Dec 3, 2014

Hey! We are Running Out of Oil in 10 years Time... NOT!

The recent collapse of the Oil market from $105 to $68 at the time of writing has led to many speculation that this might spark off a chain of bankruptcy and default among the Energy companies. Thanks to the rise of China and other emerging nations, oil prices have been hovering above $80 for the past 5 years and this has led to many companies and nations dealing with the energy market borrowing aggressively to leverage on this very profitable energy market. With a rapidly falling oil price and rising USD, there will be a wave of defaults and the question is: Will this lead to a chain effect like what happened during the 2007 subprime crisis resulting in another possible financial market collapse?

Reasons For the Fall of Oil

I have explained quite a number of times why I am not going back into the commodities market  since I exited all my commodities allocation in March 2013. Here are the arguments why I exited commodities at that point of time:

1) US tightening monetary policy will lead to a rise in USD, which will almost cause commodity prices to decline as commodity prices often have an inverse relationship with USD.

2) Slow-down in emerging markets, especially China which are the main reasons for the rapid rise in commodity price from 2003-2007 in the first place.

3) Overcapacity and diversification of commodity production as corporations and nations rushed to develop new sources of raw material due to the high commodity prices. A number of billionaires are created during this period as a result of the commodity boom.

The reasons remained the same, but the tipping point for the energy market has been breached and it seems to be going into a free-fall. Falling oil prices is a double edged sword. It is especially beneficial for consumer based economies in US and Europe as the savings as a result of the falling oil prices will provide a boost to the spending power of the consumers. However, countries which has been relying on oil revenues will be badly hit, such as Russia, Brazil, OPEC, Malaysia, Indonesia and to certain extend, Australia and Canada.

The Fear of a Chain Reaction

Other than the countries that are directly involved in energy production, other countries that have been active in the financing of resource exploration may be affected and one of the biggest financier of resource exploration has been China. Chinese companies have been borrowing heavily to expand their capacity to meet the demand of commodities in China. Some of the energy related Chinese companies have already defaulted early this year , and with the sharp drop in energy prices, more defaults are likely. In US, the percentage of high yield bonds issued by energy companies has been growing year by year and is currently at the highest point the bond market has ever seen.

2 big concerns may rise as a result of the collapse of oil price:

Will a wave of bankruptcy of energy companies in US, China and commodity producing countries lead to a chain reaction leading to another possible US financial crisis as energy companies default on their debt obligations?

Will the falling oil price deal the final blow to Russia, which has been burning through its foreign reserves as a result of the Western sanctions and deteriorating economy, leading to a default on their sovereign debt, triggering a possible Asian (Emerging Market) Currency Crisis?

Portfolio Strategy

With these scenarios in mind, it reinforce my strategy to allocate most of the portfolio into US and Europe. Despite the surging rally in China as a result of the loosening of monetary policy in China as a result of a slow-down, it still remains to be seen if it is enough to stabilize it's weakening economy. The US European focused strategy has resulted in a handsome return of 5% for the month for the portfolio. I will expect the falling oil price to bring positive benefits for the US and European economies and we will hold on to these allocation for a while longer before we take profit.

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