Weekend Edition - Oil's Rout: 6 Prisms to Peer Through - Part 1

Weekend Edition – Oil’s Rout: 6 Prisms to Peer Through – Part 1

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Unless you’ve been living under a (shale) rock the past six months, you’ll know that the price of oil has been hammered. Since West Texas Intermediate (WTI, priced in USD), the most commonly referenced “price of oil” in North America, hit more than $107 in June of this year, it is now down more than 45%, closing Friday at a jaw dropping $57.81.

There’s seemingly no let up in the free fall either. The trend is very well in tact. OK, great, tell me something that I don’t know, right? OK, I’ll try.

If nothing else, the interconnected nature of the world’s financial systems was illuminated through the financial crisis. European banks that binged on subprime mortgage backed securities packaged up by Wall Street’s investment banks in a stretch for yield offer a glimpse into that. The subsequent and historically unprecedented national drop in real estate values in the U.S. spawned a global strategy based on massive intervention and stimulus in the markets by central banks, not only by The Federal Reserve in the U.S. but also the ECB, the Bank of England and the Bank of Japan, among others.

The rout in oil speaks volumes about how intertwined the markets remain. Let’s look at the rout in oil through a number of different lenses through this two-part piece, part two of which will be published next Sunday.

Dividend Investor Perspective:

First and foremost at Dividend.com, we analyze things through the prism of dividend investing.  The rout in oil has been a particularly hot topic as related to some names you might not intuitively associate with that drop – those being Canadian banks, and more specifically two that we are particularly focused on right now: Bank of Nova Scotia (BNS) and TD Bank (TD). These names are two of Canada’s largest financial institutions, and as such have exposure to the Canadian market in general, inclusive of the Canadian real estate market, both residential and commercial. Canada is an oil exporter, so the net effect on the country’s GDP due to lower oil prices is a drop in annual GDP growth. The banks have been hit hard recently in the wake of oil’s swoon and they are both names we’re taking a close look at in terms of their viability to be on the Best Dividend Stocks list given this market movement.

In addition to these names being under pressure given real estate and other balance sheet exposure in energy rich Canada, the Bank of Canada poured fuel on the fire last Wednesday with headline fodder from its biannual Financial Systems Review, which noted that residential real estate could be overvalued by as much as 30% nationwide. Check out this succinct summary from the Toronto Star for more on this topic.

We’ve been poring through the entire BDS list in the wake of oil’s decline, with a keen eye towards the names noted above. We’ll keep members well apprised if and when we make any changes to that list, as always.

The Trader Perspective:

A trader’s reaction to oil’s drop? “I need volatility to have an opportunity to make money.”

Another Mitre Media property is the young, but growing, TraderHQ.com. Any trader worth their salt will tell you they don’t really care which way the price is moving; it just needs to be moving. Of course they care once they’ve placed a directional bet, but as they search for areas of the market to make bets, before placing them, they’re looking for securities that have been moving. The bets are predicated on price action. You need price action, as in the price needs to change. And oh boy, that has happened in oil with a 45% drop and a trend that has remained well in tact since June. Short oil traders have been loving this trend – this trend is most definitely “their friend.”

And not only has price been moving, check out the ramp up in volume of the most easily accessible trading vehicle for crude oil – USO:

While sitting on a commodities panel last Tuesday at the Global Indexing & ETF conference, the creator of USO, John Hyland, the CIO of the United States Commodity Funds, noted that as price drops and more traders are looking for USO shares, this results in a spike for the number of shares outstanding. He noted the demand for this trading instrument is largely hedge funds.

Moreover, for traders, be them hedge funds or otherwise, the second derivative, the pace of the decline, is increasing. Check out this weekly chart, and notice how the drops are becoming steeper for November and into December:

This is a very compelling trend that traders are seemingly piling onto, accelerating the decline. Given the steepness of the decline and the increasing pace of it, it is tough to see how this is a fundamentally driven decline, or at least these last legs don’t smell like it.

For more on the topic of trend trading, check out Trend Trading 101.

Technology Media Company Perspective:

A third and final perspective in Part 1 of this piece is an interesting tidbit. The popularity of the oil discussion is massive. It is quick off the tongue of anyone vested in the markets in one way, shape or form. I’d argue it has reached the point of soccer parent discussion; as in, even people watching their children play soccer are conversing about the topic on the sidelines.

Here’s the proof. Below is a chart of the traffic to the oil & gas ETF listing page on ETFdb.com:

I’ve intentionally removed the scale of measurement on the right, but the point is that it has grown more than 10x in the wake of the massive decline.

That said, despite being popular, we need to be discerning about the signal and the noise in times of market tumult like this. Our friend, The Reformed Broker, penned a telling piece about some pockets of the broader financial media called They’re All Making it Up. The punch line is two headlines from the same outlet from June (when oil price was peaking) and now in December (when oil prices have and continue to tank):

  • June headline: Oil prices jump on Iraq anxiety, stocks fall
  • December headline: Oil slump leads Wall Street to worst week in 2-1/2 years

Josh notes: To recap – Stocks sold off in June because oil prices rose. Stocks sold off today because oil prices fell. In the meantime, stocks have no current correlation with oil and they had a higher one last summer when the spike took place.

The point is we need to be very wary of these broad and easily digestible suggestions related to the interconnectedness of the markets. Nine times out of 10, that easy to read and seemingly logical headline misses a big part of the actual story.

In Part 2 of this analysis, which I’ll delve into next week, we’ll look at the rout in oil through the perspective of a municipal bond investor, a mutual fund investor and that of a commodity ETF investor.

Have a great weekend.