What Concerns Me about this Rally in Oil

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“Zombie producers” are getting new money.

By Christine Hughes, Chief Investment Strategist, OtterWood Capital:

Since energy has played a pivotal role in market gyrations the past year, I think it’s important to look at crude oil now with it up 47% in the last 20 trading days. See the 18 day rate of change in the chart below to understand how extreme a move it’s been.


Last year at this time, oil rallied 48% in about 30 trading days only to roll back over and eventually take out the prior lows. Before that rally, the commodity had fallen 60%, so we should have seen at least some supply cuts by producers. Instead, during that 48% snap-back rally, energy exploration and production companies suddenly became flush with cash, raising $70.8 billion in a short amount of time.


Investors are so starved for income that they pounce on any and all rallies in junk bonds. As a result, shale producers amazingly stayed alive, keeping supply very high which eventually caused another meltdown in the crude price.

Fast forward to today and we’ve got another quick 47% rally on our hands and I’m hearing things like this from credit guys: “I had line items that no one wanted for weeks … no matter how much I backed up the price, not a buyer to be found … today … my book got CLEARED out” – the junk market is back open for business.

With negative rates in Europe and Japan, a high yielding shale bond looks very attractive relative to LOSING 1% over two years by buying a German bund. Bank of America estimates up to 1/3rd of these recent flows into high yield are coming from Europe.

However, what people are missing is this new found financing keeps the zombie producers alive, flush with cash once again and they’re incentivized to do whatever it takes to stay alive. That may be good for each of them in the short-term but it isn’t good for crude. We’re almost at $40/barrel WTI now. Thanks to improvements in technology (paid for by last year’s cash ramp??), shale producers’ average cost of production is said to be $40/barrel, down from $60/barrel last year. If true, this means the production cuts we have seen so far this year are about to reverse. See here for further details/proof of this happening. Good luck with the OPEC production freeze once the shale guys turn the taps back on.

Production numbers have recently ticked down, I’ll give the bulls that. But production is still very, very high from an historical standpoint:


In addition, crude oil inventories continue to climb through the stratosphere. As pointed out by Jeff Gundlach this week, crude doesn’t find a bottom until inventories have been coming down for a couple of quarters.


Furthermore, many point to the ongoing weekly reduction in crude oil rig counts as proof that this time the rally is real. I would point you to the direction of natural gas rig count which has been setting a 70 year low every week for over a year. I have overlaid the price of natural gas on this chart. Lower rig counts did not produce higher prices. Confounding investors, natural gas producers have stayed alive and have continued to pump even in the face of massive price declines.

I think it is thanks to ZIRP, and now NIRP, which compels investors to reach further and further for yield even when the business idea (keeping oil and gas producers alive) is unsound longer-term. If you want a playbook for the price of crude oil, I urge you to take a look at the natural gas experience. For those loading up on energy here, buyers beware!


The general markets got a boost from Mario Draghi this week, albeit a tad delayed. He went further into negative rates despite warnings from European banks. He also increased the QE program from €60B/month to €80B/month. While everyone got excited over the latest round of Draghi QE, they forget what the first round did for risk assets (Euro Stoxx index):


North American equity markets are even more overbought than last week courtesy of Mario Draghi and I remain a skeptic on the markets. The US Fed meets next week and markets aren’t expecting much but we’ll hang off Janet Yellen’s every word as per usual. Stay tuned. By Christine Hughes, OtterWood Capital

Investors keep hoping the Saudis don’t know what they are doing. Read…  The $9.2 Billion Bet Against OPEC Dominance

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  11 comments for “What Concerns Me about this Rally in Oil

  1. Yoshua
    March 13, 2016 at 11:55 am

    I have read that shale oil producers have managed to cut their production costs a lot and that it is the offshore producers that are the high cost producers today.

  2. Spencer
    March 13, 2016 at 12:41 pm

    We all know the banks are holding worthless junk oil bonds. Who is buying now? Guess who is selling! The banks will not be the bag holders.

    Nothing has changed, period.

  3. Paulo
    March 13, 2016 at 12:51 pm

    I wouldn’t buy energy stocks or bonds with someone else’s money, let alone my own.

  4. Chicken
    March 13, 2016 at 1:34 pm

    Starve a cold, feed a fever?

  5. Jungle Jim
    March 13, 2016 at 4:34 pm

    This is not limited in any way to oil. ZIRP effectively meant that for years and years there was almost nowhere to invest and get a return. The result was a lot of surplus cash being sunk in new factories, new ships, etc. That kept increasing the amount of excess capacity worldwide. The need to keep that excess capacity busy and productive is one of the main reasons we are looking at deflation now. We have too much of everything. The incompetents at the central banks created the problem and now, they are making it worse.

  6. March 13, 2016 at 5:43 pm

    These central banks can buy junk long after everyone commenting on this site is dead and gone. And anytime they want they can have both a bailout and bailin. The gloves are off. They don’t care what you think or what you like or don’t like. They know that there are not three people posting on this site that’ll risk even a bloody nose, let alone a beating with a nightstick. The military and law enforce teams belong to the bankers and these badges will righteously put you in intensive care. Wolf suggested that everyone just hunker down, and while it wasn’t necessary since you’d have to crawl into a hole to get any more hunkered down, yet, it was good advice. It’s okay to whine unless some guys show up and tell you that you have the right to remain silent. If they do, it’ll be the best advice you’ll ever get. My partner shot a guy in the head and blood and brains covered us both. He turns and says, “Do you know where we can get some red beans and rice? I’m starving.”

    • walter map
      March 13, 2016 at 8:35 pm

      “The military and law enforce teams belong to the bankers and these badges will righteously put you in intensive care.”

      Civil government, so far as it is instituted for the security of property, is in reality instituted for the defence of the rich against the poor, or of those who have some property against those who have none at all.

      Wealth of Nations, Chapter I, Part II, 775

      • Bob Miller
        March 14, 2016 at 3:04 am

        Exactly! One needs only to study, The Declaration of Independence and the Constitution and those who drew it up and why to know why we have these documents. The Great Debates should be required reading. I often ask people I meet who are whining about the lack of political ethics, “In what document can I find the Bill of Rights?” 9 out of 10 don’t know. But then one should expect cattle to know things like that. So long as a reserve currency is a fiat currency governments can do as they please. That was the sole reason for doing away with the gold standard. Ike warned against the ‘Industrial Complex’, but who cares what wars cost in money or lives, so long as there are jobs. Bill Gates made it clear to Main Street USA, “Life is not fair. Get use to it!”

  7. March 13, 2016 at 8:48 pm

    From the Otter Wood blurb above:

    “The technology continues to improve (decreased drill time, newer drilling rigs etc.) but the biggest difference will be the use of big data analytics. Analyzing drilling data allows producers to modify techniques for each well and use the techniques in only the best parts of the shale. Using analytics could double output and lower break even costs for shale oil producers.”

    This is more BS from the drillers. The new technology affects only wells that are to be drilled or reworked not current extracting wells. (Wells cannot ‘produce’ anything, only remove.) If there is little- or no crude in a particular play there is no doubling output or lower break even costs. As it is, the entire shale enterprise is underwater … it was underwater @ $115 per barrel!

    Meanwhile, back at the ranch:

    “The general markets got a boost from Mario Draghi this week, albeit a tad delayed. He went further into negative rates despite warnings from European banks. He also increased the QE program from €60B/month to €80B/month. While everyone got excited over the latest round of Draghi QE … ”

    Some did, some didn’t. Central banks cannot create anything new (they are collateral constrained). What they CAN do is shift more credit to big business and less toward big business’ customers. The finance advantage is good for stock prices (IPOs, M&A, share buybacks) but top line revenues are walloped due to customer credit insufficiency.

    Broke customers + more driller funding = more crude flowing into storage, more pressure on refiners, more products flowing into storage and lower crude prices.

    Right now, central banks are instruments of conservation, they need to keep doing more of what they are doing … ultimately they will destroy the entire fossil fuel industry … as well as the car industry, the real estate industry, the various deadbeat governments, the real estate industry, finance itself, etc.

    That isn’t a hope it is a certainty.

  8. Mike R.
    March 14, 2016 at 8:35 am

    America’s economy is resting on a huge pile of debt. Fracking was authorized as a strategic initiative after 08-09. It would create jobs but more importantly they thought it could make the US energy independent; or less dependent. All of which was true except the cost of production is higher than current big boys like Saudia Arabia.

    In comes junk debt.

    Now that SA is playing hardball with US on a host of issues, we have no choice but to support fracking. This debt is being supported ultimately by the Fed/Treasury/POTUS and advisors. Don’t know how/don’t care. But it’s clear they will NOT let fracking totally collapse. Won’t happen.

  9. Chris
    March 14, 2016 at 3:09 pm

    The end result of the FED keeping interest rates as low as they are for as long as they have is to create a stealth subsidy for these zombie companies and ultimately the investment banks making the loans. Sure, interest rates are low and this is what is keeping these zombies alive to date. Were interest rates to reflect market demand then few of these companies would be around today. Sounds great except there is a consequence to these low rates. We have money being essentially gambled by investors pumping funds into bad investments. What do you suppose will happen when these companies finally do go bust along with their lenders? If you answered “bailout” then you would be correct. What is a bailout? The answer is it is a way in which the “too big to fail” entities in our economy are allowed to shed their debt at taxpayer expense. In other words, a stealth subsidy. The only difference between today and ’08 is that the bailout will be that much larger this time around.

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