Oil price weakness: What happened earlier this year

I hope they don’t but if they do we just need to be aware of what I worry could be huge issues for the markets & see a selloff. Again it may not happen – but if it does we just have to be aware.. China gets a mention – but that seems to be a bright spot now (I’ll look at why China is not the major worry as many are still pushing – any time) ..

Now this is going to be as unpleasant for me as it is you (unless you were short) as I quickly look at what went wrong early in the year . I don’t cover everything but the main issues -

The markets looked terrible in the first 3 weeks of 2016 – this is what we had thrown at us ..

On the first trading day China smacked -7%, its worst start of a new calendar year in the history of the Chinese equity markets. The reason for the initial selloffs in China were due to (1) a slightly weaker Caixin PMI for December, which came in at 49.7 vs mkt 49.8, below 50 for the 10th consecutive month – many cited weak Chinese growth & the spiral down had began + (2) also concerns after the Chinese sudden & unexpected devaluation of their currency - the continuing weakness of the Yuan and the related concerns regarding capital outflows, domestic monetary tightening, and corporate earnings;

So what caused the initial 2 day slump in China came about because after watching a stock-market collapse wipe out US$5 trillion of wealth in less than 3 months last year, Chinese authorities hatched a plan to stem the pain: circuit breakers that would be triggered by daily declines of 5%. The new system went into effect on Jan. 4. These guys must have thought they were geniuses – well sort of .. as their bright idea lasted all of four days.

After two terrifying sessions -- where markets stopped trading after only 30 minutes, ending the shortest trading day in their history -- that tripped the circuit breaker repeatedly and convulsed global markets, officials suspended the system after 2 consecutive -7% falls . It is clear now that those 7% stops actually became magnets for the sellers and thus only exacerbated investor anxiety and deepening the selloff. So hopefully the Chinese won’t make that mistake again….

And so it all began there & then we had a plethora of bad news that just destroyed markets & confidence… gee it was bad…

We saw the yuan weaken for 8 consecutive days – but after the markets fell so dramatically they ceased the devaluation – but there were then some adding to fears saying they may just do a 15% devaluation in one go – and if so that would decimated world markets – but we now know that didn’t eventuate – but the fear of it caused addition selling in world markets. This was and in a way continues to worry some (but most in market now don’t see this as a threat any more).

The worry came because was saw in early 2016 major concerns after the People’s Bank of China reported that its foreign exchange reserves fell by US$108bn in December(vs. a US$87bn decrease in November), to US$3.3tn at the end of the month. The large drop in FX reserves suggests the FX outflow picked up significantly from November, and is consistent with a significant increase in onshore FX trading volume during that month.

Then as turmoil emanating from China spread around the world billionaire George Soros warned that a larger crisis may be brewing – these headlines always get a lot of airplay and just add to the nerves of investors.

But also back then at the same time we had U.S. December ISM Manufacturing Index coming in at 48.2, below expectations and down from November's 48.6.

With US reporting season approaching we were also reminded that it was going to be a shocker … Analysts then were estimating profits for S&P 500 members fell -6.7% in the Dec quarter (more on this another time – this is the big issue still out there and about to hammer home soon.)

While all this was happening oil and iron ore were being smashed every single day &Copper also hit a 7 year low – it looked like the selling (and massive shorting) would never stop …

But after so much poor economic news we saw the first bit of good news where we saw stabilization in the Chinese yuan & finally some positive Chinese news with China December Trade data came in well above expectations Exports +2.3% vs cons -4.1%, Imports -4.0% vs cons -7.9% ^ the Trade balance $382.05bn vs cons $338.8bn. Everyone had been so nervous on China after a few soft growth prints the previous week and the big sudden falls in Chinese market – was this enough to arrest the falls??

No it wasn’t the global sell off continued now with fears that the Chinese GDP would come in well below the 7% estimate.

Plus we also had some idiot broker saying “sell everything” that got headlines – that stuff when markets are nervous does 2 things (1) it causes weak or uncertain traders to throw in the towel and sell & (2) historically it has coincided with a near term bottom approaching (as it did again this time – looking back in history – many will remember a famous journo (seems like a really nice guy as well) many years ago – right as the Aussie market was being massacred – telling investors to “sell everything” as another massive fall was about to hit. The market – almost that day – bottomed & then staged a great rally. When he said that – so many agreed – but market psychology at the time said – which is easy in retrospect – that the bottom was then. )

Now back to the horrors of the market s – as if all that wasn’t enough we then had Iran and Saudi Arabia got into a global spat after the Saudi’s did some executions that Iran didn’t like. Talk then of War in the Middle East added to the markets overall fear – but then the world’s most hated nation – North Korea – decided to add even more global geopolitical uncertainty after they detonated a nuclear bomb that was said to be 50 odd times stronger than the one that fell on Hiroshima. Fears of War between the South Korea (and thus the US) and North Korea reached levels not seen for many years. Which was heighted after a top North Korean official has warned the North Korea was being pushed to the "brink of war" - after South Korea continued to blare propaganda through loudspeakers across the border. In a way you can understand the North Korean’s tensions and talk of war when you hear that the South were bombarding them with karaoke favorites such as the upbeat dance hit Bang, Bang, Bang. That’d send anyone mad.

In fact – a small digression during the Waco siege the FBI blasted loud music at the compound – they played “ Tibetan chats” and there was also talk that they played that horrible song “Achy Breaky Heart” by Billy Ray Cyrus – but I have since heard the FBI decided to reject it - perhaps because officials feared some of the cult members would like it .. Given Waco is in Texas & they all drink ‘home brew’ I think the FBI had a good point.

Back to what was killing markets – yes time to mention the elephant in the room – oil price !!! This has a lot to answer for & I’ll deal with it later on – but in early January (and all February) it continued its free fall hitting a low of US$27.56 on the 20^th January – it then bounced off that level up to US$34.82 8 days later. But as we often see stocks or markets in volatile times tend to re test their lows & so it was with oil. The oil price resumed its free fall dropping to an intra-day low of US$27.24 on the 10^th Feb – its lowest level in 13 years – since 2003.

It seemed the oil price was going straight to US$10 and anyone short oil and oil stocks was making a killing.

With oil going into a free fall many argued that it was stimulatory for consumers & great for transport companies … ok but what about …. the financials

The really big problem (and this is the one I fear could easily resurface) is … financial risks were now a big threat with worries about the big US banks bracing for energy loan losses was now an added concern thrown out there.

I did some rough numbers and saw that the big US Investment Banks have exposures of around US$100 billion to US$133 billion to the energy companies (depends on numbers out there as to the real exposures) but either way it’s a lot !!!

America's biggest banks warned recently that oil prices will continue to create headaches on Wall Street -- especially if  scenarios of US$20 or  US$10 oil play out.

Look at these numbers – if oil gets back to even the low US$30 level then these numbers will be requoted…

1.     JPMorgan Chase No.1 U.S. bank by assets. Energy exposure assumed at 1.6% of total loans. JPM is setting aside an extra $124 million to cover potential losses in its oil and gas loans. It warned that figure could rise to $750 million if oil prices unexpectedly stay at their current $30 level for the next 18 months.

2.     Bank of America Corp No.2 U.S. bank by assets Energy exposure assumed at 2.4% of total loans "Energy portfolio stress analysis shows $30 oil for 9 quarters wouldresult in about $700 million of losses." "As we continue to assess and react to future changes in the energy sector, we could see lumpiness that could potentially drive provision expense over $900 million."

3.     Wells Fargo. No.3 U.S. bank by assets. Energy exposure assumed at 1.9% of total loans – they are sitting on more than $17 billion in loans to the oil and gas sector. The bank is setting aside $1.2 billion in reserves to cover losses because of the "continued deterioration within the energy sector."

4.     Citigroup. No.4 U.S. bank by assets. Energy exposure assumed at 3.3% of total loans - Citi built up loan loss reserves in the energy space by $300 million. The bank said the move reflects its view that "oil prices are likely to remain low for a longer period of time." If oil stays around $30 a barrel, Citi is bracing for about $600 million of energy credit losses in the first half of 2016. Citi said that figurecould double to $1.2 billion if oil dropped to $25 a barrel and stayed there.

5.     Goldman Sachs Group Inc No.5 U.S. bank by assets. Energy exposure assumed at 2.1% of total loans. Goldman Sachs has $10.6 billion in total oil sector exposure. Goldman Sachs only 3 weeks ago came out and said that about 40% of its oil and gas loans and lending commitments are to junk-rated firms. The figure, which counts both loans made and future promises to lend, accounted for $4.2 billion of a total $10.6 billion as of the end of December, the New York-based bank said Monday in its annual regulatory filing. Goldman Sachs has $1.5 billion in loans to energy companies rated below investment grade and $2.7 billion in unfunded commitments. The total exposure jumps $1.9 billion counting derivatives and other receivables, which were “primarily" to investment-grade firms, Goldman Sachs said. The bank’s market exposure to oil and gas firms was negative $677 millioncompared with $805 million a year earlier.

6.     Morgan Stanley No.6 U.S. bank by assets. Energy exposure assumed at 5% of total loans, US$4.8 billion of loans which is the biggest at 5% of their total loans… Morgan Stanley don’t seem to have said too much except this .. "We've seen an increase in negative marks within corporate loan book, focus is around energy."

So looking at it this way … one US broker summarized the exposures on 20^th Jan as follows..

How much have the big banks funded in outstanding debt to the oil & gas sector?

How much is that, as a percentage of the bank's total loans?

·       Morgan Stanley leads the way at 5%, followed by Citi at 3.3%, Bank of America at 2.4%,Wells Fargo at 1.9%, JP Morgan Chase at 1.6%, PNC at 1.3%, and US Bancorp at 1.2%.

·       Which banks have stowed away the most reserves relative to their oil exposure?

·       Wells Fargo leads the way here with 7.1% of the value of its exposure in reserve. US Bancorp is second with 5.4%, and JP Morgan Chase is third with 4%. Morgan Stanley,Citi, and PNC are all at 3% and Bank of America has 2.3% in reserve.

Adding to these concerns that 2016 could well be a nasty year for miners & banks exposed to this - Mining.com reported recently, that ….Already high bankruptcy and default rates in mining & metals and oil & gas willonly accelerate this year as the prolonged downturn in commodities begin to spill over into other sectors. Overall, global speculative-grade corporate defaults will increase by more than 30% in 2016 and reach the highest level since 2009, says Moody's Investors Service in a new report. And 2015 already saw close to a doubling of companies defaulting on corporate bonds or loans.

What was also worrying market was a note by Morgan Stanley saying that Australia's large banks face up to an18% increasein losses onloans from the tankingoil price. MS said that said the lower pricewould increaselosses by 18%at Commonwealth Bank, which has the biggest exposure to the oil and gas industry at $11.6 billion,11%at ANZ Bank and 13%at Westpac. The losses would occur in the first half of the financial year, Morgan Stanley said. Australia's banks have$31 billion in loans tooil and gas companies. "We would expect the material decline in the oil price to lead to risk migration and higher collective provisions, or 'overlays', in the first-half 2016 results," Its analysts said oil and gas accounted for 45% of the banks' lending to the resources sector andit assumed the big four banks would need to raise their proportion of impaired loans by 2% for the half year to take account of the oil price fall. Earnings per share would fall by about 1.5% at CBA, 1.5% at ANZand 1% at Westpac. The majority ofCBA's commodity lending is in oil and gas. At the other three big banks it is a significant minority, with NAB having the lowest levels at $4.5 billion out of a total mining book of $12.1 billion. Total loans to resources accounts for just 1.5% of the big four Australian banks' non-mortgage credit exposure.