There is little doubt that one of the major contributing factors in crude oil’s 65% decline since mid 2014 has been the US Fed’s wind-down of quantitative easing and the subsequent rally in the US dollar. But there have been other factors. At the onset of the decline there was lots talk about over-supply. That quickly shifted towards weak demand from emerging markets, and then to geo-political goings on that have resulted in a war between cartel members. All that with the backdrop of upstart frackers in the U.S.. There are a lot of moving parts and some of it is above my pay-grade. All I know is oil keeps going down.
This morning, my Fast Money friend, and a founding contributor to The Ticker District, Brian Kelly lays out the case that $20 oil is in the offing. Here were a couple of his points that make his case:
#1 It’s Marginal Costs that Matter
Once the infrastructure is in place its a sunk cost and therefore has no impact on cash flow. What this means is that its not the total cost (cost including infrastructure) but the cost to produce the next barrel of oil after infrastructure costs (marginal cost).
In the case of oil, the marginal cost for many North Dakota projects is as low as $24 per barrel. It is estimated that Saudi Arabia’s marginal cost is close to $20 per barrel. This is why even though rig counts have fallen, production has not followed. Oil producers have left the most efficient projects running so that they can cover operating costs (marginal costs). Since this level is $20 for Saudi Arabia and $24 for North Dakota t stands to reason that production will not decline meaningfully until the price of oil is in the $20 range.
#2 The Dollar Impact
he Dollar Index (DXY) and the price of oil have been a mirror image of each other for the last year. The 25% rise in the DXY from June 2014 to March 2015 resulted in an -18% decline in oil. This means that for every 1-point move up in DXY, oil moved down by $0.72.
We could overlay oil, currency and interest rate charts to make the case for a washout lower in oil, or sustained lower oil prices etc etc, but it’s really all just noise. With Crude trading below $39 as I write, are the 2008 lows near $32.50 coming to a theater near you? Probably. But the lower the commodity goes the harder the press on the short side becomes and if you were offered an even money bet for $6 lower to the financial crisis lows, or $6 higher to levels where it was trading a few weeks ago, you’d probably take higher, right?:
The last of BK’s points is sentiment. And if I can add any value in this discussion it would be here. BK thinks oil won’t bottom util there is some sort of scandal, or massive bankruptcy, (or both). Those sorts of sentiment bottoms take time to develop, and they generally happen after a period where sentiment went from guarded optimism after a sharp decline, to extreme pessimism. This happened in Crude in 2008/09, when the commodity dropped nearly 80% in less than a year. I’d say one of the big differences is the source of the weakness. Back then it was the U.S. financial crisis weakening demand and initially resulting in a dollar surge in 2008, a form of a safe haven trade. But in early 2009, when it became clear that US crisis monetary policy was wed to lowering interest rates, and weakening the dollar things reversed. The high for the dollar in 2009, also marked the low in crude oil:
This time around, global monetary policy points to continued dollar strength, which could cause crude to stay lower for longer without a meaningful uptick in demand from the likes of China (which solidified the bottom in 2009) and/or cuts in production.
Sentiment will need to take a few hits. There has been lots of talk about dividend cuts, defaults, bankruptcies and even scandals in places like Brazil. Few have hit home in the U.S., I suspect that is a 2016 thing. It’s my sense that Q1 2016 will be filled with banks who are on the hook for lots of energy company debt. This will force re-capitalizations of many oil companies. There will be no shortage of energy companies whose equity will be be deemed worthless. That process will sow the seeds for a bottom.