Here Comes $40 Oil …

Two weeks ago the European Central Bank further reassured the world that it is ready to save the day if and when the day needs saving. (That means more stimulus.) Then this past week, the Bank of Japan had the same opportunity but didn’t come off nearly as encouraging.

Oops!

Problem …

The Bank of Japan didn’t meet market expectations.

And setting market expectations properly is the only thing justifying global policymakers’ hijacking of the global financial system.

But if investors can’t feel good about putting their money in equities, what else is there?

Well, right now it’s probably not crude oil …

Crude is down more than 20% since it topped out on June 9.

Whereas XOP, an ETF of crude exploration and production companies, is down only 13% in that time. XLE, an ETF covering a broader group of energy names, is down only 5% in that time.

Why is crude falling? And are crude names set to fall further in order to “catch up” to crude prices?

First of all, the latest thrust of crude oil’s decline seems very fundamental. That is, supply and demand stats are adding pressure to the price.

Demand is sluggish-er than expected.

And U.S. crude oil inventories are rising when seasonality typically points to a decline. The reason is largely due to increased imports.

OPEC nations continue producing …

And that helps make it cheaper for U.S. refiners to import crude than transport it by rail across the country.

The result of plentiful oil is a glut of gasoline.

U.S. gasoline inventories are also bucking their seasonal trend.

And that suggests U.S. refiners won’t be rushing to grab up U.S. crude inventories at anywhere near the pace that would argue for a rally in the price of crude oil.

In other words: It looks like crude decline can continue.

I’ve said many times in the last month or two that crude is likely to break the $40 per barrel level before it breaks $60. Most recently, if memory serves, once this decline got under way I even told my subscribers that crude was more likely to hit $40 before it hit $50 again.

It’s sure looking that way.

But it is crude oil. It moves fast and changes directions rather abruptly. Chances are as soon as the market starts discounting the inevitability of sub-$40 crude oil, conditions will arise to warrant a rising price again.

For example, look at the disconnect in the price of crude and HYG, a high-yield corporate bond ETF:

The up-until-now positive correlation between the two assets was indicative of the default pressure on crude oil companies that are leveraged up on debt. With crude prices south of $40, margins fell so dramatically that these debt-laden producers could not cover the costs of financing their debt.

With crude oil rising steady from $32 to $50, producers who had not already gone belly-up were able to breathe a sigh of relief. Investors were, too, since the rising price of crude positively influenced risk appetite across much of the rest of the market.

Now the questions have become:

  • Will the high-yield market roll over to reflect souring expectations for crude producers now that crude prices are approaching $40?
  • Or will crude oil find its footing and retake $50?

Needless to say, the fundamentals I touched on above don’t bode well for the price of crude oil.

Similarly, if the Federal Reserve continues to talk about improving conditions and greater chance of an interest rate hike (as last week’s FOMC meeting suggests), then the high-yield universe is likely to come under pressure.

I think it makes sense to wait before buying into a potential rally in crude oil and energy names. If crude lingers, I think it gives energy names a chance to break down further to reflect the change in crude to date.

Think of it like chasing a rabbit into a bush. If you wait there for a bit, the rabbit will get spooked and take off running again — merely because it cannot handle waiting for you to make the next move.

Do right,

JR Crooks

“JR” specializes in trading commodities, currencies and options. He has spent nearly 10 years analyzing financial markets and writing about global economics. JR honed his trading techniques and global-macro worldview alongside his father, Jack Crooks, at Black Swan Capital. JR also …