About Resuscitation and Reinstatement

Doug Nolan

“Shock and awe” is not quite what it used to be. It still carries a punch, especially for traders long the Japanese yen or short EM and stocks. The yen surged 2% against the dollar (more vs. EM) Friday on the Bank of Japan’s (BOJ) surprising move to negative interest rates. BOJ Governor Haruhiko Kuroda has a penchant for startling the markets. Less than two weeks ago he stated that the BOJ was not considering adopting negative rates. It wasn’t all that long ago that central bankers treasured credibility.

For seven years, I’ve viewed global rate policies akin to John Law’s (1720 France) desperate move to hold his faltering paper money and Credit scheme (Mississippi Bubble period) together by devaluing competing hard currencies (zero and now negative rates devalue “money”). It somewhat delayed the devastating day of reckoning. Postponement made it better for a fortunate few and a lot worse for everyone else.

Last week saw dovish crisis management vociferation from the ECB’s Draghi. Now the BOJ adopts a crisis management stance. The week also had talk of some deal to reduce global crude supply. Meanwhile, the Bank of China injected a weekly record $105 billion of new liquidity. Nonetheless, the Shanghai Composite sank 6.1% to a 13-month low. There was desperation in the air – along with a heck of a short squeeze and general market mayhem.

Markets these days have every reason to question the efficacy of global monetary management.
 
It’s certainly reasonable to be skeptical of OPEC - too many producers desperate for liquidity.
 
The Chinese are flailing - conspicuously. As for the BOJ’s move, it does confirm the gravity of global financial instability. It as well supports the view that, even within the central bank community, confidence in the benefits of QE has waned.

After three years of unthinkable BOJ government debt purchases, Japanese inflation expectations have receded and the economy has weakened. Lowering rates slightly to negative 10 bps (for new reserve deposits) passed by a slim five to four vote margin. With the historic global QE experiment having badly strayed from expectations, there is today no consensus as to what to try next.

Kuroda remains keenly focused on the yen. After orchestrating a major currency devaluation, there now seems little tolerance for even a modest rally. The popular consensus view sees BOJ policymaking through the perspective of competitive currency devaluation, with the objectives of bolstering exports and countering deflationary forces. I suspect Kuroda’s (fresh from Davos) current yen fixation is more out of fear that a strengthening Japanese currency risks spurring unwinds of myriad variations of yen “carry trades” (short/borrowing in yen to finance higher-yielding securities globally) – de-leveraging that is in the process of wreaking havoc on global securities markets.

Notable Bloomberg headlines: (Thursday) “S&P 1500 Short Interest Is at Its Highest Level in Three Years.” (Friday): “Hedge Funds Boost Yen Bets to 4-Year High Days Before BOJ Shock.”


Bearish sentiment is elevated. Recent global tumult has spurred significant amounts of hedging across the financial markets. And, clearly, betting on “risk off” has of late proved rewarding (and gaining adherents). Draghi and Kuroda retain the power to incite short squeezes and the reversal of risk hedges. And central bankers can prod short-term traders to cover shorts and return to the long side. Yet the key issue is whether global central banks can propel another rally such as the 12% multi-week gains experienced off of August lows. Can policy measures resuscitate bull market psychology and reestablish the global Credit boom?

Subtly perhaps, yet the world has changed meaningfully in the five short months since the August “flash crash”. After exerting intense pressure and direct threats – not to mention the “national team’s” hundreds of billions of market support - Chinese equities traded this week below August lows. It’s worth noting that Hong Kong’s Hang Seng China Financials Index now trades significantly below August lows.

Bank stock weakness is anything but an Asian phenomenon. European bank stocks this week dropped to three-year lows. Even with Friday’s 2.7% rally, U.S. bank stocks (BKX) declined 12.6% in January (broker/dealers down 15.3%). European banks were hit even harder. The STOXX Europe 600 Bank Index has a y-t-d loss of 14.6%. This index is 31% below August highs and about 11% below August lows.

January 28 – Bloomberg (Sonia Sirletti and John Follain): “Banca Monte dei Paschi di Siena SpA led a slump in Italian banking shares after Italy’s long-sought deal on bad debts with the European Union disappointed investors. Monte dei Paschi, bailed out twice since 2009, fell 10%... in Milan trading, bringing losses this year to 45%. The eight biggest decliners among the 46 members of the Stoxx Europe 600 Banks Index were Italian lenders on Thursday. The agreement struck with the EU, which allows banks to offload soured loans after buying a state guarantee, is unlikely to clean up the financial system as fast as some in the markets had hoped, investors said. The plan stops well short of the cleanups organized in Spain and Ireland during the financial crisis. ‘The uncertainty in the Italian banking system will persist,’ said Emanuele Vizzini, who manages 3.5 billion euros ($3.8bn) as chief investment officer at Investitori Sgr in Milan. ‘The deal may help banks to offload part of their bad debt, but for sure doesn’t solve the problem, in particular for the weakest banks, which may need recapitalization.’”
Even with Friday’s 3.3% rally, the FTSE Italia All-Shares Bank index lost 22.8% in January. UniCredit, Italy’s largest bank, has a y-t-d decline of 31%. One is left to ponder where Italian sovereign yields would trade these days without Draghi.

When market optimism prevails and the world is readily embracing risk and leverage, the greatest speculative returns are amassed playing “at the margin.” “Risk on” ensures the perception of liquidity abundance, along with faith in the power of central banks and their monetary tools. In a world where liquidity is flowing, Credit is expanding and markets are bubbling, European securities markets provide attractive targets. And booming markets feed the perception that Europe’s economic recovery is sound and sustainable. It all became powerfully self-reinforcing.

But when cycles shift it’s those operating “at the margin” – i.e. junk bonds and high-beta stocks; leveraged companies, industries, economies and regions; leveraged financial institutions – that have the rug is so abruptly yanked out from under stability.

The thesis is that a momentous inflection point has been reached in a multi-decade global Credit cycle. A Monday Bloomberg headline: “So Yes, the Oil Crash Looks a Lot Like Subprime.” Others have noted the recent tight correlations between crude and equities prices. 
 
Let me suggest that the oil market provides the best proxy for the global Credit cycle. And it’s faltering global Credit that has been weighing harshly on commodities, equities and corporate Credit, while the bullish consensus bemoans that stocks have been way overreacting to modest economic slowdowns in the U.S. and throughout Europe.

A few months back the global bull market still appeared largely intact. Markets remained confident in central bankers and their monetary tools. Debt issuance was booming and the Credit Cycle seemed to sustain an upward trajectory. The global banking industry enjoyed an outwardly robust appearance – and was even to benefit from rate normalization in the U.S. and elsewhere. “Risk on” was secure, or so it appeared.

But it was the last (policy-induced) gasp of speculative excess, a “blow off” top that enticed more “money” into “developed world” stocks and corporate Credit. Meanwhile, finance was fleeing commodities, high-yield, China and EM even more aggressively. In reality, the Credit Cycle had turned – QE, negative rates, China “national team,” “whatever it takes” Draghi and a dovish Fed notwithstanding.

In newfound global Credit Cycle realities, highly leveraged China is an unfolding pileup. 
 
Vulnerability has precipitously emerged throughout the global banking system. European banks – luxuriating so popularly “at the margin” until recently – again appear acutely fragile. 
 
Recalling 2012, the European periphery is back in the crosshairs. A “bad bank” plan for the troubled Italian banking sector – that seemed doable back during “risk on” – seems less than workable with a backdrop of “risk off,” speculative de-leveraging and faltering global Credit.

Italy’s financial institutions and economy are acutely susceptible to weak securities markets and tightened Credit conditions. Italy is not alone. Greek yields surged 180 bps this month. 
 
Portuguese 10-year yields jumped 34 bps. For more than three years, “whatever it takes” monetary management has inflated securities market Bubbles. In the process, Bubble Dynamics have work surreptitiously to inflate financial and economic vulnerabilities.

It’s worth noting that Italian equities dropped 2.0% this week. Friday from Bloomberg: “Eighth Week of Europe Corporate-Debt Outflows Shows Limits of QE.” According to the article (Selcuk Gokoluk), $3.5 billion flowed out of investment-grade funds the past week. 
 
There is also heightened concern for the German economy’s exposure to China, not to mention the pressing immigrant issue and attendant political instability. There is as well increased focus on European financial and economic exposure to EM. European bank stock performance has been telling. Of the behemoth European banks, Deutsche Bank lost almost 26% of its value in January. BNP Paribas was down 16%, Credit Agricole 15%, Barclays 18%, Societe Generale 17% and Royal Bank of Scotland 17%.

This week saw 10-year bund yields sink to one-year lows. UK Gilt yields dropped to 10-month lows. It’s also worth noting the equities markets benefitting the most from Kuroda’s surprise and speculative dynamics. Brazilian equities gained 6.2% this week, with Mexico up 4.8%, Russia 3.9% and Turkey 4.6%. In the currencies, the beneficiaries were Brazil (up 2.3% this week), Mexico (2.8%), Russia (3.3%), South Africa (3.5%) and Malaysia (3.4%). It would appear that all the big gainers had oversized short positions.

I have been programmed over the years to take every short squeeze seriously. They often take on a life of their own. But back to the pressing issue: Can policy measures resuscitate bull market psychology and reestablish the global Credit boom? I do not expect either a resurgent bull market or a reemerging Credit boom. In truth, negative rates are a feeble tool in the face of global de-risking/de-leveraging dynamics. They are not confidence inspiring.

Dovish policy surprises do still afford a capable weapon to clobber those positioning for “risk off,” in the process somewhat restraining the forces of market dislocation. However, inciting squeezes and administering market punishment are not conducive to market stability or confidence. There’s a strong argument to be made that such a backdrop only compounds the challenge for the struggling global leveraged speculating community. Mainly, negative rates in theory are a tool to spur flows into risk assets and supposedly bolster securities markets. The irony is that negative rates are damaging to bank profitability. 
 
And as the Credit downturn gathers momentum, banking profits – and solvency – will be a pressing systemic issue.


Buttonwood

The crazy world of credit

Where negative yields and worries about default coincide
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THERE was much talk at Davos, the global elite’s annual get-together in Switzerland, of wealth inequality: the gap between the haves and the have-nots. The corporate-bond market is currently displaying a similar divide—between the have-yields and the yield-nots.

According to Bank of America Merrill Lynch (BAML), around €65 billion ($71 billion) of European corporate bonds are trading on negative yields; in other words, investors lose money by holding them. Yet the rates paid by issuers of low-quality or junk bonds have been soaring.

The spread (the interest premium over government borrowing rates) paid by junk-bond issuers has risen by nearly three-and-a-half percentage points since March last year (see chart). The gap is now nearly as great as it was during the euro crisis of 2011, although it is less than half as wide as it was after Lehman Brothers collapsed in 2008.

Odd though it may seem, these market movements are part of the same trend. As January’s stockmarket wobbles have shown, investors are very nervous and are looking for safety.

Certain corporate-bond issuers, such as Nestlé, a Swiss foods group, are perceived to be very safe. Since the yields on Swiss government bonds (even those with a ten-year maturity) are also negative, it is no great surprise that Nestlé bonds fall into the same camp.

Similarly, investors are willing to accept negative yields on German and Dutch government bonds with maturities of two and five years. Better to suffer a small loss from owning them than risk a big loss by buying a junk bond, which might default. Historically, the average recovery rate on unsecured bonds that default has been just 40 cents on the dollar. Given that risk, investors are demanding a much higher yield from junk bonds.

The proportion of junk bonds deemed “distressed” (defined as having a yield ten percentage points higher than Treasury bonds) is 29.6%, up from 13.5% a year ago. That is the highest ratio since 2009, according to S&P. Unsurprisingly, given the fall in energy prices, the oil and gas sector accounts for the biggest share of issuers in distress, at 30% of the total. The default rate, at 2.77%, has virtually doubled from the low of 2014 (although it is still below the historical average of 4.3%).  

Matt King, a credit strategist at Citigroup, thinks the reason for the turmoil is the reduced support that central banks are offering financial markets. For several years the Federal Reserve and the Bank of England used quantitative easing (or QE, the creation of money to buy assets) to drive down yields on government bonds and thus encourage investors to buy riskier assets, both equities and corporate bonds. Both have now stopped using QE (although they have yet to sell their piles of acquired assets); the Fed has also raised interest rates.

Although the European Central Bank and the Bank of Japan are still buying bonds, their efforts are being offset at the global level by sales by emerging-market central banks, including China. Net asset purchases by global central banks dipped last summer (coinciding with another market downturn) and recent data show they have done so again.

Given this backdrop, investors are sensitive to bad news. The fall in commodity prices and the slowdown in emerging markets are two adverse developments; those sectors were “where the growth was”, as Mr King points out. Corporate-bond investors have also noticed that profit forecasts have been revised lower in recent months in every industry in America. In short, Mr King concludes: “When monetary stimulus’s effect on markets fails to be matched by a corresponding improvement in the real economy, we are inevitably vulnerable to a correction.”

The big issue for the corporate-bond markets is whether the sell-off is self-perpetuating.

According to BAML, investors in high-yield bonds globally have withdrawn $4.9 billion in the past seven weeks, equivalent to 5% of their assets under management. Those withdrawals force fund managers to sell bonds, creating bigger losses for the remaining investors and encouraging more withdrawals. The impact is exacerbated by the poor liquidity of corporate-bond markets.

Banks have reduced their market-making activities in the wake of regulations imposed after the financial crisis of 2007-08.

The sell-off will be stopped if yields rise to a level where long-term investors (pension funds and insurance companies, for example) think the bonds are a bargain. But those investors probably need a dose of good news to persuade them to open their wallets.



Wall Street's Best Minds

Byron Wien: Here’s Why I’m Not Optimistic for 2016

The Blackstone strategist updates his 10 Surprises note after three weeks of falling stocks and political Fireworks.     

By Byron Wien              

 
My list of 10 Surprises for 2016 has a gloomy tone. I generally think of myself as an optimist, but some concepts that I have been brooding about for a while seem to be converging. I have been worrying about the impact of China’s slowdown on the rest of the world, the ramifications of the refugee crisis on the stability of Europe, the peaking of profit margins in the United States, the surfeit of goods around the world coupled with insufficient demand, the dependence of developed economies on central bank monetary easing for growth, the accumulation of public and private debt, income inequality and terrorism.

Many of these issues are integrated into this year’s Ten Surprises. My definition of a Surprise is an event that I believe has a better than 50% chance of taking place, but which the average professional investor would only assign a one in three likelihood of happening. Usually I get five or six of the Surprises generally on target, but last year I fell somewhat short of that score.

They are not designed to prove that I can predict the future. Nobody can do that. The Surprises are intended to provoke serious thought about important issues.         
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This is an election year, so offering a Surprise on the November outcome is mandatory. I have Hillary Clinton beating Ted Cruz. Clinton’s being chosen as the Democratic candidate would not be a surprise, or even her victory, because her party has a significant lead in likely Electoral College votes. The Surprise would be on the Republican side. Donald Trump and Ted Cruz, two extreme candidates, are leading the establishment pack by a wide margin. The conventional wisdom within the party is that neither of these candidates can win in a general election and that a ticket made up of Marco Rubio and John Kasich would have a better chance because they might bring in the electoral votes of Florida and Ohio. My view is that the extreme candidates not only have Republican supporters, they are also attracting some independents and Democrats. If the extreme candidates were still far ahead in the polls at the time of the convention, denying one of them the nomination would be very difficult.

Trump may be too controversial and some of his campaign exaggerations may make him an excessively risky candidate. Cruz, while not well-liked by many members of his party, may be more acceptable to traditional conservatives. He is smart, savvy, organized and determined.

What’s more, he has been gaining momentum in the days leading up to the primaries. The second part of this Surprise is that the Democrats take back the majority in the Senate. A number of Republican seats are being contested in states with an historical leaning towards the Democrats. If Clinton wins with a reasonable margin, many of the Democratic Senatorial candidates may be carried over the top with her. Because of disenchantment with the whole political process, voter turnout may be low. A number of Democratic voters are negative on Clinton because of, among other issues, the Benghazi controversy, lapses relating to her personal e-mail and backlash to her involvement in containing Bill Clinton’s scandals relating to women. On the other side, many Republicans have been turned off by the inflammatory positions of Trump and Cruz.

In my second Surprise I expected the Standard & Poor’s [the SPDR S&P 500 ETF tracks the index] to suffer a loss for the year. I do not anticipate a bear market (down 20% or more), but something short of that. I believe that earnings will be pressured by a combination of limited pricing power and increasing wages and that profit margins, near an all-time high now, will be lower. While the price-earnings ratio of the index is not excessive, disappointing earnings will be the key factor driving the decline. The disturbing geopolitical uncertainties around the world also have an influence on multiple contraction. Investors have a feeling of apprehension about the dangers of terrorism, oil price softness, emerging market recessions, the refugee crisis and armed conflicts in the Middle East, Africa or possibly elsewhere. As a result, they are likely to maintain higher than usual cash balances.
 
I focus on the Federal Reserve in the third Surprise. When the Fed raised rates in mid-December, they said that it was probable that there would be four rate increases in 2016 and that by 2017 the federal funds rate would be 1.35%. I believe the Fed will reconsider that statement as the economic data flows in. I think they may raise rates by 25 basis points in March, but they will not raise rates again during the remainder of the year.

While the consensus for economic growth in the U.S. is that real GDP will increase 2.0% to 2.5% in 2016, the trajectory that I see developing would make a rate below 2% more likely.

Last year vehicle sales were 17.5 million units, an impressive performance. We may find that some of those sales were borrowed from 2016. If energy capital spending stays low and housing does not surge, growth could be disappointing.

If the economic weakness that I suspect actually develops, we may find the Federal Reserve actively considers reducing rates later in the year rather than raising them.

The most crowded trade in the current investment landscape is being long the dollar. Almost everyone agrees the U.S. is going to grow faster than any other developed country or region, has a mature and fair legal system, is not likely to impose currency controls and has a democratic (if dysfunctional) political system. That’s why the dollar has been strong. If the economy were weaker than now projected and if the equity and real estate markets soften, there may be less enthusiasm for buying U.S. assets. Capital flows into America from Russia, China and the Middle East may also diminish because of economic problems in those areas. I could see the dollar declining in value to 1.20 against the euro.

In the fifth Surprise I expect growth in China to slow below 5% but avoid a hard landing. Most estimates continue to be 6% or better, although there are some bears out there who see growth as low as 2%. I believe the Chinese continue to have the resources to stimulate the economy using both fiscal and monetary tools. Data on the drawdown of foreign currency reserves supports the view that policymakers are making every effort to offset the loss of momentum in the economy. Debt to Gross Domestic Product has, however, climbed to 250% and many of the loans held by regional banks are non-performing. In recent weeks the exchange rate for the renminbi has gradually declined against the dollar. I expect the ratio to descend to seven against dollar, but I have seen estimates close to eight. I make every effort to make the Surprises consistent with each other. This one is a little tricky because it is not likely that both the dollar and the yuan would be weak at the same time.

The European Union has been under strain for at least the last five years. The original concept was that the loose alliance of nations would form a political union over time, but that was probably never going to happen. I did believe that a banking union would be developed for practical reasons, but that proved too optimistic also. When the so-called Southern Tier countries got into economic trouble after the Great Recession of 2008-9, the whole project was in question. Nevertheless, the European Union has managed to stay together with help from Germany and the European Central Bank because the consequences of a break-up are likely to be severe. The sixth Surprise is that now, with more than a million Middle East asylum seekers in Germany and at least another million seeking refuge throughout the continent, the region is again in danger of breaking up. I do not think it will happen this year but it will be actively discussed. The reasons behind it are the general difference in prosperity between the northern and southern countries, the Greek financial condition and the philosophical and political movement to the right across all of Europe.

For the seventh Surprise I have the price of West Texas Intermediate oil languishing in the $30s throughout the year. The consensus view is that crude will drift toward $50 in the second half.

One of the reasons behind the possible rise is a lack of exploration for new reserves, as reflected by a two-thirds drop in the drilling rig count. Offsetting the reduction in the number of rigs, however, are huge inventories in storage facilities and tankers which could come onto the market at any time; the unwillingness of Saudi Arabia to cut production; and additional supply coming on the market both from Iran and as a continuous flow of oil from domestic producers that need the cash to pay down debt or to fulfill lease obligations. Three or so years from now we will see prices in the $70s because the depletion of existing wells (at a rate of five million barrels a day over the course of a year), the failure to explore for new reserves and the increase in demand from the developing world will result in supply/demand strains. But for 2016, I believe prices will remain low. Thinking that the price of oil will rise this year is the second most crowded trade in the market today.

The high-end residential real estate market in New York and London has been surging the past few years as buyers from China, Russia and the Middle East move capital to places they believe are physically safe and financially secure. Economic conditions in those countries have weakened considerably and my eighth Surprise is that the expensive condominiums and other residential properties in those two cities have trouble finding buyers. As a result, the real estate developers of those projects run into financial trouble. This is not as broad a problem as the sub-prime crisis in the United States in 2008 that rippled throughout the world financial system. I still think real estate investment trusts invested in commercial and moderately priced apartment complexes will continue to provide reasonable returns, partly because of their high yields.

The third most crowded trade out there today is based on the view that, with the Federal Reserve raising short-term interest rates, medium- and longer-term yields are likely to increase.
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Many think that the 10-year U.S. Treasury yield will reach 3% before the end of the year. Given market and geographical instability, my view is that the combination of investors looking for a safe place to park their money and the general desire to maintain a high level of liquidity in uncertain times will keep high quality fixed income interest rates low. My ninth Surprise is that the 10-year U.S. Treasury yield does not exceed 2.5% during 2016.

For the final tenth Surprise I took a broad look at global growth. Most estimates, including that of the International Monetary Fund, are for growth to be about 3%, but I believe that is too optimistic. If I am right and U.S. growth is below 2%, Chinese growth is below 5%, Europe’s growth is below 2%, Japan’s growth is just above 1% and many of the emerging markets are in recessions, it is hard for me to see how world growth can be much above 2%. This estimate has relevance to my oil Surprise (#7) as well, since there is a high correlation between the pace of the world economy and the price of crude. Slow world growth, resulting from reduced overall demand, is usually associated with declining prices for energy.

Every year I always have a few Surprises that don’t make the list of ten. There are two reasons for this: some of the “also rans” are not as relevant as the ten I have picked, and for some I cannot bring myself to have conviction that they are probable, with a better than 50% chance of taking place.

The first of these is that there is no major terrorist attack in the United States or Europe in 2016. I know most of us believe the spread of terrorism has gotten to the point where a significant event is inevitable and we have to be prepared for one to take place. I think many people feel some anxiety as they go about their daily activities, knowing that somewhere a plot to inflict harm in their community is under development. Even so, I think many underestimate the effectiveness of various law enforcement agencies in preventing attacks. New York City has 1500 people devoting their careers to preventing terrorism. To be sure, officials would be the first to say it is a combination of skill and luck that has kept us safe since 2001 from a major event. Let’s hope that combination continues.

The second “also ran” is related to Japan. I did not include this one in the basic ten this year because I had included a Surprise on Japan in the Ten Surprises of 2015 and I only readdress the same topic in a Surprise in very rare instances. Last year, Japan did well relative to most global markets, and I am more constructive on the country this year.

For a long time I have been concerned that corporations have been using financial engineering to increase earnings. Growing revenues in an economic environment with relatively low demand from consumers and weak capital spending has been very hard. Companies have been buying their own shares back and making strategic acquisitions (where sales and administrative staffs can be cut) in order to increase earnings per share. They are also using inversions to decrease their taxes. So far investors have applauded these activities because they have worked to increase the stock price. I think portfolio managers are beginning to realize that these steps do not indicate that sustainable growth is taking place. Since I do not detect widespread concern about this issue yet, I left it out of the basic ten because I did not believe investors would penalize companies this year for excessive financial engineering by trimming back multiples. We will see if more concern develops in the future.

Biotechnology has long been an interest of mine and I believe there are going to be major breakthroughs in developing drugs for cancer, heart disease, Parkinson’s, diabetes and memory loss. If a pill can replace a hospital stay, it is worth a lot. This is my fourth “also ran.”

Coupled with it is the growing realization that attacking the pharmaceutical industry for excessive pricing while ignoring the research and development costs associated with the breakthrough drugs is unfair. I left this one out because I did not think it was as important as the ten I had picked.

Finally in the fifth “also ran” I said that commodity producers would cut production, prices would stabilize, recessions in the developing world would end and it would be safe to invest in emerging markets again. I put this one in the category of wishful thinking. I think it will happen sometime, but not this year.

There it is: the explanation of the reasoning behind The Ten Surprises and the five “also rans.”

The year is off to a rough start for the financial markets, and the Surprises, which were completed in December, look like I had a hint of what was coming. But a year is a long time and a lot could, and is likely to, happen between now and next Christmas. This is the year where I hope I am too pessimistic.

Editor’s Note: Wien, vice chairman of multi-asset investing at Blackstone, released his annual list of surprises on Jan. 4. Today he published an expanded version adding some of the analysis behind his observations.


The Global Economy’s Marshmallow Test

Jeffrey D. Sachs

Marshmallows
 

NEW YORK – The world economy is experiencing a turbulent start to 2016. Stock markets are plummeting; emerging economies are reeling in response to the sharp decline in commodities prices; refugee inflows are further destabilizing Europe; China’s growth has slowed markedly in response to a capital-flow reversal and an overvalued currency; and the US is in political paralysis. A few central bankers struggle to keep the world economy upright.
 
To escape this mess, four principles should guide the way. First, global economic progress depends on high global saving and investment. Second, saving and investment flows should be viewed as global, not national. Third, full employment depends on high investment rates that match high saving rates. Fourth, high private investments by business depend on high public investments in infrastructure and human capital. Let’s consider each.
 
First, our global goal should be economic progress, meaning better living conditions worldwide.
 
Indeed, that goal has been enshrined in the new Sustainable Development Goals adopted last September by all 193 members of the United Nations. Progress depends on a high rate of global investment: building the skills, technology, and physical capital stock to propel standards of living higher. In economic development, as in life, there’s no free lunch: Without high rates of investment in know-how, skills, machinery, and sustainable infrastructure, productivity tends to decline (mainly through depreciation), dragging down living standards.
 
High investment rates in turn depend on high saving rates. A famous psychological experiment found that young children who could resist the immediate temptation to eat a marshmallow, and thereby gain two marshmallows in the future, were likelier to thrive as adults than those who couldn’t.
 
Likewise, societies that defer instant consumption in order to save and invest for the future will enjoy higher future incomes and greater retirement security. (When American economists advise China to boost consumption and cut saving, they are merely peddling the bad habits of American culture, which saves and invests far too little for America’s future.)
 
Second, saving and investment flows are global. A country such as China, with a high saving rate that exceeds local investment needs, can support investment in other parts of the world that save less, notably low-income Africa and Asia. China’s population is aging rapidly, and Chinese households are saving for retirement. The Chinese know that their household financial assets, rather than numerous children or government social security, will be the main source of their financial security.
 
Low-income Africa and Asia, on the other hand, are both capital-poor and very young. They can borrow from China’s high savers to finance a massive and rapid build-up of education, skills, and infrastructure to underpin their own future economic prosperity.
 
Third, a high global saving rate does not automatically translate into a high investment rate; unless properly directed, it can cause underspending and unemployment instead. Money put into banks and other financial intermediaries (such as pension and insurance funds) can finance productive activities or short-term speculation (for example, consumer loans and real estate). Great bankers of the past like J.P. Morgan built industries like rail and steel. Today’s money managers, by contrast, tend to resemble gamblers or even fraudsters like Charles Ponzi.
 
Fourth, today’s investments with high social returns – such as low-carbon energy, smart power grids for cities, and information-based health systems – depend on public-private partnerships, in which public investment and public policies help to spur private investment. This has long been the case: Railroad networks, aviation, automobiles, semiconductors, satellites, GPS, hydraulic fracturing, nuclear power, genomics, and the Internet would not exist but for such partnerships (typically, but not only, starting with the military).
 
Our global problem today is that the world’s financial intermediaries are not properly steering long-term saving into long-term investments. The problem is compounded by the fact that most governments (the US is a stark case) are chronically underinvesting in long-term education, skill training, and infrastructure. Private investment is falling short mainly because of the shortfall of complementary public investment. Shortsighted macroeconomists say the world is under-consuming; in fact, it is underinvesting.
 
The result is inadequate global demand (global investments falling short of global saving at full employment) and highly volatile short-term capital flows to finance consumption and real estate.
 
Such short-term flows are subject to abrupt reversals of size and direction. The 1997 Asian financial crisis followed a sudden stop of capital inflows to Asia, and global short-term lending suddenly dried up after Lehman Brothers collapsed in September 2008, causing the Great Recession. Now China is facing the same problem, with inflows having abruptly given way to outflows.
 
The mainstream macroeconomic advice to China – boost domestic consumption and overvalue the renminbi to cut exports – fails the marshmallow test. It encourages overconsumption, underinvestment, and rising unemployment in a rapidly aging society, and in a world that can make tremendous use of China’s high saving and industrial capacity.
 
The right policy is to channel China’s high saving to increased investments in infrastructure and skills in low-income Africa and Asia. China’s new Asian Infrastructure Investment Bank (AIIB) and its One Belt, One Road initiative to establish modern transport and communications links throughout the region are steps in the right direction. These programs will keep China’s factories operating at high capacity to produce the investment goods needed for rapid growth in today’s low-income countries.
 
China’s currency should be allowed to depreciate so that China’s capital-goods exports to Africa and Asia are more affordable.
 
More generally, governments should expand the role of national and multilateral development banks (including the regional development banks for Asia, Africa, the Americas, and the Islamic countries) to channel long-term saving from pension funds, insurance funds, and commercial banks into long-term public and private investments in twenty-first-century industries and infrastructure. Central banks and hedge funds cannot produce long-term economic growth and financial stability. Only long-term investments, both public and private, can lift the world economy out of its current instability and slow growth.
 
 


The Battle for the Yuan: How China's Big Mama Hurt Speculators

Bloomberg News


Chinese officials are using military analogies to describe the People’s Bank of China’s bruising attack on speculators who were betting against the nation’s currency.
Take Wang Yong, an academic at the PBOC’s training school. He urged policy makers to gird for a "tough battle" and the government to stock up on grain, oil and gold as they fight to keep the yuan stable. Or Mei Xinyu, a researcher at the Ministry of Commerce, who wrote in a commentary on the front page of the overseas edition of the People’s Daily that billionaire investor George Soros’s "war" against China won’t succeed.
For traders in Hong Kong at the sharp end of the PBOC’s recent actions to prop up the currency, that kind of language fits the mood.
That was day two of a multi-pronged assault when the PBOC swept into Hong Kong’s money markets to hoover up yuan and shove interbank rates to record highs, forcing losses on speculators who were betting the currency would weaken. The message: take on Yang Ma as the PBOC is sometimes dubbed -- loosely translated as Big Mama -- at your peril.
"They wanted to say, ‘who’s the boss here,’" said Frederic Neumann, co-head of Asian economic research at HSBC Holdings Plc in Hong Kong.

While the PBOC’s actions dealt a blow to yuan bears, there’s a fair way to go before it kills them off. Twelve-month non-deliverable forwards for the yuan trade 4.6 percent weaker than the spot rate, a gap that’s narrowed from a seven-year high of 5.4 percent on Jan. 6. It averaged 3.4 percent in the fourth quarter and was 1 percent on Aug. 10, the day before a surprise devaluation.
The events early this year were just the latest in a series of sudden changes to China’s exchange-rate regime that have roiled global markets in recent months. August’s devaluation was followed in December by a decision to measure the yuan’s value against a basket of currencies, rather than just the U.S. dollar. Resulting yuan weakness in January fueled fears more was to come.
The pace of developments shocked investors and prompted policy makers from Vietnam to Washington to chide the PBOC for not communicating the changes clearly enough. Adding to a sense of panic: China’s economy is growing at its slowest pace since 1990, an estimated $1 trillion in capital flowed out last year, and stock markets in Shanghai and Shenzhen are in the midst of a renewed sell-off that has erased about $2 trillion in market value this year alone.
At the PBOC, preparation for the January push started toward the end of last year, when officials noticed unusual trading patterns in the yuan, according to people familiar with the plans. The central bank suspected that some were deliberately making a quick profit off the state’s back by arbitraging the difference between the value of the yuan traded in Shanghai and its value in Hong Kong, the people said, declining to be named as the deliberations are private.
Arbitrage Assault
That’s because China effectively has two exchange rates -- an onshore one tightly controlled by the government through a daily reference rate, and another offshore that’s traded more freely in Hong Kong and other centers. Offshore trading is meant to be part of a gradual process of eventually freeing up the yuan to the outside world.
In December, the PBOC curbed the arbitrage trades by temporarily suspending a select clutch of foreign banks, including DBS Group Holdings Ltd. and Standard Chartered Plc, from some foreign-exchange business in China, people with knowledge of the matter said at the time. Standard Chartered appealed for the ban to be shortened, said one of the people, who asked not to be identified because they’re not authorized to speak on the matter. DBS’s ban is shorter than three months, another person said.

As 2016 got underway, the PBOC stepped up its intelligence-gathering by asking Chinese banks and state-owned companies in Hong Kong to provide details on who was placing short-sell orders on the yuan. It was part of a deliberate, staged process to tackle speculators, according to people familiar with the matter. At the same time, the PBOC continued to defend the yuan in Hong Kong by selling dollars every time it fell to a certain level.
But it wasn’t always a smooth process. 
On Jan. 6, the PBOC shook markets when it set the yuan’s daily reference rate against the dollar at the weakest level since April 2011. The currency tumbled in Hong Kong the most since the day after the surprise devaluation in August and both exchange rates slumped to their weakest levels since at least March 2011 as markets interpreted the move as another deliberate shift. 
Those who had been betting against the yuan were being proved right.
The PBOC followed up with another nudge weaker at its fixing on Jan. 7, then stepped in to support the currency. The next day, policy makers brought the streak to an end, halting an eight-day run of weaker reference rates in a bid to restore some calm.
Back in Beijing, central bank officials were vexed by a surge in short selling and decided to act, according to the people with knowledge of those plans.

Pincer Move

The following Monday, the PBOC deployed a strategy that would hammer traders caught on the wrong side. First, officials told Chinese banks in Hong Kong to stop lending yuan offshore unless necessary in a move to suck liquidity out of the system. Then, the PBOC went in hard by buying yuan in Hong Kong and sparking a record surgein the city’s money-market rates in the Chinese currency to deter bearish speculators. 
On Jan. 11, the overnight Hong Kong Interbank Offered Rate surged 939 basis points to 13.4 percent.
“Chinese banks were absent from the market since Jan. 11, driving the interest rate to an unbelievable level," said Lam. "The market went into panic mode."
The next day, panic turned into mayhem. The cost to borrow yuan overnight in the city’s interbank market surged to 66.82 percent, almost five times the previous high.

Strong Words

The actions were accompanied by jawboning. In New York, Han Jun, the deputy director of China’s office of the central leading group for financial and economic affairs, told reporters on Jan. 11 that betting against the yuan will fail and described calls for a large depreciation as “ridiculous.”
“It is pure imagination that the Chinese yuan will act like a wild horse without any rein,” said Han.
By then, China had the market back in control, steadying the yuan in both onshore and offshore markets.
Inside the PBOC, officials were viewing their actions as a success and vowed to do it again if needed, according to people familiar with the matter. For good measure, state mouthpieces Xinhua News Agency and the People’s Daily followed up with commentary warning speculators that they haven’t done their homework and will fail if they take on the PBOC again.
The monetary authority has steadied its daily fixing in recent weeks, while the Hong Kong interbank rate has fallen back to the weakest level since mid-2013.
Yu Yongding, a former adviser to the PBOC, said that although the scale of the move on speculators was a surprise, he has "no complaints."

Aggressive Steps

As the dust settles, some argue the aggressive steps in Hong Kong ran contrary to a stated aim after winning reserve status at the International Monetary Fund to make the yuan a global currency.
"Investors may read these actions as an indication of despair, that the situation may be worse than what appears on the surface," said Alicia Garcia Herrero, Asia Pacific economist at Natixis SA in Hong Kong. "This is specially the case for measures that go against the spirit of China’s strategic goals."
Still, given that China is enforcing stricter capital controls on its own citizens to stem an outflow linked to expectations of currency weakness, the move to tackle foreign speculators is consistent with those steps, said London-based Stephen Jen, co-founder of SLJ Macro Partners LLP in London and a former IMF economist.
"Beijing has tightened capital controls further with regards to what the residents are doing," said Jen. "They would have to be tough with foreigners as well, right?"


The U.S. Treasury Auction - Who Is Showing Up?

by: Scott Carmack


Summary

 
- Bid-to-cover ratios are declining.

- Weakness in treasury auctions can be attributed to dealer demand NOT foreign central banks.

- Auction results point to further curve flattening in the near term.

 
In a prior perspective piece entitled "International Reserves - Savings gluts can last only so long," we laid out the foundation for higher interest rates in the United States based on the depletion of foreign FX reserves. Global reserves turned negative on a year-over-year basis in the middle of 2015 (blue-line in the chart below). In spite of this and the strong correlation of foreign treasury holdings (red-line), ten-year treasury yields have remained stubbornly low.
 
Many market pundits have theorized that central bank selling pressure in treasuries will be offset by a "risk-off" trade domestically. The argument is that during times of market uncertainty where emerging market governments are grappling with slow economic growth, a flight of capital, and weakening currencies, there is a burgeoning demand among investors and asset managers for treasuries. This demand naturally offsets the selling pressure by Central Banks as they try to stem their currency devaluations by buying their domestic currencies (selling dollars and U.S. treasuries). This paper analyzes trends in U.S. treasury auctions to see if this is indeed happening.
 
 
For those that are unfamiliar, the Treasury auctions off U.S. government debt on a monthly basis. The auction results are public information and bidders are classified as indirect, direct, and primary dealers. Direct bidders include asset management firms, like Janus, Invesco etc. who are purchasing directly and not going through an intermediary. Indirect Bidders are typically foreign entities, such as Central Banks. And finally, the bulk of the bidding comes from Primary Dealers who then re-market the securities to their clients. The success of the auction is often determined by how many prospective investors tender their bids, the co-called bid-to-cover ratio. Some investors submit competitive bids which specify the lowest yield that they are willing to accept, and some bid non-competitively, meaning that they will accept the securities at the clearing yield. All of the bids are lined up from the lowest to highest yield until the auction is fully subscribed, and all participants with winning bids are awarded treasuries at the clearing yield. The bid-to-cover ratio indicates how many investment dollars are chasing an additional dollar of supply.
 
The chart above shows the two-year treasury yield (green line) plotted against the bid-to-cover ratio (grey line) at every two-year auction for the last seven years. The red-dots are the one-year moving average of the bid-to-cover ratios and are displayed for the purpose of smoothing the data. The bid-to-cover axis is inverted, and shows that as the ratio declines, yields on the two-year treasury tend to rise. This makes intuitive sense since less demand relative to supply generally causes asset prices to fall and yields to rise. Over the past three years the moving average of the bid-to-cover ratio has steadily declined from 3.8 to 3.3. Concurrently, the two-year treasury yield has risen from approximately 20 bps to 87 bps.
 
 
The above chart further decomposes the demand-side of these auctions by tracking the amount of direct, indirect, and primary dealer bids at each auction. Primary dealers provide the bulk of the demand, however, over the last three years, primary dealer tenders (blue-line) have declined from a peak of over $100 Billion to just over $60 Billion. Direct tenders (red-line) have declined from around $25 Billion per auction to just above $5 Billion. And finally, indirect bidders or foreign entity demand (green-line), has declined but appears more stable. Over the last three years, it has been range-bound between $10 Billion and $20 Billion per auction. These results suggest that rising short-term yields are more a function of curtailed dealer demand, than a drop-off in demand from foreign Central Banks-a curious finding given that every time there is a spike in short-term yields, anecdotal references blame the PBOC. This evidence doesn't support that notion.
 
 
Longer-dated treasuries have been even more resilient, currently just above two percent, and having briefly breached that level last week. The above chart shows the ten-year yield against the bid-to-cover ratios at every ten-year auction over the last seven years. Again, the right axis is inverted. As bid-to-cover ratios rise, the ten-year yield tends to fall, and vice versa.
 
Interestingly, over the past couple of years, the bid-to-cover ratio has been in a relatively tight range, between 2.6 and 2.7. It has yet to breakdown from these levels, like the two-year auction has. Also, in the face of this steady auction demand, yields have continued to move lower, from their high at the beginning of 2014 of three percent to the current two percent level.
 
 
The demand elements of the 10-year auctions are much more stable than the shorter maturity auctions. Indirect tenders (green-line) have been stable over the past five years and actually seemed to have hooked upward to around $15 Billion over the past year. Primary dealer and direct demand has fallen, but only marginally. In any case, this evidence would suggest that any temporary weakness in the ten-year treasury note over the last couple of years, would be more a function of domestic demand than foreign.
 
Conclusión
 
The treasury curve has been flattening, so it makes sense that auction demand for shorter dated treasuries would be less robust than longer maturity auctions. However, the often cited reason for increasing short-term yields due to PBOC and other foreign central bank selling is not accurate.
 
Foreign demand for treasuries has held up relatively well in the face of declining FX reserves. I still think that this poses a threat to rising yields in the future, especially since the year-over-year change in foreign treasury holdings only just recently hit zero percent (chart 1), but this has NOT happened yet. Whether an increase in domestic demand could offset such a drop remains to be seen. However, given the waning primary dealer tenders at recent auctions, I doubt it. In any case, I will be paying close attention to the 2016 auction results, with particular interest in both the bid-to-cover, and the indirect tender.

Bundesbank transferred 210 tonnes of German gold in 2015

©Bloomberg
 
 
Germany’s Bundesbank released further detail on its gold holdings on Wednesday, saying it transferred 210 tonnes back to the country last year from vaults in Paris and New York.
 
Frankfurt is now the largest storage location for the country’s reserves after New York, it said in a statement.

“The transfers are proceeding smoothly. We have succeeded in once again significantly increasing the transport volume compared with 2014. This means that operations are running very much according to schedule,” Carl-Ludwig Thiele, Member of the Executive Board of the Deutsche Bundesbank, said.

The statement is the latest sign of transparency by the central bank after the eurozone sovereign debt crisis in 2012 led to public questions about the safety of the country’s reserves.
 
Most of the country’s gold holdings were built up starting in the 1950s, when trade surpluses were exchanged for gold under the Bretton Woods system that tied the US dollar to the yellow metal. That led to a build-up of gold in vaults overseas, especially in New York under the Federal Reserve.

During the cold war the Bundesbank wanted to keep its gold in the west in case of an invasion from the Soviet Union.

Last year the Bundesbank released a 2,300-page inventory of every single bar it held stored in vaults in Frankfurt, London, Paris and New York.

The Bundesbank aims to store half of its gold reserves in Germany by 2020. Since 2013 it has brought a total of about 366 tonnes of gold to Frankfurt, roughly half of the total to be transferred, it said.


60 Reasons Why Oil Investors Should Hang On

By: OilPrice.com


Inventories will continue to rise, but the momentum is slowing.

The following are some observations as to how we got here and how we're gonna get out.

9 reasons why oil has taken so long to bottom:

1. OPEC increased production in 2015 to multiyear highs, principally in Saudi Arabia and Iraq where production between the two added 1.5 million barrels per day (mb/d) to inventories after the no cut stance was adopted.

2. Russian production increased in 2015 to post Soviet highs.

3. Long planned Gulf of Mexico production began coming on in late 2015.

4. An overhang of 3,000 or 4,000 shale wells that were drilled but uncompleted ("ducks") entered a completion cycle in 2015.

5. Service companies and suppliers went to zero margin survival pricing (not to be confused with efficiency). The result has been an artificial boost to completions that cannot be sustained.

6. Resilience among a few operators in the Permian who felt the need to thump their chests, creating the rally that killed the rally last spring (disclosure: I own stock in Pioneer Resources but am going to dump it if they don't cut it out!).

7. The dollar strengthened.

8. Iranian exports are coming.

9. And, finally, China.


5 Demand-Side Reasons Why We Need to Hang-On:

1. Chinese oil demand is up year-over-year by 8 percent. It is expected to slow in 2016 to as low as 2 percent (maybe) but it is still growth in a tightening market.

2. Watch Chinese car sales. They were sluggish in early 2015 but finished very strong in what could be a 2016 V-shaped recovery.

3. The Indian economy is on a tear. The IMF has it as the world's fastest growing large economy.

GDP growth was 7.3 percent in 2015 and is projected to be 7.5 percent in 2016. That trumps Chinese growth. Although India's oil demand is only one-third that of China, it is the growth picture that should be better covered by analysts and headlines. India is about to be the world's most populous nation with a middle class that is likely to double over the next 15 years. 40 cars now service 1,000 people but that is rapidly changing. And this is not something that will occur sometime, someday in the future. 2015 Indian consumption grew by 300,000 barrels per day (bpd).

4. U.S. consumption has been increasing with higher employment and lower fuel costs. Truck and full size SUV sales have been extraordinary.

5. Europe, the world's largest oil market, is in a decade long decline but not as steeply as it was. Asia demand is strong with Vietnam's GDP growing 7.5 percent in 2015. Middle East countries are seeing increases in consumption. And as a final observation, go back one year when most oil analysts were looking at supply as the means to a correction. Demand was thought to be too inelastic and would thus take too long to play out. But it was demand that responded first.

When the story is written, it will be demand that outplayed supply 2 to 1 on our way to parity.

Thereafter, if we go into imbalance, it will be the damage done to supply that really moves prices.

16 Supply-Side Reasons Why We Need to Hang On

1. Earlier in 2015 global supply exceeded demand by about 2.2 mb/d according to the EIA.

Others had it at 2.5 mb/d. The EIA now has it down to 1.3 mb/d and change. We are still nowhere near an inflection point but we are converging.

2. The rig count in OPEC's GCC countries has not corrected down with prices. It is mostly maintenance drilling and somewhat additive in Saudi Arabia. The level of production that we have seen lately likely means the GCC is close to or at capacity.

3. There is near universal acknowledgement that there will be another 300,000 to 500,000 bpd decline in U.S. production this year. It could be more given the struggles of the onshore conventional market which alone should give up 150,000 bpd. Shale's steep decline rates will easily make up the rest even against increasing Gulf of Mexico production.

4. Global non OPEC, non U.S. production will decline by 300,000 to 400,000 bpd in 2016 according to the IEA. This number could increase as marginal production at current low prices comes off line due to lifting costs.

5. After an upside surprise in 2015 Russian production, there is a building consensus that 2016 results will be off with further declines thereafter. Russian oil giant Lukoil is stacking contractor rigs which will show up fairly soon in the numbers. State backed Rosneft is showing financial strain.

6. Pemex production is down 10 percent.

7. North Sea production, which has increased over the last few years, will slip in 2016.

8. Long-term Canadian oil sands projects will come on in 2016 as will some production in Brazil, but even collectively the amounts are small. It's probable too that some of the oil miners will put a hold on production due to lower product costs (about $15/bbl less than WTI) and extraordinarily high lifting and processing costs (some of the sands are subjected to subsurface CO2 drives, others are surface mined).

9. Anticipated Iranian exports are here, but the projections are all over the place from the Iranian government's claim of 1 million b/day in 6 to 12 months to Rystad Energy's claim of 150,000 b/day.

Even the middle ground argument of 500,000 b/day assumes Iran can get back to their long term trend line, which had been declining during the 5 years prior to 2011 sanctions. Fields are in poor repair and the gas drives essential to production have been mostly abandoned. All in, it's most likely that production will stutter step up to the trend line due to delays caused by political process and infrastructure funding. This, like all things, will take longer than expected but watch out for early sales. You will be seeing more inventory than production as Iran unloads the 30 to 45 million barrels of oil in storage. Allow some time to work off stocks to get an idea of the actual production numbers which will likely disappoint.

10. Depending on the source, $140 to $200 billion of expenditures has come off of long term projects in 2015 with calls for another $40 to $150 billion in cancellations and postponements in 2016. This won't be made up by renewables. The current and projected crude and natural gas prices have dis-incentivized consumers from wind and solar. Governments after the Paris accord may throw money around but consumers will likely not follow until commodity prices make them.

11. All said, these capex cuts will result in a loss of at least 5 mb/d in long-horizon production.

These are the goliath type projects that we absolutely need to match to current plus anticipated consumption increases.

12. Existing wells have natural decline curves. Some hold up better than others but all said the global yearly decline rate without additional drilling is right around 4 mb/d.

13. Hedged bets started coming off in late 2015 and will continue in early 2016. Accompanying this could be the capitulation in activity and production that the market has been looking for.

14. Global capex declines have occurred here and there over the past 20 years but always rebound the following year. For the first time in recent history, the global oil complex has charted two consecutive years of declining budgets. 2014 showed a small constriction but 2015's 20 percent capex decline is unprecedented in terms of size and is the highest by percentage in 20 years. And right now, 2016 doesn't look like it's going to have much bounce to it.

15. The world seems to be moving closer to a supply side disruption. Middle East wars, skirmishes and terrorist attacks are increasing in size and frequency. Libyan oilfields are a constant target.

Nigerian installations are vulnerable. ISIS controls most of Syria's small oilfields. Yeminis missiles are targeting Saudi oil installations and would have hit their targets in December launches had the Saudi's not shot most of them down. Iraqi production is somewhat safe, but only somewhat.

Venezuela's PDVSA is teetering in its ability to pay for the imported diluents needed to export its crude. Tankers are stacking up in the Jose Petroterminal demanding payment up front before unloading up to 3 million b/month of naphtha. And then there's the torched embassies, mass beheadings, a resurgent Shiite state and a hardening Sunni stance amid a claw back of freebies to Saudi Arabia's citizens. It's not good. Not at all. Our best hope is that price rebalancing will occur quickly through supply and demand metrics rather than bloody supply-side shocks.

16. At $25 oil, the Bakken is at $13 to $15 after transportation which puts operators up there underwater after lifting costs, taxes and carrying royalty owner costs. Sub $30 oil will not only kill development drilling, but it will be where production stops. In cases where operators are committed to selling natural gas produced alongside oil there may be a reason to continue due to supply obligations, but otherwise what's the point? If you want to lose money buy a boat. It's more fun.

6 Things to Ignore

1. This is not the 1980's with 14+ mb/d spare capacity. In 2016, we are oversupplied by about 1.5 percent and it will be at zero by early to mid-2017. The last time we were at zero was late 2013/early 2014 when WTI was at $100 and Brent up around $105+.

2. Lower for longer is true but $29 oil is not. This is a classic over-sold scenario and likely somewhere in the realm of capitulation. Operators and service companies can find a footing at $50 oil. We won't prosper but we'll survive. $100 may be a long way off and that's because ridiculously high, sustained oil prices only leads to ridiculously low sustained oil prices. But who wants $100? It will only get us back to $30. The industry makes no sense at the top or the bottom. The high middle is best.

3. Demand is dropping. Not true. Demand growth may be slowing but not by much. Consumption is up and it is increasing.

4. Chinese demand is down. The rate of growth may slow in 2016 but it will still be up year-over-year. A 6.8 percent Chinese economy is consuming more oil now than a 10 percent economy was 5 years ago. A lot more.

5. We're going to float the lids right off our oil tanks. Don't worry. You can sleep tight. We're not.

6. Efficiency gains are offsetting the declining rig count. This one is always amusing. Give me the rig count and higher density fracking and you take all the recent efficiency gains and let's see who gets invited to the bank's Christmas party.

6 Things You Shouldn't Ignore

1. Q1 oil prices are going to be ugly. Try and ignore them if you can. The market will remain uncertain over Iran as it determines and adjusts to how much oil is coming on.

2. Hedges coming off will not bode well for producers and the service companies looking to them for a lifeline.

3. Spring debt redeterminations may knock the wind out of the E&Ps. If capitulation hasn't already occurred, it will then.

4. China. The sinking Shanghai Composite Index is oil's anchor.

5. Pioneer and other chest thumpers getting too aggressive. Any recovery will be short lived if they jump the rig count as they did in the short-lived Spring 2015 rally. Traders are fixated on even meaningless moves in the rig count. Best to play it cool. We all want to work but operators need to practice some restraint.

6. Lack of capitulation. There will be no recovery until there is general agreement that the shorts cannot drag the market any lower. The Saudi's, with Russia following, can always point to a large U.S. failure as proof that they did not blink first.


14 Things We Owe Ourselves:

1. The water wars of 3 or so years ago are mostly solved. Recycling frac water is now a "gimme".

Marcellus operators like Shell and Cabot are able to boast of 99 percent recycle rates. We still have hurdles with deep well brine injection but the issues are getting defined and will be addressed.

2. Progress is being made on recognizing and reducing methane emissions from well sites.

Ultimately, this could slow drilling in places like the Bakken until infrastructure is in place, but it will also move operators to effectively use lease gas to power operations.

3. No government agency provided directives for Halliburton and Pattison to build dual fuel frac fleets that run on clean burning lease gas. They just did it in cooperation with their customers.

4. We've proven than natural gas is beyond abundant.

5. There have been fewer bankruptcies than anticipated.

6. No one has been arrested yet for fracking.

7. Harold Hamm was still able to write a billion dollar personal check.

8. Aubrey McClendon was still able to raise fresh money.

9. T. Boone Pickens overshot the mark with an $80 call but his optimism helped us - a lot.

10. Even President Obama jumped in and did us a favor with the elimination of the 40 year old export ban. It might have been done grudgingly but we got it.

11. LNG exports will set sail by March 2016.

12. Coal miners displaced by the current administration's EPA in Kentucky and West Virginia have been finding work in oil and gas fields. Hopefully they'll find more soon enough.

13. We can celebrate the abrupt end of the glossy multicolored booklets from fawning jewelers and art auctioneers arriving in the mail.

14. David Einhorn's crass and predictable "mother fracker" short on Pioneer Resources was a yawn.

The stock even climbed after the news. If this was a political statement, which was my read of the subtext, then short the stock now big guy.

The inevitable will occur. Supply and demand will cross. The question is will Wall Street notice?

Some of the analysts caught the cross in early 2014 but most didn't. For full disclosure, I missed it too.

The question this time around is will we see it coming and if so will it be an orderly reaction?

Or will the market miss the coming wake-up call and instead deliver a severe supply disruption with skyrocketing prices and a political response along the lines of windfall profits taxes? My worry is that everything takes longer than you think, from recognizing coming imbalances in the global crude complex to painting the house. In the meantime, just hang on and keep your equipment running.

You're going to need it. Until then, all the best of luck.