Submitted by Lance Roberts of STA Wealth Management,
"While oil prices have surged this year on the back of geopolitical concerns, the performance of energy stocks has far outpaced the underlying commodity.
The deviation between energy and the price of oil is at very dangerous levels. Valuations in this sector are also grossly extended from long term norms.
If oil prices break below the consolidation channel OR a more severe correction in the markets occurs, the overweighting of energy in portfolios could lead to excessive capital destruction.
While the argument has been primarily focused on the 'yield chase,' the 'price destruction' will far outweigh the desire for income. It is a good time to take profits in the sector and reweight portfolios back to target goals."
As oil prices took out the long term trend line, the expected reversion in equity prices also began.
There is no doubt that the current selloff in oil prices has gotten extreme. However, what is interesting is that such price declines in oil prices have often been associated with rather sharp economic slowdowns or recessions. Currently, economists are expecting robust economic growth going into 2015 and suggesting that falling oil prices will boost consumption. However, as I discussed recently, there is very little evidence to support that claim.
"Personal Consumption Expenditure (PCE) number that comprises roughly 2/3rds of the economic GDP calculation. Therefore, we can also analyze falling gasoline prices as it relates to total PCE. Again, falling gas prices should lead to increases in PCE."
"While the argument that declines in energy and gasoline prices should lead to stronger consumption sounds logical, the data suggests that this is not actually the case. With consumers heavily leveraged already, any increases in disposable incomes from lower gasoline prices are likely negligible in terms of their monthly spending."
The purpose of today's post is to give you a series of charts to analyze the current decline in oil prices and provide some clarity on the expected impact to both the energy sector and the economy as a whole.
Historically, when the 24-month rate of change in oil prices has exceeded 100%, it has been a precursor to economic weakness.
Of course, the economics of oil are driven by supply and demand.
"The drop in demand is being driven, no pun intended, by a change in demographics, a rise in telecommuting, a structural shift in unemployment (large pool of working age individuals outside of the labor force) and increases fuel efficiency. These dynamics are likely not to change in the foreseeable future as economic growth rates globally continue to 'muddle along.'"
As discussed above, the price of oil has now broken below very important long-term trend lines.
Oil is now on an important "SELL" signal which suggests that prices still have more downside risk at the moment.
Since it is primarily the speculation in the options pits that move the price of oil in the short term, it is not surprising to see a collapse in both the net reportable contracts outstanding and oil prices.
However, it is worth noting that the current price divergence between the S&P 500 index and oil prices has historically not been sustainable.
The Economics Of It
As with all things, eventually the price of oil is a supply/demand issue. As shown above, the sharp increase in production brought on by "fracking" has certainly been quite remarkable. However, this remarkable resurgence in oil production currently faces two extremely strong headwinds. The total amount of available refining capacity and the level of end demand are both declining.
While the "fracking miracle" has boosted the production of raw crude in recent years, such production is only useful if you can convert the base commodity into a useful byproduct. The problem, as shown in the two charts below, is that the the number of operating refineries has continued to fall, as the regulatory environment has stifled the ability to build new plants, and operating plants are already running near full capacity.
With very little spare capacity available domestically, the "hope" is that the U.S. can start exporting the excess to foreign countries. However, as discussed in the first chart above, global demand for oil is dropping as the Eurozone and Japan struggle with extremely weak economic growth.
Finally, since oil is priced in U.S. dollars, the surging U.S. dollar as of late only makes oil more expensive to foreign customers which will crimp demand further. The chart below shows the long history of the inverse correlation between the US Dollar and Oil Prices.
For investors long "energy" at the current time, oil prices are indeed extremely oversold and are due for a bounce. That "bounce" should likely be used to substantially reduce energy positions in the short term as an increasing amount of data suggests oil prices could go lower.
For longer term investors, the decline in energy prices also suggests a much weaker domestic economy. As I have discussed for a while now, the deflationary pressures from abroad will impact the U.S. more substantially than most economists predict currently. That risk to economic strength, and ultimately corporate profits, puts extremely elevated stock prices at risk.
In either case, the decline in oil prices is a clear message that "something is awry" globally and investors should take heed that risks of a market decline have risen markedly. While I am not saying that the economy is about to slide off into a recession, previous declines in oil prices of the current magnitude have been associated with poor outcomes for investors. Caution is advised.