Investors' Confidence Destabilized By Increasing Oil Supplies

by: Tom Dorsey


Oil oversupply has driven oil prices down from over $100 a barrel to under $29.

The markets aren't providing a bottom at this time, and investors jump every time the price of oil drops.

Midstream and downstream energy companies are less affected by the cost of oil because they buy and sell at market prices and can still profit.

There is an end to the drop, but we cannot see it at this point given the lack of clarity on oil prices.

2016 has started with a bang, but unfortunately not in the way we would like. However, because we are where the markets have taken us, there is an opportunity for those with patience and education. I did not see this big of a drop coming in the new year, but we have discussed the effects of China forcing the markets down from time to time.

The Cold, Hard Facts

Since the summer of 2014, when Saudi Arabia chose not to reduce its output to stabilize the world's supply with demand, the amount of production has exceeded demand. The world has stored the excess at a cost, but that has driven the price of WTI oil down from about $105 a barrel to close on Monday, Jan. 19, 2016, at $28.46.

Since the first week of January 2016, the stock markets reacted strongly to bad news from China about its economic reports. And oil jumped on the bandwagon to push stocks down further. After the first week, the Chinese effect has lessened and the oil price effect continues to push the markets down. The Dow Jones Industrial Average opened the year at 17,405 and dropped to a low of 15,842 on Jan. 15, closing at 15,988 that day. That is down 1417 points (8%) for the year.

China released its GDP of 6.9% on Monday, Jan. 19, 2016, which would be strong for any other country, but this number has been falling over the last 10 years. China will not be able to maintain higher growth rates, but the markets don't like to see drops. Investors and the markets should be looking for steady growth, not the double digits from years past. We have just begun the reporting cycle, and many stocks have reported positive earnings for the fourth quarter and Christmas season, along with a nice profit and expected dividends. Stocks on their own merit should not be dropping in price like this.

The Challenge

Sometimes, various factors push markets into unforeseen realms. Or maybe not unforeseen, but beyond most logical conclusions based on all the factors in the market. The financial crisis of 2007-08 could have been avoided; the effect from about 7% of the loans issued being defaulted on caused larger ripples throughout the markets than should have been created.

In today's oil market, the effects could be limited to the price of oil, which would affect the exploration and production (E&P) companies. Midstream and downstream companies should not feel much pain, as it does not directly affect their operations or profit margins in the big picture. Let me explain this point before too many readers overreact.

A midstream company might charge a set price to move the product X amount from point A to point B. That is regardless of the current price of oil. Oil could sell for $100 or $20, but the cost to move it is the same. The midstream keeps its cash flow the same and earns a profit. The same applies to a refinery's operation. They will buy the oil at market price, refine it and send it to retailers while they add their costs. Their earnings may drop, but usually equivalent to the cost of oil, so at the end of the quarter the refinery still earns their profit. That might be oversimplified, but it's a general assessment of the business operations. On the other hand, when prices go up the cost of the product goes up, but every participant keeps their profit margin in line in order to stay in business.

The Market's Reactions

Markets are often seen as overreacting and swings are greater than the whole. This is often due to some investors jumping in and out of the market, and the supply and demand energizes the swings to appear to be greater than the reality behind them. A recent example was on Aug. 24, 2015, when the Chinese economic data scared investors around the world and we saw the market take a huge one-day drop. Many companies I track dropped over 10%, with several near the 50% mark. However, by the end of the day or the end of the week most had recovered all -- or nearly all -- of what they lost in the drop.

For the beginning of January 2016, China's economic data started the new year off poorly and many large and small investors who had taken some time off during the holidays stayed out of the markets, or bet it would drop more. It took a week for the markets to calm down from the Chinese economic data, and during that time more pressure from the increasing supply of oil pushed harder, driving both prices and the market down.

The world's oil production continues to remain high as most producers are attempting to sell as much as possible to keep the cash flowing. Most countries that produce oil use this as government revenue to run their countries. In free market countries (like the U.S.), the individual oil companies are taking the brunt of the economic disaster. All of these oil producers are hurting by low prices and falling short compared to two years ago.

Saudi Arabia is the only country in the past 25 years that would increase or decrease its production to maintain stability in the world's oil prices. With the U.S. increase in production, the Saudi's have chosen to maintain their share of the oil market and to allow the price to drop. Their goals are assessed in multiple layers, but first to hurt Russia and Iran, and, second, to force some U.S. producers using the new technologies of fracking to reduce production. Although production has not slowed significantly, new construction of wells is near a standstill. As these wells reduce their flow of oil, the production numbers will drop, but still not reach the balance between supply and demand.

Outside of the U.S., many countries in the world are in a recession and the economies are sluggish. It will take a positive year for them to climb out and create better economic conditions for more companies to hire and grow.

The Bad News

The world will not see an improvement in oil prices in 2016 as the balance of supply and demand work toward a balance. Two factors must work here to achieve balance and work down the amount of extra oil in storage. First, the demand for oil must increase -- and this will be driven by consumers when the world's economies improve and demand goes up. The second is the reduction in production of crude oil. In the U.S., the oil production doubled over the last eight years while demand did not. Although the U.S. is a consumer above its own production level, the rest of the world's producers overproduce to sell to the world. We still must buy oil, and all must be willing participants in the supply and demand solution to manage oil prices better.

Going Forward

As of today's writing, the market has fallen since the beginning of the year and not found its basement. As of Saturday, Jan. 17, 2015, the embargo against Iran selling oil on the world market has been lifted. There will continue to be uncertainty in the oil market, likely pushing prices lower. If you are considering investing in the market, hold your cash for now until the markets settle.

If you are in the market and have seen your portfolio take that big hit in 2016, there is several things to consider. First, the drop in the market is not due to weakness in the U.S. companies or U.S. markets. Most of the drop in the U.S. markets are a reaction to world events. Most U.S. companies are good values to be invested in.

Oil prices have created the uncertainty and will for the near future. As prices drop, this creates a buy opportunity -- but only when we find the bottom. As of the open on Jan. 19, 2016, the Dow Jones Industrial Average had only one company, Wal-Mart (NYSE:WMT), as up for the year to date. The markets will calm over the next several weeks.

There is an opportunity for a bounce in market prices. News from China that its markets are steady or an additional stimulus coupled with oil prices moderating would help ease investors' minds, and help focus on trading for value in the market. Prices will begin to settle and there will be an uplifting of prices. The timeline is not clear, but we will see 10 of the Dow's 30 companies climb into the black for the year with any stability in the market.

I would look for Apple (NASDAQ:AAPL), Walt Disney (NYSE:DIS), Coca-Cola (NYSE:KO), Exxon Mobil (NYSE:XOM), Nike (NYSE:NKE), and Pfizer (NYSE:PFE) to jump to the positive as soon as the dust settles in the market. As for many of the oil MLPs we track, Alon Partners LP (NYSE:ALDW), CVR Refining (NYSE:CVRR), Northern Tier Energy LP (NYSE:NTI), and Calumet Specialty Products Partners LP (NASDAQ:CLMT) will announce their quarterly reports in late January and February with their ex-dates for their distributions. Our assessments of lower quarterly distribution will stand as the crack spread was down and should reflect on earnings, profit and the distribution.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in ALDW, CVRR, NTI, CLMT over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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