Bad News: $2 Gas Is Back and Fed Will Hike Rates

Why is $2 Gas Bad?

If you’re driving across the country for the Holidays you will definitely save money as gasoline prices are nearing 7 year lows. However, cheap gas and falling commodity prices everywhere are symptomatic of the global economic weakness pervading our future expectations and cautious consumers are saving this windfall as shown by the rise in the personal savings rate to 5.6%. Lower energy prices also mean high yield junk bonds are becoming riskier as smaller oil companies in the fracking business file for bankruptcy. Oil companies acquired $247 Billion of risky high yield debt to finance the oil shale boom since 2010 and over $35 Billion is currently in virtual default and will accelerate in the months to come. About 40 companies have gone under this year (60 during crash of 2008/09) and if Oil prices remain under $40 to $50, then many more will be bankrupt in 2016 as their Oil futures hedges expire.

What we see in this chart below is the severe stress on stock market values when energy prices collapse sending high yield bond prices falling. When stocks are hitting new highs while these junk bonds are falling it creates a negative divergence. We noted this Sell signal divergence in May, June and July when stock prices were peaking at record highs. Those warnings led to a 14% market correction – the largest in 4 years. In November and December we have again warned of this negative divergence Sell as stocks approached their old record highs again. Thus far the correction is a modest 6% from the 2015 peak and dependent upon even lower Oil prices for a more severe correction in stocks.

SP vs HYG 12-2015

Why Fed Rate Hike is Bad

Our central bank – the Federal Reserve – can influence interest rates to impede or stimulate the economy. The Fed Funds rate is essentially the rate at which commercial banks and credit institutions can borrow from the Fed. To raise rates the Fed sells/retires Treasury debt which sequesters cash and shrinks the Money Supply. While there is an 80% consensus the Fed will raise rates when they meet on the 16th this week, we place the odds closer to 100%. Since the market has already priced in a “dovishly” packaged rate hike announcement we doubt there will be much of a reaction in stock prices. The bad news is that this rate hike, while very mild, is still contractionary during a tenuous economic environment that is already slowing with rising credit risks and falling rates of inflation. The Fed is worried that keeping rates too low will fan the inflationary flames too quickly for them to raise rates later without causing a panic. Their concern of being too late to the party seems a bit illogical in an era of raw material deflation and rising credit default rates in the energy and emerging market sectors. It remains to be seen just how capable Global Central Banks can be after 7 years of massive stimulus that has consistently failed to ignite producer asset inflation in a world swimming in excess capacity. To begin raising rates when the industrial economy is deflating may not cause a recession, but is nonetheless a negative and premature.Fed funds rate

Industrial Deflation

This era of excess can be seen in our US Capacity Utilization rate of 77%. Despite efforts to curtail factory capacity and shift production overseas, the US still struggles to increase manufacturing efficiency. Expect more of the same in 2016 as the industrial economy remains in a slow or no growth mode with contractions in mining and drilling.

Capacity Utilization 12-2015

Western economies began realizing long term overcapacity at the turn of the century and now BRIC countries led by China are feeling the weight of excess manufacturing space and have begun reducing raw material orders. China consumes half the world’s steel and copper and for the first time in over 15 years China will shrink production and reduce imports of most industrial commodities. The cure for high prices is high prices. The cure for low prices is low prices and capacity surplus related bankruptcies of creative destruction in search of supply and demand equilibrium. 

Exec Spec July Forecast for Sub-$2 Gas

Here is our chart from early August when gasoline prices peaked over $2.65 at the pump and we said to expect a drop back to $2 and lower. 

gas price average

$2 is now confirmed! The consensus failed to predict that production would remain high despite lower prices and the inventory glut would continue to grow. Before the end of January we favor technical targets of $29 and $32.50 a barrel in Oil and average gasoline prices in the US well under $2 with the $1.80’s potentially.

Gas prices 12-2015

 Jet Fuel distillate prices have maintained a close relationship with historical Oil prices moving to new 10 year lows just under the crash bottom in 2009.  Jet fuel is the largest cost in operating planes so we should expect a “mild” drop in airfares in early 2016. It will take a slower economy (less air travel) before prices fall more steeply since passenger miles flown are still rising and seat occupancy remains robust at 83%.

jet fuel 12-2015

Oil Glut Will Continue

The recent capitulation in Oil prices under 40 to test $34.50/barrel this week  followed on the news that OPEC would maintain peak production levels and not cut output as some had expected. Investors should have known that  dictatorships do not cut production in response to lower prices as our free market system does to maximize profits. Corrupt authoritarian states like OPEC, China and Russia respond to falling prices with higher output to maintain the same revenue stream. Not only will OPEC keep pumping as much oil as they can but Iran is coming online in early 2016 and have stated they will produce as much as they can regardless of price.  US Oil and distillate inventories will definitely remain at record levels. Despite optimistic consensus projections for a 1.4 Million barrel consumption growth in 2016 oil production will continue to outpace demand levels. Natural Gas continues to touch new 14 year lows in price with even lower prices likely in January.

Oil glut chart

 December Oil inventory contractions in Texas “may” give a false glimmer of hope through this month, but it will be an illusion. Texas taxes incentivise producers to turn Oil into distillates (Heating Oil, Gasoline…) and keep excess inventories offshore until January to avoid special taxation. A January inventory surge above expectations may be the bigger surprise during a period where prices are seasonally weak. Another Bearish factor we mentioned a couple months ago was the expectation for a warmer than normal winter due to a record El Nino (not Global Warming). We said to expect above normal temps in the northern half of the US and wet weather in CA and FL and thus far it is occurring as expected.Warm weather induced reductions in Natural Gas and Heating Oil demand expectations are sinking into the markets adding to the excess supply influence. Our ideal forecast a year ago was Oil under $40 with a worst case scenario of $29 to 32 a barrel for WTI Crude Oil. Perhaps we were not Beatrish enough, but until we work through most of January it would be advisable to sell the energy rallies and avoid long positions in the energy and metals market related commodities and stocks. 

Long term Oil will remain in excess and prices may rally from the $20’s back up to the 40’s and 50’s eventually. Such a rally will not be a new Bull market for energy as new Oil drilling technology is still in its infancy awaiting rallies back to this year’s highs in the 60’s reopen the spigots. Saudi Arabia and OPEC are not controlling these markets as we have claimed since the 2014 Bear market began. OPEC is merely hanging on for the ride praying that the economic growth in the US and China finally accelerate before their Governments violently implode.

Stock Market Targets

It would be shocking if Federal Reserve Chair Yellen didn’t raise the Fed Funds rate to 0.25 to 0.50% range this week. Stocks are using a weaker China, falling Oil and fear of the higher Fed Funds rate as an excuse for the Dow’s over 900 point (6%) correction in recent weeks. However, the consensus firmly expects this rate hike, so keep your eyes more focused upon Oil prices and the Yen for your clues of what’s next. As the Yen rises and Oil falls investors will keep selling stocks.  Since Oil is quite oversold short term and the Yen has rallied to key short term resistance, we wouldn’t be surprised to see stocks stabilize briefly and rally short term. As this chart shows we nailed our key short term support in the March SP index of 1977 to 1991 today (midpoint= 1984 which was the low today). 

sp chart 12-2015

Below this zone short to medium term support begins to break down and a retest of the 14% correction lows of August would then be potential. With the Santa Claus rally losing a few reindeer recently and oversold conditions mounting we may have to wait until January to discern new inflection points that could lead to a deeper correction or set up the foundation for a technical rally to new highs. The 5 months of corrective action warrant a more Bullish investment posture upon any surge to new highs. . Exec Spec traders are in cash while long term investors are still 90% invested moving to 85% should the March SP trade trade under 1984 during December. 

See our November interview on Financial Sense @ http://www.financialsense.com/contributors/kurt-kallaus

Exec Spec 

by Kurt Kallaus

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