In my introductory post, I mentioned that a major reason I wanted to start writing and blogging was to explain seemingly confusing financial issues in a simple manner. My hope was that people, who are neither financially savvy nor knowledgeable, could learn a thing a two.
Truth be told, I don’t believe I’ve done a good enough job focusing on this and have let some readers down. With that being said, many of you have probably seen on the Today Show or heard on your local news broadcast that “markets are down, primarily because of low oil prices.”
The problem with these statements is that it gives no insight as to WHY this one of the main influencers of this recent drawdown. In this post, the end goal is for the everyday financial lay(wo)man to understand why oil is driving the equity markets.
It would besmirch Fly and Bluestar (you don’t see these two with common thoughts that often) if I didn’t mention that their posts have inspired me to write this, and have educated me on this topic. This article differentiates itself by appealing to Mainstreet.
It is essential to understand the following concepts and relationships when trying to decipher the current oil crash (or any asset class in general):
1. Credit (or debt) that is issued (or lent) losses its value as the asset, which was used to support the issued debt, drops in price. I realize that this may sound elementary to most, but it’s important.
2. Most, if not all, of the major stock sell offs that are persistent and resilient are preceded by a drop in the credit markets and surrounding leverage conditions.
Why is that the case? The best explanation is that businesses need credit for capital investments, purchase inventory, and fund on-going operations. When credit dries up and banks are no longer willing to lend, these businesses are not able to perform activities that allow them to grow. This leads to lower expected revenues and profits, which are then reflected in the stock price.
How can you tell if credit markets are hurting? You look at the credit spreads. In a nutshell, these compare the interest rate provided on a risky debt instrument vs. a risk-free instrument. The higher the spread, the higher the need to be compensated for the extra risk due to the increased likelihood of that person not paying back their debts.
Think of this way… On a loan of $100,000, you are much more likely to be paid back by Warren Buffett than your old college drinking buddy who still lives in his parent’s basement. To account for that extra risk, you insist on a higher interest rate.
Now onto the discussion of oil and how it all relates to what is laid out above.
Want to impress some girl or guy you’re attracted to into thinking you’re smart and educated about worldly events and financial complexes? Repeat these three statements if the discussion of why oil has dropped so much comes up a dinner party or rave or hipster hangout:
- There’s an oversupply, due to OPEC (mainly the Saudi’s), refusing to cut production. However, U.S., Canadian, Russian, and everyone else haven’t stopped, and now Iran has joined the party (insert snarky thanks Obama).
- There’s a decreased global demand because of an economic slowdown; many people will rightfully point to China, but there’s a ton of economic exhaustion in other places. Just ask Super Mario of the ECB.
- A strong U.S. Dollar aka King Dollar. Commodities are priced in U.S. Dollars. When someone wants to buy oil abroad, they have to convert their currency into King Dollars. But because King Dollar is flexing on all other ass clowns, that other currency cannot buy as much.
Oh yeah, when interest rates are raised, the U.S. Dollar gets stronger, especially in a low yield environment. This is because, again, people outside of America must purchase U.S. Treasuries with U.S. Dollars, and thus drives the demand for King Dollars. You can thank Grandma Yellen and academic minions later for exacerbating this equity selloff.
So here we are. According to Exodus, there’s about $1.3 trillion in debt for the entire oil and gas industry, which includes drilling, exploration, equipment and services, pipelines, and refining. Some more risky than others, but still, that’s a crap ton of debt.
As the price of oil keeps dropping, the risk that a non-insignificant amount of energy companies could default on their debt increases. As I’ve pointed out in a prior post, the credit spreads in high yield (extra risky debt) really began to shoot up since mid-November 2015. The high yield credit spread hasn’t been this high since 2009. The Bloomberg US Energy Corporate Bond Index accelerated its drop just around the same time (130 to 120 today).
This has obviously spilled into all energy related stocks. But why the general market fear and drawdown, beyond the fact that a ton of U.S. economic growth was driven by the energy renaissance in the oil patch and over 100,000 energy related jobs were lost last year?
In my opinion, Bluestar’s most recent post is spot on. By the way, he called this in November 2014 so a major hat tip to him.
To summarize what he’s saying; a major hedge fund(s) or global banking institution(s) own and are exposed to financially radioactive oil derivatives. Because other gigantic money machines are most likely on the other side of the trade or are indirectly exposed, they’re preserving their capital in the event of financial contagion and defaults. They are not able to bid up these low stock prices because they know they’ve over extended their risk at the moment.
What is a derivative? Simply, it’s a side bet that is based on the outcome of a previous agreed upon bet. The previous agreed upon bet was that oil would keep going up, but it hasn’t.
Understand that it’s derivatives that truly speed up a credit problem, just like it did with the housing crisis in 08-09 (think of oil today like houses then, but not as risky to the financial system). There is much less regulation on these, which encourages more risk taking.
Hopefully this gives you, the average investor who checks the online or mail statement once a month, some insight and knowledge as to the dynamic between oil and the equity markets, beyond what the mainstream media will simply flash in your face and have you repeat.
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Thanks. I now know what credit spreads are. I’ve heard “credit spreads are blowing out” many times. I knew it was bad, but I didn’t know what it really meant.
I’m sure there’s a few of us non financial types that peruse the hallowed halls at IBC. I might not know everything that’s being written about, but I know I’m at the right place for no bs market analysis.
I couldn’t see your piece here go without any comments. I’d hate to see you not do another “tutorial” because you thought nobody appreciated your effort. So if you do more I’ll be reading.
Now I’m off to bash that frog guy who’s always clogging up the comments section on Fly’s pieces.
Glad I could teach a couple things. Miles, I was you just a few years ago, wondering what do all these terms mean. I tell you one thing, if you can understand credit markets, even at a basic level, stocks make much more sense. It’s strange a-ha moment, but it pays off.
Good stuff. A few other things: fueling the negative sentiment on the loan side are a few other problems… 1) value destruction in credit has crushed CLO, BDC, other structured funds/products NAV due to leverage. For example, if I owned a basket of loans worth 100 cents on the dollar 1 year ago, and given the sell-off, that basket is now 90 cents, if I have 5x leverage, NAV has fallen by 50% (100 cents to 50 cents as equity is first loss). This leads to less dry powder available as equity dry powder harder to come by and no one wants to fund leverage of 50% NAV vehicles. 2) from a technical perspective, as energy / weak credits are cracking, fund managers susceptible to retail flows, which have been negative for a long time, are trying to get ahead of redemptions and starting to liquidate higher quality assets… Selling is leading to more selling. Cracks appearing everywhere and little liquidity.
Marcus, this piece was meant to appeal to non-financial folks but you come in here and totally blow up any confidence they might have found. Just giving you a hard time; you’re a top source of knowledge when it comes to credit markets, and I defer all related questions/topics to you.
I definitely agree with what you added. And don’t forget the strong possibility about regional and national banks holding simple straight forward loans that may default; they’ve got to up their reserve requirements which is another huge “risk off” move.
P.S. for the people who were wondering what he said, 1) higher leverage (“borrowing” more risk than you have on paper) in combined and tranched (think mortgage backed securities in housing crisis) financial products leads to institutions holding more cash to cover their risk taking and less ability to take on risk through bidding up stocks. 2) big fund managers are selling stocks to appease requests from their investors that they want their money back.
“Checks statement once a month.” Hah – doubtful anyone on this site. More like once a day.
Great post boyaj! Very well simply put. Let’s start discussing behavioral investing and emotion in trading and how to handle short term vs long term investments
Thanks for the compliment Game. I am very interested in that subject, and should be putting out a piece soon about how I’ve adjusted my investing method in my IRA. It relates to those momentum strategies (i.e. 200 M.A.) but attempts to reduce the luck component.
Thanks-Well put.
I appreciate the response Gorby!
Good analysis. You should contribute more.
Thank you chgo. I’ve been slacking on my posts recently; performing at my real job, managing money for friends and family, and planning a wedding. No excuses though, I’ll be putting out more content.
Nice write up, well described. Even I can understand it. Although, I fear, it would be lost on the 47%ers who are too busy scratching off lotto tix, smoking Pall Mall unfiltereds with their Old Milwaukee, collecting Government Cheese, and queuing up to vote for The Bern. I’ll be passing this along to a couple of coworkers who have market interest but aren’t degenerates like the rest of us here.
Hahaha. You know, if those lotto ticket buyers knew they could do the same with stocks, except have better odds, they’d probably become real degenerates like us. I hope you can convert your coworkers.
You begin with “I wanted to…explain seemingly confusing financial issues in a simple manner”.
Then you proceed to blow smoke up everyone’s asses with “because other gigantic money machines are most likely on the other side of the trade or are indirectly exposed, they’re preserving their capital in the event of financial contagion and defaults”
Sarge, fair point to extent haha. I mean, there’s no other way to explain these banks and hedge funds; that’s what they are. Also, people who have a third grade reading level understand the phrase ‘other side of the trade’; if they don’t, then they should give their money to you or I to manage. However, I could’ve avoided or used different language instead of ‘financial contagion and defaults.’
Thanks
No problemo hope you picked up some new knowledge.