Oil Falls Over 5%

The main reason why the stock market fell Wednesday was because of a 5.38% decline in WTI oil. My prediction for oil prices to fall because of a high amount levered long trades and high inventory levels finally began to come true. My thesis has been that oil prices falling to the high $30s would hurt energy firms’ profits. Since energy earnings are expected to grow the fastest out of any sector, by far, if growth misses expectations significantly, aggregate S&P 500 earnings will fall. This will cause the stock market’s multiple to shrink less than expected; the multiple is very high making the market need accelerated earnings growth to sustain itself. Regulatory cuts brought about by the Trump administration cannot save energy companies from falling crude prices.

Before I get into discussing oil prices, I will show you one other thing which isn’t sustaining itself. Global credit impulses are falling on a year over year basis because Chinese banks can’t sustain the pace of credit creation they have been on. Without Chinese credit creation, the global economy must rely on productivity and population growth to improve its GDP. The largest credit expansion as a percent of global GDP in, at least, the past 24 years has ended. This does have some relation to oil prices since tightening credit conditions could cause China’s demand for oil to fall.

As I said, oil prices fell over 5% on Wednesday. This crash was the largest percentage drop since February 2016. With energy traders all piling into long positions, the only thing needed to spark a crash was a catalyst. The catalyst was the U.S. Energy Information Administration’s report which showed oil stockpiles increasing by 8.2 million barrels to a record high. The increase was over 4 times the increase expected by analysts. As you can see from the chart below, the spread between oil inventories and the 5-year average is elevated. The last time inventories rose, there was a major price correction. Even though prices fell which caused production to slow, the inventory levels never got back what they were at in 2013.

U.S. oil production hit 9.1 million barrels per day which is the highest in over a year. As you can see from the chart below, the rig count bottomed about 12 months ago and production started growing soon afterwards. Growth in U.S. production is happening faster than OPEC would like. It counteracts any of the cuts made to boost prices. OPEC no longer controls the oil market because it wants oil prices to be higher than what American firms are willing to produce it at.

Adding to the negative pressure that the supply glut had on oil prices is the strengthening dollar. The dollar is up because the Fed is expected to hike rates in March which will start its goal of raising rates 3 times this year. The dollar index is $102.20 which is $1.60 below the high made in December. The chart below shows the recent divergence between oil and the dollar, before the price crash on Wednesday March 8th. It shows how the dollar had been pushing oil lower. A higher dollar will also crimp multinational’s profits, further supporting my prediction that S&P 500 earnings will come in lower than the 9.8% growth which is currently expected.

As I said, OPEC’s production cuts are trying to boost oil prices. From January to May 25th, OPEC nations have agreed to a cut of 1.8 million barrels of oil production per day. The UAE oil minister said the decision about whether to extend the oil production cuts will depend on the price of oil, the stockpile of oil in America, and the response shale producers have. The problem which could arise is if oil prices fall and shale producers increase production. In response to this possibility the Saudi oil minister stated the production cuts would occur for a "restricted period of time" and OPEC has no plans to "underwrite the investments of others at our own expense and long-term interests.” Saudi Arabia is providing most of the cuts and Iraq appears to be cheating. This makes this statement important. Saudi Arabia doesn’t want to cut production and have low oil prices; that would be the worst of both worlds.

Besides the decision of whether to continue the production in May, the other aspect OPEC must deal with is its members cheating by producing more than their quotas. Shale production in America has weakened OPEC’s power over oil prices; it can give it a death knell if it causes oil prices to fall so low that OPEC firms must cheat to make up for the lost revenues. If OPEC buckles to its knees, oil prices will fall precipitously.

The final chart I have below shows oil’s contango and backwardation levels. Contango is when oil prices in the future are higher than the spot price and backwardation is when future contracts are priced lower than the spot price. When contango has occurred, it has been bullish for oil prices and when backwardation has occurred, it has been bearish for oil prices. Lately the amount of contango has shrunk to near nothing which signals the bullish trend in prices may be near its end. If prices move higher, backwardation will likely occur which would be a bearish signal. One other point worth noting is many traders purchased 1 year leases on oil storage last year. This oil is now flooding the market as it doesn’t make sense to renew that lease now that the contango barely exists.

Conclusion

There are three bearish indicators for stocks waving red flags. The Chinese banks are slowing the credit spigot, the dollar index is rising, and oil prices are falling. If the Fed raises rates 3 times this year, the dollar will break past its 52-week high it made in December. The real data shows the economy is slowing as Q1 GDP growth is expected to be below 2%. Slower economic growth would hurt demand for oil, sending it lower. As I mentioned, cuts to energy regulations will lower costs for oil firms, but it won’t make up for oil prices declining into the $30s.

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