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Oil and Commodities Drop

2016 has been off to a rough start – in fact it is the worst start in history – and for many, 2016 is stirring up memories of 2008. I believe that this fear is unfounded and stemming from misinterpreting the oil and commodities drop. They are symptoms, I believe, of overproduction that stemmed from futures contracts made in the 1990s and 2000s, and the resulting credit bubble burst. Despite this, I still believe that we are in a super cycle, and as with previous super cycles, there will be some winners and some losers. We wouldn’t be in a super cycle if everything was going smoothly.

Where oil and other commodities are concerned, there is an excess of supply compared to demand. Oil production in 2015 was at 96.3 million barrels per day but demand was just 94.5 million barrels per day, and the excess went into storage. Demand has not dropped off; it was a record high in 2015. During the 1990s and 2000s, it was believed that the price of oil would only continue to rise and so many futures contracts were taken. Airlines and other real consumers took out contracts with the intention of taking delivery but hedging against future price increases. Yet, as many as 50% of the contracts taken were speculative, and had no intention of ever taking possession. These were simply initiated as speculation on the price of oil increasing. Simultaneously, it became common for commodities to be treated as an asset class, and more investors joined the speculative boom through those means. Futures contracts make sense if the prices continues to climb, but if the price drops, not only do you lose your investment, but you can owe additional money as well (as these contracts are usually highly leveraged with borrowed money). In this way, I believe that the drop in oil prices was also the catalyst for other commodity prices to fall when the bubble popped.

The speculation that prices were only going to increase also saw trillions invested into factories, plants, and drilling to keep up with the false demand. $2 trillion was invested into factories in India and China alone, and $6 trillion was invested into oil drilling in the Brazilian coast, Australia outback, and South Dakota. The additional investment helped create the oversupply. China’s steel production quadrupled between 2000 and 2015. At the end of 2015 there was an excess of 600,000,000 tons, and across the globe in Scotland, steel factories are closing – and we are likely to see them closing in the US as well. A lot of money went into factories, as during the housing market when a great deal of building resulted in many empty homes.

In 2015, 25 energy companies defaulted on their loans and I suspect there will be more than 150 additional bankruptcies to come. Despite the drop in oil, the oil companies the S&P book value have continued to grow. I think this is because oil companies saw the drop as very temporary and continue to carry reserves at full value ($100 to $110), and this spring auditors will force them to write them down with a mark-to-market value. I believe this will result in significant defaults and bankruptcies which will affect the market and earnings.

There is good news for the American companies and consumers looking to purchase steel, oil, and other commodities. The price drop will make raw materials cheaper to purchase. I also believe that outside of energy and commodities there will be real growth coming in the market. But as I have said before, to quote Richard Bernstein, it will be a tough year for investors, but perhaps not for investing.

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