Crude Oil in Record Setting Plunge.
Just two weeks ago, a barrel of West Texas Intermediate Crude Oil (WTIC) fetched $75, a new multi-year high. Today, that same barrel trades at just above $55, a loss of 27%. This price collapse in Oil was the largest in that short of a time period in history. What does it mean?
Crude Oil prices are the result of the forces of supply and demand. Large, sudden changes in supply are historically very rare. A new oil discovery usually takes several YEARS before any of that oil becomes available. Recently though, the shale boom has brought on line 5 Million barrels per day for the United States since 2010.
The United States is now the world’s leading crude producer. It has just surpassed both Russia and Saudi Arabia, which produce roughly 11 million barrels per day each. Domestic production is projected to rise to 14 million barrels a day by 2020.
This additional supply of oil, (from shale), in such a short period of time is unprecedented. By comparison, conventional oil fields are only able to increase production very gradually over many years.
Prudhoe Bay in Alaska remains the LARGEST commercial discovery. Containing an estimated 25 Billion Barrels of Oil, Prudhoe Bay began producing in 1977, 10 years after it was found. At its peak, Prudhoe Bay produced, in contrast to shale, only 1.5 million barrels per day and is now down to under 300,000 (https://en.wikipedia.org/wiki/Prudhoe_Bay_Oil_Field).
Economic cheerleaders point to the burgeoning supply of Shale for the price collapse, rather than falling demand.
Is Exploding Supply or Vanishing Demand Responsible?
Supply is said to be “inelastic”, or “not very responsive” to changes in price. Changes in supply in the near term are limited to measures such as drawing from or adding to storage. As prices rise, new wells get drilled, but it takes years before they become part of the world supply.
If prices decline sufficiently, marginal wells become uneconomic and are shut in. Or, alternatively, tankers of undelivered oil become floating storage. This floating storage is unloaded when conditions improve.
Demand, too, is said to be inelastic, especially in the short run. No matter how high prices go, the resulting reduction in demand will be fairly small. Over time, new energy saving technologies are adopted such as increased fuel mileage of the car fleet.
Currently, the world production of oil is about 81 Million barrels per day (https://en.wikipedia.org/wiki/List_of_countries_by_oil_production). Of the top producers, the United States has added 5 million per day since 2010. Russia has added 5 million since 2000. Saudi Arabia has added 2 million, Iran 2 million, and even China has added to production. Even if US. Production meets or exceed projections, it will still account for less than 20% of the World.
Despite all the increases in production, a growing economy could easily absorb the increase in supply. But, not now? And, all of a sudden, in the last two weeks?
Robust US Growth AND Plunging Oil Demand?
United States GDP growth has been reported to be very solid in the last 2 quarters. According to the Bureau of Economic Analysis (BEA), GDP for the 2nd and 3rd quarter were reported to be 3.5% and 4.2%. These are the highest back-to-back numbers in more than a decade (https://www.bea.gov/news/glance).
Clearly, the reportedly strong US economic growth and precipitous fall in crude oil prices don’t mesh.
While Crude has crashed, so have the commodity indexes. The Goldman, Sachs Commodity Index (GSG) briefly looked like it was breaking out to new highs and is suddenly close to multi-year lows. The strong Dollar (USD) is suggestive of some DEFLATIONARY, not inflationary winds. None of these are consistent with strong growth.
Precious Metals Continue to Sputter.
Weakness in Gold and Silver has been pronounced. Both are threatening to make new multi-year lows. Similarly, the Gold and Silver Miners (GDXJ) are at or near new lows.
Precious metals are FAR more consistent with the prospect of economic weakness not strength.
James Cramer, high profile analyst for CNBC, was interviewed Friday, November 16th. He gained a great deal of notoriety with a now famous “rant” in 2008. Cramer blamed the Federal Reserve for failing to anticipate the 2008-9 financial debacle. He has been proven right.
Cramer sees much of the same today. He observes that signs of inflation are not evident in the markets. (We discussed some of these issues in our piece: “Peekaboo Inflation” https://markonomics101.com/2018/11/05/peekaboo-inflation-now-you-see-it-now-you-dont/).
Cramer says that he is having numerous “off-the-record” conversations with CEO’s of companies about the economy. They are telling him of a very rapid slowing. The CEO’s blame the effects of higher interest rates and TARIFFS for the sudden, sharp slowdown (https://www.cnbc.com/2018/11/15/cramer-says-ceos-are-telling-him-off-the-record-the-economy-has-cooled.html).
For more on the effect of Tariffs, see “Trade Wars, Elections, and Stock Markets” (https://markonomics101.com/2018/11/07/trade-wars-elections-and-stock-markets/) and “Can Anyone Win A Trade War?” (https://markonomics101.com/2018/07/09/can-anyone-win-a-trade-war/).
Jim Cramer’s evidence may be anecdotal, but not without much corroboration.
General Electric Blows A Fuse.
For most of the last decade, GE was top dog in market capitalization, peaking at nearly $400 Billion.
It was highly profitable, had consistent earnings, highly respected management, a generous dividend, and growth opportunities from its financial arm, GE Capital.
At one time, GE was one, of a select few, whose debt drew a AAA rating. Since then, it has been downgraded to BBB+.
GE’s $115 Billion of outstanding bonds now trade at levels equivalent to those associated with “junk” bonds (https://www.cnbc.com/amp/2018/11/16/ge-once-elite-is-now-fighting-to-avoid-becoming-a-junk-bond-name.html). In other words, the once mighty GE is considered a real bankruptcy risk. Investors anticipate further downgrades.
There is an argument that General Electric is an isolated event. However, this isn’t your grandfather’s light bulb company anymore.
GE is arguably one of the most diverse companies in both geography and businesses. Revenues are down, but still run $120 Billion per year. It still ranks roughly the size of General Motors. The company lost money in 2017 for the first time in decades (https://www.marketwatch.com/investing/stock/ge/financials).
GE may very well be an early warning signal. If the economy is truly strong, GE would not be in the middle of meltdown.
With GE threatening to be the largest “fallen angel” ever, the Junk Bond market shows extreme weakness. Junk Bonds are those of lesser credit quality than Investment Grade Bonds. Junk Bonds are also known as “High Yield” because they compensate the holder with a higher return for bearing greater credit or default risk.
“Fallen Angels” are those companies who once boasted excellent credit quality and were Investment Grade. They become fallen angels once they are downgraded to “Below Investment Grade” or Junk status. Investment Grade is defined at AAA, AA, A, and BBB. High Yield is BB, B, C, and D.
Corporate bonds are typically strong against the backdrop of non-inflationary economic growth.
While the Bureau of Labor Statistics and Bureau of Economic Analysis continue to release rosy reports, the various markets are showing structural weakness. Crude Oil, General Electric, and the High Yield bond market all are flashing Red.
The markets and economy are showing yet more signs of danger. More than ever, the best strategy is to “Be Informed, Not Misled”
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