Cheap oil is a curse, and it's going to get worse

by David Nelson, CFA, chief strategist of Belpointe Asset Management

"It's deja vu all over again" - Yogi Berra

As early as Thanksgiving 2014, when Saudi Arabia announced to the world it would no longer be the world’s swing producer controlling the supply of crude, conversations started to emerge as to whether cheap oil would be a blessing or a curse.The knee-jerk reaction was that this was good news, and today consumers get that benefit every time they pull up to the pump.

 

But with each step lower in crude, a darker force  emerges. In the last year, oil and the stock markets have traded in lock step. With some analysts predicting the commodity could trade below $20, cheap oil has truly become the Black Swan event we all feared. 

 

Source: Bloomberg
Source: Bloomberg



On Thursday, with markets reeling, a single Tweet by a WSJ correspondent, "OPEC is ready to cooperate on a cut,” turned oil and stocks on a dime--both heading higher into the close. The rally continued Friday,as WTI Crude (CLH16.NYM) finished the day up more than 12%, dragging stocks up along with it.

 

I'll concede that Jamie Dimons purchase of 500,000 shares of JPMorgan (JPM) added to the euphoria, but the story begins and ends with oil.  We’ve heard these rumors before. Without Saudi Arabia on board, that’s just what they are--rumors. 

 

Source: Bloomberg
Source: Bloomberg

The Big Picture

Think about it. For the last 35 years, the world’s industrial complex has learned to live and profit from expensive oil. Now that model is upside down. They say technology is disruptive. What could be more disruptive than fracking, which has launched a world war for market share?

In a race to the bottom, the world’s producers are pumping as fast as they can. The more the price of the commodity falls, the more they have to pump to maintain cash flow. For many, it’s the difference between life and death. 

Past is prologue 


True bear markets usually have their roots in the credit markets. In 2008, it was the mortgage crisis. Over-leveraged banks and brokerage firms cracked as credit default swap spreads exploded on the heels of an implosion in the securitization of mortgage-backed securities. Here we areeight years later, and as the late Yogi Berra would say, “It’s deja vu all over again."


The last leg down for the markets has been led by the banks, notwithstanding the big financials rally Friday. Fears are starting to emerge that there are credit issues at some of the world’s largest financial institutions. 


We’ve known for some time that oil companies were at risk, and we’ve already seen our first wave of bankruptcies. About 16% of the high-yield market is made up of energy. Whenever there are problems in the debt markets, you can bet that banks aren’t far behind. 

 

Source: Bloomberg
Source: Bloomberg


There is even concern about sovereign nations. Sure, everyone knows Venezuela is looking into the abyss, but what about larger OPEC nations, like Saudi Arabia. You can see in the Credit Default Swap Curve comparison to a year ago that the cost of insuring its debt is rising. 

 

Source: Bloomberg
Source: Bloomberg



Large U.S. oil companies, such as Chevron (CVX) and Exxon (XOM), have seen their CDS spreads widen for some time.

 

Source: Bloomberg
Source: Bloomberg


Then there are the banks, which lend to these companies and nations. The cost of insuring even Bank of America (BAC) debt has risen dramatically in the last year.

Source: Bloomberg
Source: Bloomberg

Deutsche Bank’s (DB) spreads are exploding.

 

It’s difficult to say just how this will end. All the players are waiting for the other guys to blink, and at some point they will. The good news is that oil doesn’t have to climb dramatically to ease the situation. It just has to stop going down.