Some have remarked I have focused to intensely on oil.  A major reason for this myopicy is the close correlation between oil and equities since July 2014.  The correlation is over 90% according to Bloomberg.

It has often been written the most obvious conclusions are those which are ignored.  Many times I have compared 2014-16 to 1999; the last time oil plunged because of excess supply and shrinking demand.  In March of 1999 oil rose about 50% in 20 days and doubled by year end because of stronger demand.

Oil has rebounded about 50% since the mid-February lows and many are suggesting prices will soon again plunge.  Yesterday crude fell about 2.5% on inventory concerns.

As noted many times oil infrastructure spending has collapsed.  Since 2015 over $300 billion in projects have been shelved, a record by a margin of 2:1.

Because of this cut in infrastructure spending, the International Energy Agency (IEA) is now stating the depletion of old oil wells is expected to surpass new sources of supply in 2016.

It is a general rule of thumb that the annual depreciation rate of global oil supplies is between 6% and 7%.  These stores must be replaced.  I think it is noteworthy that the seven major global oil producers have only replaced 75% of the oil used in 2015, the first such shortfall in over 20 years.

The IEA is now suggesting during 2016 existing fields will lose about 3.3 million per day while new fields brought on line will only add 3 million barrels.

Because of lack investment, the IEA states the supply/depletion balance will further widen in 2017 as the new sources of production will rise by 1.2 million barrels in 2017 and further widen in 2018 and 2019 given the lack of “upstream” investments, investment that cannot be turned quickly around.  If demand remained unchanged, depletion would be about 2 million barrels more than supplies in 2017.

Speaking of demand, gasoline demand is rising at a rate greater than expected.  Economics 101 dictates there is no cure for low prices except low prices which stimulates greater demand.

And then there are geopolitical risks that have all but been ignored.  The Middle East is facing the greatest anarchy since the dissolution of the Ottoman Empire 100 years ago.  In my view the planned production freeze is symbolic in nature given that OPEC is already producing at capacity.

Speaking of capacity, spare global capacity is at a record low of 1 million barrels a day according to the IEA.

I ask what happens if there is a major supply disruption because of failed nation states.  Historically when a country fails, so does its means of economic production.  Libya is essentially off line producing about 200,000 barrels day down from almost 2 million in 2011.  The odds of Libya increasing production is extremely low.

And then there is Nigeria and Iraq whose annual production has dropped about 700,000 day since mid- February because of violence and lack of infrastructure spending.

I rhetorically ask what if this slump in Nigerian and Iraqi production is a harbinger of things to come?  Iraq has no money to invest in a major oil field whose production has dropped about 47% in the last eight weeks.  Will violence continue?  According to Foreign Affairs, this is the sixth Caliphate in history.  The previous five ended extremely bloody with societies—specifically Islamic societies—decimated by the warring Islamic factions.

Commenting briefly about Iran, Iran has not yet and is not expected to be a significant contributor as many has predicted because the lack of western funds to modernize its fields.

If the most obvious conclusions are truly ignored, I think the oil narrative will diametrically change by the end of the second quarter and if the oil/equity correlation maintains, stock prices should be higher.

At some juncture however rising oil prices will be viewed negatively, as a proverbial tax upon the economy.  But at this juncture rising crude is extremely closely correlated to higher stock prices.

Commenting about yesterday’s market action, equites rallied as FRB Chair Yellen’s remarks were interpreted dovish, trumping the decline in oil prices.

What will happen today?

Last night the foreign markets were up.  London was up 1.71%, Paris up 1.92% and Frankfurt up 1.73%.  China was up 3.60%,  Japan up 1.31% and Hang Sang up 2.15%.

The Dow should open moderately higher on Fed optimism and an increase price of crude, the result of a survey that suggested inventories did not rise as much as expected and increased gas usage and falling dollar.  The 10-year is unchanged at 1.82%.


The views expressed herein are those of Kent Engelke and do not necessarily reflect those of Capitol Securities Management. The information contained herein has been compiled from sources believed to be reliable; however, there is no guarantee of its accuracy or completeness. Any opinions expressed are statements of judgment on this date and are subject to certain risks and uncertainties which could cause actual results to differ materially from those currently anticipated or projected. Any future dividends, interest, yields and event dates listed may be subject to change. An investor cannot invest in an index, and its returns are not indicative of the performance of any specific investment. Past performance is not indicative of future results. The material provided in Daily Market Commentaries or on this website should be used for informational purposes only and in no way should be relied upon for financial advice. Please be sure to consult your own financial advisor when making decisions regarding your financial management. Members of FINRA and SIPC, Capitol Securities Management is a privately owned full-service retail brokerage and investment advisory firm headquartered in Richmond, Virginia. For nearly 30 years, we have been serving the needs of our investors. Today, more than 200 Capitol Securities Management investment professionals and support staff serve approximately 18,000 customer accounts from Southern Florida to the New England coast.
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