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More Thoughts on the Current Oil Market

April 16, 2015 by EconMatters   Comments (0)

By EconMatters

WTI surged to close at $56.01 a barrel on Wednesday, while Brent closed at $62.86 after the US crude oil inventories showed a 'less-than-expected increase'. The latest weekly inventory (week ending April 10) from EIA showed an increase of 1.3 million barrels, much less than the 10.9 million barrels of build from the previous week. The report also showed that total motor gasoline inventories decreased by 2.1 million barrels, while distillate stockpiles rose by 2.0 million barrels.

Chart Source: Nasdaq.com Apr. 15, 2015


Inventory Build Is A Buy Signal?

I'm not sure exactly when and how market players started equating a 'less-than-expected oil inventory build' with a buy signal. This to me merely suggests a slowdown of crude oil production increase, hardly a reason to buy up the market.

Furthermore, the inventory build in distillate, which is used primarily in industrial activities, seems like a sign of weaker broader U.S. economy, which could mean the gasoline inventory would start to build again.

Shale Output To See Its First Decline in 4 Years

Indeed, the U.S. shale oil industry is starting to feel the pinch from lower oil price, down ~60% since 2H14.  Another EIA report already predicted U.S. shale will see its first monthly production drop in 4 years this May.

Among the five major U.S. shale oil regions, the Niobrara formation, northeast of Denver CO, will lead the month-over-month decline, followed by the Eagle Ford shale in Texas and the Bakken formation in North Dakota, while output from the Permian in Texas and the Utica in Ohio is expected to rise in May.

Oil rig count has been dropping like a rock since 2H14 when oil market turned bearish , and it looks like well inventory has been sufficiently depleted to finally make a dent on production.  

% Change Since January 3, 2014
Chart Source: BofA via Business Insider, April 14, 2015

Shale Drillers Are More Resilient Than Expected

However, the advance in oilfield and oil and gas upstream technology has brought tremendous increase in productivity and efficiency in the U.S. shale industry, which means shale drillers, now in survival mode, are more resilient than most people (including Saudi) originally thought.  If oil prices stabilize at or above current levels, expect drillers to move in again, rig count and production would quickly recover.    

OPEC Still Flooding The Market

So overall, the signs are mixed in the U.S. oil market.  Outside of U.S., geopolitical tension is still high in the Middle East -- escalating fighting in Yemen, and Iran nuclear deal is still pending.  Meanwhile, almost like repenting the oil geopolitical premium put on by a Saudi-led campaign of air strikes against Iran-allied Houthi rebels at Yemen, OPEC pumped 31.02 million barrels per day in March, near a two-year high, pressuring any positive sign from demand or anywhere, for that matter.  In a way, Saudi is trying to delay or put a stop to the ongoing energy switch and substitute due to decades of high oil prices.  

Iran Could Replace U.S. Shale Cutback

The production cutback by U.S. shale could be interpreted as a positive sign for oil prices in the short term, but the loss from U.S. shale could easily be offset by the increase in Iranian oil export since Iran nuclear deal is expected to have a formalized plan by mid-year.

China Sputters

For the longest time, China's has been one popular excuse cited by Oil Bulls.  Yes, China was on its way to replace the U.S. as the world's largest oil consuming nation, but the growth engine is now sputtering which was confirmed when China saw its economic growth slow to 1.3% in 1Q15, compared with growth of 1.5% in the previous three quarters.  

$900 Bn Wealth Transfer by Cheap Oil 


Lower energy prices means lower energy costs for the net oil importing countries while many oil exporting countries inside and outside OPEC are hurting. The IMF estimated in December that the oil price crash could bring in 0.7% GDP growth worldwide. Bloomberg crunched the numbers and came up with a map (above) so we know who gets what and how much.  According to Bloomberg,

Net oil importers like the U.S., Europe, and Asia are getting a nearly $900 billion economic stimulus from cheaper oil prices.  The Middle East and Russia are the ones getting stuck with the bill.  

In other words, cheaper oil has initiated a wealth transfer effect of about $900 billion a year between net oil importers and oil exporters reversing decades of historical trend.  The U.S. along gets $180 billion, and Europe and Asia (i.e. China) are even bigger beneficiaries of this wealth transfer by cheap oil.    

Lower for Longer?

So in the grand scheme of things, I agree that oil prices, just like rig count, should become 'lower for longer" until a supply or demand shock triggered by, for example, another financial crisis, or shale oil becomes depleted / dried-up (shale typically has accelerated declining production curve, so this scenario is quite plausible). Nevertheless, the wild card would be the OPEC meeting this June amid mounting pressures for some kind of coordinated production cut.      

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China, Taiwan, Japan and The U.S. In the West Pacific

April 12, 2015 by EconMatters   Comments (0)

By EconMatters

There have been several interesting and significant events taking place in the West Pacific region since our last update about the island row between China and Japan in the East China Sea and a semi-sub rig of CNOOC in South China Sea rubbing several neighboring countries the wrong way.

China's Artificial Island Expansion

New satellite images released in February show China has built an artificial island covering 75,000 square yards—about 14 football fields on disputed South China Sea reefs.  According to experts who have studied the pictures, the structure seems to include two piers, a cement plant and a helipad, at a land formation called Hughes Reef. The reef, above water only at low tide, lies about 210 miles from the Philippines and 660 miles from China.

Graphic Source: WSJ.com

The pictures also show that China is building similar infrastructure in two other places, Johnson South Reef and Gaven Reefs.  This naturally put the U.S. at extreme unease.  The U.S. Office of Naval Intelligence has just published its first report on the Chinese navy since 2009, and says that China "appears to be building much larger facilities that could eventually support both maritime law enforcement and naval operations.”

China's New Long Range H-6 Bombers Can Hit Guam 

 H-6 Bomber, image source: PLA Air Force 

On March 30, China announced that its new H-6 strategic bombers have carried out its first military drills flying over the Bashi Canal, which is between a Taiwanese island and a Philippines island.  With a combat radius of 2,000 kilometers, the H-6 bomber could launch attacks against US military facilities on Guam. Furthermore, flying nuclear-capable bombers so close to Taiwan looks like a déjà vu of the 3rd Taiwan Strait Crisis about 20 years ago.

U.S. Marine F-18 Landed at Taiwan  

On April 1, just 2 days after the H-6 bomber drill, a pair of  U.S. Marine F-18 Hornet aircrafts did a 'precautionary landing' (i.e., no immediate emergency) at Tainan air force base in southern Taiwan and left after 48 hours.  This has lead to many discussions because of several factors:

F18 in Formation, Image credit Paul Nelhams/Flickr 
  • No U.S. military aircraft has ever touched ground in Taiwan for almost 30 years due to the sensitive nature of the island's political status.     
  • F-18 Hornet is considered one of the more advanced warplanes currently deployed by the U.S. with movement and whereabouts typically on a very low 'classified' profile.  Taiwan is probably the most conspicuous option for a 'precautionary landing'. The two F-18 could have made landing at a less-controversial location such as the Japanese airfield at Shimoji island, just 120 miles east of Taiwan.     
  • Military analysts noted that the presence of F-18 typically means electronic warfare EA-6B Prowler plane and a carrier vessel or group are nearby.        
  • April 1 also marked the 14-year anniversary of Hainan Island incident when a U.S. Navy intelligence aircraft collided with a Chinese interceptor fighter jet.  
  • The Tainan air base where the two F-18s landed has a long history dating back to WW II with deep ties with CIA, a known fact among people in Taiwan.  

As you can imagine, this is a fertile ground for many conspiracy theories.  Washington Times thinks the F-18 fighter jet landings, while may well be unintended, appear to be Pentagon sending a message to China of U.S. resolve two days after China signaling a threat to U.S. Guam.

Taiwan's military analysts were all excited to actually see F-18s 'parked locally', and speculate that since Taiwan has long been interested in purchasing F-18s, this unusual landing after a 30-year absence could mean the U.S. is warming up to the idea.  In addition, this also seems to signal U.S. 're-pivoting' to Taiwan's geographic and strategic significance in U.S. West Pacific military layer.

China Nuclear Subs in the Indian Ocean

A Chinese nuclear submarine in 2009, image Source: Reuters


Diplomat reported on April 12 that Chinese nuclear submarine – presumably a Type 093 Shang-class – as part of the anti-piracy patrol of two ships and a supply vessel operating off the Gulf of Aden. Submarines are not exactly appropriate for dealing with pirates, and analysts are still trying to decipher the enormous implications of such a strategically significant move while setting alarm bells ringing in the Indian Navy.

U.S. Re-acquainting With Taiwan?

According to experts who have studied the satellite images released in February, China "appears to be building a network of island fortresses to help enforce control of most of the South China Sea—one of the world’s busiest shipping routes—and potentially of the airspace above".  U.S. has been in high anxiety over China's increasing military and financial (i.e. AIIB) expansion and blatant ambition over the region.  As the map shows (for illustration purpose only, the map below could be outdated) U.S. currently has significant military 'pocket' surrounding China in Japan, South Korea, Philippines, and Singapore, leaving a gaping hole exposing Guam, Hawaii, even the U.S. West Coast should China launch a direct attack.

For now, the U.S. can only make declaratory protests (leading to Xinhua calling U.S. a butt and fishing for trouble), and China will almost always ignore these protests.  A more 'pro-active' counter-measure by using U.S. naval warships would be an escalation and carry risks.  This leaves Taiwan the only friendly suitable and more effective response to China plugging that hole.

China to Make A Move on Diaoyu in 2020?

Regional military analysts are already speculating China could be planning to make to move to forcibly take Diaoyu Islands (aka Senkaku Islands in Japan) in 2020 when the Summer Olympics to take place in Tokyo.  While things are still shifting and unraveling awfully fast in the region, one observation we have and agree with:  

“Nations have no permanent friends or allies, they only have permanent interests.”   


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GE Resorts To Financial Engineering to Boost Stock Price

April 12, 2015 by EconMatters   Comments (0)

By EconMatters

GE Underperforms Market

Jeff Immelt feeling the pressure for a stock that has vastly underperformed the financial markets since his reign at the throne of GE, and since the financial crisis of 2008 where QE Infinity juiced many a subpar company in this era of massive financial engineering through unprecedented stock buybacks made possible by Central Bank`s zero interest rate policies has finally taken financial engineering to an entirely new level.

Beware of Wall Street Investment Banks

Of course every investment firm on Wall Street has been advising GE to do this for years, that it will create more shareholder value by dumping the financial and real estate portion of the company, that GE`s valuation will catch up to its peers in the industry; shorthand for raising the stock price. This is true in the short run, but in the long run Jeff Immelt and GE just devalued the company, and will hurt its long-term profit potential. Of course, none of this really matters to Jeff Immelt and GE as he will have long since retired from the company. The smart shareholders will take the quick profits from the stock buyback run in the stock! And over time the reduced earning`s will ultimately punish any bag holders not smart enough to realize this is just a financial gimmick from a company just like IBM that has seen its best days a decade ago.


Energy Splitting: Upstream & Downstream Operations - Bad Advice

This is similar to how all the Investment bankers advised the big Energy companies to jettison their downstream refining operations to take advantage of the perceived higher margins in the upstream portion of the business, i.e., your stock prices will rise. Forgetting to properly analyze that downstream operations are a hedge for when oil prices drop like we currently have now in a supply glut environment where refiners are doing much better than producers in this bear market pricing environment. Well GE`s financial and real estate portfolio (when they aren`t leveraged to the hilt in bad loans) is a hedge and financing function that enables more deals to be made with their partners who lack the credit capabilities to finance many of GE`s deals on the open market when everyone isn`t throwing around free money during the credit booms that come and go during the business cycles. Make no mistake size matters in business, and just like the oil producers in Conoco and Marathon who now regret splitting up their companies and reducing their natural economic hedges and profit generation capabilities over the long haul of the business cycles, GE is less valuable as a company for getting smaller.


Short-Term & Long-Term Value for Shareholders

S&P 500 Versus GE Returns on % Basis 7 Years
Will the stock rise through this gimmickry? Of course it will for goodness sake they are buying their own stock to the tune of 50 Billion Dollars! However, mark my words the financials will progressively deteriorate over time at GE. Earnings will disappoint quarter after quarter, and in five years GE will be a shadow of its former self. Wishing they never listened to the Wall Street Investment bankers, and became a smaller fish in a larger global ocean. Size is power, the more size you have as a company the more synergies that can be leveraged, the more business deals that can be completed, the larger profits that can be reaped through economies of scale, and competitive advantages across the divergent business segments of the company can be realized. Deals often happen on a grand scale, and the more resources a company has at its disposal the greater potential there is for business development, just ask a salesperson or deal maker at GE, this just made their job twice as hard.

Liquidation of Core Assets

Thank you Jeff Immelt for running GE into the ground during your tenure, instead of being fired 10 years ago by the gutless GE board for incompetent leadership, or shareholders putting pressure on him to resign, they just dumped the stock as an investment. And now to hang on for as long as possible GE and Jeff Immelt have taken the final step in the gutting of this once great company. Liquidating revenue generating assets for a short term pop in the stock to get shareholders off the company`s back for a couple more years. Furthermore, mark my words Jeff Immelt will not be at the company in three years when the realization hits home with shareholders that GE is worse off as a result of this financial engineering gimmickry. He will have long since benefitted from cashing out his robust stock options and retire with his golden parachute while the stock price is higher, only to leave his predecessors and long-term investors dealing with the unintended consequences of liquidating GE`s assets and resources at fire sale prices. 

GE isn`t taking a first quarter ‘restructuring charge’ because they are getting a good deal on these asset sales; and expect more and more of these ‘restructuring charges’ in the future quarters as the years go by as the fallout from this deal peels off on the financials. Sure there is an immediate difference between the book value and goodwill on the GE books of these assets worth versus what they can get for these assets in the marketplace. But what about the future revenue that these same assets generate for the company`s earnings? First there is the ‘restructuring charge’ language but there will be some other euphemistic accounting terminology for future quarterly earning’s statements reflecting deteriorating revenue generation conditions at GE. Make no mistake this is pure and simple a fire sale, one giant money grab by GE, with no vision or respect for the future of GE as a going concern.

Financial Markets: The Greater Fool Theory

This is part of the reason that ultimately the stock and financial markets are giant Ponzi schemes, all these investments need future investors to come in and be a greater fool than previous investors, prop up the giant charade that is financial markets, ultimately leaving somebody holding the bag when all the stock buybacks have dried up, the zero percent borrowing stops in the next business cycle, and there are no more employees to fire or assets to liquidate. It’s the same reason 401ks become cut in half during the next bear market cycle, companies continue to get kicked out of the indexes, and legitimate long-term investing is a thing of the past. You better Market Time as well as possible given the circumstances of the modern era of financial markets. Shoot GE will probably not even be in the DOW Industrials in 10 years if history is our guide! Therefore, enjoy the ride if you are a GE shareholder, just get out before the music stops in this once proud American Icon of a company. Financial engineering is usually a last ditch gimmick to try and squeeze a little more value out of an incompetently run company which has lost its competitive edge in the marketplace and is no longer growing its businesses versus its historic growth metrics.

GE Management Training Program

Any other coach would have long since been fired for such poor performance, it is quite a feat for Jeff Immelt to have survived this long at GE, but just like at Microsoft the Peter Principle is alive and well in many companies of the fortune 500, and can continue to thrive as long as others are more incompetent, and this latest financial engineering just smacks of incompetent desperation at the top of GE Management. Rather ironic considering their much vaunted Management Training Program of the past, GE sure has produced a bunch of incompetent leaders over the years. Give me a Steve Jobs over Jeff Immelt any day and twice on Sunday and he never went through a vaunted Management Training program, shoot he didn`t even have a college degree. But Apple`s innovation over the same tenure as Jeff Immelt at the helm of GE is the biggest indictment of the upper management at GE. Jeff Immelt must really be good at playing the ‘corporate game’ because his survival sure isn`t based upon performance at GE.

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Another 8 Million Barrels Added to Oil Storage

March 26, 2015 by EconMatters   Comments (0)

By EconMatters

 

EIA Inventory Report

The EIA Petroleum Report came out today and the report was pretty bearish. Much worse than the API Report released the night before. Of course, Oil was up on the report, in fact had a robust day at the close as the shorts got squeezed. This is nothing new for the market, almost every Wednesday or EIA Report day ends in the green, especially the Bearish ones, this goes back a long way in oil trading folklore. So much so that a funny joke amongst oil traders is “Crude Oil finished up $2 on the day, must have been a bearish inventory report!”


 
Year ago
Most recent
 
03/21/14
03/20/15
03/13/15
03/06/15
02/27/15
02/20/15
02/13/15
02/06/15
U.S.
382.5
466.7
458.5
448.9
444.4
434.1
425.6
417.9
East Coast (PADD 1)
9.2
15.8
16.5
16.2
16.6
17.0
15.3
12.2
Midwest (PADD 2)
98.4
142.7
138.0
134.9
133.3
130.0
128.1
124.1
Cushing, Oklahoma
28.5
56.3
54.4
51.5
49.2
48.7
46.3
42.6
Gulf Coast (PADD 3)
200.3
227.2
225.7
222.4
219.9
214.5
210.2
208.2
Rocky Mountain (PADD 4)
21.4
22.4
21.5
20.8
20.6
20.7
20.8
20.7
West Coast (PADD 5)
53.1
58.5
56.9
54.5
54.0
51.9
51.3
52.7

Almost all the 8 million build is centered on the Midwest to Cushing to the Gulf Coast refinery corridor route which is even more bearish as all 3 storage outlets are building together. There is so much oversupply in the market that they cannot even make one energy hub appear better by moving the oil from one storage hub to the next a la the massive pipeline initiatives from Cushing to the Gulf Coast Region. Just look at the year ago numbers, the already bloated Gulf Coast Region added another 27 million barrels to storage from this time last year. Cushing has added almost 28 million barrels to storage in a year, and the Midwest has added an astounding 44 million barrels to storage in a year. Moreover, we are still in the middle of the building season, as I have seen years where we build right through May and a couple weeks in June putting in higher and higher overall oil inventories. This year better be a short building season, or the rails are going to come off the oil market rather quickly over the next couple of months.

US Oil Production

In regards to the production side of the equation we had another higher high in the Production Trend:

Year ago
Four-week averages
Year ago
Week ending
 
03/21/14
03/20/15
03/13/15
03/06/15
03/21/14
03/20/15
03/13/15
03/06/15
U.S. production
8.166
9.383
9.349
9.314
8.190
9.422
9.419
9.366

 

We produced 9.42 million barrels per day versus 9.41 the prior week and up 1.23 million barrels per day versus this time last year. No wonder we keep having these large upside inventory builds each week. This illustrates that the Rig Count Number is highly misleading, what matters is the Overall Well Count Number. Producers can bring additional wells online to the existing Rigs in operation while cutting less efficient Rigs from the equation, and the total wells producing oil can actually go up while the overall rig count numbers are coming down. The result lends itself to higher production output numbers each week.

Oil Imports

Year ago
Four-week averages
Year ago
Week ending
 
03/21/14
03/20/15
03/13/15
03/06/15
03/21/14
03/20/15
03/13/15
03/06/15
Crude oil, excluding SPR
7.337
7.262
7.234
7.136
7.617
7.392
7.496
6.793

 

Oil imports used to come down on a one to one basis as the domestic production increased but this correlation has come off the past year as imports have discovered a floor and continue to stay around these levels. As 7.39 versus 7.61 million barrels a day for a week isn`t going to offset the increased US Production gains year over year. Part of this is that certain refineries are set up in this country for Brent Oil, and they aren`t changing anytime soon because of the costs involved. So the baseline Brent comes to the US, the US Production keeps growing, and although the US exports refined product to reduce some of the North American Production, there just isn`t that level of demand to alter the supply demand imbalance in the market. There is just too much supply and not enough outlets via domestic demand, dwindling storage space, or export possibilities via products that changes this oversupply market dynamic.

Numbers, Assumptions & Capacity Constraints

The US has added almost 85 million barrels to storage facilities since January of 2015; that is an average of 7.67 million barrels of oil added to storage every week for the last 11 weeks, and it shows no sign of letting up anytime soon. So those who believe that there is plenty of storage available in the US need to start running the numbers. For example, on 09/26/2014 there was 356 million barrels in storage and now there is 466 million barrels as of 03/20/2015; that is an addition of 110 million barrels added to storage in roughly 6 months’ time. Furthermore, the trend of growing inventory builds is going the wrong direction for those thinking storage capacity isn`t an issue in the marketplace. What I mean by that is the builds are getting consistently bigger on average with each passing month. This last 8 weeks of inventory builds has really been unprecedented in the oil market, the run of consecutive large builds is unchartered territory for modern oil markets. Therefore all those storage capacity experts out there; what assumption are you building your model upon? Is it the last 12 months, 9 months, 6 months or 3 months from an inputs standpoint? If inventory builds stop this month that is one thing, but the ironic part of low oil prices means producers are finding more and more creative ways to pump more product to make up for lost revenue.

Unchartered Territory when everyone needs more Cash to Pay Existing Obligations

In short they need the cash to pay bills, who is to say that we don`t have inventory builds until the oil market finally crashes and production is forced offline? We really don`t know how this will all play out as this is unchartered territory in the modern era of oil markets. Even when prices were high oil inventories were well above their five year averages, so we are already at a poor structural starting point for a bear market in oil and the storage capacity issues that go along with this environment. I would say that if we have inventory builds from this point forward just based upon looking at the prior year`s additions in oil builds we have the following guideposts: In 2014 we continued to add to inventories through May 09, 2014, we added to oil inventories through May 24th for 2013, and builds continued through June 22nd for 2012. At this pace of builds things should get interesting in regards to storage capacity, and the economic decisions revolving around this logistical constraint. And if low prices throw a new dynamic in the market as yet un-factored into many pre-existing models in this modern era of high oil prices, the builds could possibly be much bigger on average compared with the previous three years from this point forward, and they may continue for much longer than usual.

500 Million Barrels Outside of SPR in Storage?

Another alternative scenario is that they just flat line through the drawing season, setting the stage for a fall collapse in oil prices if US production doesn`t come in substantially for the next inventory building season starting the latter part of this year. My point is it all depends on what the input numbers end up being, and nobody with a high degree of certainty has a good handle on these input assumptions, as we really are in unchartered territory. What if we have 10 more weeks of 8 million barrel inventory builds; that is 80 million barrels right there added to constrained existing storage facilities. This high an assumption I believe is problematic for both storage capacity and oil prices, and can it absolutely be ruled out? Who knows when everyone is incentivized to increase production as much as possible to make up for lower revenue streams to pay debt obligations and stay in business? We are already seeing secondary share issuances, the need for cash throws an ironic twist into the oil oversupply equation. What if we have builds straight through the summer driving season?

Economic Demand: Domestic & Global Perspective

Throw in the fact that US GDP and economic manufacturing data has been weak the first quarter of 2015; things seems to have slowed once again from an economic standpoint here in the US. In looking at the global perspective China`s latest weak PMI economic numbers indicate that their economy is really at its lowest growth phase in over a decade, and throw in the fact that they are done adding oil to their inventory reserves stocking program and the global demand picture for oil looks less than robust as well.

Still Oversupplied Oil Markets

In conclusion the demand picture looks weak both from a domestic and global perspective, the supply side of the equation is still a problem, and we haven`t even touched on Iran chomping at the bit to export more oil with some kind of a Nuclear Program Deal easing existing sanctions. The world had too much oil sloshing around 5 years ago, it had even more 9 months ago when prices started to decline, and it has even more today with $50 oil. Maybe the oil market needs to crash like the 1980s for the supply/demand imbalance to be rightsized in the market. Who knows where oil prices are ultimately headed and for how long, but one thing that does appear certain, is the supply demand picture hasn`t gotten any better since Saudi Arabia first signaled to markets that there was a problem. There is still far too much oil supply in the market right now with nowhere to go!

Electronic ‘Paper’ Energy Markets & Central Banks Distorted Fundamentals from Prices

The electronic artificial oil market where nobody took delivery for the physical commodity for the last decade with derivative style fiat stimulating markets juiced up by QE and ZIRP from central banks, throw in meaningless Arab Spring & Middle East Geo-Political Premiums to boot, and it is little wonder everybody and their uncle was suddenly in the oil producing business. The problem is that since the financial crisis, and the end of the commodity bull cycle after China`s Hosting of the Olympics was in the rear view mirror, the price of oil has been highly disconnected with the fundamentals of the global economy. And I am afraid that until electronic markets become physical delivery markets, prices will still outpace the fundamentals of the oil market, and the supply imbalance will take longer to right size with actual demand. This is where storage constraints eventually will balance out the supply demand equation, and bring about some discipline on behalf of producers. Storage constraints will eventually force a market crash in oil prices, until the oil market crashes completely like the 1980s, there are still too many oil producers currently in the market. Forget about Rig Counts, we need to see Producer Counts go down considerably, until that happens the oil market hasn`t bottomed.

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Thoughts on The Current Oil Market

March 23, 2015 by EconMatters   Comments (0)

By EconMatters

Crude oil has headed into a definitive bear market starting 2H14.  Since most of the oil companies (majors as well as E&Ps) based their budget, growth, and strategy trajectory on ~$50 oil price scenario even for the most conservative, the current ~ $45 WTI price environment has created a crisis situation for many oil and gas producers.

WTI 6-Month Chart

Chart Source: nasdaq.com, as of 3/23/2015 am

The immediate response has been reflected abundantly in rig count.  Oil rig count has dropped drastically particularly in the high-cost basins such as Permian in W. Texas / New Mexico and problematic transport regions such as land-locked Bakken in N. Dakota /Montana. For example, according to the latest Baker Hughes data, the number of rigs in the once red-hot Bakken fell to double-digit levels for the first time in at least four years, down 50% from the most-recent high in October, 2014.  Likewise, oil rigs drilling the Permian Basin also plunged ~50% from November, 2014.  

We probably already learned the main contributors to the steep drop in oil prices include stagnant demand & global economy, rising production from U.S. Shale, and a strong dollar depressing all commodities priced in dollar.  I personally believe these macro-economic factors are unlikely to change that much as to lift oil out of the bear market in the next 12 months.  Nevertheless, I'm going to discuss my views on some other popular oil-market related topics.

Saudi Arabia

A decision and/or announcement from the Kingdom to cut its production would certainly give an immediate boost to oi price.  However, my observation is that Saudi is dead serious about protecting its market share, and unlikely to cut its production.

To illustrate, Taiwan's news media reported that in late 2014, Saudi sent a group of delegates courting one of the two refineries/petrochem plats in Taiwan which was the first ever in over 40 years.  According to EIA, Taiwan oil consumption is ~ 1 million barrels a day in 2013, which explains why Saudi never sent delegates visiting such a small client before.  This only demonstrated how Saudi is hunkering down to secure every bit of its market share.  In addition, Saudi is one oil producing country seen $10 oil before (as opposed to U.S. Shale Industry's total shock by $50 oil).  Another psychological factor, if Saudi has hung in this long watching oil falling from $100 to $50, a production cut at this stage would only show weakness by the Kingdom to deviate from initial resolve.    

Wells Drilled but Not Completed

Wells that operators do not want to produce at current low oil prices. Well backlogs have sparked some concern that holding back completions until oil prices rise would simply cause a production surge in the future, leading to another oil price plunge. For example, Platts reported EOG Resources (EOG) sees a backlog of about 350 wells this year and Anadarko (APC) says 125 wells. Continental Resources (CLR) said it had deferred completions in the Bakken by 25% in Q1, while Chesapeake (CHK) will have about 100 wells in its Eagle Ford Shale inventory.

Unlike rig count, well backlog is not a statistic tracked by anyone on a regular basis.  Platts cited estimates of 1,400-2,000 'fracklog' wells in the U.S.  However, I think this 'fracklog' seems more like a 'spin' by E&Ps (and Wall Street) to frame a better story for capex and/or production cuts of 2015+ rather than something of a material impact.

A lot of small and mid E&Ps typically cannot afford to remain so 'strategic' as they need cash just to stay afloat to fund operations and interest expense (See 'E&P Funding Crisis' section below).  Furthermore, the steep decline production curve, a characteristic of oil Shale, suggests the production impact most likely would not be significant and long enough as to bring about another oil bear market once oil prices recover.

E&P Funding Crisis

The long good days of $100 oil have spoiled many E&Ps into reckless spending and leverage.  Oil falling to 6-year low has put some E&Ps in jeopardy.  Reuters is reporting that JPMorgan has been shopping the entire Whiting Petroleum (WLL), the biggest oil producer in Bakken, to potential buyers but they're scared off by $5.6 billion in debt. Whiting piled up debt after the acquisition of Kodiak Oil & Gas last year.  Quicksilver Resources, a natural-gas-weighted producer, filed Chapter 11 on March 17 following Dune Energy and BPZ Resources.

I think this 'funding crisis' is individual-company based instead of an industry wide tsunami.  There are 100+ publicly traded mid to small E&Ps and E&P MLPs in North America.  Many risky and high levered companies were able to hide under the high oil price in the past.  This time around, the higher break-even point of Shale Oil dictates only the strong will survive.  So now is the time for some industry consolidation to weed out 'sour apples'.  In the end, bigger, smarter and healthier companies will remain, which is a good thing for investors and the U.S. energy industry as a whole in the long run.

Dividend Cut by ExxonMobile?  

A couple of weeks ago, CNBC had a segment talking about earnings per share vs. dividend per share and concluded that some of the bigger oil companies such as Hess (HES), ConocoPhillips (COP), and BP may need to cut dividend as earnings fall short of dividend.  ExxonMobile (XOM) name was also verbally discussed in this particular CNBC segment.

Frankly, I think it is plausible Hess, ConocoPhillips and BP cutting dividend due to lower oil prices & revenue; however, XOM has never ever cut dividend since the stock was $5, so I doubt the oil major would break tradition this time.  After all, XOM is sitting on $4.7 Bn cash and $53 Bn in Current Assets (as of 12/31/2014) .  XOM stock is more a dividend play rather than energy, so I don't quite understand Buffett's rationale of dumping all of his XOM holdings while still keeping IBM.        

Merit of The Integrated Model 

Oil price plunge has also brought about the age-old debate over oil majors such as ExxonMobile keeping its integrated model (Upstream + Downstream) instead of spinning off the refining business like Marathon (MRO) and ConocoPhillips (COP) did.

Sure, when oil prices are high, upstream (exploration & production) makes all the money while downstream (i.e. refining & marketing) drags.  But when oil prices go bust (like now), downstream actually serves as a natural hedge for the Upstream arm of the integrated model.  This is one reason integrates like XOM should fare better in the current oil price environment than the pure E&Ps.

As I indicated before, shifting away from the integrated model is a short-sighted move blinded by Wall Street sales talk of  'unlocking shareholder value' (banks get hefty fee and shares in a spin-off). Marathon and ConocoPhillips would certainly be a lot better off if they still have the steady cashflow from their old refining business to fall back on.          

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The 5 Most Crowded Trades on Wall Street: Part 3

March 17, 2015 by EconMatters   Comments (0)

By EconMatters

The Utility Sector

This crowded trade revolves around a common theme Central Bank Policy and its effects on financial markets. The third most crowded trade in our series is the Utility Sector Stocks. Investors have piled into this sector due to the perceived defensive nature of the sector with the fact that this sector pays a hefty dividend, a dividend higher than say a 10-Year Bond. And because bond yields have been driven so low by yield chasers, utility stocks get even more of a bid than they otherwise would given their fundamentals. In short, utility stocks and the utility sector in general have become surrogate bond instruments for investors.

 
Yield Plays

Utilities have always been attractive yield plays for conservative investors, but with the age of 10 basis point borrowing costs and lower, anything with a 2% yield looks attractive, not to mention a 3% plus yield. As a result large investors are playing utility stocks with borrowed money for the substantial yield delta above and beyond their abnormally low borrowing costs.

Low Natural Gas Prices for Longer

Natural gas prices are low and steady so electricity prices and margins are not that great for the industry, and we aren`t capacity stretched like we were 10 plus years ago before the financial crisis when the electricity market was much tighter from a supply and demand perspective.

Fundamentals Not So Great

This sets investors up for quite a rude awakening as the fundamentals of the industry are not that great, low for longer natural gas prices are going to keep the peak demand electricity prices much lower in the spike periods of increased demand as this is the swing commodity for bringing increased generation online. Hence the utilities margins are not going to be that robust like they were in 2005.

Sector Switch for Dividend Investors

This sector really is a central bank play, and most of the run-up the last five years, and last three years specifically is the result of the yield chasing bond proxy investment class. As interest rates rise, and they are only going up from here, not only in the United States, but around the globe, this sector is in for some major pain. Actually for the conservative yield investors they may want to switch out of this Utility sector for beaten down energy companies where the dividend will remain safe, and there is no bankruptcy concerns regarding some of the niche shale producers.

Think in terms of Exxon as they have never cut their dividend, and my father has owned this stock since oil was $5 a barrel. But these conservative investors who normally seek refuge in utilities are going to lose a lot of principal gains when the momentum players leave the sector as interest rates rise both in the US, and eventually around the globe over the next 5 years.

Utilities never meant to be Sexy Momentum Asset Class

Utilities were never supposed to become a sexy investing sector, and that has been what they have become, sexy momentum plays not just for the yield returns but for the price appreciation gains. It is one thing when the fundamentals are robust in the industry, but this isn`t the case, and it isn`t going to be the case for the foreseeable future. The utility sector has become very much a momentum sector just like an Apple stock, and that should worry investors who normally invest in this sector.

This sector has a whole lot of investors and capital that is playing around in this sector who normally don`t invest in utilities. This is fast money, and it isn`t in for the long haul, and unfortunately their mass exodus is going to take a lot of your conservative principal along with it as this massive trade unwinds. Ergo, the utility sector is set for some major declines over the next five years as the crowded nature of this trade becomes ‘less crowded’!

February Exodus

Investors were seeking safe haven in utilities providing a further boost to the sector during the January overall market selloff. However as the market gained traction investors transferred out of this sector into more perceived riskier stocks as the market rose in February. There has been some rotation out of the sector, but this is from the all-time highs, and if you consider the fundamentals of the industry versus the gains in the sector over the last 5-7 years there is still ultimately significant downside risk for investors in this sector.

However when I look at the individual yields of the companies for this sector they are quite appealing compared to bonds. This tells me that the fundamentals for this sector are even worse than I first diagnosed, some of the individual name`s charts look quite bearish, and dividend cuts may be in the cards for some of these companies, which would put more downside risk for investors in this sector.

Better Valuations Than Anticipated in this Sector

As I started this analysis I had a preconceived bias for this sector that it was just off the charts over-valued, but after some further digging, and a little reflection, the utilities sector is not as over-valued as other parts of the market. It wouldn`t make my top five after this research project, it is good to keep an open mind and be flexible to new information in financial markets as you research investment themes. I would probably replace Utilities with some other sector like Bio-Tech.

But who knows in comparison to my first two pieces in this series being Apple, and the Bond Market everything looks like a much more decent value proposition. This research just further validates my thesis that those two are blatantly over-valued and frankly bloated pigs of investment. Investors should be running for the hills in those two investments. When you consider Apple`s market cap overlays so many fortune 500 solid companies total value if you put a Venn Diagram Market Cap analysis over the entire market it really points out the absurdity of Apple`s current and unsustainable stock price.

In other words, I would take the other companies business prospects over Apple`s business prospects from a Market Cap expansion standpoint even if the overall Market Cap of the market contracted. Apple`s Market Cap would contract more versus the rest of the fortune 500 companies in the Venn Diagram as a spread trade.

Final Thoughts

The sector will be hurt by the momentum players leaving this sector and despite the recent profit taking, the utilities sector was up 24% in 2014. Thus despite what appears to be attractive yields for some of the individual companies with the sector, bad earning`s releases are going to be punished in 2015. Moreover, given the fundamentals of the industry I expect a lot of continued profit taking as interest rates rise the second half of 2015.

Therefore, sell the spikes in utilities or use these spikes to take profits in your positions and wait for the yields to become even better values down the road. Yield returns can only go so far when you lose 24% of your principal as the momentum investors leave this sexy 2014 investing sector.

And finally be careful just like in the energy sector, some of these attractive dividends may be cut, so do your individual research on the history of what the company does when their stock falls due to weaker results – do they stay the course with the dividend during tough revenue periods? Maybe take a lower dividend from a company within the sector which has a solid history of standing by their dividend even during difficult times like Exxon Mobil Corporation (XOM) in the Energy Sector. But as my father says he hopes (XOM) falls another $15 a share so he can add to his current position. Therefore like Warren Buffet sometimes the best position is no position, having a large cash position near market tops is not such a dreadful investment strategy. Buy when there is real “blood in the streets”!

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The 5 Most Crowded Trades on Wall Street: Part 2

March 16, 2015 by EconMatters   Comments (0)

By EconMatters

Editor's Note: This is part 2 of a 5-part market series by EconMatters.  Read Part 1 here.  

Bonds

The most crowded trade on Wall Street, the globe, or a beach in Brazil is the Bond Yield Chasing/Price Appreciation trade. This sector or asset class is an absolute bubble, the magnitude of which has never been seen in a mainstream asset class, and one that is deemed conservative and safe by investors which makes the tail risk for these assets off the charts. We literally are looking at an 8 sigma event down the road in this asset class.

Liquidity Bubble

It is driven by a liquidity bubble, there is just far too much capital via cheap money sloshing around financial markets with no place to go, and this has been the case for the last five years. And now that Japan and Europe have jumped on the QE bandwagon the last several years, the liquidity bubble just keeps growing. Investors have made a boatload of money over the last 7 years with Global ZIRP and each year they keep needing bigger asset storage places to put all this paper wealth.


Central Banks Irresponsible Promotion of Risk Seeking Behavior

The problem is that central banks let this get so out of hand and frankly are freaking clueless as to the magnitude of the problem that they have created that future losses on European bonds alone I surmise makes all European banks completely insolvent once these bonds that have little to no reserves set aside to offset future losses are marked to market 10 years from today.

US 10-Year Bond Yield (1970-2015)

Complacency

The fact that financial markets have become so complacent due to a leading Central Bank in the US Fed being ultra-dovish that even in changing language for a rate hiking cycle they will go out of their way to be seen as dovish. This is ridiculous, is the financial system that fragile after 7 plus years of ZIRP? It shouldn`t matter to financial markets whether the Fed will bend over backwards for a 25 basis point rate hike at this stage of the recovery process! This should be worrisome to the Fed regarding just how far markets are off sides with dovish complacency, and the ridiculous need for hand holding from the Federal Reserve.


Laziness of Investors

Bond investors look at the world this way they have all this money and they need to invest it somewhere; they cannot store these types or vast sums of money in cash. It requires too much work to research alternative investments, they refuse to put this money to work for lending, infrastructure investments, growth projects, capital expenditure investments like power plants; all these type investments are considered riskier than just an electronic transfer into bonds with ZIRP.

Euro Area 10-Year Bond Yield
Reinforcing Nature of Bond Bubble

The problem with this mentality is the bubble keeps growing, yields keep going lower, and investors not only are not losing money they are making money, further re-enforcing the mentality that these are the best places to put capital to work as investments. You know the logic that house prices can never go down! This further reinforces their mentality of bonds being safe stores of capital value regarding principal; that big deal bonds sell off and they lose 2.4% on the investment! Moreover, given all the profits they have made in the past and the fact that they have stored this capital ‘safely’ adds to the bond complacency trade and is an additional part of the problem.

Historical Valuation Norms

It is the degree of bond prices now relative to historical norms where bond investors are underestimating their exposure. It doesn`t matter if you have to work harder to find alternative investment options to bonds but these investors better make this choice because it takes a substantial lead time to put in the work on these type investment strategies. Not to mention that unwinding some of these bond positions will take years, and not months!

Germany 10-Year Bond Yield
Debt-to GDP Ratios

By the time that the Debt to GDP Ratios start to matter again on outright and blatant insolvency risks; that these bond holders are going to have to take major haircuts on these positions becomes a legitimate concern given their cost structure of abnormally low interest rates. The liquidity trap ensures that when everybody exits the principal losses on some of these humongous bond portfolios and positions is going to be well above 50%, not the 2.4% that they have in their current models.

Risk Premium Completely Abolished in ZIRP World

The US keeps pushing out more and more debt each year, they keep having to raise the debt ceiling every year, what happens in 2018 when the entitlement`s curve starts kicking in? This event is just three years away! By having cost basis or artificially low central bank subsidized entry costs on some of these bond positions at current valuation levels, the losses on these investments which should never have been encouraged by Central Banks are going to be in the 6 sigma range once the entitlements’ curve kicks in regarding the true nature of the US`s debt obligations. This brings to the forefront what is currently lacking in the bond models that bond premiums are supposed to represent for investors – the haircut factor.

Japan 10-Year Bond Yield
European & Japanese Bonds: 8 Sigma Plus Risk Profile

This is the US, forget about European and Japanese Bonds there is no hope for even haircuts for these bond holdings. There is no bond valuation model that makes any of these holdings worth 10 cents on the dollar in just 10 years from now! It doesn`t matter whether there is inflation right now, central banks need to discourage ‘haircut investments’ of all kind. This is how financial markets crash with derivatives: losses beget losses, leverage exacerbates the problem, CDS`s, Asset Margin Collateral, Options Spike, Volatility Explodes, Counterparty Risk soars, and distrust of the system causes the entire financial system to implode like the 2007 financial crisis. But this time all central banks have no more tools, the entire world is at ZIRP Warp Mode.

Poor Capital Allocation Investment Hurts Both Sides of the Debt-to-GDP Equation

France 10-Year Bond Yield
Inflation will rear its ugly head again, but this is the least of Central Banks concerns it is the amount of Global Debt that continues to pile up relative to GDP. If central banks incentivized actual investment with all this cheap money in growth producing projects the world and financial system might have a fighting chance. But this is counter-intuitive to their logic so they keep rates artificially low, incentivizing poor capital allocation strategies, continuing building the bond bubbles. This sets the stage for 6 sigma events at the minimum because the yields are so out of whack with historical norms. The debt keeps piling onto governments` balance sheets because interest rates and borrowing costs are so low negatively reinforcing proper addressing of the escalating government debt. Therefore no need for structural reforms, and voila Central Banks just reinforced the bubble getting bigger and bigger until market forces make it pop due to the realization that haircuts are the only way out!

The Haircut Era for Bond Holders

Consequently the Bond bubble is not only a crowded trade, an overcrowded trade, a bubble of historic proportions but it will cause the entire crash of the financial system if it continues at its current pace of massive expansion; and is certainly the next global recession to hit financial markets. It will be the cause for 401ks becoming 201ks or less sometime over the next 10 years as the liquidity bubble, leads to the bond bubble, leads to the re-pricing bubble based upon historical valuation norms; that ultimately leads to what I call the “Haircut Era” for bondholders!

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The 5 Most Crowded Trades on Wall Street: Part 1

March 16, 2015 by EconMatters   Comments (0)

By EconMatters

Herd Mentality

Here are 5 of the most crowded trades in financial markets, where a lot of group think has led to large fund flows on one side of the trade. This has been a very common phenomenon the last couple of years in financial markets, partly due to participating in the same investment conferences, limited trading opportunities, lack of imagination, investors seeking security with the crowd, Fed incentives, shared information and networking otherwise called industry collusion, trend trading, and going with ideas that have worked in recent history.

 
Risk/Reward Perspective

Now crowded trades can remain crowded trades for a long time, they can even become overcrowded trades long before they start to reverse themselves. However it is important to know that a lot of funds have already been committed to these trades from a one sided perspective. Thus the price to value relationship or value proposition from a risk reward perspective is just not that great, and in some of these five cases, is in fact pretty bad or skewed in the opposite direction.

Apple

Let’s start things off with Apple this stock has had an amazing run from the large pullback when Samsung pulled ahead of Apple with the better smartphone with a bigger screen. Since then Apple has finally reacted and upgraded their phone`s specs with the culmination being the large screen size in the last phone iteration. Samsung has come out with some small improvements for their last smartphone iterations, but currently Apple probably has the overall consensus best smartphone as viewed by the mass high end smartphone buyers. Samsung is coming out with the Edge Smartphone in April, and this phone`s specs are probably better than Apple`s latest product offering, but it remains to be seen if the specs are noteworthy enough to gain market share from Apple for the high end buyer given Apple`s Higher Brand Value among consumers.

So You Have Done The Big Screen…What Now?

I think that once Apple finally came to market with the big screen phone there are only small incremental improvements to smartphones from here on out, and smartphone margins are going to come down across the industry. I also think that Apple will no longer have the best smartphone in four months as the other companies bring out their latest offerings to market. I look for one more really good earning`s report from Apple, but that is probably as good as things are ever going to get for this company. The downside risks as all the Hedge Funds and Management Funds unwind this trade on profit taking and seeking better returns elsewhere in the markets is significant.

Smartphones are fully Commoditized

I know this company is sitting on a lot of cash, but cash can be burnt through rather fast on the downside of a major commoditization cycle in a company`s hardware offerings. I wouldn`t be surprised if Apple drops below a $50 stock over the next three years, and remember how fast Apple dropped the last time all the money managers left this stock. The amount of fund managers who currently hold this stock in their portfolios is off the charts from a percentage standpoint, it is probably the second most crowded trade on the street.

In fact, I would categorize Apple as an overcrowded trade right here, not that it cannot go higher, but probably an ideal candidate for legging into a short position at anything above $130 a share, if it ever gets back to those levels. Maybe hope for a spike on second quarter earnings and start building a short position in this overvalued stock. The ideal time for establishing a short position was when it spiked on all that hysteria over building the next I-Car, speaking of how companies can burn through loads of cash reserves by going outside their core competencies.

Apple Meets the Definition of an Overcrowded Trade

But from the standpoint of who is left to buy this stock, those already heavily invested on the street, and the downside risk from these elevated levels as the Fed ends its easy money policies, Apple is setting up for one of the greatest exoduses that we have seen on the street in ages. I wonder if similar to the last time Apple dropped like a rock and a bunch of fund managers got left holding the bag citing valuation arguments and the increased need to bail their underwater positions out with increased share buybacks; if the same phenomenon occurs again.

Deer in Headlights

This stock price is much higher this time around, and once the exodus starts, and key technical support levels fail, the very nature of how overcrowded this trade is will become apparent to investors. They can lose so much value on their positions in less than 6 months’ time once the sentiment turns on this name that I would say Apple is the most dangerous holding on the street right now for portfolio managers. Once this name starts breaking you cannot worry about slowly unwinding the position, you just have to start dumping this stock like a fire sale because everybody else will be trying to get out at the exact same time. Those slow to anticipate the magnitude and breadth of the selloff in this Halo Stock once the selling momentum snowballs will be left looking like Deer in Headlights.

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The ECB Should End QE Next Month

March 14, 2015 by EconMatters   Comments (0)

By EconMatters

Mario Draghi backed into Unenviable Corner

This was an instance where the markets pushed Mario Draghi in a direction that really wasn`t necessary, an area he knew deep down was fruitless, and in the end will be proven to be a complete waste of time, forestalling the inevitable structural changes required for Europe to grow in a competitive fashion over the next decade.

Germany, South Korea & United States

Where are the Apple`s and Samsung’s of Europe? This is the real problem for European growth, they don`t produce innovative companies that compete on a global basis. There is no Silicon Valley for Europe. Germany has great engineering minds, and their country’s business prospects reflect their competitive innovation in this area, Germany has been a dominant player in the luxury automobile market for decades. Subsequently the problems facing Europe are really country specific and it revolves around which countries have educational, cultural and business infrastructural systems in place that cultivate competitive and innovative new business models that can compete for market share on a global basis with the likes of China, South Korea, Germany and the United States.

German 10-Year Bond Yield
France Serial Underachiever

France has immense resources at its disposal but as a country is a serial underachiever in terms of competing in areas of innovation beyond the fashion and cosmetics Industry. They should be much more prominent in promoting technological and scientific advancements and offering up entirely new industries for the next century. If alternative energy and green energy focus is where France feels comfortable investing and promoting  as a society then start at the grass roots, educate your citizens in the sciences to dominate this industry, and invent the next paradigm for solar technology and energy storage battery technology. Start producing the next generation of Elon Musk’s from your country`s vast educational, cultural and financial resources.

France 10-Year Bond Yield
Shale Technology Didn`t Just Fall from Heaven

In short be the very best in some industry that generates real competitive advantage on a global scale, be the Apple or Samsung of Solar. But it starts with having the right structural environment for industry to build upon, i.e., Silicon Valley in the United States, Advanced Engineering in Germany, and Technological Commitment and Innovation in South Korea. For example, the United States has become the experts on Shale Technology revolving around the energy industry, and the US dominates in their understanding and development of this advancement in energy extraction techniques. This didn`t happen by accident! The Free Market system of Capitalism set the stage for Shale Development in the United States as high energy prices motivated the entrepreneurial spirit and created innovative technological advancements to meet these energy demands from the marketplace.

Italy 10-Year Bond Yield
Germany & the European Union Laggards

This is the real problem and is country specific within the European Union, there is basically Germany and everyone else, most of the laggards of the European Union just aren`t very innovative, or offer any competitive industries that the world needs on a large enough scale to move the needle in regards to promoting real country growth and revenues. This is the real issue with Europe, one of structural environment, and providing the necessary infrastructure in the laggards of the European Union to compete over the next century on an ever changing global landscape.

Portugal 10-Year Bond Yield
On the other hand Mario Draghi buying German Bunds pushing the yield on the 10-year bond from 30 basis points to 20 basis points is just beyond absurd, and frankly very dangerous. The reason this is dangerous is the fact that Germany is already a very strong economically structured economy, and their currency is in effect through a weaker Euro being far too undervalued compared to the strong economics of the country. This is going to result in even stronger growth for Germany, and they risk having an over-heating economy, and an inflation problem down the road which is specific to Germany. The ECB instead of buying bonds to push already extraordinarily and unsupportable bond yields any lower would have been better served by issuing new “European Educational Bonds” to build ‘science academies’ or ‘business entrepreneurial  development programs’ or ‘engineering programs’ in Poland, Italy, Portugal, Spain, Ireland and many of the other underperforming European countries.

Spain 10-Year Bond Yield
South Korean Business Strategy & Model

The South Korean government made a concerted effort to develop industries that would compete for market share on a global basis. You cannot stroll through the appliance department these days and not realize South Korea`s advancement and influence in this area where they were not even a player 20 years ago. This didn`t happen by accident, South Korea analyzed what model they needed to employ from a structural and environmental business climate standpoint, promoted this landscape through investment, education and cultural commitment, and now are dominate players on a global scale in many industries. This is what Europe needs to do from a structural business strategy standpoint.

Belgium 10-Year Bond Yield
European Politicians & Structural Reforms

Mario Draghi got talked into this European QE nonsense when it wasn`t required because European politicians keep trying to kick the can down the road on real European structural reforms. Europe already had a QE program, as they benefitted immensely from the QE programs in the United States. The fund flows and derivative effects of the US QE Programs, being that the United States and European financial markets are very closely aligned, flowed through to Europe on a grand scale. Therefore, an additional QE program just isn`t going to have much positive effect in real terms because bond yields are already historically and insupportably low for the long term in Europe.

Ireland 10-Year Bond Yield
Germany Risks Overheating Economy & Runaway Inflation

The benefit of a weaker Euro may seem appealing for the short term, but it isn`t really a solution to Europe`s structural problems, and in fact may exacerbate the structural differences between the strong and weak countries in the European Union. This could result in runaway inflation in the stronger European countries and increased trade imbalances between European Member countries that only widen the economic inequity, social and political interests’ gap. The Euro has already been devalued considerably, European Bonds are at unsupportable levels, and it is pretty apparent that a QE program in Europe just isn`t needed at this point, there is nothing more for it to do!

Greece 10-Year Bond Yield
Europe Wants Growth Then Raise Interest Rates: Healthy Capital Rates Motivates Healthy Capital Allocation Strategies that Promote Real Growth Projects in the Actual Economy

The supposed goals of a European QE Program have already been accomplished through essentially market front running by financial institutions and players, and as soon as it began, its end is already in sight. The biggest QE in Europe and the United States was the lowering of interest rates to zero, once the zero bound is reached, the only real stimulus to actually motivate real investment growth and fund flows into growth oriented projects it to raise interest rates. This changes and motivates financial players to find alternative financial returns as opposed to just yield chasing opportunity returns in bond to borrowing cost leverage paper market plays.

South Korea 10-Year Bond Yield
European QE is Dead On Arrival

I am not sure how long Mario Draghi can carry on this QE Charade but it is quite obvious that the benefits have already been gained, there is nothing more to be gained from the program, and I am sure it will continue on a couple more months for appearances sake. But I look for European QE to end much sooner than they anticipated when rolling out this program. They talked about it for so long, built up the front-running momentum for years, that when it finally gets installed, all the intended results have already been essentially front run by financial markets. European QE is a massive instance of a Buy the Rumor, and Sell the News event.

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Michael Lewis is Right “Spoofing” Proves Market Rigged on Daily Basis

March 13, 2015 by EconMatters   Comments (0)

By EconMatters

Brent Spoofing & HFT

As the European Market closes today and oil has some bearish sentiment to the trading day, one of the common techniques is to bang the European close in the Brent contract which being a much less liquid contract than WTI can be quite profitable. Usually this takes place around 10:00 to 10:30 am CST but with the time changes this week everything is pushed back an hour here in the US with the European close now being 11:00 to 11:30 am CST.

Specific Example of Spoofing

Well as this bang the close strategy is happening in Brent pushing the futures contract down $56.50 to $55.50 in 10 minutes a nice illustration of HFT Algo strategy plays out, in other words blatant market manipulation also called spoofing was conducted by some large firm. Here is the case and this isn`t specific to Brent, Oil, or an unusual event this happens in all markets throughout the trading day. So as Brent is going lower some firm wants it to go lower some more so around the $55.75-80 area they park a large order around 900 futures contracts. Now this isn`t a real order, the seller isn`t really going to sit there and take in 900 buyers, it is meant to manipulate the other trading algos and buyers in general from stepping in and buying oil with the idea of pushing the contract lower. In essence “Scare” the market lower! This usually works and today it worked pushing the Brent contract down to $55.51, and needlessly to say this firm benefited from this technique and covered before eventually pulling the entire order once a couple of contracts hit on the price that the seller parked this large fake sell order.

Easy to Regulate Spoofing Activity

Now this kind of activity would be pretty easily to reign in, easily trackable, and easy to identify which firm utilized this spoofing manipulative strategy. Just pull up the Brent trading records on the ICE exchange for 3/13/2015, and see which firm entered an order previously to sell the Brent contract, then wanted to juice their returns or move the market in the direction of their scalp by placing an additional large order all at once as price is going down during the European Close around 11:25 am CST (900) contracts give or take, and then cancels this same large order once it is hit with a couple of offers to buy at that price. Needless to say Brent traded much higher than this original sell order once it was pulled from the market as the objective of pushing the price lower to fill their existing order was already achieved! This is spoofing, a common technique used in markets, often revolving around HFT strategies, is highly manipulative with both intent and market effect, and happens right out in the open for all to observe. This example of HFT manipulation is far more straight forward than some of Michael Lewis`s HFT claims that are much harder to prove beyond a ‘reasonable’ doubt.

Spoofing just one HFT Market Manipulation Strategy

This kind of spoofing strategy usually takes place with 100 order lots in the oil markets, and the 900 contract effort was just hilarious, taking overkill to an entirely new level. I have even seen several firms lined up with 100 contract fake sell or buy orders on consecutive price levels. For example, 100 at $48.51, 120 at $48.52, 150 at $48.53, 105 at $48.54 etc. all with the same intent to move prices in the opposite direction of these orders. They don`t really want to get filled, in fact they will never get filled, as soon as a couple contracts hit one of these orders they are pulled from the market.

Now big orders get filled all the time but somebody with a big order doesn`t just advertise to the entire world in most cases, and if legit doesn`t cancel the order when it gets hit. Usually large orders are disguised in the market via various methods to maintain a lower or better cost basis on the overall position. This Spoofing Strategy works, and is highly profitable because its frequency has increased over the last three years with more and more firms adopting this HFT trading strategy. There have been a couple of small fines for this behavior, but the blatant occurrence of this strategy and the increasingly brazenness of the manipulative trading technique shows there is no regulatory force enforcing this trading impropriety by participants.

Markets are Rigged at both the Macro & Micro Level from the Fed to HFT Firms

Now this is just the tip of the iceberg when it comes to market manipulation, I thought I would just provide a concrete example of the kind of funny business that goes on every day in financial markets. The financial markets are manipulated from the macro perspective by the Federal Reserve with their outright asset purchases and various other market interferences all the way to the micro level of HFT scalping algos.

There is nothing wrong with scalping per se, but utilizing manipulative techniques like fake orders to ensure the scalp works and to increase the tick size profit of the scalp is illegal, and occurs every day at the micro level of market manipulation, and is one HFT strategy that is easy to prove which firms are conducting this illegal market manipulation activity.

Accordingly, Michael Lewis is right markets are rigged, but he really is underestimating the extent of market manipulation, financial markets really are the wild west, investors should always be wary of how they are being taken advantage of in financial markets. The phrase Caveat Emptor ‘Let the buyer beware’ applies here.

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