I previously wrote about oil and the consumer as the twin engines of the economy in a recent post “Why I dumped all my holdings…”, noting both are sputtering.
Both engines are now in full fail mode, with consumer activity shrinking by the most in history, and oil experiencing its worst-ever decline with some parts of the futures curve in negative territory.
Quick note on negative oil: This is exactly what one should see in the oil market, and it is not surprising. There has been an unprecedented negative demand shock, which has led to output exceeding storage capacity. When that happens, an energy producer has three options: (1) Shutdown; (2) Burn the oil off, dump it in the ground or dispose with it, all of which will incur environmental costs; (3) Pay someone to take responsibility for it. Option 1 has not yet largely occurred because Energy and Production (E&P) companies are facing extreme balance sheet risk, and at this point, they are options on oil; if they shut down, they are just very likely bankrupt, whereas if they wait it out, maybe the price will rise and can stave off bankruptcy. Perverse incentives with shutdown economics only triggered by bankruptcy. We saw this in the coal sector a couple of years ago (perhaps the subject of a future post). Option 2 and Option 3 are related; if you have to pay to dispose of the oil, you might consider offering the oil for negative cost.
Technical note: The Monday decline to negative $37/bbl for West Texas Intermediate (WTI) was somewhat technical in nature, driven by contract expiration (beyond the scope of this post, see here for more details) and will not stay in such deep negative territory (the rest of the futures curve already reflects this).
But the point remains, oil is in dire straits, and we have not seen capitulation in the form of bankruptcies from E&P’s. First, we will see growth capex cut, then second we will likely see bankruptcies. This remains a massive headwind to the market.
Why this is a massive headwind to the market
As I wrote in a previous post, “The market is a feckless child…”, the market is ignoring very real problems in the economy and myopically rising on continued stimulus hopes and prospects for the economy to reopen. There is nothing like the shock factor of imminent bankruptcies to wake the market up.
Most importantly, the sharp decline in oil has massive knock-on ramifications for large portions of the US economy. It is not simply the case that oil is correlated with other sectors; it directly drives large portions of the economy as the US is net long oil and when production and spending slow, derivative sectors, such as industrials, will experience negative demand. And in the present climate where the consumer is absent, they are not experiencing the benefit in the form of lower input prices (usually a partial offset and a strong consumer compensated in 2015).
It’s not just Industrials; there are numerous ripple effects to many sectors. Rather than list them, here’s a look at the number of companies citing oil in their earnings calls over time. The dotted box shows the 2014/2015 period when oil fell from $100/bbl to $40/bbl. Notice the number of companies citing oil (for the most part as a headwind). That’s almost half of stocks in the S&P 500 off of which this study is based. Basically every sector showed an increase in this topic on the calls (exception being energy where it was unchanged as they always talk about oil).
As another confirmation of oils increasingly important role on the economy, correlations have generally fallen in recent years (which is not unusual in a rising market). But not for oil; oil’s correlation to various sectors has risen.
Things need to get worse before they get better
We likely need to see massive cutbacks in E&P capital expenditures to reduce supply, but that’s likely not enough. Bankruptices probably will occur, and demand needs to return and consumers need to spend, but that seems very far from happening. Remember, one clue to when this will happen is when school’s reopen, and that does not appear imminent. See the exhibit in “The market is a feckless child…” for a look at school closings nationally.
So if you haven’t yet evaluated if you can withstand a precipitous and long market drop before recovery and noted the unique challenges this market faces, now may be a good time. Here are some thoughts on that.