23-28 December: Record Highs on Santa Rally; Russia Say Ruble Crisis Over; Japanese Prices Slip Yet Lower

With nothing much happening in the markets, this edition of the Daily Grail will have its net dispersed over a wider spectrum of events. I hope readers had an enjoyable Christmas. Don't worry about putting on a few pounds, the gym welcomes you on Monday so you start the new year fit as fab.

On a serious note, 2014 has been a relatively positive year for the markets, and events in general despite the slew of negativeness including the 2 downed Malaysian Airliners, the Ebola outbreak that did have the world panicking for a while, massive gains on almost all aspects for the terror group ISIS, and other shenanigans. Don't forget that we saw one of higher variances in central bank policies this year, I don't think we have felt the full brunt of those consequences to come. Maybe 2015 will draw up those curtains. You might not be very aware of this, but quite a number of records were set this year; market related and non-market related.

Regardless of those negatives, we have collectively seen more progress than regress, markets are generally placated and happy. Although I will not write a note on my expectations for 2015 and also a "year in review" for a very eventful 2014, I believe 2014 has sown the seeds for what might be a very interesting year ahead.

US Closes Friday At Record Highs, Sellers On Holiday

The S&P 500 index closed at a record high of 2083 at Friday's close, capping what has been an ebullient Christmas week where equities have historically enjoyed outsized returns relative to volatility. Indeed, the S&P 500 was joined by the Russell 2000 index of stocks and the DJIA (Dow Jones Industrial Average of 30 stocks) to close Friday at their respective record highs.

Trading volumes have been thin across the board, perhaps not so in China where people apparently are told not to celebrate the festivities of Christmas, as markets there remained opened for the entire week. Apart from American markets, the Shanghai Composite surged to a record high this past week. Reason? Mainstream media has been blaring more stimuli from the PBoC. If indeed true, that the PBoC is indeed gearing up for more stimulus come 2015, it would indeed be trying to balance a very tricky scale. Readers will recall that earlier in December, the PBoC reigned in on shadow banking by tightening collateral rules; and now wants to prop up asset prices by introducing more stimulus via other conduits? Seems like some central bankers over there are a little confused on what they actually wish to achieve with their Schrödinger policies.

China’s Securities Depository Corporation announced (CSDC) Tuesday that they would no longer accept non AAA-rated corporate debt securities as collateral in repurchase transactions, essentially raising the cost of short term collateralized borrowing in the private sector. AAA-rated corporate debt securities to be pledged as collateral must also originate from AA-rated issuers. The CSDC aims to improve the dexterity of short term borrowing albeit at higher borrowing costs by creating a mandatory preference for up-in-quality securities; to better prepare its financial and private sectors against any untoward financial circumstances. This also comes on the back of the heels of the Cabinet’s decree to clear lower quality debt including the local government financial vehicles (LGFVs) from the repo market. Given that more than 1trn Yuan of outstanding corporate bonds are now deposited at the CSDC, analysts estimate that around 500bn Yuan of those securities would then be ineligible for repo dealing.

Apart from tightening collateral rules, the PBoC also fixed the Yuan higher as it tried to clam down on excessive risk taking in the local equity and corporate debt markets. The results were not as encouraging as the intentions of the PBoC were. The Shanghai Composite saw its largest 5.6% daily decline in more than 5 years as money rotated out of Chinese equities and into the the safety of safe haven assets like Treasuries. Chinese IG and HY credit both saw spreads widening significantly and this carried over to American trading. Interest rate swaps have been propelled higher while corporate debt sold off strongly. The Yuan saw its largest drop against the greenback since late 2008 despite the PBoC bidding efforts. Overall, there was a net outflow of capital from the Chinese financial markets as even bond yields on Chinese government debt rose significantly.

China has hinted rather overtly it wants to drastically reduce leverage in its stock and bond markets, and is partially working on this goal by tightening monetary policy through indirect tools; fixing Yuan higher and raising collateral standards and reducing availability.
— Business of Finance

Fast forward 3 weeks and the PBoC loosens policy yet again. The PBoC was reported to have lowered the non-bank deposit reserve rate to zero; this essentially means non banking financial institutions can create as much loans as they wish to without constraints on reserves. This, together with expectations of further loosening of policies, rammed the Shanghai Composite, for the second day in a row, 2.8% higher to close Friday at 3,158. The Chinese know their way around the lack of a Santa Rally in the West, don't they?

This chart courtesy of ZeroHedge illustrates how divergent key US risk markets have been over the course of this year. Equities remain the best performer while HY has failed consecutively to break to new highs. The toughest question to square remains the outperformance of the long bond, as the logical assumption that treasuries should be offered as risk is bid doesn't seem to hold up here

This chart courtesy of ZeroHedge illustrates how divergent key US risk markets have been over the course of this year. Equities remain the best performer while HY has failed consecutively to break to new highs. The toughest question to square remains the outperformance of the long bond, as the logical assumption that treasuries should be offered as risk is bid doesn't seem to hold up here

Equity markets aside, other measures of risk including HY credit and inversely the entire yield curve has not been as excited about ending 2014 with a bang. As the chart above illustrates, the real decoupling of HY credit and credit spreads happened late February possible due to a shift in the Fed's language pertaining to policies going forward, and of course the eventual end of a tapering QE program that has been fodder for risk assets since 2009. Credit has inevitably been more sensitive to monetary policy (Fed funds forward rate) than equities have been, but what remains peculiar is the bull flattening treasury curve. What does the long bond know that most other risk assets don't? We should leave that question open until the market fixes itself, hopefully next year.

What is certain however, is that 2014 will go down the books as one of the most consistent streaks of gains for US stocks and leaves 2015 hanging midair as they are set to end 2014 at record levels.

Japan Slips Deeper Into Recession As Prices Continue Their Plight

Across the Atlantic, the slow motion train wreck that is the "Land of The Setting Sun", continues to unfold in a grotesquely and cringe-worthy fashion. Without boring readers with the usually chicanery, here are the gruesome details that we were updated with on Boxing Day. Sheer carnage indeed.

  • November housing starts fell 14.3% YoY, more than 13.2% decline expected than worse than October's -12.3%;
  • The Tokyo core CPI for November rose by less than expected at 2.3% YoY against the forecast 2.4% and is down 0.1% from October;
  • The National core CPI for November fell to 2.7%, inline with expectations but 0.2% under October's print;
  • The Tokyo CPI was unchanged at 2.1% YoY for November, while the National headline CPI fell to 2.4% YoY from 2.9% in October;
  • The November unemployment rate held steady at 3.5%, matching estimates;
  • Household spending decline by 2.5% YoY in November, leas than the 3.8% fall expected, an improvement from October's 4% decline. The sequential figure came in at 0.4%, better than the 0.2% foretasted but down from October's 0.9%. However, this still marked the 8th straight month that real consumer spending has dropped declined YoY since the consumption tax hike;
  • Real consumer spending on housing continued to slump in November, down 20.3% from a year ago, marking the largest YoY decline in 3 months. Real consumer spending fell 1.4% YoY;
  • Industrial production fell sequentially by a massive 0.6%, versus an estimated 1% increase and was another far cry from October's 0.4% gain;
  • Manufacturer shipments were -1.4% lower than in October, marking the first contraction in three months. As a result, the inventory ratio rose 4.0% from October;
  • Retail sales missed widely in November, up 0.4% YoY against expectations for a 1.1% increase and down massively from October's 1.4%;
  • Real wages for November fell a stunning 4.3%, worse than October's 3% YoY decline. This makes it the largest decline in real wages since the 4.8% decline recorded in December of 1998;
  • Average cash earnings fell by 1.5% YoY in November, missing widely on expectations of a 0.5% increase and down from October's 0.2% gain

The absolute stunner remains consumer wage growth, or in this case, wage contraction. Real wages remains the age old indicator for future consumer expenditures because wages less current consumer spending equals savings. If we have understood one thing from the countless prologues, it is that the Japanese are pretty darn good savers.

First of all, readers must understand that much of the consumer expenditure we saw earlier in the year was actually pushed forward due to the VAT hike. The controversial consumption tax hike was something that formed a fundamental part of Abebonics - PM Shinzo Abe's grand fiscal plan to evoke a supernatural recovery in the Japanese economy after decades in the doldrums.

As a result of knowing that goods and services will see higher prices once the tax hike started came about early 2014, Japanese consumers naturally drew from their savings and spent an abnormal sum of money on purchasing just about all they could before everything got more expensive. It is not inaccurate to say that the spike in consumer spending at the start of 2014 was essentially borrowed spending from the future. This was exactly what we saw. Whether this was part of the intended consequences stemming from Abenomics is not out concern.

The tax increase was a massive disrupted both to the Japanese economy and also to vital economics stats. As seen in the charts below, the tax hike had all kinds of effects on nominal and real wages, and of course consumer prices. It is therefore wise to factor in and ultimately exclude the effects arising from the tax hike from economic assessments.

The distortion caused by the consumer tax increase in January is apparent. Adjusting for these distortions, almost all of Japan's relevant economic indicators have not been better of, chief of which is the slump in real wages which was the worst drop in 16 years

The distortion caused by the consumer tax increase in January is apparent. Adjusting for these distortions, almost all of Japan's relevant economic indicators have not been better of, chief of which is the slump in real wages which was the worst drop in 16 years

Using prices as a prime example, November's National core CPI slowed to a mere 0.7% YoY when the tax hike effect was adjusted for, versus the 2.7% headline figure. Just by factoring out the BoJ's calculation of a 2% price boost from the consumption tax hike, we start to appreciate the scale of disinflationary pressures pressing on all sides of the Japanese economy. The same can be said for consumption and retail sales. All of these were merely brought forward because of the tax hike.

Shoving powder back and forth doesn't constitute an improvement in Japan's economy. It merely creates a façade of doggy improvements in the former stages of said policies. This also frankly why no one should have been shocked to find that Japan was once again mired in its fourth technical recession in 5 years when it's 3Q14 GDP declined. Output was merely borrowed (for lack of a better substitute), and not created.

Even if we talked about the organic economic situation, prices will continue to face headwinds, and one can bet big that the 2% central banking holy grail headline inflation figure will not be attained anytime soon in 2015. Japan is a major net energy importer, energy prices have crashed and will continue to stay low as I've painstakingly outlined here, here, and here.

In my opinion, prices are only an indication of more central planning idiocy to ensue in Japan as the country edges every deeper into its economic twilight zone. It seems that the the leaders that are so incompetent are leading the populace to a slow slaughter; because very soon Japan won't enjoy the status as the third largest economy of the world. We are seeing a slow motion train wreck as mentioned in the onset of this section.

Doing the same thing over and over again and expecting a different outcome is the definition of insanity in its purest form. As long as Japan continues to chase its own tail, failing to address its fundamental shortcomings, and administering entirely inappropriate economic and financial medicine use to treat cyclical rather than structural maladies that are a legacy issue, continue to bet with the trend; that is to say continue to expect the usual stuff from a boring and soon to be incontinent country.

Abenomics, for all the pomp it has created, has done absolutely nothing to better the state of the real economy. What it has however done, is create multiple layers of faux prosperity through what is known in traditional economics as the Wealth Effect - consumers feeling better off because of higher asset (stocks) prices, and therefore behaving differently than they otherwise would have; spending more as they feel increasingly wealthy due to higher asset prices. We have clearly seen the potency of the wealth effect in America, but Japan isn't America; this positive feedback loop hasn't been triggered yet and will probably never be.

As we've seen, not only has Abenomics created heightened uncertainty and obfuscation amongst Japanese consumers and businesses, it has also led the country down a path of ruin. Readers only need to revert to the above set of charts to remind themselves how worse off Japan actually is than before the grand plan of nothingness was launched in 2012.

The sole beneficiary of all that Japanese madness, and the only thing that matters to traders, is most assuredly Japanese financial assets (namely stocks and bonds). A weak Yen be damned, in fact now that energy and most input prices are falling, the BoJ has all the leeway in the world to weaken the Yen by as much as it wishes, thereby stoking another match of global currency wars that saw much drama is 2010. As one would logically expect then, that Japanese stocks (Nikkei 225, Topix et al) and those infamous JGBs (Japanese Government Bonds) continue to see almost unlimited upside only capped by the level of insanity of the Japan's very own central planners.

The markets on the other side of well-intentioned economists, only wish for the continuity the Necromancer's marching to the anthem of Abenomics, the placebo of a large monetary bazooka. By the looks of it, there should not be an iota of a concern that any of this induced insanity would stop.

Of course, for readers who wish to see even more color in the graying canvas, here is more from Bloomberg and Reuters for your reading pleasure:

Japanese annual core consumer inflation slowed for a fourth straight month in November due largely to sliding oil prices, highlighting the challenges the central bank faces in achieving its 2 percent inflation target.

Factory output unexpectedly fell and real wages marked the steepest drop in five years, underscoring the fragility of the recovery and dealing a blow to premier Shinzo Abe’s stimulus policies aimed at pulling the economy out of stagnation.

The core consumer price index (CPI), which excludes volatile fresh food but includes oil products, rose 2.7 percent in November from a year earlier, matching a median market forecast, government data showed on Friday.

Stripping out the effects of a sales tax hike in April, core consumer inflation was 0.7 percent, slowing from 0.9 percent in October and far below the Bank of Japan’s 2 percent target.

”While the economy is recovering, falling oil prices and slowing inflation will force the BOJ to ease policy further at some point next year,” said Hiroshi Watanabe, senior economist at SMBC Nikko Securities.

In a worrying sign for the central bank, inflation-linked government bond prices slumped over the past several weeks as investors’ inflation expectations hit their lowest since Haruhiko Kuroda became BOJ governor in March 2013.

Japan’s economy slipped into recession in the wake of April’s tax hike, though analysts expect growth to rebound in the current quarter as exports and output pick up.

Factory output slid 0.6 percent in November after two straight months of gains, largely the effect of big-ticket items such as computer chip-making equipment and boilers boosting October output and confounding market expectations of a 0.8 percent rise.

In a glimmer of hope, however, manufacturers surveyed by the government expect output to rise 3.2 percent in December and increase 5.7 percent in January.

Economics Minister Akira Amari told reporters the drop in November was likely a temporary blip, given the sharp increase projected for coming months.

Kuroda stressed last week that Japan was on track to hit the price goal, shrugging off speculation that a recent plunge in oil prices would weigh on consumer prices and force him to ease policy again early next year.

But many analysts remain doubtful that the BOJ can meet its pledge of accelerating inflation to 2 percent in the next fiscal year, beginning in April 2015.

Reflecting the recovery, job availability hit a 22-year high and the number of part-time workers exceeded 20 million for the first time since relevant data became available in 1984.

But companies remained reluctant to increase wages, a bad sign for consumption. Household spending fell 2.5 percent in the year to November, against a market forecast for a 3.8 percent drop.
— Reuters
Japanese drew down savings for the first time on record while wages adjusted for inflation dropped the most in almost five years, highlighting challenges for Prime Minister Shinzo Abe as he tries to revive the world’s third-largest economy.

The savings rate in the year through March was minus 1.3 percent, the first negative reading in data back to 1955, the Cabinet Office said.

A higher sales tax combined with the central bank’s record easing are driving up living costs, squeezing household budgets and damping consumption. Abe’s task is to convince companies to agree to higher wages in next spring’s labor talks to sustain a recovery.

“Households are suffering from a decline in real income,” said Hiromichi Shirakawa, an economist at Credit Suisse Group AG who used to work at the Bank of Japan.

The savings rate, which the Cabinet Office calculates by dividing savings by the sum of disposable income and pension payments, peaked at 23.1 percent in fiscal 1975.

As Japan’s population ages, its growing ranks of elderly are tapping their savings, according to the Cabinet Office. Consumers also ran down savings to make purchases ahead of a sales tax-increase in April, the first since 1997.

The report offers perspective on a debate of decades ago over Japan’s trade surplus with the U.S., which caused periodic bouts of tension between the military allies. While respective savings rates have moved in opposite directions, the U.S. still had a $56 billion deficit with Japan in the first 10 months of 2014, U.S. government data show.

The preliminary wage data released today lack a large enough sample and include some biases, so the final figures may be revised upward, according to Hiroaki Muto, an economist at Sumitomo Mitsui Asset Management Co. “Looking ahead, wages will probably rise but not accelerate,” said Muto.
— Bloomberg

Russian Ruble Rebounds Sharply, Inflation Up To 10.4%, Deep Recession Ahead

The once roaring bear has quietened to a whimper as the economic and financial situation in world's largest country (by land mass) looks increasingly dismal following a rout in global oil and energy prices, and heavy financial and trade sanctions imposed on it by NATO nations after it was accused of being directly involved in the still ongoing war in neighboring Ukraine.

Readers will know from our extensive coverage on the developments in Russia (see here, here, here, and here), Russia has just seen the worst economic crisis since 1998 courtesy of a currency that has weakened 50% against the greenback in 2014 alone, isolation from the West, and hyperinflation on domestic soil. However, the Kremlin hardly curls into a ball even when it faces extreme stress from all fronts. Besides the back-and-forth vendetta between NATO and Russia, Moscow has also come out to declare the end of the crisis in the currency.

The ruble has risen strongly from a low nearing  80 to a dollar on 16 December to around 50. This is a 30,000 pip swing or just over 36% and is astounding by any standards

The ruble has risen strongly from a low nearing  80 to a dollar on 16 December to around 50. This is a 30,000 pip swing or just over 36% and is astounding by any standards

Recall that on the day USDRUB reached an all time high of around 80, we publicly said that we felt the lows in the ruble (and therefore the Russian stock market) had been carved in. So far, we have been proven right. A day after the worst selloff in the ruble, the CBR (central bank of Russia) accounted 7 drastic measures to stabilize the Russian banking system as well as halt the crash in the currency. Apart from raising its key interest rate to 17% from 10.5% a week earlier, the CBR had also been actively conducting intense rounds of FX interventions by selling foreign reserves (allegedly to have included Gold) that is had accumulated through decades worth of trade surpluses. Readers should not forget that Russia is still an energy giant in the oil and gas market, and especially so in Europe. Low energy prices have put inflicted huge dents in Moscow's position but it doesn't spell the end of its supremacy.

Back to the issue at hand, as a result of its constant FX interventions, Russia's foreign reserves have slumped to below $400bn for the first time since 2009 (adjusted for currency disparities). As bold as Finance Minister Anton Siluanov was when he declared the end of his nation's currency crisis, he also prepared Russians for more economic pain to come. Specifically, he mentioned that the official inflation rate had risen to 10.4% and could reach 11% just before the turn of the year. Actual inflation (prices on the street) is unquestionably higher than the official figure, and is already in hyperinflationary territory.

Besides prices, economic growth is set to worsen further as the full burden of its victimization by NATO and the new low oil price paradigm have yet to be borne. Credit rating agency Moody's said that it expected Russia's output to shrink by 5.5% in 2015. Various rating agencies have threatened to downgrade Russia's credit rating to below investment grade or even to junk status. Russia is reported to be in closed end talks with these rating companies in order to avert said downgrades.

Russia said on Thursday its currency crisis was over even though its forex reserves have plunged and annual inflation has climbed above 10 percent, adding to the problems facing the government as it fights its worst economic crisis since 1998.

The ruble plunged to all-time lows last week on heavy falls in the price of oil, the backbone of the Russian economy, and Western sanctions over the Ukraine crisis that made it near impossible for Russian firms to borrow on Western markets.

But it has since rebounded sharply after authorities took steps to halt its slide and bring down inflation, which after years of stability threatens President Vladimir Putin’s reputation for ensuring the country’s prosperity.

Those measures included a hike in interest rates to 17 percent from 10.5 percent, curbs on grain exports and informal capital controls.

”The key rate was raised in order to stabilize the situation on the currency market. ... That period has already, in our opinion, passed. The rouble is now strengthening,” Finance Minister Anton Siluanov told the upper house of parliament on Thursday.

He added that interest rates would be lowered if the situation remained stable.

Standard & Poor’s credit ratings agency said this week it could downgrade Russia to junk as soon as January due to a rapid deterioration in “monetary flexibility”.

Keen to avert a downgrade, Russia said it had started talks with ratings agencies to explain the government’s actions. Siluanov said the budget deficit next year would be “significantly more” than the 0.6 percent of gross domestic product originally planned.

The ruble slumped to 80 per dollar in mid-December from an average of 30-35 in the first half of 2014. It has strengthened in the last few days to trade as strong as 52 per dollar on Thursday, in part thanks to government pressure on exporters to sell hard currency.

Russians have tracked the exchange rate closely since the collapse of the Soviet Union, when hyper-inflation wiped out their savings over several years in the early 1990s. The central bank had to spend heavily in recent months to prop the currency.

Last week, Russia’s gold and foreign currency reserves dropped by as much as $15.7 billion to below $400 billion for the first time since August 2009 and down from over $510 billion at the start of the year.

Analysts said around $5 billion were spent on propping up the ruble, while around $7 billion was due to foreign currency loaned to banks as part of repo operations, meaning the money will be returned to the regulator at a later stage.

Russia imports large amounts of food, high-tech equipment and cars. As the ruble weakens it has to pay more for its imports, which pushes up inflation at home and in turn encourages people to protect their earnings by buying dollars, thereby adding to the pressure on the rouble.

Putin’s economic aide Andrei Belousov said on Thursday that annual inflation was at 10.4 percent and could reach around 11 percent by the end of the month, surpassing the psychologically key 10 percent mark for the first time since the 2008/09 global financial crisis.

Prices for some goods, such as beef and fish, have risen 40 to 50 percent in recent months after Russia slapped an import ban on certain Western food products in retaliation for European Union and U.S. sanctions over Ukraine.

Bank officials say they saw a spike in withdrawals from ruble deposits in mid-December as Russians rushed to convert their savings into hard currencies.

The deputy head of top state lender Sberbank, Alexander Torbakhov, said this week that demand for hard currencies spiked to five times usual levels last week, when the rouble plummeted to all-time lows.

But he added that the bank had seen depositors returning in large numbers after most lenders ramped up their deposit rates, some offering as much as 20 percent in annual interest.

”We have managed to cope (with deposit withdrawals). Can the situation be repeated? Yes, it can,” Torbakhov said, declining to discuss what could trigger a new flurry of withdrawals.

Analysts say that apart from oil prices, they will watch ratings agency decisions.

S&P warned this week there was at least a 50 percent chance it would cut Russia’s sovereign rating below investment grade within 90 days. Moody’s ratings agency warned this week that Russia’s GDP could contract by 5.5 percent in 2015 and 3 percent in 2016 due to weaker oil prices and the ruble’s slide.
— Reuters

One fact that is not widely mentioned, is that despite the allegations of direct involvements in the violence and ongoing war in Eastern Ukraine, despite the global controversy and condemnation of it's annexation of Crimea, and despite the current economic turmoil, President Vladimir Putin's approval ratings are still at one of the highest they have been. Unfortunately, affairs in Russian politics are always layered with grime, making it difficult to peer much deeper than the surface. Nevertheless, we will continue to cover critical developments concerning Russia.

US Natural Gas Prices Under $3, First In Almost 3 Years

When we say global energy prices are slumping together with crude oil we quite mean it. Sure enough, natural gas (America produces quite alot of it) prices have fallen under $3/mBTU (per million British Thermal Units) during Friday's trading session. Natural gas prices have historically been much more volatile than that of crude oil, and unlike the crude oil market, the gas market isn't globally priced but remains fragmented. For example, prices for the same quantity of gas in America will differ vastly from that of gas in China. This is mainly the result of the difficulties and costs arising from compressing the fuel from a naturally occurring gaseous state to a much denser liquid state; as such gas produced in a continent hardly gets shipped around across oceans. What this essentially means is that there is no one global natural gas market; prices of gas in Europe and Asia have always been higher than in the US.

Natural gas prices have been extremely cyclical. However, ever since 2007, the supply glut has ensured that prices never $6/mBTU for good

Natural gas prices have been extremely cyclical. However, ever since 2007, the supply glut has ensured that prices never $6/mBTU for good

The main reasons cited for the low prices are over supply, and winter demand that has been over priced into the market. The market had expected normal winter, but forecasts have emerged that this winter would be a milder one, just like we say last December. Whether it not America faces another polar vortex come January 2015 is anyone's guess. Meanwhile, we await the surge in consumer spending by US consumers now that less of their disposable income gets channeled to utilities, on top of the already cheapened prices at the pump.

Futures settled at the lowest in 27 months and have plunged 26 percent in December, heading for the biggest one-month drop since July 2008, as mild weather and record production erased a surplus to year-ago levels for the first time in two years. Temperatures will be mostly above average in the eastern half of the U.S. through Dec. 30, according to Commodity Weather Group LLC.

Natural gas for January delivery fell 2.3 cents, or 0.8 percent, to settle at $3.007 per million Btu on the New York Mercantile Exchange. Futures touched $2.973, the lowest intraday price since Sept. 26, 2012. Volume was 54 percent below the 100-day average for the time of day at 2:32 p.m. Gas dropped 13 percent this week, a fifth straight weekly decline.

In the absence of extreme weather, rising production will leave inventories at an all-time high above 4 trillion cubic feet by the end of October 2015, BNP Paribas SA said in a report Dec. 23.

BNP Paribas lowered its estimate for average 2015 gas prices to $3.60 per million Btu from $3.75.

“Unseasonably warm weather this month now necessitates extreme conditions ahead in order to avert a surplus,” Teri Viswanath, director of commodities strategy for the bank in New York, said in the report.

Gas stockpiles fell by 49 billion cubic feet to 3.246 trillion cubic feet in the seven days ended Dec. 19, below the five-year average withdrawal for the fourth straight week, EIA data show.

Supplies were 150 billion, or 4.9 percent, higher than year-earlier levels. The surplus will “balloon to just shy of 200 billion cubic feet” by the start of next year, according to JPMorgan Chase & Co.

Production of the heating and power plant fuel expanded in 2014 to an all-time high for the fourth consecutive year, rising 5.5 percent to 74.26 billion cubic feet a day, EIA data show. Daily output will rise another 3.1 percent next year to 76.58 billion, marking a decade of gains as technologies such as hydraulic fracturing, or fracking, made it more economic to extract fuel from shale rock.

The Marcellus formation in the East has emerged as the biggest driver of gas production growth in the U.S. Production from the shale formation may average 16.3 billion cubic feet a day in January, up 19 percent from a year earlier, the EIA said in its monthly Drilling Productivity Report on Dec. 8.
— Bloomberg

US Oil Production Estimated To Increase In 2015 Despite Low Prices

Without further beating a partially dead horse, the surprise story to those who have been following the markets, is that US oil production is estimated to surpass that of 2014, according to EIA estimates. This comes on the back of declining oil rig counts amid a new paradigm in the global crude oil market.

American producers are expected to boost production by 300,000bbl/day in 2015, up to a yearly average of about 9.3 million barrels per day. It is easy to forget that the US is the world's largest oil producer, albeit also the largest importer in part due to its gas guzzling culture. The number of oil and gas rigs in operation is already beginning to drop as highlighted by the chart below. For week before Christmas total rig count dropped 18 to 1,875 from 1,893 a week earlier, indicating that exploration companies are starting to reduce investments in prospecting for new fields.

The Baker Hughes rig count has recently seen a sharp decline. Chart doesn't show the most recent decline in count to 1,875. If history repeats itself, this count will have a lot of catching up to do

The Baker Hughes rig count has recently seen a sharp decline. Chart doesn't show the most recent decline in count to 1,875. If history repeats itself, this count will have a lot of catching up to do

Many analysts believe that low oil prices are here to stay mainly because the Saudis need to retain their market share by keeping prices low. We wrote about this strategy a few days back:

When the OPEC summit failed to yield any supply cut from the Middle East, traders and money managers started to panic - the market had then priced in a slight production cut by OPEC.

As oil continued to decline, now accelerating in velocity, concerns started spreading - concerns about lower oil prices and more importantly the shift in OPEC’s strategy to counter the rise of small and medium shale oil producers in America.

At this moment, markets are already crashing in the Middle East - markets there are more tied up to oil prices and hence national revenues from energy exports than anything else, hence Middle-Eastern markets were very highly geared to oil prices.

As oil continued to tank, an increasing number of smaller scale producers that leveraged on the shale revolution started to loose money for every marginal barrel of oil they produced. However, if they stopped production, this would mean the Arabs had won via their new strategy to crowd out smaller US producers using low prices - on the basis of them having a much lower per barrel breakeven price than their American competitors.
— Business of Finance

Extrapolating this thesis one step further, we are able to logically correlate oil prices, US rig counts, and the future trajectory of the crude oil market. If the main goal of OPEC is to crowd out US producers (those with higher breakeven costs), then until enough producers have dropped out of production, oil prices should remain low around the region of $50-60 all else equal. Although current prices are a result of both supply and demand, it is apparently clear to us that there is a pathological and objective based strategy at work here. There are veteran analysts in the energy space who also agree that the key to projecting the future performance of oil prices is to watch the rig count figure closely.

The troubles don't stop at producers and explorers themselves. As reported by oilprice.com, offshore and onshore rig producers have been hit has hard if not harder than front line energy firms have been. This again relates directly to capex (capital expenditures) of producers and explorers who are increasingly facing cost pressures and thinking margins.

However, the slowdown in drilling activity is having a much more immediate and acute effect on a separate set of companies – those supplying the rigs.

Offshore oil contractors such as Halliburton or Transocean have seen their share prices tank worse than exploration companies because their revenue comes from being paid to drill, not necessarily from oil production after wells are completed. That means that when drilling slumps, their profits take an immediate hit. Even worse, exploration companies may see rising profits from existing production as oil prices rebound, but drilling service companies don’t benefit if their drilling contracts had been put on hold or cancelled.

The problem is compounded by the fact that a slew of new offshore oil rigs are set to come into operation – an estimated 200 over the next six years. As Bloomberg reports, these new rigs will mean there could be a surplus of about 140 rigs, meaning offshore oil contractors will have to scrap that many to bring new ones online.

If oil prices stay where they are now – in the neighborhood of $60 per barrel – a deep contraction in shipping rig supply will be inevitable. In 2015, spending on offshore exploration may be slashed by 15 percent, which will mean taking a deep knife to companies providing rigs and contracting. Transocean has already announced that it is idling seven deepwater rigs, along with several other drillships.

However the shakeout may take some time because offshore contractors can resort to using older rigs in order to bring down the rates they are charging, essential to maintaining market share. In order to entice exploration companies to keep up the drilling frenzy, older ships can keep costs lower.

But that may not be a tenable prospect since offshore contractors will feel compelled to put the new and more state-of-the-art rigs into operation. That will force companies with older fleets to start discarding the most dated drilling rigs.

Transocean already took a $2.6 billion impairment charge in the third quarter of this year, due to a “decline in the market valuation of the company’s contract drilling services business.” By scrapping more ships, it expects to write down at least $240 million in the fourth quarter. More may be in the offing – Transocean released an update on the status of its fleet in mid-December, confirming its plans to scrap 11 ships. The statement also added that “additional rigs may be identified as candidates for scrapping.”

Perhaps it is Seadrill, another offshore drilling services company, that has taking the worst of the oil price downturn. The company decided to cancel its dividend in November amid falling oil prices, a move that sent its share price tumbling downwards. Seadrill has seen its shares lose almost 75 percent of their value since July.

As with the rest of the industry, the fortunes of offshore drilling services companies depends on the price of oil. However, unlike the oil majors, which have more diversified interests both upstream and downstream, offshore contractors take it on the chin first when oil prices go down.
— OilPrice.com

All still pandering to disinflation...

More updates to come as we go into 2015. Have a Happy New Year!