Article / 01 December 2014 at 10:00 GMT

Daily Shot: Oil selloff proves contagious

TradingFloor.com Team / Saxo Bank
Denmark
  • Eurozone deflation appears to be worsening
  • Italian unemployment unexpectedly passes 13%
  • Commodities sector hits a four-year low

By Walter Kurtz

We start with some data out of the euro area, where deflationary pressures seem to be worsening:

1. Spain remains in deflation. 

Spain
2. The German Consumer Price Index fell to 0.6% year-over-year.

Germany
























3. The overall Eurozone CPI is now at 0.3% year-over-year. A negative CPI print looks increasingly likely in the near-term, given what’s transpired in the energy sector.

CPI
4. The area’s consumer confidence unexpectedly fell again.

Consumer confidence
5. And to make matters worse, the Italian unemployment rate unexpectedly rose above 13%. As discussed before, Italy’s economic situation is quite alarming.

Italy
For those who still believe that deflation is a good thing (and I have gotten numerous emails on this), consider the fact that assets (such as home prices) on the balance sheets of households and companies are declining in value, but liabilities (such as mortgages) are not.

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Related to the situation discussed above, German longer-dated government bond yields hit another low. A number of economists and politicians are increasingly calling for Germany to borrow more at these rates and invest in infrastructure.

Bond yields
As a result of collapsing rates, European insurers are facing headwinds similar to those faced by Japanese firms. Insurers need to generate sufficient return on their capital to meet long-term liabilities (for example life insurance payouts). And that has become nearly impossible in the current environment.

"Nearly one in four European insurers could have trouble meeting financial obligations to policy holders in the coming years if rock bottom interest rates persist, the EU's insurance watchdog EIOPA said on Sunday." — Reuters

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The final item related to the Eurozone is the buildup of speculative short euro positioning. While fundamentally this certainly makes sense, it has become a crowded trade. 

EUR shorts
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Now let’s focus on energy. Although Opec's decision to maintain current crude production quotas was not entirely unexpected, the market reaction was violent. WTI crude futures fell by 10% Thursday through Friday of last week. As of Sunday evening, WTI is weaker again — dropping below $64.

Crude oil
 
At these levels, North American producers have a real problem on their hands. While Eagle Ford is still profitable, both Bakken and Permian Basin are in now the red.

"Based upon an analysis of more than 50 oil plays across Canada and the United States, we estimate that ‘mid-cycle breakeven costs’ in the North Dakota Bakken (1.05 mb/d) are roughly US$69 per barrel and in the Permian Basin in Texas (1.63 mb/d) about US$68. While some producers have hedged forward at higher prices, if WTI oil remains around US$70 for more than six months, it appears likely that drilling activity will slow in more marginal areas of these plays as 2015 unfolds. Funding for independent oil producers will also tighten. However, the ‘liquids-rich’ Eagle Ford (1.45 mb/d) will be little impacted, with breakeven costs averaging only US$50." — Scotiabank

That's why we've had such an extreme selloff in US oil & gas exploration & production shares on Friday...

Oil and gas
Source: Yahoo! Finance

...and Canadian shares (red) underperformed due to significant energy exposure. 
Canadian shares
 
If prices persist at current levels for months to come, the Saudis will achieve their objective of dealing a blow to North American oil production. Current expectations of the US outpacing Saudi Arabia as the number one oil producer will be shelved for some time. 

The only thing the US government could do at this point to support the domestic oil industry is to begin increasing the Strategic Petroleum Reserve. Of course, such a measure would be temporary and if global demand does not improve, prices will begin falling again.

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The impact of collapsing energy prices has been felt throughout the financial markets. Here are some of these effects:

1. The Mexican peso came under pressure as markets priced in the impact on Mexican energy production and exports. 

MXN
2. The Russian ruble fell to over 50 rubles per one dollar — a new record low.

RUB
3. The Norwegian krone also came under pressure due to weakness in the energy sector.

EURNOK
4. US high-yield bonds sold off, as spreads on energy names widened. Leveraged firms in the sector — both in the US and Canada — will face some serious headwinds.

Bonds
5. Gold will test another support level at around $1140.
Gold
6. Commodities as a whole hit a four-year low.

Commodities
7. And US longer-term inflation expectations (implied from TIPS) continued to fall.

US inflation
Source: Federal Reserve Economic Data

The Federal Reserve will view these events as a sign of rising deflationary risks, with the first rate hike now on hold until possibly a year from now... or even later.

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Now a couple of updates on US equity markets:

1. Small caps have underperformed sharply last week (blue in the chart below). It was somewhat surprising given that smaller firms will benefit from lower energy prices and low interest rates. 

Small caps
2. US homebuilders saw their shares outperform the market since the October correction. Demand for rental housing and high-end homes remains relatively strong and lower mortgage rates are helping as well.

Homebuilders
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Finally, some food for thought. It’s not too late to get that deal on a new gadget. Consumer electronics prices in the US hit the lowest point in the days following Black Friday and then rise through the holiday season.

Consumer electronics
 
-- Edited by Michael McKenna

* Walter Kurtz is an alias

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