Oil and the U.S. Dollar
Is Oil Going Back to 50?
Is oil going back to $50? And what does the price of oil, now in the low $60s, portend for future production?
Those have been the foremost questions in my mind lately, and I hope to give you some reasonable answers by the end of this article. But before we get to that, we're going to have to take a little excursion into a world that few individual investors ever see: that of currency markets.
As I have frequently discussed in these pages, the price of oil is intimately tied to the valuation of the U.S. dollar. The two have had a very strong inverse correlation for a long time, which makes sense if you think about it: Since most of the global oil trade is priced in dollars, if the dollar loses value, the price of oil would have to rise just to preserve the value of the black stuff. Only the price of oil moves a lot more than the value of the dollar, as this chart from the beginning of 2007 to the present shows:
As we would expect, when oil fell off its mid-July peak, the dollar staged an impressive rally, appreciating 22% against the Euro and 15% against the yen.
But by rights, one would expect the dollar to be dragging the bottom after a stunning round of borrowing and dollar-printing by the Fed, in order to stave off the worst scenarios in the ongoing financial crisis. Printing money by the trillions ought to severely devalue the dollar. So what gives?
The rest of the world, that's what. As bad as the carnage on Wall Street has been, it has been far worse in the world's developing markets, which have suffered losses roughly half again as bad as ours:
Stock Market Change
Those developing economies were the darling of OECD investors in the first part of the year. Hundreds of billions of dollars from hedge funds, institutional investors and even sovereign wealth funds poured into the BRIC (Brazil Russia India China) economies, seeking outsized returns from the world's red-hot economies.
So when the subprime debacle started taking the legs out of the financial sector in mid-June, and the massive deleveraging process began, money rushed right back out of those economies, taking their stock markets down sharply.
Consider this: the world as a whole has lost roughly $29 trillion, or half of its equity market wealth, in the past year.
The currency contagion then spread to emerging market currencies, affecting Australia, New Zealand, Iceland, South Africa, Poland, South Korea, Hungary, Mexico, Turkey, Indonesia, Ukraine, Belarus, Pakistan, and Argentina...some of whom have already been forced to turn to the IMF for help.
This has left the US dollar and the Japanese yen among the world's two most desirable currencies, where borrowing rates are low and liquidity is high. The "yen carry trade," which has been lively for nearly two decades, is now being unwound, and all that money that was borrowed for next to nothing from Japan and invested elsewhere in the world is now coming back home, pushing up the value of the yen to levels not seen in years. The yen hit a 13-year high against the dollar at one point last week.
This has destroyed Japanese equities, since Japan's market relies so heavily on exports, which are now much more expensive. Japan's Nikkei Index has crashed from a historical peak of 40,000 to around 7,000, a decline of 83% to a 26-year low. Consider this: If the Dow Jones Industrial Average were to mimic that move, it would see 2,450...about a quarter of its present level.
As the declining currencies of the rest of the world push up the US dollar in relative terms, the price of oil has fallen accordingly. Indeed, the prices of nearly all fuels and commodities have been slashed by one-half or more in the past three months.
And it's not over yet. First we had the banking fallout from the subprime mess in the US, then in Europe. Then we saw the global credit derivative swap market fall apart and the massive deleveraging of huge funds, which in turn led to forced liquidations, driving the prices of commodities lower still. All of the above led to the current carnage in the currency markets. Next, as prices continue to recede, causing more hedge funds to go belly-up, we'll start to see another wave of liquidations from even deeper-pocketed players, like the sovereign wealth funds of the Middle East.
Last week, trading in shares of the Central Bank of Kuwait was suspended after one of its customers defaulted on a derivative contract, for a possible loss of $750 million. One contract, and it put the whole bank in limbo. The derivative was a bet on the euro, and it was destroyed when the euro fell against the dollar. Such losses only worsen the tightness of the credit markets.
Hoping to keep its own credit markets from seizing up, Saudi Arabia announced last week that it would designate a special $2.7 billion account to fund regular loans to citizens.
As oil prices fall, it puts even the Middle Eastern giants in jeopardy. Alert to the threat, OPEC announced a 1.5 million barrel per day cut in its official production targets last Friday, yet oil continued to go lower.
What this all points to is a vicious feedback loop. As emerging economies struggle with trade deficits and reduced liquidity, borrowing costs rise, leading to more credit defaults, higher interest rates, and even tighter credit, which in turn slows down growth even more, causing businesses to shrink, and their creditworthiness to be further impaired.
This feedback loop will continue to drive down the price of oil and other commodities for the near future. This is why I have been saying for roughly the last two months that the trade in energy and commodities is simply broken, having more to do with the mechanics of global big money flows than fundamental business considerations.
Lower US and European demand for Asian goods will continue to put the hurts on Asian economies. Depressed growth expectations for China and India will feed back to the US and Europe in the form of lower equity prices, particularly in energy and commodities.
The withdrawal of European investors from emerging markets will slow them down even more. European banks lent $3.5 trillion to these economies—roughly 7 times what the US lent—and accounted for three quarters of loans to China and India, according to Stephen Jen, chief currency strategist at Morgan Stanley in London.
The global credit markets have only just barely begun to thaw from their recent freeze. Earlier this week, the New York Times reported that a close reading of recent comments by Treasury Secretary Henry Paulson and other key banking officials and senators suggests that much of the $850 bailout package won't be used to buy out bad loans at all, but to recapitalize the banks and restructure the banking system.
Tight Credit Bullish
The banks' continued unwillingness to take on new loans, even after the Treasury injection, is beginning to bite into the daily movement of goods, with far-reaching consequences. Two weeks ago, reports surfaced of grain piling up on shipping docks in the US and South America, as sellers didn't feel they could trust the banks behind the letters of credit they receive in exchange for their goods.
This week, Bloomberg reported that "as many as 20 of the 100 deepwater oil rigs on order worldwide may be delayed or canceled as loan availability erodes, possibly slowing developments including the biggest petroleum discovery in the Americas in three decades," that of the Tupi find off the coast of Brazil. Petrobras CFO Almir Barbassa voiced his concerns about credit problems all along the supply chain for its drilling equipment.
Just a day earlier, the company's head of refining worried that credit-related delays would make it difficult for them to meet anticipated global oil demand, and so would put a floor under prices. At $60/barrel, he said, exploring for oil in the Canadian tar sands, and developing the ample reserves of heavy oil from Venezuela's Orinoco Basin would be uneconomical.
Legendary oil man Charles Maxwell, in a recent interview with The Money Show, noted that much of the world has fairly high breakeven cost points, which he cited as follows:
Most of OPEC
Iranians and Venezuela
Therefore, at the most recent range of $62-65, oil is already at or below the breakeven cost for most of the world's remaining oil reserves!
It is not inconceivable that producers might produce at a loss for a short while. For example, some drillers will need to keep the cash flowing in order to meet regular payments on their next order of rigs, or risk losing their place in the rig delivery queue, with significant impacts on their future production schedules.
But at some point, oil producers will have to see profitability return, or they will lay down their rigs. (Numerous natural gas drilling rigs are already being idled in North America, due to the similarly depressed price of natural gas.) Eventually, the reduced supply will put the fire back under prices.
When that might happen, though, is hard to say. We must be somewhere near to a floor in oil, if we're already under the breakeven costs. If oil went back to $50, it couldn't stay there for long.
Strong Dollar Bearish
At the same time, it's hard to make a case for a sustained bull market any time soon. The dollar will continue to be favored as long as other economies continue to decline, and as long as the dollar is (relatively) strong, it will keep oil prices down.
A dour global economic outlook is also weighing against high oil prices. We are now staring down an almost-certain global recession. Over the last 150 years, recessions have typically lasted 18 months. Depending on when you start the clock, we're now somewhere between just starting and being about 1/3 into the current one.
A recession would make most stocks poor investments, and barring a spike in inflation, would favor bonds and other low-risk investments, as well as anything that offers a high yield. In recessionary times, a regular cash flow of 20% dividends from relatively safe energy stocks would be far preferable to risky growth stocks.
On balance, I think the price of oil will continue to be essentially the story of the dollar. If the European Central Bank cuts its interest rates again next month, as they signalled yesterday, it will strengthen the dollar and oil will stay low. But eventually, we will experience the blowback from trying to print out way out of this mess, which could mean hyperinflation, with oil going hyperbolic. Again, the real question is when.
Energy Stocks Are Ridiculously Cheap
I think the answer is "not yet, maybe in a year or two." In the meantime, how can you not want to lay some money on the table now, with so many high-quality companies dealing in critical, lifeblood commodities like oil trading at P/Es of under 5, in some cases with market caps less than their assets are worth, and at half (or less) their stock prices of just a few months ago? That's just crazy.
With the thought of a nearby floor in oil and ridiculously cheap energy stocks in mind, I am cautiously-very cautiously-considering taking some positions again. But at a time like this, when volatility is so great that if you bought it on the wrong day you could find yourself down 20% just two days later, it would be extremely foolish to buy full positions. (Trust me when I tell you that I am speaking from painful experience here! If I could only follow my own advice more often.)
Instead, one should look carefully at the candidates' balance sheets, seeking out the ones with low debt, high cash flow, low valuations, and high yields. The ones that make the cut should then be accumulated slowly, using a dollar-cost averaging approach, as my colleague Steve Christ recommended earlier this week. For example, buy one-twelfth of what you might like to eventually own each month for the next year. A year from now, you should be sitting on a full position with a better than average cost basis, but you accumulated it with lower risk.
I hope that helps you to play your cards wisely, and profit amid the panic.
Until next time,
P.S. We have picked out some North American energy trusts for the $20 Trillion Report that have a nice yield, rain or shine, with good reserves on their books. Since they're domestic, they should also have an excellent growth outlook, particularly as we lose access to global oil exports. Check it out and see if our recommendations are right for you.
Energy Demand will Increase 58% Over the Next 25 Years
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