mortgages (by the big 6 banks) are non-recourse. They can walk away! Pay attention to Royal Bank especially: There’s definitely a reason why the Bank of Canada is very concerned! By Christine Hughes
If things are getting better, why do global rates keep falling?
To much debt is causing deflation.
US has the highest relative rates, hence where everybody wants to invest.
The global economy is producing far to much supply of most things, chasing to-little-demand from cash strapped consumers.
Prices of other industrial commodities are in steep decline.
Billions of dollars in investment capital are “risk off”.
An untold number of jobs spread across America are at risk.
Television pundits and business writers who are relentlessly pounding the table on how cheaper home heating oil and gas at the pump is going to provide a consumer windfall and ramp up economic activity have a simplistic view of how things work.
Oil-related companies in the U.S. now account for between 35 to 40 percent of all capital spending. Announcements of sharp cutbacks in capital spending and job reductions by these companies create big ripples, forcing related companies to trim their own budgets, revenue assumptions, and payrolls accordingly.
The announcements coming out of the oil patch are picking up steam and it’s not a pretty picture. Last week Schlumberger said it would eliminate 9,000 jobs, approximately 7 percent of its workforce, and trim capital spending by about $1 billion. Yesterday, Baker Hughes, the oilfield services company, announced 7,000 in job cuts, roughly 11 percent of its workforce, and expects the cuts to all come in the first quarter. Baker Hughes also announced a 20 percent reduction in capital spending. This morning, the BBC is reporting that BHP Billiton will cut 40 percent of its U.S. shale operations, reducing its number of rigs from 26 to 16 by the end of June.
When Big Oil cuts capital spending, we’re not talking about millions of dollars or even hundreds of millions of dollars; we’re talking billions. Last month, ConocoPhillips announced it had set its capital budget for 2015 at $13.5 billion, a reduction of 20 percent. Smaller players are also announcing serious cutbacks. Yesterday Bonanza Creek Energy said it would cut its capital spending by 36 to 38 percent.
Other big industrial companies in the U.S. are also impacted by the sharp slump in oil, which has shaved almost 60 percent off the price of crude in just six months. As the oil majors scale back, it reduces the need for steel pipes. U.S. Steel has announced that it will lay off approximately 750 workers at two of its pipe plants.
On January 15, the Federal Reserve Bank of Kansas City released a dire survey of what’s ahead in its “Fourth Quarter Energy Survey.” The survey found: “The future capital spending index fell sharply, from 40 to -59, as contacts expected oil prices to keep falling. Access to credit also weakened compared to the third quarter and a year ago. Credit availability was expected to tighten further in the first half of 2015.” About half of the survey respondents said they were planning to cut spending by more than 20 percent while about one quarter of respondents expect cuts of 10 to 20 percent.
The impact of all of this retrenchment is not going unnoticed by sophisticated stock investors, as reflected in the major U.S. stock indices. On days when there is a notable plunge in the price of crude, the markets are following in lockstep during intraday trading. Yes, the broader stock averages continued to set new highs during the early months of the crude oil price decline in 2014 but that was likely due to the happy talk coming out of the Fed. It is also useful to recall that the Dow Jones Industrial Average traveled from 12,000 to 13,000 between March and May 2008 before entering a plunge that would take it into the 6500 range by March 2009.
Both the Federal Open Market Committee (FOMC) and Fed Chair Janet Yellen have assessed the plunge in oil prices as not of long duration. The December 17, 2014 statement from the FOMC and Yellen in her press conference the same day, characterized the collapse in energy prices as “transitory.” The FOMC statement said: “The Committee expects inflation to rise gradually toward 2 percent as the labor market improves further and the transitory effects of lower energy prices and other factors dissipate.”
If oil were the only industrial commodity collapsing in price, the Fed’s view might be more credible. Iron ore slumped 47 percent in 2014; copper has slumped to prices last seen during the height of the financial crisis in 2009. Other industrial commodities are also in decline.
A slowdown in both U.S. and global economic activity is also consistent with global interest rates on sovereign debt hitting historic lows as deflation takes root in a growing number of our trading partners. Despite the persistent chatter from the Fed that it plans to hike rates at some point this year, the yield on the U.S. 10-year Treasury note, a closely watched indicator of future economic activity, has been falling instead of rising. The 10-year Treasury has moved from a yield of 3 percent in January of last year to a yield of 1.79 percent this morning.
All of these indicators point to a global economy with far too much supply and too little demand from cash-strapped consumers. These are conditions completely consistent with a report out this week from Oxfam, which found the following:
“In 2014, the richest 1% of people in the world owned 48% of global wealth, leaving just 52% to be shared between the other 99% of adults on the planet. Almost all of that 52% is owned by those included in the richest 20%, leaving just 5.5% for the remaining 80% of people in the world. If this trend continues of an increasing wealth share to the richest, the top 1% will have more wealth than the remaining 99% of people in just two years.”
The oil boom that lifted home prices in Texas, Oklahoma and Louisiana is coming to an end.
Crude oil prices have crashed since June, falling by more than 54 percent to less than $50 a barrel. That swift drop has started to cripple job growth in oil country, creating a slow wave that in the years ahead may devastate what has been a thriving real estate market, according to new analysis by the real estate firm Trulia.
“Oil prices won’t tank home prices immediately,” Trulia chief economist Jed Kolko explained. “Rather, falling oil prices in the second half of 2014 might not have their biggest impact on home prices until late 2015 or in 2016.”
History shows it takes time for home prices in oil country to change course.
Kolko looked at the 100 largest housing markets where the oil industry accounted for at least 2 percent of all jobs. Asking prices in those cities rose 10.5 percent over the past year, compared with an average of 7.7 percent around the country.
Prices climbed 13.4 percent in Houston, where 5.6 percent of all jobs are in oil-related industries. The city is headquarters to energy heavyweights such as Phillips 66, Halliburton and Marathon Oil. Asking prices surged 10.2 percent in Fort Worth and 10.1 percent in Tulsa, Oklahoma. In some smaller markets, oil is overwhelmingly dominant — responsible for more than 30 percent of the jobs in Midland for instance.
The closest parallel to the Texas housing market might have occurred in the mid-1980s, when CBS was airing the prime-time soap opera “Dallas” about a family of oil tycoons.
In the first half of 1986, oil prices plunged more than 50 percent, to about $12 a barrel, according to a report by the Brookings Institution, a Washington-based think tank.
Job losses mounted in late 1986 around Houston. The loss of salaries eventually caused home prices to fall in the second half of 1987.
That led Kolko to conclude that since 1980, it takes roughly two years for changes in oil prices to hit home prices.
Of course, there is positive news for people living outside oil country, Kolko notes.
Falling oil prices lead to cheaper gasoline costs that reduce family expenses, freeing up more cash to spend.
“In the Northeast and Midwest especially, home prices tend to rise after oil prices fall,” he writes in the analysis.
Oilfield worker on a rig Active pumping rig located on Highway 385 south of Odessa, photographed Tuesday, Sept. 24, 2014. James Durbin/Reporter-Telegram. Source: MRT.com
MIDLAND — With oil prices plummeting by more than 50 percent since June, the gleeful mood of recent years has turned glum here in West Texas as the frenzy of shale oil drilling has come to a screeching halt.
Every day, oil companies are decommissioning rigs and announcing layoffs. Small firms that lease equipment have fallen behind in their payments.
In response, businesses and workers are getting ready for the worst. A Mexican restaurant has started a Sunday brunch to expand its revenues beyond dinner. A Mercedes dealer, anticipating reduced demand, is prepared to emphasize repairs and sales of used cars. And people are cutting back at home, rethinking their vacation plans and cutting the hours of their housemaids and gardeners.
Dexter Allred, the general manager of a local oil field service company, began farming alfalfa hay on the side some years ago in the event that oil prices declined and work dried up. He was taking a cue from his grandfather, Homer Alf Swinson, an oil field mechanic, who opened a coin-operated carwash in 1968 — just in case.
“We all have backup plans,” Allfred said with a laugh. “You can be sure oil will go up and down, the only question is when.”
Indeed, to residents here in the heart of the oil patch, booms and busts go with the territory.
“This is Midland and it’s just a way of life,” said David Cristiani, owner of a downtown jewelry store, who keeps a graph charting oil prices since the late 1990s on his desk to remind him that the good times do not last forever. “We are always prepared for slowdowns. We just hunker down. They wrote off the Permian Basin in 1984, but the oil will always be here.”
It is at times like these that Midland residents recall the wild swings of the 1980s, a decade that began with parties where people drank Dom Pérignon out of their cowboy boots. Rolls-Royce opened a dealership, and the local airport had trouble finding space to park all the private jets.
By the end of the decade, the Rolls-Royce dealership was shut and replaced by a tortilla factory, and three banks had failed.
There has been nothing like that kind of excess over the past five years, despite the frenzy of drilling across the Permian Basin, the granddaddy of U.S. oil fields. Set in a forsaken desert where tumbleweed drifts through long-forgotten towns, the region has undergone a renaissance in the last four years, with horizontal drilling and fracking reaching through multiple layers of shale stacked one over the other like a birthday cake.
But since the Permian Basin rig count peaked at around 570 last September, it has fallen to below 490, and local oil executives say the count will probably go down to as low as 300 by April unless prices rebound.
The last time the rig count declined as rapidly was in late 2008 and early 2009, when the price of oil fell from more than $140 to under $40 a barrel because of the financial crisis.
Unlike traditional oil wells, which cannot be turned on and off so easily, shale production can be cut back quickly, and so the field’s output should slow considerably by the end of the year.
The Dallas Federal Reserve recently estimated that the falling oil prices and other factors will reduce job growth in Texas overall from 3.6 percent in 2014 to as low as 2 percent this year, or a reduction of about 149,000 jobs created.
Midland’s recent good fortune is plain to see. The city has grown in population from 108,000 in 2010 to 140,000 today, and there has been an explosion of hotel and apartment construction. Companies like Chevron and Occidental are building new local headquarters. Real estate values have roughly doubled during the past five years, according to Mayor Jerry Morales.
The city has built a new fire station and recruited new police officers with the infusion of new tax receipts, which increased by 19 percent from 2013 to 2014 alone. A new $14 million court building is scheduled to break ground next month.
But the city has also put away $39 million in a rainy-day fund for the inevitable oil bust.
“This is just a cooling-off period,” Morales said. “We will prevail again.”
Expensive restaurants are still full and traffic around the city can be brutal. Still, everyone seems to sense that the pain is coming, and they are preparing for it.
“We are responding to survive, so that we may once again thrive when we come out the other side,” said Steven H. Pruett, president and chief executive of Elevation Resources, a Midland-based oil exploration and production company. “Six months ago there was a swagger in Midland and now that swagger is gone.”
Pruett’s company had six rigs running in early December but now has only three. It will go down to one by the end of the month, even though he must continue to pay a service company for two of the rigs because of a long-term contract.
The other day Pruett drove to a rig outside of Odessa he feels compelled to park to save cash, and he expressed concern that as many as 50 service workers could eventually lose their jobs.
But the workers themselves seemed stoic about their fortunes, if not upbeat.
“It’s always in the back of your mind — being laid off and not having the security of a regular job,” said Randy Perry, a tool-pusher who makes $115,000 a year, plus bonuses, managing the rig crews. But Perry said he always has a backup plan because layoffs are so common — even inevitable.
Since graduating from high school a decade ago, he has bought several houses in East Texas and fixed them up, doing the plumbing and electrical work himself. At age 29 with a wife and three children, he currently has three houses, and if he is let go, he says he could sell one for a profit he estimates at $50,000 to $100,000.
Just a few weeks ago, he and other employees received a note from Trent Latshaw, the head of his company, Latshaw Drilling, saying that layoffs may be necessary this year.
“The people of the older generation tell the young guys to save and invest the money you make and have cash flow just in case,” Perry said during a work break. “I feel like everything is going to be OK. This is not going to last forever.”
The most nervous people in Midland seem to be the oil executives who say busts may be inevitable, but how long they last is anybody’s guess.
Over a lavish buffet lunch recently at the Petroleum Club of Midland, the talk was woeful and full of conspiracy theories about how the Saudis were refusing to cut supplies to vanquish the surging U.S. oil industry.
“At $45 a barrel, it shuts down nearly every project,” Steve J. McCoy, Latshaw Drilling’s director of business development, told Pruett and his guests. “The Saudis understand and they are killing us.”
Pruett nodded in agreement, adding, “They are trash-talking the price of oil down.”
“Everyone has been saying ‘Happy New Year,’” Pruett continued. “Yeah, some happy new year.”
NEW YORK (Reuters) – DoubleLine Capital’s Jeffrey Gundlach said on Tuesday there is a possibility of a “true collapse” in U.S. capital expenditures and hiring if the price of oil stays at its current level.
Gundlach, who correctly predicted government bond yields would plunge in 2014, said on his annual outlook webcast that 35 percent of Standard & Poor’s capital expenditures comes from the energy sector and if oil remains around the $45-plus level or drops further, growth in capital expenditures could likely “fall to zero.”
Gundlach, the co-founder of Los Angeles-based DoubleLine, which oversees $64 billion in assets, noted that “all of the job growth in the (economic) recovery can be attributed to the shale renaissance.” He added that if low oil prices remain, the U.S. could see a wave of bankruptcies from some leveraged energy companies.
Brent crude approached a near six-year low on Tuesday as the United Arab Emirates defended OPEC’s decision not to cut output and traders wondered when a six-month price rout might end.
Brent has fallen as low as just above $45 a barrel, near a six-year low, having averaged $110 between 2011 and 2013.
Gundlach said oil prices have to stop going down so “don’t be bottom-fishing in oil” stocks and bonds. “There is no hurry here.”
Energy bonds, for example, have been beaten up and appear attractive on a risk-reward basis, but investors need to hedge them by purchasing “a lot, lot of long-term Treasuries. I’m in no hurry to do it.”
High-yield junk bonds have also been under severe selling pressure. Gundlach said his firm bought some junk in November but warned that investors need to “go slow” and pointed out “we are still underweight.”
Gundlach said U.S. stocks could outperform other countries’ equities as the economic recovery looks stronger than its counterparts, though double-digit gains cannot be repeated.
He also reiterated that it’s possible yields on the benchmark 10-year Treasury note could drop to 1 percent in 2015. The 10-year yield traded around 1.91 percent on Tuesday, little changed from late on Monday after hitting 20-month low of 1.8640 percent.
“The 10-year Treasury could join the Europeans and go to 1 percent. Why not?” Gundlach told Reuters last month. “If oil goes to $40, then the 10-year could be going to 1 percent.”
The yield on 10-year German Bunds stood at 0.47 percent on Tuesday.
This is the title of the latest webcast from DoubleLine Capital’s Jeffrey Gundlach, who just wrapped up a webcast giving his outlook for 2015.
We last heard from Gundlach in December when he held a presentation called “This Time It’s Different,” in which he talked about the oil markets, the dollar, and how the 10-year Treasury bond could get to 1%.
Among the things Gundlach believes 2015 has in store for the market is more volatility, lower Treasury yields, and a Federal Reserve rate hike, “just to see if they can do it.”
Gundlach spent a good chunk of his open talking about the effects that the decline in oil will have on jobs growth and capital investment in the US, noting that 35% of capital investment from the S&P 500 is related to the energy sector.
The bull case for the US in 2015, Gundlach said, is predicated primarily on the strength of the US labor market. Meanwhile the chart of the year so far is the US 10-year yield against other major economies, with the US clearly having space to converge towards the super-low yields seen on 10-year bonds in Japan, Germany, and Switzerland.
We’ve broken out a number of Gundlach’s slides below and added commentary taken as he spoke live on Tuesday.
Gundlach says of the title that it stands for the fifth year that he’s being these webcasts, but also has a market theme. “Most risk markets have gone into a V since about June.”
Says that the “touchdown” part of the drop in oil is that consumers get more money in their pocket. “I think that’s one of the reasons, rightly, that people view the oil decline as somewhat positive.”
Gundlach says that there is a sinister side to the oil decline, which is potential impacts on employment in the US, particularly in the energy space.
Gundlach says “all of the job growth” from the recession until today can be attributed to the shale oil boom.
“It wasn’t the US of A in 2014, but the US of Only.”
US stocks were the only really strong equity markets among major developed economies. Chinese and Indian stocks were big winners among emerging markets.
Gundlach says he’s been positive on the US dollar since 2011. This was a huge consensus trade in 2014, and Gundlach says sometimes the consensus is right.
“It looks to me like the dollar is headed higher.”
Gundlach says he knows long dollar is a crowded trade, but the fundamentals bolstering a strong dollar remain in tact.
Additionally, Gundlach thinks the Fed will raise rates with a few more months of strong payrolls gains, which will only make the dollar stronger.
Oil prices have been correlated with GDP growth 18 months forward.
And so this chart implies 3+% global growth going forward.
“On balance this should be viewed as an encouraging indicator.”
Gundlach doesn’t think, however that global growth is going to be upgraded in 2015, and like the last several years will be downgraded as the year goes along.
Gundlach says US outperformance “isn’t really a great sign.” But says US is probably the preferred place to invest against the rest of the world, however.
“It’s almost impossible for the gains from June 2014 to now to be repeated this year.”
“I’ll bet you dollars to donuts the red line goes down.”
Gundlach says that oil just can’t stop going down. Last year, Treasury yields couldn’t stop going down, and this year oil can’t seem to stop going down.
Adds that contrarianism is dagnerous in commodities and stocks, says that contrarian investing is tempting, but oil is just a dangerous trade right now.
Gundlach says that once oil broke $70, it would create acceptance that oil isn’t going back to $95, causing producers to increase production because they need the revenue, not cut production to boost prices.
Gundlach says the bond chart of the year is part of the argument about why oil at $40, weighing on inflation, could bring the 10-year below its 2012 lows.
Gundlach says that with online sales at 9% of retail sales coming online, it seems low. But consider that you can’t buy gasoline online, you don’t really buy groceries online.
“I think of all the car companies, Tesla is less of a car company than any other.”
“I’m surprised that anyone would change their car buying habits based on the six-month price of oil. Tesla isn’t so much a play on cars being sold, but on batteries being transformative in many phases of life.”
Gundlach again talking about potential for Tesla’s batteries to get homes entirely off the grid.
“Tesla has as good a chance as anybody to develop a battery that can change the world.”
Says that the stock is hugely overvalued if you just look at the auto sales.
Bill Gross, the former manager of the world’s largest bond fund, said the Federal Reserve won’t raise interest rates until late this year “if at all” as falling oil prices and a stronger U.S. dollar limit the central bank’s room to increase borrowing costs.
While the Fed has concluded its three rounds of asset purchases, known as quantitative easing, interest rates in almost all developed economies will remain near zero as central banks in Europe and Japan embark on similar projects, Gross said today in an outlook published on the website of Janus Capital Group Inc. (JNS:US), where he runs the $1.2 billion Janus Global Unconstrained Bond Fund.
“With the U.S. dollar strengthening and oil prices declining, it is hard to see even the Fed raising short rates until late in 2015, if at all,” he said. “With much of the benefit from loose monetary policies already priced into the markets, a more conservative investment approach may be warranted by maintaining some cash balances. Be prepared for low returns in almost all asset categories.”
Benchmark U.S. oil prices fell below $50 a barrel for the first time in more than five years today, as surging supply signaled that the global glut that drove crude into a bear market will persist. Gross, the former chief investment officer of Pacific Investment Management Co. who left that firm in September to join Janus, said in a Dec. 12 Bloomberg Surveillance interview with Tom Keene that the Fed has to take lower oil prices “into consideration” and take more of a “dovish” stance.
Yields on the 10-year U.S. Treasury note fell to 2.05 percent today, the lowest level since May 2013. Economists predict the U.S. 10-year yield will rise to 3.06 percent by end of 2015, according to a Bloomberg News survey with the most recent forecasts given the heaviest weightings.
For the second straight month, Midland showed the nation’s largest over-the-year percentage gain in employment, according to figures released last week by the Bureau of Labor Statistics.
Midland reported a 6.2 percent increase in employment during the month of November. The number of employed increased from 95,200 to 96,000. Odessa (a drilling town next door to Midland) was second in the nation with a growth rate of 4.7 percent.
Midland also bettered its position among the metropolitan statistical areas with the lowest unemployment rates. In October, Midland was tied for fifth with a 2.5 percent jobless rate. In November, with the rate dropping to 2.3 percent, Midland was ranked fourth. Lincoln, Nebraska, took home the top spot with a 2.1 percent rate. Makato, Minnesota, and Fargo, North Dakota, tied for second at 2.2 percent.
There were 14 MSAs with unemployment rates at or below 3 percent during the month of November, including Odessa at 2.8 percent. There were 34 MSAs at 3.5 percent or below.
The following are the lowest unemployment rates in the nation during the month of November, according to the Bureau of Labor Statistics:
Lincoln, Nebraska, 2.1
Mankato, Minnesota, 2.2
Fargo, North Dakota, 2.2
Midland 2.3
Bismarck, North Dakota, 2.5
Ames, Iowa, 2.5
Logan, Utah, 2.5
Iowa City, Iowa, 2.6
Rochester, Minnesota, 2.6
Grand Forks, North Dakota, 2.7
Sioux Falls, South Dakota, 2.7
Odessa 2.8
Minneapolis, St. Paul, 3.0
Omaha, Nebraska, 3.0
Lowest rates from October:
Bismarck, North Dakota, 2.0; Fargo, North Dakota, 2.2; Lincoln, Nebraska, 2.3. Also: Midland 2.5
Lowest rates from September:
Bismarck, North Dakota 2.1; Fargo, North Dakota 2.3; Midland 2.6
Lowest rates from August:
Bismarck, North Dakota 2.2, Fargo North Dakota 2.4; Midland 2.8.
Lowest rates from July:
Bismarck, North Dakota, 2.4; Sioux Falls, South Dakota, 2.7; Fargo, North Dakota, 2.8; Midland 2.9.
Lowest rates from June:
Bismarck, North Dakota, 2.6, Midland 2.9, Fargo, North Dakota, 3.0.
Lowest rates from May:
Bismarck, North Dakota, 2.2, Fargo, North Dakota, 2.5, Logan, Utah, 2.5, Midland 2.6.
Having totally and utterly failed in 2014, the consensus for 2015 is once again higher rates (well they can’t go any lower right?) with year-end 2015 expectations of 3.006% currently (having already plunged from over 3.65% in July). However, at the other end of the spectrum, DoubleLine’s Jeff Gundlach told Barron’s this weekend, the 10-yr Treasury yield may test the 2012 low of 1.38% as the Fed’s short-term rate increase is poised to trigger “surprising flattening” of the yield curve. Source:Zero Hedge
Gundlach’s forecast is ‘very’ anti-consensus…
as the curve has already flattened dramatically…
Following the 2002-06 path almost unbelievably perfectly…
Gundlach adds,
U.S. GDP growth for ’15, ’16 may not achieve 3%+ target as dollar strength hurts exporters, oil price drops cause deflationary pressure, job and spending cuts for energy industries, Gundlach said
USD appreciation will continue as growth stumbles in other parts of the world, making U.S. bonds “all the more attractive” for foreign buyers, Gundlach said
“Trouble lies ahead” for the euro zone; people in Europe “are obviously losing confidence and scared” as German yield turns negative, Gundlach told Barron’s
This story by Matt Schfrin appears in the November 24, 2014 issue of Forbes.
The master of his domain: DoubleLine founder Jeffrey Gundlach relaxes among his Warhols in Los Angeles (photo: Ethan Pines
Bill Gross’ spectacular fall from the top of the bond market has put tens of billions in play at a time when minuscule yields demand a fixed-income superstar. A brilliant, battle-scarred billionaire, Jeffrey Gundlach, stands ready to be coronated.
Bond manager Jeffrey Gundlach is wearing a white T-shirt, faded blue jeans and worn leather boat shoes as he traipses about the blooming morning glories in his perfectly landscaped backyard, perched high above a canyon overlooking the deep blue Pacific Ocean. It’s the middle of the afternoon on a work Monday in October; European bank stocks are tumbling; oil prices are down 25% since June; and against the backdrop of an anemic economy and 2.25% ten-year Treasury, the Federal Open Market Committee is about to make an important announcement. These are unsettling times in the financial markets, but for Gundlach it’s a picture-perfect autumn day in southern California, and he is living in paradise.
What’s next for the Fed? Gundlach would much rather discuss the iconic framed “Lemon Marilyn,” by Andy Warhol, above his mantel or how his “Progressions,” by minimalist Donald Judd, in the hallway is influenced by the Fibonacci sequence. “It is negative and positive space governed by a rule that happens to describe the shape of the solar system, which is exactly the opposite of what was popular in the ’50s, all this emotional stuff,” he says, pointing to his de Kooning. A few moments later he is explaining to a visitor that the geometry of the lot on which his new 13,000-square-foot, $16 million Tuscan mansion sits was designed to be in perfect harmony with the canyon cliff side it mirrors.
It is a paradise, but importantly Gundlach is finally feeling at ease because his new sanctuary is well fortified. Anyone wanting to get close to him or his prize paintings must breach the 8-foot wall surrounding his suburban residence or face the scrutiny of an armed naval vet at his front gate who asks visitors for a picture ID. Gundlach makes a point to show off one of the 50 concrete foundation caissons supporting his property. Each measures 3 feet in diameter and extends down as much as 75 feet through the porous desert soil into California bedrock.
After 30 years of staring into the black-and-green abyss of a Bloomberg terminal managing bond portfolios, Gundlach is making a statement with his magnificent new residence, one that underscores his ascendance in the business. Casa Gundlach is unlikely to succumb to the sudden mudslides known to take down other California palaces in places like Mill Valley or Malibu. And with a stellar performance record, $60 billion in assets under management and a killer contemporary art collection accumulated over the last decade, Jeffrey Gundlach has finally joined the billionaires club. More importantly, Los Angeles-based DoubleLine Capital, the house that Gundlach built in under five years, couldn’t be on better footing.
Just about a month earlier Bill Gross of Pacific Investment Management Co., the reigning master of the bond universe for two decades, requested an audience with Gundlach. In a scene that can only be described as Shakespearean, the incumbent bond king drove an hour up the 405 Freeway in the middle of the afternoon to Gundlach’s new castle to more or less grovel at his feet. Gross was certain PIMCO’s German owners were about to fire him, and he was asking his nemesis for a job–a portfolio manager position at DoubleLine. Gross said he wanted to run an “unconstrained” bond fund a small fraction of the size of the $200 billion-plus Total Return Fund he was famous for building. With the sun falling over the Pacific and shimmering on the surface of Gundlach’s infinity pool, Gross was deep in suck-up mode.
“He said to me, ‘I’m Kobe Bryant, you’re LeBron James. I’ve got five rings, you’ve got two, but you are maybe on your way to five and you’ve got time,’ ” says Gundlach, 55. (Gross, 70, refuses to comment on the meeting.) “ Bill was in his own world,” says a house-proud Gundlach, with a tone of disdain. “He doesn’t say anything [about my place]. Nothing. Doesn’t eat anything or even take a sip of water in three hours.”
Gross left the meeting with no deal in hand and ultimately jumped to Denver-based stock manager Janus Capital. From his office in Orange County’s Newport Beach, Gross now manages a $79 million mutual fund for Janus, roughly 0.03% the amount of assets he used to control.
Though a Gundlach-Gross alliance would have surely quickened the asset flight to DoubleLine from PIMCO–which has reported redemptions of $48 billion since Gross was forced to resign on Sept. 26–Gundlach claims to be relieved. “Our clients would have asked, ‘What is this? How is this going to work?’ I hear he is a difficult guy.”
Jeffrey Gundlach: A big thinker whose ambitions go beyond bonds (photo credit: Ethan Pines)
With Gross’ banishment the battle was over, but the spoils of the greatest market share shakeup in the history of the $45 trillion bond business is just getting under way. There may be as much as $100 billion in PIMCO assets in play, and DoubleLine is vying for them against larger rivals BlackRock, Dodge & Cox, Loomis Sayles and even index fund giant Vanguard. All are strong competitors, but none has lead managers like Gundlach, who combine bold market predictions with impressive long-term performance.
Gundlach’s superstar status can be viewed as both a blessing and a curse for DoubleLine. Like Gross–who has helped transform stodgy bond investing from a financial backwater to a lucrative playground for young M.B.A.s and Ph.D.s–Gundlach is well known for his arrogance, eccentricities and volatility. Institutional investors loathe the type of drama that unfolded at PIMCO–also, unfortunately, the hallmark of Gundlach’s style.
“You can’t please everybody, and I’m not gonna try,” insists Gundlach, as Pandora’s Sinatra Radio streams over his home’s sound system. “They point to our key man risk, and we say, ‘Everyone knows that it is key man reward.’ ” The lesson of Bill Gross is: Don’t put your money with a star manager who is owned by a parent company that controls him.”
The importance of being in control is something that Gundlach learned the hard way. For most of his 24-year tenure at Los Angeles’ Trust Company of the West (TCW), leading up to 2009, Gundlach was pegged as a star, a brash and brilliant money manager with a knack for calling markets. His specialty is mortgage-backed securities. The mutual fund he managed through 2009 beat 98% of all mutual funds in its category for a decade. Even more impressive was that he correctly foresaw the coming collapse of the housing market in 2007 and managed to hold on to more of his pre-crisis gains than any of his peers. In 2005, at age 46, he was made chief investment officer of mighty TCW, and by 2009 he was overseeing some $70 billion of its $110 billion in assets under management. In 2009 alone Gundlach’s annual compensation totaled no less than $40 million.
But despite his immense contribution to TCW’s success, at the end of the day Gundlach was still just a hired hand with no equity or control of his own destiny. He wanted more. He wanted to be named chief executive of TCW, but perhaps because of his abrasive style, the firm’s French owners, Société Générale and its billionaire founder, Robert Day, didn’t think he was fit for the job.
DoubleLine’s global developed credit chief Bonnie Baha and Luz Padilla (seated), who heads the firm’s emerging markets team (photo credit: Ethan Pines for Forbes)
“Look, it is clear that Jeffrey doesn’t suffer fools gladly, and he doesn’t tolerate people not thinking before opening their mouths,” says Bonnie Baha, a 19-year TCW veteran who has witnessed Gundlach’s biting tongue but is currently DoubleLine’s global developed credit chief.
Gundlach’s unhappiness prompted him to consider alternatives. He was courted by competitors, including Western Asset Management and PIMCO, which according to court documents considered him a potential successor to Gross. Then on Friday, Dec. 4, 2009, just after the market closed in New York, TCW fired Gundlach preemptively and had its outside counsel chase him out of its downtown L.A. office tower. In an effort to prevent institutional investors from taking their money and leaving with him, TCW simultaneously acquired cross-town bond manager Metropolitan West. In what former TCW employees describe as a surreal scene, Gundlach team members showed up the following Monday morning to find Met West traders sitting at their desks.
Despite promises of huge pay raises by TCW, 40 Gundlach loyalists defected, and within a month Gundlach had formed DoubleLine Capital. He found backers in Howard Marks and Bruce Karsh of Oaktree Capital Management, who had a similar acrimonious divorce from TCW 14 years earlier. (Distressed bond specialist Oaktree shares an office tower with DoubleLine and still owns 20% of the firm.) TCW had been gutted of its best fixed-income talent, and some $30 billion in assets eventually fled the firm.
But the drama was only beginning. Ugly lawsuits and counter lawsuits were filed. Gundlach was sued for more than $300 million and accused of everything from stealing hard drives to maintaining stashes of porno and pot. Distraught, Gundlach called a meeting of the 45 TCW coworkers he had lured away with a handshake promise of equity. His new firm had no assets and faced an immense potential liability, but he pledged that if the firm was forced out of business, he would find them all jobs. Gundlach counter sued for more than $500 million in fees he said he was owed.
The whole ordeal lasted two years, including a six-week jury trial in Los Angeles County Superior Court. All the while Gundlach and his bond traders persevered. The group continued to outperform, and DoubleLine assets swelled. By late 2010, barely a year after the firm opened its doors, assets reached $7 billion, hitting break-even, according to Gundlach.
Ultimately in late 2011 the jury found that Gundlach & Co. stole TCW’s trade secrets, but no damages were awarded. Instead, the jury awarded Gundlach $67 million for compensation he was owed. Before the appeals could be filed, TCW and Gundlach settled.
By then DoubleLine funds were already a screaming success and fast on the way to $50 billion in assets. Meanwhile, Morningstar’s “fund manager of the decade,” Bill Gross, was suffering from subpar returns in his mighty PIMCO Total Return fund. In 2011 he bet wrong on rates, missing the rally in Treasury bonds. That left PIMCO’s Total Return fund 87th among its competitors, returning just 4.2% to investors, compared with 9.5% for Gundlach’s flagship Total Return fund.
On Dec. 4, 2012, exactly three years from the day he had been fired from TCW, Gundlach rented a restaurant in the lobby of TCW’s headquarters to throw a lavish party. Cristal champagne was flowing, and his now wealthy employees and partners were treated to filet mignon and tuna tartare. A banner that read “DoubleLine $50 billion” was hung over the bar for all of TCW’s remaining salary men to see as they filed out of the building.
A brilliant analytical thinker who is both meticulous with his facts and mercenary in making rational decisions, Gundlach cares deeply for the loyalists who followed him to DoubleLine but rarely shows any emotion. He almost never socializes with his 125 co-workers.
A native of suburban Buffalo, N.Y., Gundlach’s DNA practically preordained him for entrepreneurial success. His paternal grandfather, Emanuel, was the son of a German minister and became a stockbroker during the roaring 1920s. Gundlach claims his grandfather foresaw the 1929 crash and banked the sizable sum of $30,000 ($400,000 in today’s dollars) ahead of the Great Depression. He then became a bathtub chemist, concocting hair tonic from the roots of witch hazel shrub. His product, Wildroot Hair Cream, became a national brand by the 1950s.
“He would give us bottles when I was a kid,” says Gundlach. “It was called greasy kid’s stuff. You know, like the Fonz.”
Gundlach’s uncle Robert was a physicist and renowned inventor, coming up with a process that allowed Rochester, N.Y.’s Haloid Photographic Co. (later known as Xerox) to make the copy machine commercially viable.
Gundlach’s father was a chemist for coatings maker Pierce & Stevens, and his mother a teacher and homemaker from a working-class family. Though the extended Gundlach clan spent summers at his grandfather’s rural upstate New York retreat, Starlit, his branch of the family never enjoyed the affluence of his famous uncle Robert, who had dozens of Xerox patents. “My uncle was very parsimonious–never wanted to spend a dime,” laments Gundlach.
Thus Gundlach was raised squarely in the middle class and to this day is uncomfortable hobnobbing with moneyed society members. Gundlach recalls that his maternal grandparents had such a distrust for the upper crust that they lobbied for his older brother Brad to go to the University of Buffalo over Princeton. (He eventually chose Tiger orange and black.) To this day Gundlach continues to brag about his “hammer swinging” eldest brother, Drew, who never went to college and remodels houses in upstate New York. Gundlach spends his Fourth of July and Thanksgiving holidays at Drew’s home.
Gundlach was a top student in high school with a near perfect score on the math SAT. Financial aid allowed him to attend Dartmouth, where he graduated summa cum laude in 1981 with a degree in math and philosophy. He considered becoming a philosophy professor, but then after studying the works of Austrian-British philosopher Ludwig Wittgenstein, he gave up. “I stopped caring about philosophy,” he says, explaining, “Wittgenstein was a mathematical philosopher, and his whole thing is that philosophy is just words that don’t mean anything. It’s like a fly that goes into a fly bottle and can’t find its way out. What is the meaning of life? It sounds like a , but it doesn’t mean anything.”
So Gundlach dived deeper into mathematics and was accepted in the doctoral program at Yale.
“My thesis was the probabilistic implications of the nonexistence of infinity,” explains Gundlach. “There is no infinity. It’s an illusion; there is absolutely nothing empirical that suggests infinity exists and nothing that operates under the assumption of infinity that has any practical implications.”
Apparently Gundlach’s thesis not only didn’t please his Yale advisor but was diametrically opposed to the work of one of the most influential mathematicians since Aristotle, Austrian logician Kurt Gödel and his Incompleteness Theorem.
So in 1985 Gundlach, who had been playing drums in bands while at Dartmouth and Yale, donned a spiky bleached-blond haircut and moved to Los Angeles to become an alternative rock star. A series of bands he played in, including one called Radical Flat, had limited success, and Gundlach was forced to hold down a day job in the actuarial department of Transamerica. He decided to apply for a job in the investment business after he watched a Lifestyles of the Rich and Famous episode lauding the profession as the highest paying.
A blind solicitation letter ultimately landed Gundlach in the fixed-income department of the Trust Company of the West. He devoured the math-heavy bond market primer Inside the Yield Book the week before starting, learned trading on the job and eventually came to be the most powerful mortgage-backed securities money manager in the company.
It’s late October, and Gundlach is delivering the keynote speech at ETF.com’s Inside Fixed Income conference in Newport Beach, Calif. before an audience of 175 investment professionals and advisors. It’s about a month after the Bill Gross resignation bombshell shook the bond market, so attendance is higher than expected and the audience hangs on his every word.
“People like my macro stuff,” he muses. “There is very little patience for long wonky bond presentations, but people are interested in different ways of interpreting the forces behind macroeconomic events and geopolitics.”
His 56-slide PowerPoint presentation is entitled This Time It’s Different–directly thumbing his nose at legendary investor Sir John Templeton’s famous warning that those are the four most dangerous words in investing.
But Gundlach means it. His first slide is a quote from Greek philosopher Heraclitus: “No man ever steps in the same river twice, for it’s not the same river, and he’s not the same man.”
Gundlach is referring to the bizarre current market environment and insists that analysts studying the economic and monetary policy axioms of the past are making a serious mistake.
“In the past the feds would raise rates to be preemptive against inflation. There is no inflation today, and you see finance ministers saying that one of the dark clouds hanging over the global economy is that inflation is not accelerating,” he says. “So raising interest rates against that mentality is very different, and taking an average of the past rate-raising cycles is not going to give you a good road map as to where things go this time around.”
Here is the new bond king’s view of the world today:
The Fed may raise the federal funds rate for the wrong reasons.
“They don’t really need the rates to be higher, but they seem to want to reload the gun so they aren’t stuck at zero without any tools.”
Deflationary forces will accelerate if the Fed raises rates.
“With a tightening, the dollar is going to not just be strong, but it will run up like a scalded dog. If that happens, then commodity prices are going down, we will import deflation and you will see an episode of deflationary scare.”
The long end of the Treasury curve will stay put and possibly go down further.
“There’s a 30% chance that importing deflation creates a panic into Treasurys creating a ‘melt-up,’ moving rates to German Bund levels today of around 1%.
It’s not okay to own risk assets when the Fed starts hiking rates.
“What is fascinating is, if you sell junk bonds and buy Treasurys, the minute the Fed hikes the first time, going back to 1980, in every case you did well.”
Don’t be surprised to see the yield curve flatten and possibly invert.
“Long rates have done nothing but fall. That tells me the market is saying to the Fed, ‘Go ahead, make my day.’ The curve is going to invert when and if fed funds hit 2.5 to 3%.”
Be long the dollar, especially in emerging market bonds.
“We have been all dollar [denominated in our foreign bond holdings] since 2011. For a while it didn’t really matter, but now it matters a lot. If you are nondollar you are really in trouble.”
Stay away from home builders, TIPs and mortgage REITs, and oil will fall further.
“I am convinced the Saudis want the price of a barrel of oil to go to $70. They don’t care if they run a short-term deficit if it slows down U.S. fracking and turns the screws on countries in their region that mean them harm.”
As we get closer to 2020 interest rates and inflation (and taxes) could really start rising.
“We are in the calm right now before the hurricane. I’m talking about the aging of the great powers, which is undeniable and can’t be quickly reversed. The retiree-to-worker ratios, the size of labor forces globally. China will have no one in the labor force. Italy’s losing 39% of labor force in the next generation and a half. Japan has an implosion of working population and no immigration. Russia is facing one of the greatest demographic crisis in the history of the world, absent famine, war and disease. It’s pretty bad. Italy has no hope,” says Gundlach matter-of-factly.
“The Federal Reserve bought the bonds from the deficits of 2011, 2012 and 2013, and those will roll off increasingly over time. Come 2020 you are not just financing massive entitlements like Social Security and Medicare but also old debt. No one talks about that. It’s a big deal. China doesn’t have the demographics to buy that debt. Who’s going to buy it?”
The coming debt storm–which Gundlach says is too early to worry about tactically–will hit financial markets just as DoubleLine approaches its tenth anniversary in business.
Giant pension funds and endowments are typically plodding in the redeployment of assets because it often requires coordinating board meetings, soliciting bids from new firms, listening to presentations and gathering votes. But with tens of billions likely to shift out of PIMCO over the next few months, DoubleLine is buzzing with activity. The task at hand is proving to existing clients and to new ones that the drama days are over and DoubleLine is all grown up.
“I don’t think the controversies surrounding his TCW days are really relevant anymore in the analysis of DoubleLine,” says Michael Rosen, the chief investment officer at Angeles Investment Advisors, whose firm advises on $47 billion in pension and endowment money and who had resisted recommending DoubleLine to clients in the past. “That is ancient history at this point.”
Perhaps because of Gundlach and DoubleLine’s toxic inception the majority of its $60 billion in assets is held by individuals in the firm’s mutual funds, predominantly his mortgage-heavy DoubleLine Total Return Bond Fund, which has $38 billion under management and is up 8.93% annually since inception in 2010, and DoubleLine Core Fixed Income Fund, which is up 7.19% annually since inception. DoubleLine also has $4.5 billion in its Opportunistic Income, a hedge fund strategy, which uses leverage and deploys an amalgam of its manager’s best ideas.
So far Gundlach reports that it has gulped down $4 billion in new assets since Gross’ departure. However, competitors like BlackRock, Loomis Sayles and Vanguard are also seeing big inflows.
Somewhat unique to DoubleLine among big competitors is that it has no interest in the low-fee bond index fund money that BlackRock and Vanguard specialize in. He also insists he will close his funds to new investors before they get too large. “Our so-called flagship strategy Total Return will never go to $100 billion unless the bond market grows ten times in size,” he says. “We are not ambulance chasers.” Still Gundlach is clearly drooling at the prospect of feasting on PIMCO’s remains, because he doesn’t hesitate to gun at his competition.
What does he say about the reorganization of Bill Gross’ famous Total Return Fund? “Who’s managing it?” says Gundlach. “I don’t buy for a second that they will all work together and with no conflict. ”
Of PIMCO’s newly named Chief Investment Officer Daniel Ivascyn: “ He is their hottest performer in recent times. I hear he is reasonably good at explaining things, the fact that he read from a teleprompter and couldn’t answer any of the real questions notwithstanding. I’m sure he’s articulate.”
Gundlach even feels the need to neutralize two seemingly nonexistent threats, Bill Gross and Mohamed El-Erian, the former PIMCO co-chief investment officer executive, who remains on the payroll of PIMCO parent Allianz.
“People are too harsh on Gross’ performance. It’s not bad, it’s just average,” he says. “This past year it’s been bad, but for 5 years it’s been average.”
As for El-Erian, “Mohamed’s track record is hard to find, and when you find it, it’s bad.”
Gundlach protege, Jeffrey Sherman: Gumdlach says he is the rare quant manager with the “special sauce.” (photo credit: Ethan Pines for Forbes)
Meanwhile DoubleLine is bending over backward to show off the breadth and depth of its bench as Gundlach’s top portfolio managers make the rounds with salesmen. Key in this pursuit are veteran emerging markets manager Luz Padilla, global developed credit manager Bonnie Baha, mortgage-backed manager Vitaliy Liberman and a young portfolio manager named Jeffrey Sherman.
Sherman, 37, rides shotgun to Gundlach at DoubleLine’s monthly fixed-income asset allocation meeting, attended by all key portfolio managers. Gundlach sits at the head of the table, but Sherman organizes large parts of the 70-plus slides Gundlach presents at these important meetings covering macro themes and sector allocations for the firm’s multi-asset strategies. Sherman is emerging as the front-runner to eventually succeed Gundlach.
With his shoulder-length brown hair parted in the middle and his hipster beard, Sherman gives off a laid-back California surfer vibe, yet he impresses visitors with his ability to demystify complicated economic concepts as well as articulate big-picture strategies.
“What we are trying to do in these asset allocation programs is look at the entire portfolio. We are not allocating to each sector and asking each manager to outperform each month, we are thinking about how the whole portfolio works,” says Sherman, mentioning that government bond chief Gregory Whiteley, for example, is currently being asked to underweight his sector and hold long-duration bonds. “We are paid not on assets that each one of us is managing but on the collective success of the firm. That is very deeply entrenched in our process and very different from other firms.”
Like Gundlach, Sherman has humble roots. Neither of his parents attended college: His father worked in the oilfields of Bakersfield, Calif., and his mother is a bookkeeper. Also like Gundlach, a scholarship helped pay for his applied mathematics degree at University of the Pacific, where he also taught statistics. Upon graduating in 1999, Sherman saw the wave of quants heading to Wall Street and wound up pursuing an M.S. in financial engineering from Claremont Graduate University. A summer internship led him to the risk analytics department of TCW, and ultimately he defected to DoubleLine.
“Sherman is extremely analytic, which I am always attracted to,” says Gundlach. “But he also understands psychology. There are a lot of people who are quants, and they think you can explain the world with an econometric model. You just get the coefficients right and you can explain everything about the future. Sherman understands all of the coefficients and can derive all the equations just like I used to do, but he understands that it won’t predict where the market is going to be in a month. He is also good at explaining, which, of course, is the secret sauce of this business.”
In addition to Sherman’s key role in DoubleLine’s multi-asset strategies, Gundlach has put him in charge of new product development. This is critical to long-term growth because DoubleLine is still largely perceived as a mortgage bond specialist.
Besides two new NYSE-listed closed-end funds, DoubleLine has developed a commodities strategy, gathered $164 million in an enhanced S&P 500 stock index fund created in partnership with Nobel laureate Robert Shiller and started a small-cap stock fund. It’s also developing an infrastructure loan fund and a commercial-mortgage-backed-securities fund.
“I am really interested in doing distressed funds when the credit cycle turns, but you have to wait,” says Gundlach in anticipation of the debt woes on the horizon. “That’s one reason why we have been expanding our capabilities in bank loans, high yield, emerging markets debt and CMBS.”
Original backer Oaktree Capital, which has never wavered in its Gundlach bet, has already taken out more than $90 million in distributions on its original $20 million investment ( Oaktree also invested $20 million in DoubleLine’s hedge fund) through September 2014, and its 20% stake is estimated to be worth close to $400 million. Says Howard Marks, Oaktree chairman: “Jeffrey thinks beyond being a bond manager, and I don’t know if you noticed, he is a pretty confident guy.”
Gundlach is so self-assured that he has even taken to painting in the style of the masters in his art collection. Piet Mondrian–the inspiration for DoubleLine’s red, blue and black logo–is his favorite. Says Gundlach, “I knocked [Mondrian] off. Very hard to do. Surprisingly hard. Hard to make the lines crisp. Mine are more crisp than his, but that’s because I used tape.” Gundlach pauses, reflecting on his work. “It’s an interesting thing: There is this moment when you are not sure if you are done or not.”
Oil consumption remains strong and is likely to increase thanks to cheaper prices.
Historically oil rebounds quite quickly, especially when the U.S. and global economy are growing.
Investors are overly negative on oil ever since the OPEC meeting, but production cuts could still be on the way.
Ever since the November 27th OPEC meeting the price of oil has plunged by about 20% and many stocks are off by much, much more. The doomsayers and shorts are out in force now, emboldened by the weakness in this sector. There is a tremendous amount of negative sentiment towards oil now. But this extreme level of negativity appears to be very overdone. It also seems to be based on psychology, forced margin call selling, panic selling and tax-loss selling. With all these factors, it’s been a perfect storm that has brought some small-cap oil stocks back to levels not seen since the depths of the financial crisis. Back in 2009, oil plunged to the $40 range, but the U.S. and the global economy were in free fall and oil consumption was also falling. The factors that drove oil to collapse in 2009 like bank failures, financial system imploding, home prices collapsing, massive layoffs, and other negatives that just do not exist today. That is why it does not make sense to be expecting oil to plunge back towards the lows seen in 2009. Furthermore, it is really important to realize that even when oil plunged in 2009, it rebounded very, very quickly (in spite of all the doomsayers back then). That is another big factor to consider because since the global economy is significantly stronger now, it could rebound sooner than most investors realize. Here are a few more reasons why this is a buying opportunity as oil is not likely to go down much more and why it is not likely to stay down for very long:
Reason #1: Energy company insiders are calling the recent plunge in stocks a “fire sale” and they are buying at a pace that has not been seen in years. Oil industry insiders have seen the ups and downs in oil prices and have experienced market pullbacks before. If oil company insiders are buying en masse now, there is a good chance that they see bargains and a strong future for oil. This supports the idea that there is a disconnect between the current market price of many oil stocks and the longer-term fundamentals of this industry. Citigroup (NYSE:C) recently made a strong case that indicates there is a disconnect between asset prices in the oil industry and the fundamentals. A Bloomberg article details some of the recent insider activity, it states:
“This is an absolute fire sale,” he said. “It’s an overreaction and the result is it’s oversold.” With valuations at a decade low, oil executives such as Rochford and Chesapeake Energy Corp.’s (NYSE:CHK) Archie Dunham are driving the biggest wave of insider buying since 2012, data compiled by the Washington Service and Bloomberg show. They’re snapping up stocks after more than $300 billion was erased from share values as crude slipped below $70 for the first time since 2010.”
Reason #2: Just because OPEC did not act at the November 27th meeting, it does not mean they won’t act. OPEC is scheduled to meet again in 2015, but there is always the possibility for an emergency meeting at any time. Even a statement from OPEC discussing the willingness to cut production or to address “cheating” by some members who are producing more than their quota allows could cause a significant short-covering rebound in the oil sector. A CNBC article points out that some industry watchers believe OPEC could act soon with an extraordinary or “emergency” meeting, it states:
“We see the possibility they call an extraordinary meeting sometime next year,” said Dominic Haywood, crude and products analyst with Energy Aspects. “We think they’re going to address countries not living within their quota.” OPEC has a quota of 30 million barrels a day, but it has been producing more.
On December 2, a Saudi Prince stated that his country would cut production if other countries would also participate. This seems the first “olive branch” since the OPEC meeting and it appears to be in response to the slide in oil since that meeting took place.
Reason #3: The perceived “glut” of oil is much smaller than most people realize. Furthermore, that excess supply could be taken out rather rapidly because cheaper oil is likely to lead to more demand and consumption. Toyota (NYSE:TM) just reported that sales of its 4Runner sport utility vehicle just jumped by 53% in November and sales of the Prius fell by 14% in the same period. This is just one example of how quickly demand for oil can rise and if you multiply even slight increases in global oil consumption because of much lower prices the numbers get quite large. Urban Carmel (a former McKinsey consultant and President of UBS Securities in Asia) believes that oil is going back to $80 per barrel and a recent article he wrote explains why the perceived glut is not going to last long, he states:
“Excess oil supply (over demand) is presently about 1 mbd. That would be a problem for oil prices except for one thing: existing fields lose about 6% of their production capacity each year, equal to about 5.5 mbd. That means that even if demand is flat, at least 4.5 mbd in new production is needed. Opec has spare capacity of only about 3 mbd. The remainder must come from new investment. New deep water and oil sand projects have a breakeven cost of about $80-90. There will be little incentive to make these investments unless the price of oil is at least $80. If the price stays lower than $80, supply will be insufficient for demand. It’s exactly under those circumstances that spikes higher in oil prices have occurred in the past.”
Reason #4: Oil can be very volatile, but it historically rebounds very quickly because it is used in very large quantities every day. The chart below shows that oil has reached a level that is giving investors a buy signal. Also, it is worth noting that prior oil price slides typically lasted about 20 weeks and the current slide is on week 25 which is another sign a rebound is way overdue. Oil and most oil stocks are extremely oversold now and that means a powerful relief and short covering rally could be coming soon. Some “smart money” investors are recognizing the buying opportunity at hand. Hedge funds are starting to position for a rebound in oil as there is a growing belief that the oil slide has run its course and is now due for a rally.
Oil is already down by about 40%, and the global economy is not in a current state that would support drastically lower prices as some are predicting. It is worth noting that most analysts and economists have a terrible track record when it comes to forecasting oil prices. If you had told anyone that oil was going to surge to over $100 within a couple years of the financial crisis you would have been ridiculed. I believe that the inaction at the OPEC meeting triggered margin call selling, and as we know, selling begets selling especially at this time of year when tax-loss selling fuels even more downside pressure. Some investors are making too much of the oil price decline by trying to connect the dots which should not be connected. I don’t believe that oil’s decline is a major sign of global economic weakness, I believe it is partially because supplies are temporarily a bit higher than needed, the dollar has been strong, and because too many speculators held futures contracts that were suddenly liquidated after the OPEC meeting sparked a sell-off. This has created bargains, especially in small-cap oil stocks. I have been primarily focusing my buying on companies that have no direct exposure to the price of oil and significant contract backlogs. This has led me to buy stocks like McDermott International (NYSE:MDR) which is now incredibly cheap at less than $3 per share. This company is an engineering and construction firm that specializes in the energy industry. It has a $4 billion contract backlog and it has about $900 million in cash and (incredibly) a market cap of just $584 million. That means that this company could buy all the outstanding shares and still have over $300 million left in cash on the balance sheet. McDermott shares are also trading for less than half of the stated book value which is $6.30 per share. On November 14, David Trice (a director) bought 20,000 shares at $4.16, which was about $83,000 worth of stock. But, due to immensely negative sentiment in the oil sector, panic selling, margin call selling, and tax-loss selling, this stock is down by about 40% just from when this insider bought, even though this company has no direct exposure to oil prices and enough business (with the $4 billion+ contract backlog) to keep it busy for the next two years. It also does projects for the natural gas industry and investors seem to have overlooked that natural gas prices have remained solid.
I also see opportunity in Willbros Group (NYSE:WG) which trades for just over $4 now (down from a high of about $13 this year). It specializes in pipeline projects for the energy industry which includes oil and gas, petrochemicals, refining as well as electric power. This stock took a hit several weeks ago when the company announced it would restate earnings due to a charge on a pipeline project that was estimated to reverse about $8 million in previously reported pre-tax income. This caused the company to be delayed in filing the latest financial report and the market overreacted by knocking off about $160 million in market cap in just a few days after the restatement issue was announced. Willbros Group has a strong balance sheet and a $1.7 billion backlog which absolutely dwarfs the restatement numbers and the market cap of just about $215 million. It also recently announced plans for an asset sale that is estimated to generate up to $125 million. For more details, read my recent article on Willbros Group.
I expect that small cap stocks like McDermott and Willbros will rebound as tax-loss selling should fade by December 19th which is the Friday before the holiday season. This causes most traders and investors to have completed their tax planning issues before taking off for the holidays and that often leads to a significant “Santa Claus” and “January Effect” rally in beaten-down small caps.
Keep An Eye On Futures
Oil Futures Structure Seen as Encouraging Traders to Store Crude.
Brent oil in a contango will encourage traders to take delivery of crude and wait for higher prices, according to U.S. economist Dennis Gartman.
Brent for February delivery is $6.10 a barrel cheaper than the February 2016 contract. February Oman oil traded on the Dubai Mercantile Exchange is $8.30 cheaper than the year later contract after being $6 more expensive about six months ago.
“Not enough people pay attention to the importance of term structure,” Dennis Gartman, author of the Suffolk, Virginia-based Gartman Letter, said yesterday in a phone interview. “The market is saying it will pay traders to go into storage.”
Gartman said contango arbitrage is easier to trade on the broader benchmarks than the Oman contract because banks prefer to provide financing for markets that are more heavily traded. Investors can earn a “nearly riskless return” of 8 percent by selling crude futures and storing oil at current prices, Gartman said.
The cost of warehousing and lending has hindered popularity of the trade, Gartman said. Shipbroker Charles R. Weber said this month that oil tanker rates are too high to spur floating storage. There are 28.8 million barrels of oil being stored at Cushing, Oklahoma, about three million barrels above the 2014 average.
If you bought or rented in 2014 a larger portion of your income went to housing. Rents and housing values are quickly outpacing any pathetic gains to be had with wages. With the stock market at a peak, talking heads are surprised when the public is still largely negative on the economy. Can it be that many younger adults are living at home or wages are stagnant? It can also be that our housing market is still largely operated as some feudal operation. Many lucrative deals were done with big banks and generous offers circumventing accounting rules. This works because many perceive they are temporarily embarrassed Trumps, only one flip away from being a millionaire. Why punish financial crimes when you will likely need those laws to protect your gains once you join the club? The radio talk shows are all trying to convince people to over leverage and buy a home because you know, this time is the last time ever to buy. Yet home sales are pathetic because people don’t have the wages to support current prices. So sales drop and many sellers pull properties off the market. You want to play, you have to pay today. Rents are also rising and this is where a large portion of household growth has occurred. 2015 will continue to see housing consume a large portion of income and will lead many into a new modern day serfdom.
The Gain Of 7 Million Rental Households
Over the last decade we have added 7 million renting households. Is this because of population growth? No. This trend was driven because of the boom and bust in the housing market. Investors crowded out regular home buyers in buying single family homes and now, we have millions of new renters out in the market. Many of these people are folks who lost their homes via foreclosure.
Take a look at the obvious jump in renters:
For better or worse, home ownership is a path to building equity. It is a forced saving account for many. Most Americans don’t even benefit from the stock market peaking because nearly half of the country doesn’t even own stocks. And many own only a small amount. Most Americans derive their net worth from their primary residence. With fewer buying and more renting, I doubt that on a full scale people are suddenly buying stocks for the long-term. But it is also the case that many are simply renting because that is all they can afford. Many young Americans have so much debt that this is all they can pay. Think of places like San Francisco where jobs pay well but rents are simply out of this world and home prices are nutty.
Rents More Stable Versus Wild Housing Prices
Thanks to low rates, generous tax structures, and the American Dream marketing machine home values are operating in a casino like environment. This wasn’t the case in previous generation but take a look at fluctuations in rents versus home prices:
A crazy year for rents is when rents go up over 4 percent year-over-year. For home values we routinely had year-over-year gains of 25 percent in the last 20 years (including the latest boom in 2013). Rents are driven by net income of local families. No funny leverage here. But with buying homes, you have investors chasing yields, or loans that allow tiny down payments for buyers but then tack on a massive 30 year mortgage with a monthly nut that seems reasonable but only because of a low interest rate. Some of these people have no retirement account yet take on a $600,000 or $800,000 mortgage without batting an eye. So what we find is this psychological shift where some that want to buy are convinced that they need to start at the bottom of the ladder and pay an enormous price tag just to get in. To move out of serfdom, you have to embrace the cult of Mega Debt.
Young Adults More Likely To Stay Close To Home – And Rent
Young adults are facing the biggest impact of the housing crunch. Many are living at home because they can’t even afford current rents. Those that do venture out, will likely rent as their first step. A recent survey found that many young adults are planning on staying local. Say you live with your baby boomer parents in Pasadena or San Francisco. You want to buy like they did but good luck. So many have their network within said community and will likely rent (or live with mom and dad deep into their 30s and 40s):
I found this data interesting. People are simply moving less from their home area. So this will create more demand for rentals in these markets. In California, we have 2.3 million adults living at home. Pent up demand? Unlikely. The main reason they are at home is because of financial constraints. These are people that can’t even afford a rental. I’m sure this trend is occurring in other higher priced metro areas as well.
Rental Income Soaring For Investors
Rental income has soared since the bust happened. The biggest winners? Those who bought properties to become the new feudal landlords. You can see by the below chart that there was a larger concerted effort to consolidate rental income beyond the mom and pop buyers of former years:
Serfdom is also occurring to many households buying. They are leveraging every penny into their mortgage payment. Think you own your place? Try missing a few payments and become part of the 7 million completed foreclosures since the crisis hit. 2014 simply saw more net income going into housing. Is this good? Not really since housing is a dud for the economy unless we have new construction being built but that is not happening on a large scale. 2015 will likely see this continuation of serfdom via renting or buying but at least you might save a few bucks with lower oil! The road to serfdom apparently runs through housing.
Texas is by far the largest producer of oil in the US.
Oil production represents a disproportionate portion of Texas’s economy.
With oil prices down 45%, oil’s share of Texas GDP may fall 50% or more.
Unlike Russia and other countries, Texas cannot depreciate its own currency, magnifying the economic effect.
Texas is the largest oil producer in the US. And oil prices are down almost 50% in the past 4 months. Yet nowhere in the news do we hear about the risk of Texas entering a recession. The facts and figures below should concern investors in securities with economic exposure to the Texas economy. The risk is real.
As seen in the below chart by the EIA, Texas is the largest oil producing state in the US, producing 3x as much oil as the next largest producing state.
In September, Texas produced 3.23 million barrels of oil per day. This compares to 1.1 million barrels of oil per day produced in the second largest oil producing state, North Dakota, and much smaller quantities by other traditional oil producing states such as Alaska, California, and Oklahoma. And by comparison, Russia produces 10.9 million barrels per day.
Quantifying the value of this production, at $100 oil, that would be $323 million worth of oil produced per day, or $118 billion of oil produced per year. With the current price of oil hovering around $55 per barrel, that same oil production is only worth $178 million per day, or $65 billion. This is a loss of $53 billion of oil sales revenue just in the state of Texas.
This $53 billion in lost revenues compares to Texas’s GDP of $1.4 trillion in 2013 – it would be 3.8% of the State’s GDP, which is now “missing” due to oil prices having fallen. This is only the direct loss to the state – the indirect loss is likely several times as much. Direct oilfield activity is slowing down dramatically, as oil producing companies cut their capital expenditure budgets for 2015. Oilfield services stocks (NYSEARCA:OIH) are already down 37% from their peak earlier this year in anticipation of an activity slowdown. And for every job lost on a rig or in an oil company’s office, there are several additional jobs that may be lost, from the gas station manager to the sales clerk at a store to the front desk worker at a hotel.
The oil industry is unusual in that both the upstream independent producers and the service companies tend to outspend their cash flow, typically on local (to Texas) goods and services, on everything from drill pipe to rig manufacturing to catering. This means that for every dollar of lost oil sales from the lower oil price, there may be several dollars less spent across the Texas economy. This could be devastating for the Texas economy, and has not yet been widely discussed in the financial media.
To see an extreme example of the impact of lower oil prices on an economy tied to oil production, we can look at Russia (NYSEARCA:RSX). The Russian economy is more oil dependent than Texas’s. Russia’s GDP was $2.1 trillion in 2013. This compares to Texas’s GDP of $1.4 trillion. So Russia produces 3.3x as much oil as Texas, but only has 1.5x the GDP. So on a direct basis, assuming “ceteris paribus” conditions, a $1 decline in the price of oil would have 2.2x the impact to the economy of Russia as to the economy of Texas.
So what is happening in Russia? Already, the ruble has dropped in value by 50% in the past year. And numerous sources are calling for a severe recession in 2015. This would be expected, considering the high portion of the GDP that is attributable to oil production.
However, Russia has an advantage that Texas does not have. It has its own currency. While a 50% drop in a currency may not sound great if you’re looking to spend that currency elsewhere, it is crucial if you are an exporter and your primary export just dropped in price by 45%. The ruble denominated impact of the drop in the price of oil is a mere 10%. Unfortunately, for Texas, the dollar denominated drop in oil is 45%. So despite the lower economic exposure to oil, Texas does not have the benefit of a falling currency to buffer the blow of lower oil prices.
It may get even worse. With less drilling activity, oil production growth in Texas may slow, and eventually may decline. Depending on the speed of this slowdown, Texas could even see production decline by the end of 2015. This is because most of the new production has been coming from fracking unconventional wells, which can decline in production by as much as 80% in the first year. Production growth has required an increasing number of wells drilled, and has been funded with 100% of oil company cash flow along with hundreds of billions of dollars of equity and debt over the past few years. With the recent crash in oil stock prices (NYSEARCA: XOP) and in oil company bonds (NYSEARCA: JNK), oil drillers may be forced to spend within cash flow, and that cash flow will be down at least 45% in 2015 if the oil price stays on the path projected in the futures market.
All of this means that in 2015, Texas oil wells could be producing less than the 3.23 million barrels of oil per day it was producing in September 2014, and their owners could be receiving 45% less revenue per barrel produced. Again applying an economic multiplier, the results could be devastating. And without the cushion of a weak currency that benefits countries like Russia, it is hard to see how Texas could avoid a recession in 2015 if the price of oil stays near its current low levels.
The American Petroleum Institute said last week the U.S. oil and natural gas sector was an engine driving job growth. Eight percent of the U.S. economy is supported by the energy sector, the industry’s lobbying group said, up from the 7.7 percent recorded the last time the API examined the issue. The employment assessment came as the Energy Department said oil and gas production continued to make gains across the board. With the right energy policies in place, API said the economy could grow even more. But with oil and gas production already at record levels, the narrative over the jobs prospects may be failing on its own accord…. The API’s report said each of the direct jobs in the oil and natural gas industry translated to 2.8 jobs in other sectors of the U.S. economy. That in turn translates to a total impact on U.S. gross domestic product of $1.2 trillion, the study found.
According to a new study, investments in oil and gas exploration and production generate substantial economic gains, as well as other benefits such as increased energy independence. The Perryman Group estimates that the industry as a whole generates an economic stimulus of almost $1.2 trillion in gross product each year, as well as more than 9.3 million permanent jobs across the nation.
The ripple effects are everywhere. If you think about the role of oil in your life, it is not only the primary source of many of our fuels, but is also critical to our lubricants, chemicals, synthetic fibers, pharmaceuticals, plastics, and many other items we come into contact with every day. The industry supports almost 1.3 million jobs in manufacturing alone and is responsible for almost $1.2 trillion in annual gross domestic product. If you think about the law, accounting, and engineering firms that serve the industry, the pipe, drilling equipment, and other manufactured goods that it requires, and the large payrolls and their effects on consumer spending, you will begin to get a picture of the enormity of the industry.
Another way of visualizing the impact of the shale industry on the US economy comes courtesy of this chart from the Manhattan Institute which really needs no commentary:
The Institute had this commentary to add:
The jobs recovery since the 2008 recession has been the slowest of any post recession recovery in the U.S. since World War II. The number of people employed has yet to return to the 2007 level. The country has suffered a deeper and longer-lasting period of job loss than has followed any of the ten other recessions since 1945.
There has, however, been one employment bright spot: jobs in America’s oil & gas sector and related industries. Since 2003, more than 400,000 jobs have been created in the direct production of oil & gas and some 2 million more in indirect employment in industries such as transportation, construction, and information services associated with finding, transporting, and storing fuels from the new shale bounty.
In addition, America is seeing revitalized growth and jobs in previously stagnant sectors of the economy, from chemicals production and manufacturing to steel and even textiles because of access to lower cost and reliable energy.
The surge in American oil & gas production has become reasonably well-known; far less appreciated are two key features, which are the focus of this paper: the widespread geographic dispersion of the jobs created; and the fact that the majority of the jobs have been created not in the ranks of the Big Oil companies but in small businesses, even more widely dispersed.
Fast forward to today when we are about to learn that Newton’s third law of Keynesian economics states that every boom, has an equal and opposite bust.
Which brings us to Texas, the one state that more than any other, has benefited over the past 5 years from the Shale miracle. And now with crude sinking by the day, it is time to unwind all those gains, and give back all those jobs. Did we mention: highly compensated, very well-paying jobs, not the restaurant, clerical, waiter, retail, part-time minimum-wage jobs the “recovery” has been flooded with.
Here is JPM’s Michael Feroli explaining why Houston suddenly has a very big problem.
In less than five years Texas’ share of US oil production has gone from around 25% to over 40%
By some measures, the oil intensity of the Texas economy looks similar to what it was in the mid-1980s
The 1986 collapse in oil prices led to a painful regional recession in Texas
While the rest of the country looks to benefit from cheap oil, Texas could be headed for recession
The collapse in oil prices will create winners and losers, both globally and here in the US. While we expect the country, overall, will be a net beneficiary from falling oil prices, two states look like they will bear the brunt of the pain: North Dakota and Texas. Given its much larger size, the prospect of a recession in Texas could have some broader reverberations.
By now, most people are familiar with the growth of the fossil fuel industry in places like Pennsylvania and Ohio. However, that has primarily been a natural gas story. The renaissance of US crude oil production has been much more concentrated: over 90% of the growth in the past five years has been in North Dakota and Texas; with Texas alone accounting for 67% of the increase in the nation’s crude output over that period.
In the first half of 1986, crude oil prices fell just over 50%. At the end of 1985, the unemployment rate in Texas was equal to that in the nation as a whole; at the end of 1986 it was 2.6%- points higher than the national rate. There are some reasons to think that it may not be as bad this time around, but there are even better reasons not to be complacent about the risk of a regional recession in Texas.
Geography of a boom
The well-known energy renaissance in the US has occurred in both the oil and natural gas sectors. Some states that are huge natural gas producers have limited oil production: Pennsylvania is the second largest gas producing state but 19th largest oil producer. The converse is also true: North Dakota is the second largest crude producer but 14th largest gas producer. However, most of the economic data as it relates to the energy sector, employment, GDP, etc, often lump together the oil and gas extraction industries. Yet oil prices have collapsed while natural gas prices have held fairly steady. To understand who is vulnerable to the decline in oil prices specifically we turn to the EIA’s state-level crude oil production data.
The first point, mentioned at the outset, is that Texas, already a giant, has become a behemoth crude producer in the past few years, and now accounts for over 40% of US production. However, there are a few states for which oil is a relatively larger sector (as measured by crude production relative to Gross State Product): North Dakota, Alaska, Wyoming, and New Mexico. For two other states, Oklahoma and Montana, crude production is important, though somewhat less so than for Texas. Note, however, that these are all pretty small states: the four states where oil is more important to the local economy than Texas have a combined GSP that is only 16% of the Texas GSP. Finally, there is one large oil producer, California, which is dwarfed by such a huge economy that its oil intensity is actually below the national average, and we would expect it, like the country as a whole, to benefit from lower oil prices.
Texas-sized challenges
As discussed above, Texas is unique in the country as a huge economy and a huge oil producer. When thinking about the challenges facing the Texas economy in 2015 it may be useful, as a starting point, to begin with the oil price collapse of 1986. Then, like now, crude oil prices collapsed around 50% in the space of a few short months. As noted in the introduction, the labor market response was severe and swift, with the Texas unemployment rate rising 2.0%-points in the first three months of 1986 alone. Following the hit to the labor market, the real estate market suffered a longer, slower, burn, and by the end of 1988 Texas house prices were down over 14% from their peak in early 1986 (over the same period national house prices were up just over 14%). The last act of this tragedy was a banking crisis, as several hundred Texas banks failed, with peak failures occurring in 1988 and 1989.
How appropriate is it to compare the challenges Texas faces today to the ones they faced in 1986? The natural place to begin is by getting a sense of the relative energy industry intensity of Texas today versus 1986. Unfortunately, the GSP-by-industry data have a definitional break in 1997, but splicing the data would suggest a similar share of the oil and gas sector in Texas GSP now and in 1985: around 11%. Employment in the mining and logging sector (which, in Texas, is overwhelmingly dominated by the oil and gas sector) was around 3.7% in 1985 and is 2.7% now. This is consistent with a point we have been making in the national context: the oil and gas sector is very capital-intensive, and increasingly so. Even so, as the 1986 episode demonstrated, there do seem to be sizable multiplier effects on non-energy employment. Finally, there does not exist capital spending by state data, but at the national level we can see the flip side of the increasing capital intensive nature of energy: oil and gas related cap-ex was 0.58% of GDP in 4Q85, and is 0.98% of GDP now.
Given this, what is the case for arguing that this time is different, and the impact will be smaller than in 1986? One is that now, unlike in 1986, natural gas prices haven’t moved down in sympathy with crude oil prices, and the Texas recession in 1986 may have owed in part also to the decline in gas prices. Another is that, as noted above, the employment share is somewhat lower, and thus the income hit will be felt more by capital-holders – i.e. investors around the country and the world. Finally, unlike 1986, the energy industry is experiencing rapid technological gains, pushing down the energy extraction cost curve.
While these are all valid, they are not so strong as to signal smooth sailing for the Texas economy. Financially, oil is a fair bit more important than gas for Texas, both now and in 1986, with a dollar value two to three times as large. Moreover, while energy employment may be somewhat smaller now, we are not talking about night and day. The current share is about 3/4ths what it was in 1986. (Given the higher capital intensity, there are some reasons to think employment may be greater now in sectors outside the traditional oil and gas sectors, such as pipeline and heavy engineering construction).
As we weigh the evidence, we think Texas will, at the least, have a rough 2015 ahead, and is at risk of slipping into a regional recession. Such an outcome could bring with it the usual collateral damage that occurs in a slowdown. Housing markets have been hot in Texas. Although affordability in Texas looks good compared to the national average, it always does; compared to its own history, housing in some major Texas metro areas looks quite dear, suggesting a risk of a pull-back in the real estate market.
The national economy performed quite well in 1986, in spite of the Texas recession. We expect the US economy will perform well next year too , though some regions – most notably Texas – could significantly under perform the national average.
* * *
So perhaps it is finally time to add that footnote to the “unambiguously good” qualified when pundits describe the oil crash: it may be good for everyone… except Texas which is about to enter a recession. And then Pennsylvania. And then North Dakota. And then Colorado. And then West Virginia. And then Alaska. And then Wyoming. And then Oklahoma. And then Montana, and so on, until finally we find just where the new equilibrium is following the exodus of hundreds of thousands of the best-paying jobs created during the “recovery” offset by minimum-wage waiters, bartenders, retail workers and temps.
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