Why Oil And Energy Stocks Are Set For A Massive Fall

by: James A. Kostohryz

Short-term supply/demand issues have caused a spike in spot crude oil prices. At roughly $97 for WTI and $113, crude oil prices are looking positively bubbly. In the meantime, global demand fundamentals for the medium term are collapsing.

The last time such a situation occurred was in mid 2008.

Oil traders again seem to be “whistling past the graveyard” as existential threats to global demand threaten to precipitate a massive collapse of crude prices within the next six months.

Oil Markets Ignoring European Crisis

Oil markets are clearly not registering the massive threat to global demand posed by the crisis in Europe. As I wrote this, the situation was as follows:

· Italy’s benchmark 10 year yield is at 6.94%, a level which all agree is unsustainable.

· 10 year yields are at 8.21% for Ireland and 11.44% for Portugal. These are yields that are discounting a significantly high probability of default.

· Spanish 10 year yields are at 5.85%. This is significantly better than the Italian yield, but on the verge of unsustainability.

· French 10 year spreads to Bunds are at 166 bps. This is a level of spreads that Italy and Spain were at not long ago and sends a clear signal that French sovereign debt is no longer in the same asset class as Bunds.

The Euro area is the world’s largest economic block. Global bond markets are signaling threats to the European financial system and economy that are of generational significance. The spillover effects of a major European crisis cannot be expected to be any less than the knock-on effects that the US financial crisis had on the global economy in 2008.

Other Markets Reflecting Fear and Pessimism

Sovereign bond markets are not alone in reflecting pessimism about global growth prospects.

· Interbank markets, reflected in various spreads and indicators, are experiencing substantial stress.

· Various commercial and investment bank shares in the US look to be in the process of testing the catastrophic 2008 lows.

· Chinese equities are near multi-year lows.

· Industrial metals and basic material stocks are mired in major downtrends.

A Repeat of 2008?

In 2008, interest rate and debt markets were clearly signaling a possible collapse of the US financial system. At the same time, energy traders were oblivious, driving crude prices to all-time highs.

Interestingly, in 2008, oil service stocks such as Weatherford (NYSE:WFT) and Hercules (NASDAQ:HERO) served as a leading indicator for the subsequent massive collapse in the crude market. The sort of divergences that are currently occurring between the price of oil service stocks (NYSEARCA:IEZ) and the price of crude oil are reminiscent of what occurred just before the collapse of crude in 2008.


There is a very wide divergence that has developed between the global growth prospects reflected in a number of leading asset classes and crude oil.

For reasons that I have outlined extensively, I believe that the European economy and financial systems will likely experience a major crisis that will threaten global growth. Europe’s problems are, if anything, greater than those faced by the US in 2008. Thus, as the crisis begins to unfold in earnest, I would expect global asset prices to reflect levels of stress similar to those experienced in 2008.

In the event of a full-blown sovereign debt and financial crisis in Europe, I would expect to see crude oil (WTI) at roughly the $60 range – or perhaps below. Oil integrated oil stocks such as Chevron (NYSE:CVX) and Royal Dutch (NYSE:RDS.A) could trade down 20%+. Independent producers such as Anadarko (NYSE:APC) and Apache (NYSE:APA) could decline by 35% or more. Despite large declines already, oil services stocks such HAL could suffer declines of 40% or more. With a one-year time horizon, given the very real risks, I can see no compelling reason to own oil or oil-related stocks at this time.

Investors should not expect crude oil to act as a hedge to the eventual prospect of monetary easing in Europe or the US. History has repeatedly shown that in the event of a global economic crisis oil prices will collapse. This time will not be different.

If anything, this time could be worse than the 2008 experience since the nature and extent of the downside risks posed by a global financial and economic crisis to China’s growth are greater than they were in 2008. A very large proportion of the imbalances that exist in China have actually been accumulated since 2008. These imbalances were brought about precisely due to the massive fiscal and monetary stimulus implemented by China to counter the 2008 global financial and economic crisis. The accelerated unwinding of those imbalances triggered by a new global crisis will greatly complicate any Chinese efforts to apply effective countercyclical policy.

Disclosure: I am currently long January IEZ puts. I am looking for an appropriate entry for a short crude oil position.

About this article:

Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500.
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here