I Wish I Could Quit You

Will stocks and oil prices go their sep­a­rate ways?

Bloomberg Businessweek (Europe) - - FRONT PAGE - By Peter Coy and Matthew Philips

It’s scary out there. The rout in the stock mar­ket that be­gan around Jan. 1 took a turn for the worse early this month. By Feb. 10 the Stan­dard & Poor’s 500-stock in­dex was down 9 per­cent for the year. That’s its worst start since the re­ces­sion year of 2008. Fall­ing oil prices were blamed: A meet­ing be­tween Saudis and Venezue­lans aimed at curb­ing pro­duc­tion had ended in­con­clu­sively. West Texas In­ter­me­di­ate fell again below $28 a bar­rel—more than 70 per­cent off its 2014 high. Trig­ger-happy in­vestors have got­ten ac­cus­tomed to sell­ing stocks when­ever oil dips. With oil in se­ri­ous over­sup­ply, it’s hard to sus­tain any kind of re­cov­ery on Wall Street. “The tough­est prob­lem for peo­ple to deal with is oil get­ting linked with the mar­ket,” says To­bias Levkovich, Cit­i­group’s chief U.S. equity strate­gist.

Just in time for Valen­tine’s Day, it ap­pears that oil and stocks have de­vel­oped an un­healthy, code­pen­dent re­la­tion­ship. They’re way too deep into each other. Where one mar­ket goes, the other fol­lows. If they were peo­ple, a coun­selor would be urg­ing a trial sep­a­ra­tion. “This is highly un­usual,” Torsten Slok, chief in­ter­na­tional econ­o­mist at Deutsche Bank, wrote to clients in late Jan­uary. “Call it the oil cor­re­la­tion co­nun­drum.”

Or oil­maged­don, as Cit­i­group econ­o­mists have named it. Be­fore you join the Cas­san­dras, though, here are a few things to con­sider: First, cheap oil isn’t the boogey­man you’d think it is from read­ing the head­lines. Up­ward spikes in en­ergy prices cause re­ces­sions; dips don’t. The na­tional av­er­age price of gaso­line is down $1.01 from last sum­mer. The money peo­ple save is fu­el­ing pur­chases of things like take­out food. “If you’re driv­ing to work ev­ery day and you save $10 at the gas pump, you stop at Star­bucks or what­ever and spend part of that sav­ings,” says Michael Mont­gomery, an econ­o­mist with IHS Global In­sight.

True, Amer­i­cans are bank­ing most of their sav­ings right now. But that’s good in the long run, too. Amer­i­cans’ debt pay­ments, rent, leases, and other obli­ga­tions are close to their low­est share of in­come since the Fed­eral Re­serve be­gan track­ing the ra­tio in 1980. Since con­sumers ac­count for the lion’s share of the U.S. econ­omy, any­thing that im­proves their fi­nan­cial sit­u­a­tion makes it more re­silient.

Se­cond, the no­tion that cheap oil sig­nals re­ces­sion—the idea be­ing that the price de­cline in­di­cates de­clin­ing global de­mand—is con­tra­dicted by the ev­i­dence. Far from fall­ing, world oil con­sump­tion rose by 3.1 mil­lion bar­rels a day in the two years through the third quar­ter of 2015, ac­cord­ing to the In­ter­na­tional En­ergy Agency. It’s just that the sup­ply grew even faster, by 5 mil­lion bar­rels a day. “With the mar­ket al­ready awash in oil, it is very hard to see how oil prices can rise sig­nif­i­cantly in the short term,” the agency said on Feb. 8. Prices might even go lower tem­po­rar­ily be­fore re­bound­ing. “I wouldn’t be sur­prised if this mar­ket goes into the teens,” Jeff Cur­rie, Gold­man Sachs’s head of com­modi­ties re­search, told Bloomberg TV on Feb. 8.

Third—and now we’re lay­ing out the other side of the ar­gu­ment—all this doesn’t mean Wall Street is en­tirely ir­ra­tional to trem­ble when crude tum­bles. The mar­ket tur­moil is shak­ing up com­pa­nies as far afield as St. Louis-based Emerson Elec­tric, headed since 2000 by Chief Ex­ec­u­tive Of­fi­cer David Farr. Emerson makes prod­ucts rang­ing from oil-pro­duc­tion in­stru­ments to closet or­ga­niz­ers. “The last 30 days have been what I would call the most un­usual in my time at Emerson. I’ve never seen a mar­ket­place go so volatile,” Farr told an­a­lysts on Feb. 2.

ExxonMo­bil is fac­ing a po­ten­tial credit down­grade for the first time since the Great De­pres­sion. Cono­coPhillips is cut­ting its div­i­dend for the first time in a quar­ter-cen­tury. En­ergy stocks ac­count for 6.6 per­cent of the S&P 500’s mar­ket value. While that’s only half their share of five years ago, it’s still big enough for them to drag down the over­all in­dex on bad days.

In 2014 the en­ergy in­dus­try ac­counted for nearly one-third of S&P 500 com­pa­nies’ cap­i­tal ex­pen­di­tures, ac­cord­ing to data com­piled by Bloomberg. At least $1 tril­lion in spend­ing is get­ting can­celed, says Steven Ko­pits, pres­i­dent of Prince­ton En­ergy Ad­vi­sors. When en­ergy com­pa­nies cut back, pipe mak­ers, truck­ers, rail­roads, and busi­nesses in other in­dus­tries suf­fer.

Then there’s the fi­nan­cial sec­tor. Oil drillers bor­rowed heav­ily to ex­pand pro­duc­tion, and many can’t make money at to­day’s su­per­low prices. As much as 15 per­cent of the face value of high-yield bonds owed by U.S. oil pro­duc­ers and ser­vice com­pa­nies could go into de­fault

this year, ac­cord­ing to BCA Re­search. “The ma­jor risk banks have isn’t to their nor­mal retail-ori­ented stuff, it’s to the oil space,” says An­drew Bren­ner, head of in­ter­na­tional fixed in­come at Na­tional Al­liance Cap­i­tal Mar­kets in New York. Mar­kets were rat­tled on Feb. 8 af­ter the Debtwire news ser­vice re­ported that Ch­e­sa­peake En­ergy, the No. 2 U.S. nat­u­ral gas pro­ducer, had hired a law firm to re­struc­ture a $9.8 bil­lion debt load. The com­pany is­sued a state­ment say­ing it has no plans to pur­sue bank­ruptcy.

Trou­ble could ra­di­ate out­ward if banks, their bal­ance sheets weak­ened by de­faults in the oil in­dus­try, cut back lend­ing to other en­ter­prises. Says Ni­cholas Sar­gen, chief econ­o­mist at Fort Wash­ing­ton In­vest­ment Ad­vi­sors: “There are some peo­ple be­gin­ning to worry that this thing could spread like the sub­prime cri­sis. Peo­ple said then that it was too small to mat­ter, and then you find out there are link­ages you didn’t know about.”

How long will oil and stocks con­tinue their doomed em­brace? No one

knows for sure, but there are signs that emo­tion has got­ten the bet­ter of in­vestors. Once things calm down, the un­der­ly­ing strengths of the U.S. econ­omy could start to be­come clearer. At that point, stocks could start to re­bound even if—or be­cause!—the global glut of crude keeps oil prices low.

His­tory is a use­ful guide. So far this year, the S&P 500 is mov­ing in closer tan­dem with West Texas In­ter­me­di­ate, the bench­mark U.S. crude oil, than in any year since 2000 ex­cept for 2010. The rea­sons for the high cor­re­la­tion in 2010 were sim­i­lar: abun­dant oil sup­plies and fears about global growth. In­ter­est­ingly, around the se­cond week of Fe­bru­ary 2010, the mood turned. The cor­re­la­tion con­tin­ued, but with oil and stocks both ris­ing in­stead of fall­ing.

Stocks and oil tend to move up to­gether in times of op­ti­mism about de­mand and fall to­gether in times of pes­simism about de­mand, ac­cord­ing to a 2008 anal­y­sis by An­drea Pesca­tori, a Fed­eral Re­serve Bank of Cleve­land econ­o­mist who’s now at the In­ter­na­tional Mon­e­tary Fund. If that’s so, the cur­rent high cor­re­la­tion is as much a barom­e­ter of sen­ti­ment about the out­look for global growth as it is an in­di­ca­tion of what’s hap­pen­ing in the real world. “Right now, any­thing that’s partly val­ued on the out­look for growth is go­ing to go down. You have a growth scare,” says Russ Koes­terich, global chief in­vest­ment strate­gist at Black­Rock.

Light­ning-fast fi­nan­cial mar­kets don’t re­ward sub­tle think­ing. Traders pre­fer to sim­plify the world to a stark daily de­ci­sion: risk on or risk off. If it’s a risk-on day, peo­ple scoop up high-yield debt, stocks in emerg­ing mar­kets, and in­dus­trial com­modi­ties, in­clud­ing oil—any as­set that’s volatile but does well in pe­ri­ods of growth. On risk-off days, they re­treat to ul­tra­safe but low-yield­ing in­vest­ments such as U.S. Trea­sury se­cu­ri­ties.

There have been a lot of risk-off days lately. That ex­plains why the 10-year Trea­sury note’s yield, which de­clines when its price rises, fell below 1.7 per­cent on Feb. 10, from al­most 2.5 per­cent last

June. It also helps ex­plain why both oil (risky) and the S&P 500 (kind of risky) have been heav­ily sold off. “If you have a mul­tias­set port­fo­lio and you’re look­ing to de-risk, and you have prob­lems in one sec­tor, you’ll at­tempt to sell oth­ers to get your over­all risk pro­file lower,” says Kr­ishna Me­mani, chief in­vest­ment of­fi­cer at Op­pen­heimer Funds in New York.

Syn­chro­nized plunges this ex­treme in stocks and oil usu­ally in­di­cate that in­vestors are ex­pect­ing a U.S. re­ces­sion, which would kill cor­po­rate prof­its and de­mand for crude. But how likely is a re­ces­sion over the next year or so? Not im­pos­si­ble, but not prob­a­ble.

The most im­por­tant in­di­ca­tor of eco­nomic health is em­ploy­ment. The U.S. cre­ated 151,000 jobs in Jan­uary, less than in pre­vi­ous months but more than enough to ab­sorb the nor­mal flow of en­trants into the la­bor force. The un­em­ploy­ment rate dropped to 4.9 per­cent, which the Fed­eral Re­serve con­sid­ers full em­ploy­ment. Av­er­age hourly earn­ings rose 2.5 per­cent from the year be­fore. That’s a real pay raise for Amer­i­can work­ers, since it’s above the in­fla­tion rate, yet it’s not so high as to get the Fed wor­ried about an in­cip­i­ent wage-price in­fla­tion­ary spiral. Mean­while, com­pa­nies show no sign of re­trench­ing on em­ploy­ment: In De­cem­ber listed job open­ings were the high­est as a share of all jobs, filled and un­filled, since record keep­ing be­gan in 2000, ac­cord­ing to data re­leased by the Bureau of La­bor Sta­tis­tics on Feb. 9.

Cheap oil, sup­pos­edly an eco­nomic threat, has done one good thing for the U.S. econ­omy and stocks. It’s kept the over­all in­crease in con­sumer prices through De­cem­ber to just 0.7 per­cent. That could help per­suade the Fed to throt­tle back its plans to raise rates. On Feb. 10, Fed Chair Janet Yellen sug­gested that fur­ther rate hikes would de­pend on whether the mar­ket tur­moil per­sists. “Mon­e­tary pol­icy is by no means on a pre­set course,” she told Congress. Low rates are good for both the econ­omy and Wall Street, be­cause stocks be­come a more en­tic­ing al­ter­na­tive when rates are low.

The bears are right that cheap oil is dam­ag­ing high-cost pro­duc­ers around the world, and some of those are in the U.S. Amaz­ingly, though, some shale pro­duc­ers in Amer­ica can make money even with prices as low as they are. Ac­cord­ing to an anal­y­sis by Bloomberg In­tel­li­gence, pro­duc­ers in the Ea­gle Ford basin in DeWitt County, Texas, could break even with West Texas In­ter­me­di­ate as cheap as $22.52 a bar­rel. The coun­tries re­ally be­ing slammed by cheap oil are not the U.S. but the likes of Rus­sia and Venezuela, which have a fa­tal com­bi­na­tion of heavy de­pen­dence on oil ex­ports and high pro­duc­tion costs. U.S. de­pen­dence on those coun­tries as ex­port mar­kets is triv­ial, as are Amer­i­can bank loans to them. Amer­i­can banks are more ex­posed to U.S. shale pro­duc­ers, of course. But BCA Re­search pre­dicts that only 5 per­cent to 10 per­cent of bank loans to that sec­tor will go into de­fault this year—and most of those will even­tu­ally get re­paid as the com­pa­nies emerge from re­struc­tur­ing.

Yes, de­clines in cor­po­rate earn­ings tend to presage re­ces­sions, and S&P 500 op­er­at­ing earn­ings have been fall­ing in re­cent quar­ters from year-ago lev­els. But take out en­ergy stocks and they’ve still been ris­ing. His­tor­i­cally, stocks and the econ­omy brush off weak oil earn­ings: Bruce Kas­man, chief econ­o­mist at JPMor­gan Chase, notes that the only years in the re­cent past when S&P 500 prof­its fell while the econ­omy held up were 1986 and 1998—which were years when oil prices tum­bled, as they’re do­ing now. Gold­man Sachs econ­o­mists re­cently put the chance of a U.S. re­ces­sion at 18 per­cent within one year and 23 per­cent within two.

The sense that fall­ing oil is bad for stocks is mostly a mat­ter of tim­ing and con­spic­u­ous­ness. The bad parts of the oil plunge are hit­ting now: the credit down­grades, the de­faults, the in­vest­ment cut­backs, the lay­offs of rough­necks. They’re mak­ing news and rat­tling peo­ple’s con­fi­dence. “We’ve taken the big hit up­front,” says Chris Var­vares, co-founder of St. Louis-based Macroe­co­nomic Ad­vis­ers. Even­tu­ally, the money freed up by cheap oil will leak into other parts of the econ­omy. When oil prices crashed in 1986 and gaso­line sud­denly got cheap, it didn’t show up in the con­sump­tion num­bers for more than a year, says David Rosen­berg, chief econ­o­mist at Gluskin Sh­eff.

In any case, oil prices this low aren’t likely to last long. The mar­ket for crude is driven in­creas­ingly by high-fre­quency, com­puter-based mo­men­tum trad­ing. In July, the CME Group—for­merly the Chicago Mer­can­tile Ex­change—ended the 167-year his­tory of ac­tual hu­mans trad­ing com­mod­ity fu­tures in open pits in Chicago and New York. Com­puter trad­ing has proved more ef­fi­cient, but not al­ways bet­ter. “There was a gov­ern­ing qual­ity of hu­man in­put that’s been lost in the mar­ket, that sort of pre­vented this kind of lu­nacy,” says Dan Dicker, a for­mer oil trader on the Nymex and pres­i­dent of Mer­cBloc, a wealth-man­age­ment firm. “Peo­ple could only move but so fast.”

At the mo­ment, says Ko­pits of Prince­ton En­ergy Ad­vi­sors, “there’s a weird dis­con­nect be­tween any kind of long-term fun­da­men­tals and cur­rent mar­ket val­ues.” Fun­da­men­tals tend to win out in the long run. Sup­ply will be curbed as drillers drop projects that are un­prof­itable at $30 a bar­rel. And de­mand will ac­cel­er­ate; peo­ple are al­ready driv­ing more miles, al­beit in more fuel-ef­fi­cient ve­hi­cles. (A 2015 Ford F-150 pickup gets 30 per­cent bet­ter gas mileage on the high­way than the 2005 model.) Oil traders spent most of 2015 in­creas­ing their bets that oil prices would fall. Since midJan­uary they have slightly pared their short po­si­tions and bought more con­tracts that gain value when oil rises. Barry White be­gan Can’t Get Enough

of Your Love, Babe by say­ing, “I’ve heard peo­ple say that too much of any­thing is not good for you, baby.” Cheap oil is kind of like that for the stock mar­ket. But with any luck, their dys­func­tional dy­namic won’t last much longer. <BW>

−With Dani

Burger and Oliver Renick

Gold­man Sachs puts the chance of re­ces­sion in the next year at 18 per­cent

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