Just as I predicted, OPEC is not and never planned to cut production. It’s all political theatre and tape-bomb chaos! Oil will continue to head lower and as it does, we’ll continue to see fear grow about US banks’ exposure to energy defaults. Naimi reiterated Saudi’s strategy again yesterday in Houston: choking off high-cost producers is how the Kingdom plans to “balance” oil markets.
ABSOLUTELY NOTHING HAS CHANGED IN SAUDI STRATEGY SINCE 2014!
As logic would have it, this means high-cost producers – AKA US frackers, Canadian oil-sands steamers and Brazilian deep-water drillers, can’t just reduce production, they have to be eliminated altogether! Thusly, when the lights go out, the bank doesn’t get paid, so sell all banks now! The strategy seemingly makes sense. However, these fears are misplaced. The Saudis have underestimated both the strength and the persistence of the correlation b/w US high-yield markets, Treasury yields and oil prices. Amidst today’s bleak landscape of $7 trillion of negatively yielding sovereign debt or roughly ~30% of global issuance, US debt markets will continue to prime wellheads across the US. Those homegrown, “Made-in-America” E&Ps will find sustained financings (via equity and straight debt) because the yields available on such investments are simply too juicy in the short-term – even with principal repayment exposed to risk, for a sufficient number of investors to ignore. Just look at yesterday’s IPO – the year’s largest, of Silver Run – a $400mm blank check for oil-related investments. Saudi’s ongoing battle will be remembered as a classic example of reflexivity at work in contemporary markets.
The cycle is pretty straightforward:
Lower oil prices lead to lower treasury yields due to:
- lack of oil-sparked broader inflation
- macro-signaling of weak growth prospects via low oil prices/demand, and
- the dollar’s relative strength as a safe-haven in a lackluster global economy
Investor demand for higher yielding/higher risk assets grows, which in turn, subsidizes higher-cost oil production methods and – ala Taylor Swift, those Frackers Gonna Frack, Frack, Frack, Frack, Frack! The US maintains its “swing producer” title and oil stays cheap, further perpetuating the cycle.
Naimi’s strategy relies on a breaking point, either (1) an absolute price – so low, that below it, high-cost producers break, or (2) an extended duration of sufficiently low prices – so long, that beyond it, high-cost producers fail. Such an absolute price can’t be much lower than Saudi’s own cost of production, between $5 – $20. That’s a difficult scenario to envision, given that many exporters would be selling oil at negative prices, given their current discounts. Moreover, I don’t think it’s a coincidence that within 120 seconds of oil falling to a $25 handle at 2:32 pm on 2/11/16, we received the first non-Saudi rejected production cut rumor. Given these facts and the front-month futures contract’s technicals, $30ish feels like a “Goldilocks” level to hold for an extended duration.
Creditors will amend – rates lower, and extend – maturities further, than Naimi expects. Thereby, enabling high-cost producers to produce in sufficiently significant volumes, at lower prices, for longer than export nations without sufficient access to dollar-denominated debt can fund themselves.
Back to the banks for a moment.
US yields recently appear to be driven by oil prices. March 2015’s bottom in oil sparked the three month rise in the 10yr yield. June 2015’s high in oil preceded the 10yr yield’s high and led the ensuing 4 month march lower in rates. In November, rates began to rise in anticipation of a December Fed hike and in divergence to oil prices. Despite the December Fed hike, rates decided to swiftly follow oil lower, bottoming out together in early February. The 2/11/16 OPEC production cut rumor led the recent turnaround in both rates and crude. If even the Fed can’t sustain higher rates, then without higher oil prices, yields simply won’t rise. Without higher yields, amend and extend is the name of the game. The Frackers get to keep fracking and banks continue to be shielded from energy-related defaults.
The reflexivity of lower oil prices will keep high-cost producers producing at sufficiently significant levels, such that Saudi’s strategy won’t work, at least in the medium-term. For the time being, expect oil to move lower, rates to stay low and to the surprise of many, energy defaults to be limited.
Given this view and the propensity for oil-propelling tape-bombs, getting long bank names with the worst market-sentiment is a great way to gain exposure to unwarrantedly and overly beaten down stocks and a convenient way to hedge your oil shorts.
The thesis here is that oil is either moving higher, in which case concerns over energy-related defaults/losses is moot and bank stocks have been overly discounted or, oil is moving lower, but as explained above, banks won’t suffer losses and their stocks have been unwarrantedly discounted. I want to get long the stocks the market thinks are at the highest risk of energy-related losses, due to my investment thesis that such risks won’t materialize and/or don’t exist. I looked to the largest US money-center banks (BAC, C, GS, JPM, MD and WFC) and two heavily traded, optionable ETFs (KBE and XLF).
In finding the ideal candidate to go long, I wanted to find the stock that had the largest gearing to oil prices (highest beta) and the stock that moved most consistently with oil prices (highest correlation).
I wanted to find which stock the market believed was most levered to oil prices. To do so, I regressed three years of each stock’s daily closing prices against the front month crude future’s closing prices. This established a baseline for the “normal” post-financial crisis gearing of each stock to oil. I repeated the regressions but for only the period beginning in 6/2014, when oil first started its decent. This produced a “low-oil” environment gearing. The ideal candidate would have the highest beta versus both its peers and the market in both gearing environments. Moreover, as oil prices fell, the market should have punished the stock most believed to be exposed to oil incrementally more than the market and its peers were in the “baseline” environment. Put differently, the stock with the largest increase in oil beta in the “low-oil” environment should be the stock the market considers to be most exposed to oil prices. [Note: equities largely diverged from oil beginning in Summer 2014. As a result, oil betas declined. Therefore, the smallest decline in oil beta in the “low-oil” environment versus “baseline” should be characteristic of the stock most believed to be exposed to oil prices.] Comparing these absolute gearing levels and the change between the two revealed BAC and JPM as the stocks which the market believed to be most levered to oil prices.
Next, I looked at tracking consistency. I ran correlation analyses for both the “baseline” 3 year period and the “low-oil” period, since 6/2014. Similar to the beta analysis, the best candidate would be the stock with the highest correlation in both periods and the largest increase in correlation during the “low-oil” period versus “baseline.” The results were less clear cut this time in that they only really excluded GS, WFC and XLF as the best candidates.
On balance, BAC and JPM revealed themselves to be the stocks the market believed to be most exposed to oil prices. Based on technicals, BAC looks easier to play from the long side and with its lower absolute stock price, a better option to gain additional leverage to through calls. I expect to see oil tumble today and equities to roll out of bed, so I’m going to wait a little before putting this hedge on. I’ll be sure to provide an update on the specifics of the trade, ahead of time.