Yep, we’re going to talk about oil again… though this conversation will be a bit different from the last few we’ve had.
If you’ve read my last couple of columns for Wealth Daily, you’ll know that last week I said oil would hit a point where certain oil stocks would become good buys.
Then, on Monday, I told you the proposed buyout of Canada’s Talisman Energy was the sign we were waiting for.
Buyouts are often a sign that prices have reached an attractive point. The theory behind Monday’s is that oil stock prices have fallen to the point where it makes sense for a bigger company with cash on hand to buy a weaker company.
And you can see it in today’s action. After the announcement that Talisman would indeed be taken out at $8.9 billion (a ~50% premium to Monday’s closing price), oil stock prices went nuts. A couple of the stocks I mentioned Monday as prime buyout candidates — Oasis Petroleum (NYSE: OAS) and Laredo Petroleum (NYSE: LPI) — made yesterday’s “top gainers” list, up as much as 20% and 15%, respectively.
Yes, Monday’s article was timely. It’s a standard trading exercise to recognize when certain stocks have been beaten down enough and take a stab at bottom fishing the sector.
But even though oil stocks have been killed, it doesn’t explain why the Dow is down ~700 points in the last seven days…
Sure, the energy sector won’t make as much money with oil prices at $60. But the energy sector makes up about 9% of the S&P 500. So if it makes 50% less for all of 2015, we’re talking about $3 to $4 less in per-share earnings for the entire S&P 500.
What might’ve been $128 in per-share 2015 earnings could now be $124.
That’s a reason for a decline, yes… but not the borderline panic we’re seeing.
And quotes like this one from a recent Yahoo! Finance article don’t help explain the situation, either:
Additionally, low gas prices could have an adverse effect on Europe’s fragile economy, asserted Paul Christoper, chief International investment strategist at Wells Fargo Advisors. He noted that that continent’s feeble inflation levels could be edged into deflation if consumer prices decline. That would be bad news for everyone. “We’re still in a disinflationary world,” he said.
Really? Cheap gasoline pushing the EU economy into deflation is why stocks are getting creamed? That’s just silly. Whoever said that doesn’t understand the definition of deflation.
It’s not just cheaper prices. Deflation occurs when demand is contracting. Demand for oil is still rising — it’s supply that’s the issue. There’s too much oil on the market.
But never mind, you can’t talk sense into some people…
No, to get the real picture of what’s going on, you have to understand the situation at Petrobras (NYSE: PBR), Brazil’s state-run oil company.
Giant Killer
In 2006, Petrobras discovered 8 billion barrels of oil under 22,000 feet of ocean, rock, and salt. Originally called the Tupi field, the name was changed in 2010 to the Lula field, in honor of former Brazilian president Lula da Silva.
Within two years of that massive oil discovery, shares of Petrobras would peak above $70 a share, valuing the company around $295 billion.
Today, Petrobras shares are trading under $7. The company is worth around $40 billion. And the reason has very little to do with current oil prices.
The Brazilian government owns ~70% of Petrobras, and it is milking it for all it’s worth. Petrobras has been mismanaged by the government and bilked by politicians and contractors.
For instance:
- In 2010, Petrobras paid $43.5 billion to the Brazil government for the rights to the Buzia offshore oil field, which has 5 billion barrels of oil. Petrobras has spent another $200 billion developing the field and now has to pay another $1 billion for permission to exceed its original production agreement (yes, it has to pay to pump more oil).
- In 2010, the Brazilian President demanded that Petrobras sell gasoline below costs to keep inflation in check. Petrobras lost $8.4 billion at its refineries division that year.
- Petrobras lost billions of dollars on an oil refinery in Pernambuco and spent $1 billion on a plant in Texas — signed off by Rousseff — that was sold two years later at a markdown of 80%.
- Last month, Brazilian police arrested officials at construction companies that allegedly formed a cartel to win contracts, including 59 billion reais ($23 billion) of work from the oil producer.
- Former senior executive Paulo Roberto Costa was just arrested as part of a massive fraud investigation. He claims 12 Brazilian senators, 49 federal deputies, and at least one governor had allegedly received money diverted from the public utility. Police estimated those involved embezzled around $4 billion.
Petrobras has sold $51 billion in bonds over the last five years to yield-starved global investors — nearly a quarter of all corporate bonds emanating from Brazil and the most of any emerging-market company. Total debt for Petrobras is now around $150 billion.
What should have been the best of times for a major oil company was really just an opportunity for politicians to line their pockets. And now that they have saddled the company with $150 billion in debt, oil prices have crashed.
Oh, and U.S. bond giant PIMCO owns $6.45 billion in Petrobras debt. Mutual fund giant Fidelity owns another $3.75 billion.
How will Petrobras pay its debt? How will Brazil fund its government now that it has destroyed its best asset in Petrobras?
As you might guess, this is not an isolated event. What do you think Putin is doing with Gazprom in Russia? Or Maduro in Venezuela with PDVSA?
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It’s All Fun and Games Until Oil Crashes and the U.S. Dollar Rallies
Emerging markets have been on a debt binge for the last few years. Brazil is just one example.
The Bank for International Settlements estimates that international banks had loaned $3.1 trillion to emerging markets in the first half of 2014, mainly in U.S. dollars. These countries have also issued U.S. dollar-denominated debt securities totaling $1.95 trillion.
If you haven’t noticed, the U.S. dollar has been rallying sharply over the last few months. That makes U.S. dollar-denominated debt more expensive because the borrower has to trade its depreciated currency for more expensive dollars.
This world has a debt problem. A big debt problem.
As we saw before the financial crisis, rising debt doesn’t always look like a problem so long as asset prices are rising, too. But when the subprime loan bubble burst and housing prices started falling, the debt problem was laid bare.
Right now, falling oil prices are shining a light on emerging market debt. And investors clearly do not like what they see.
Emerging economies are vulnerable to currency crashes right now, like the ones that swept across Asia in 1997. High debt levels and a strong U.S. dollar make it too expensive to defend a currency.
This is what investors are worried about right now.
Until next time,
Until next time,
Briton Ryle
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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.
