Monday, December 29, 2014

Dont celebrate the low oil prices yet

When the Organization of Petroleum Exporting Countries failed to cut production quotas last month, the initial investor reaction was: Hallelujah! Lots more savings for energy buyers! Blowout Christmas spending by consumers!

The celebrations may have been premature. True, the $1 decline in U.S. gasoline prices since April is the equivalent of a 1 percent rise in consumer spending power. Of course, some of that may be saved and not spent, at least initially. And in countries with fixed fuel taxes, including China, the economic effect will be greater. At the same time, U.S. auto makers may benefit from increased sales of low-mileage SUVs and light trucks, which are highly profitable.

Net energy importers, including Japan, South Korea and other East Asian countries, also benefit from lower energy prices. China imports 60 percent of the 9.6 million barrels of oil it uses each day.

Other energy importers helped by lower prices include India, Turkey and Western Europe. Pakistan, Egypt, India and other countries that subsidize energy costs will be able to reduce those expenses. Some of the benefit, though, is offset because the euro and other currencies are weak and oil is priced in more expensive U.S. dollars.

But the list of oil losers may overpower the winners. Almost immediately, energy companies started to cut capital spending, which equaled 0.9 percent of U.S. gross domestic product in 2013, the largest share since the early 1980s. An index of oil-field service companies is down about 40 percent from its peak.

Also harmed are oil-sands producers in Canada, where a lack of transportation had pushed prices to $48 a barrel by late November, well below all-in production costs of about $85. Canadian Oil Sands, the largest owner of the giant Syncrude oil sands joint venture, plans to cut its dividend by almost half.

Also vulnerable are highly leveraged North American oil and gas producers. The 10 worst-performing energy companies in the Russell 3000 index have debt that is four times their market value. By comparison, the energy sector's average is 1.2 times.

Energy companies issued junk debt with abandon in recent years. Strained financial conditions may force weak energy producers and service companies to divest properties or sell themselves, yet buyers are likely to be scarce until energy prices stabilize. Many low-quality master limited partnerships in the energy area could be in trouble.

The weakness in junk bonds is spreading beyond energy-related issues as scared investors retreat. Since June, they have pulled $22 billion from junk-bond funds as they begin to realize they were further out on the risk curve than they wanted.

Also, post-financial crisis regulations are limiting banks' involvement in junk-security markets, removing their cushioning effect as providers of liquidity. Ditto for leveraged loans that banks often make to finance private-equity deals (and the subject of considerable worry at the Federal Reserve).

Overseas, grossly mismanaged oil producers, including Venezuela and Nigeria, are obviously in trouble. They need prices well above $100 a barrel to meet budget needs.

Russia, of course, is the poster boy for troubled oil exporters. Even before Russia's central bank raised interest rates to 17 percent from 10.5 percent on Dec. 16, it said the economy could contract by as much as 4.7 percent next year if oil remained near $60.
Russia's Putin with Obama
I've been looking for an economic shock to end the disconnect between soaring equity prices (fueled by central bank largesse) and limping economies. Since the 2008 financial crisis, central bank money has encouraged individuals, businesses and countries to borrow at low rates. The nosedive in oil and other commodity prices makes it hard to pay back those loans as deflation spreads worldwide and almost every currency declines against the U.S. dollar.

The U.S. stock market, while pointing up now, may yet have a negative response to declining energy costs, suggesting that the financial risks from falling oil prices may outweigh the benefits to consumers.

If a full-blown global financial crisis unfolds, along with an accompanying worldwide recession, investment strategy will no doubt shift from the current "risk on" stance to "risk off." In that scenario, you would expect to see a rush into the safety of Treasury bonds and the U.S. dollar and a stampede out of commodities and stocks globally.

Interestingly, most of this is already in tow. Treasuries are rallying as Americans and foreigners pour in; yields recently hit 2014 lows. The dollar has been robust against the deliberately devalued yen and euro, as well as the currencies of commodity exporters Australia, New Zealand, Canada and Russia. And commodity prices, from oil to copper to sugar, are falling.

Only stocks remain to turn down decisively, and even that could change if oil prices keep sinking.

Monday, December 22, 2014

Oil prices could go lower than expected

When the U.S. Federal Reserve ended its quantitative-easing program in October, it also ended the primary driver of U.S. stocks during the past six years. So long as the central bank kept flooding the markets with money, investors had little reason to worry about a broader economy limping along at 2 percent real growth. 

Now investors face more volatile markets and securities that no longer move in lock-step. At the same time, investors must cope with slower growth in China, minuscule growth in the euro area and negative growth in Japan. 

Such widespread sluggish demand -- along with ample supplies of oil and most everything else -- is the reason commodity prices are falling. They have been since early 2011, but many people failed to notice until recently, when crude oil prices nosedived. 

Normally, less demand and a supply glut would lead the Organization of Petroleum Exporting Countries, beginning with Saudi Arabia, to cut production. As the de facto cartel leader, the Saudis would often reduce output to prevent supply increases from driving down prices. 

Of course, this also cost the Saudis market share and encouraged cheating by OPEC members. Saudi leaders must grind their teeth over the last decade's unchanged demand for OPEC oil, while all the global growth has been among non-OPEC suppliers, principally in North America. 

That may explain why, while Americans were enjoying their Thanksgiving turkeys, OPEC surprised the world. Pressed by the Saudis and other rich Persian Gulf producers, it refused to cut output despite a 38 percent drop in the price of Brent crude, the global benchmark, since June.  

OPEC, in effect, is challenging other producers to a game of chicken. Sure, the wealthier producers need almost $100 a barrel to finance bloated budgets. But they also have huge cash reserves, which they figure will outlast the cheaters and the U.S. shale-oil producers when prices are low. 

The Saudis also seized the opportunity to damage their opponents, especially Iran and what they see as Iran-dominated Iraq, in the Syria conflict. They also want to help allies Egypt and Pakistan reduce expensive energy subsidies as prices fall. 

Then there’s Russia, another Saudi opponent in Syria, with its dependence on oil exports to finance imports and 42 percent of government outlays. With the ruble collapsing, the Russian central bank let the currency float in November after blowing through $75 billion to support it. Then the central bank tried to stop the free fall by raising interest rates by 6.5 percentage points to 17 percent on Dec. 15.  

Still, the Russian currency is floundering, along with the economy. Consumer prices in Russia rose 9.1 percent in November from a year earlier. The economy will be in recession next year, the website of the Russian economy ministry acknowledged for a few hours on Dec. 2, before the posting was deleted. 

Venezuela is also suffering. The government needs $125-a-barrel oil to cover its spending, of which 65 percent depends on oil exports. Its crude production is down a third since 2000. With inflation raging, the bolivar officially sells for 6.29 a dollar, but for 180 on the black market. 

In Nigeria, where oil and natural gas account for 80 percent of government revenue and almost all its exports, the Naira has fallen 11 percent versus the greenback so far this year. 

How low can oil prices go? In the current price war, the global market price needed to support government budgets isn't really the main issue. Nor are the total costs for exploration, drilling and transportation.  

What matters are marginal costs -- the expense of retrieving oil once the holes have been drilled and pipelines laid. That number is more like $10 to $20 a barrel in the Persian Gulf, and about the same for U.S. shale-oil producers. The estimated $50 to $69 a barrel break-even point for most new U.S. shale-oil production is less relevant.  

Developing countries that depend on commodity exports for hard currencies to service foreign debt will produce and export even at prices below their marginal cost. Until some major producer chickens out and cuts production, oil prices should remain low. 

They could decline a lot more than the 50 percent drop so far. 

Monday, December 8, 2014

Gary Shilling explains why currency differences dont make much difference to consumers

You might expect a strengthening dollar to depress U.S. economic growth by encouraging cheaper imports and reducing more expensive exports, but the actual effects are small, as are the resulting deflationary pressures. When a currency strengthens, exporters don’t pass on the cost to buyers but shave their profit margins to avoid losing sales.  

Conversely, importers don’t pass all of the currency's rise onto customers, and instead fatten their profit margins. These actions explain why import-price volatility is only about a third the volatility of a currency. 

Instead, the principal force affecting imports and exports is economic growth. When an economy is growing, consumers and businesses buy more of everything, especially imported products. The correlation between U.S. imports and the dollar is weak, but the relationship between imports and GDP is strong. My firm’s statistical models show that imports rise 2.8 percent for each 1 percent rise in GDP, but fall only 0.1 percent for each 1 percent rise in the dollar.  

Wednesday, December 3, 2014

King Dollar is here to stay


China wants the yuan to be a global currency but not at the expense of tight government control. 

Earlier suggestions that the euro might rival the dollar have been replaced by worries over whether the Teutonic North and the Club Med South can remain under one currency. There is no common fiscal policy in the euro zone and none is likely, considering the region's vast cultural and economic differences. 

The Japanese government is taking small steps toward globalizing the yen, but fundamentally doesn't want the yen to be an international currency. 

The dollar has been the primary trading and reserve currency since World War II and is likely to remain so for decades. Rapid growth in the economy and per-capita output weigh in the dollar’s favor. American financial markets are broad, deep and transparent, as is the economy. Despite the dollar's decline since 1985, its credibility is substantial.  And there is no real substitute for the dollar as a global currency. 

Monday, December 1, 2014

US Dollar looking good both short and long term


The forces pushing up the dollar are likely to persist in the short run. Among them are deliberate devaluations of the euro and yen, weakness in commodity-driven currencies, slower growth in China, the carry trade, the dollar’s safe-haven appeal and developing-economy woes.  

The greenback is also likely to remain strong in the long run. To put it into perspective, the dollar reached a peak against major currencies in 1985, then slid 52 percentage points over the next 25 years. It's been rising since August 2011, yet has recovered only 8 percentage points of that 52-point slide. 

Of course, there’s no assurance that the dollar will regain its 1985 peak, yet there are concrete reasons to expect it to remain strong over the long haul.