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My opinion on energy and economy: a dime a dozen December 17, 2015

Posted by hslu in Economics, Energy, Global Affair, Oil.
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A friend in Dallas asked for my opinion about the current state of the energy and stock markets in light of market’s expectation of Feds’ decision to raise the federal funds rate by ¼ of a point. Since opinion is cheap and it didn’t cost me any to express mine, I offered the following a few days ago:

 

There are several time bombs which might make the market ill prepared for the consequence when one or two explode in our faces:

 

  1.    China slowing down resulted in big turmoil in all commodity markets. Many countries which depend on a booming commodity market for growth and spending; all OPEC nations, Canada, Australia and Russia, are facing an uncertain future. Economies will no doubt slow down in these countries. Nations’ wealth will suffer too. This is bad for the growth of world GDP. I am actually not worried about China because China’s economy needs to slow down and the Chinese government is doing something to slow it down. Transformation of Chinese economy has to be done otherwise China will be stuck in the middle class trap. No country in the world can grow at 6 or 7% per year, not to mention 9 to 12%, into infinity and I won’t be surprised if China eventually slows down to 3 to 4% level when China’s economy becomes large. The effect of a 3 or 4% growth with a larger economy will equal to that of a 5 or 6% growth out of a smaller economy. The rate of growth isn’t important. It is the net growth of economic activities that’s crucial in the future. Besides, inflation at a higher economic growth rate is more difficult to control. A growth rate slightly higher than the natural inflation rate, many at the Fed, ECB and BoJ are talking about 2%, would be idea.

 

  1.    The energy market is causing a lot of hemorrhage all over the world. I said it before and I will repeat it now: Saudi has done it multiple times in the past and Saudi can take it. Saudi’s national debt is only 10% of its GDP. All banks will rush to Saudi’s front door and ask Saudi to take their money because Saudi can pay the loan easily. Saudi has 250 billion barrels of oil reserve in the ground. Some say that Saudi can produce its oil at $5 per barrel. Frankly, Saudi is still making money hand over fist. They lowered the oil price to kill shale oil producers in the US. And Saudi is doing a very good job. Russia is taking lower oil price in stride as well. Yes, oil price is lower by a lot. But Russia’s oil export volume hasn’t changed.

 

Russia’s oil export in US dollar terms is lower. But Ruble has dropped by a large amount since the financial crisis. In the end, Russia doesn’t suffer that much in Ruble terms. Don’t forget, Russia can produce its oil at $15/bbl from existing wells. US shale oil companies’ cost is anywhere from $40 to $80 per barrel. There is simply no comparison here. The talk of US will eventually be the largest oil producer in the world a few months ago has disappeared as fast as spring snow on the ground: 曇花一現。Shale oil production in the US will never come back as fast as it did since 2005 and 2006 because Saudi is watching and bank will not lend.

 

You don’t need me to tell you how bad the stock prices are for almost all domestic shale oil producers. These oil producers have to borrow money at 8, 9, 10 or 12% to drill and drill in order to replace their lost productivity. These oil producers have hedged their oil price to a higher level in 2014. As a result, the financial report from these companies isn’t really bad in 2015. These hedges are finishing in the 4th QTR of 2015 and, with WTI settling at around $40/bbl, the financial reports of these companies will be terrible going into 2016 and beyond. The oil in the ground, which these companies used as collateral, becomes less valuable. If these companies don’t have extra credit line waiting in the wing, the loans may be called. With declining oil prices, this equals to death knell for these shale oil companies. Several companies are standing right in front of the gate to hell right now.

 

I have said that Saudi will not back down and they have doubled it down and removed the quota from OPEC production limit. Price will collapse as it is happening now. All oil companies, including ExxonMobil, Shell, Texaco, ConocoPhillips, Total, etc. will suffer mightily. All have cut their capital spending way back to offset the lower oil prices. The next step is to cut back their dividends followed by laying off people. What follow are mergers and take overs. Then there will be more layoffs to reduce redundancy. By that time, capital spending has cut back to the level that production will not be able to meet demand (low oil price is good for economy growth.) Saudi will cut its production to pop up oil price. Price will recover because of market force and Saudi’s action. Saudi will gradually reduce its production further to balance the demand and supply. Saudi accomplishes its objective: regaining market shares. Price will recover. Many shale oil companies will disappear, the new companies will take this slowly and the market will go back to normal. This will take four, five, six or ten years. We are only in the second year. There are a few more years to go yet but no one knows when. I have sold all my energy stocks because I didn’t like what I saw. I will wait for the scenarios to play out before I go back to bottom fishing for yields and future returns.

 

  1.    The Fed is expected to raise the federal funds rate this week. Once the Fed starts to raise the short-term interest rate, it will rush the US and world economies and financial markets into a new era. I don’t think the Fed will stop at just one interest rate hike because the Fed wants some cushion room (i.e., a few rate hikes) to be able to fend off another financial crisis which may be lurking just around the corner. Let me ask you this: do you think Europe is ready to take a rate hike in the largest economy in the world? The answer is of course a resounding “NO.” Take a look of Taiwan. Taipei’s real estate market rose 3.46 times (something like this. Don’t quote me) over the last three years. Many other countries saw similar rises. In Taiwan, many if not all mortgages have floating rates because first time buyers couldn’t afford a much higher 30-year fixed rate. The negative impact of higher interest rates on the real estate market all over the world will be obvious. Many commodity dominated countries are in the same boat. They are ill prepared to take a higher interest rate.

 

  1. The high yield market, those with 6, 7, 8, 10% or higher interest rates, is collapsing under the weight of Fed’s interesting rate hike. Bankruptcies will happen. Takeover will accelerate. Junk bond market will implode. Many hedge funds have stopped clients’ withdraw of their investment funds in the junk bond market because as many wealthy and not so wealthy people try to get out of this narrower and narrower door, junk bond price will drop to an unspeakable level. The effects will be devastating. The energy companies account for about 15% of the junk bond market.

 

  1.    The US is facing a higher rate environment but central banks all over the world are printing money as fast as they can as if a competition for the first place is going on right now. US dollar will strengthen due to a perception of higher interest rate in the future. Many emerging countries’ currency will not be able to keep their values against the US dollar. If a country has borrowed too much US dollar denominated loans when interest rate was low, it may have trouble paying the loans back when rate is getting higher. Its currency will drop in value. Inflation will spike. Interest rate will follow. Economy will tank. Real estate market will collapse. Living standard will suffer. Country may bankrupt because no bank will lend to this poor country so that they can’t pay back their US dollar denominated loans. We might have another financial crisis as fast as we can write it down on a piece of paper.

 

  1.    Division of rich and poor has reached unprecedented level in many countries in the world. The risk of civil unrest, like those happened in Taiwan and Hong Kong, may be a common scene soon. The result is capital flight, stagnation of local economy, depreciation of currency and inefficient government.

 

  1. Then, we have rising geopolitical unrest to deal with. The market has more or less ignored the geopolitical risk since Hillary and Obama abandoned Qadhafi which led to his death, the revival of al Qaeda, eventual birth of ISIS, terrorist incidents all over the world and millions of Syrian immigrants evading certain deaths to Europe, England and other western countries. No one knows what’s going to happen next. Many dictatorship countries in the Middle Eastern might be in danger of losing their strong hold of their countries. If this happens, it will certainly be qualified as a black swan event for sure. The market will crush and gold price will soar.

 

Now, Google 1994 bond and stock markets and you’ll see the bond market was under a lot of pressure from Feds’ rate hike and the stock market suffered some loss too. Other research pointed out that the first-rate hike hasn’t been a major market mover and market usually will recover from the initial shock. But, I rather wait on the side line and look for opportunities when the market presents itself.

 

I do not know when it will happen but I will be watching. I will stay away from high yield bond market now. The next run of stock buying will be energy stocks with good dividend yields because oil price will for sure closer to the bottom than to the top. Once the round of dividend cutting is over and once the oil price is staying at the bottom of the U long enough, the next move on oil will be up.

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