Deducing The Crash In Oil: How Would Sherlock Holmes Drill Beneath The Headlines?

Is oil right now the biggest threat to the overall market? 

On Monday, oil fell to the lowest level since March as traders worried about signs of weak demand and increasing supplies. Chevron (CVX) and Exxon Mobil (XOM)  were among the biggest decliners in the Dow Jones industrial average.

As much as we would like to think that our economy is on the mend, oil is clearly sending us a different message. Oil prices touched a four-month low. WTI posted the biggest monthly decline of 2015. For the month of July, U.S. crude lost 21%

On Friday  two of the biggest oil giants sent a very clear message to the stock market. Exxon reported its lowest profit since 2009. Chevron recorded its lowest profit in more than 12 years. On that news, the shares of both companies fell to their lowest levels in more than three years. Exxon cut share repurchases for the current quarter in half. There was nothing in their earnings reports even the most stalwart of bulls could find to like.             

Perhaps the single greatest risk we face as investors is holding onto beliefs long after the thesis has changed.  We are reluctant to recognize changes when they don't fit our thesis. We are reluctant to admit  when we are wrong. To learn from it and move on. But as Holmes would say,

“The greatest sign of an ill-regulated mind is to believe things because you wish them to be so.”

“I have steadily endeavored to keep my mind free so as to give up any hypothesis, however much beloved, as soon as facts are shown to be opposed to it."

And with that thought in mind, I present you with the facts concerning the oil sector right now.

Exxon Mobil cut its spending budget by $1.54 billion. The stock is off 22% from its high while oil prices have been cut in half. The stock has not found a bottom yet.  Chevron maintained its quarterly dividend at $1.07 per share in the second quarter, Exxon raised its dividend to 73 cents per share from 69 cents in the first quarter. Hopefully, they won't have to cut. How many IRAs and 401-ks in the US will this affect? People may be very surprised when they open next month's brokerage account summary.

Digging below the numbers, Sherlock might ask: How will the crash in oil affect the economy at large? Will it impact a lot of people? Will it impact a lot of jobs?  You can expect to hear of even more layoffs coming from Exxon and Chevron.

Chevron is feeling the pain in lower oil prices even more than Exxon.  It is 31% from its high. Quite a plunge. 

Chevron is laying off 1,500 workers. So not only have investors felt a lot of pain in the oil sector, but as Sherlock might uncover,  it is the workers that are really getting hit.

This oil plunge could not have come at a worse time. It is like a kick in the shins to a weak leg that was barely healing. Our economy has  experienced very tepid growth since the 2009 recession. It is possibly the weakest recovery in recent memory. 

Last year, all the economists and journalists were observing how the fracking boom was heaven-sent and would buoy the US economy. What a difference a year makes. Now they are scratching their heads trying to figure where they got it so wrong as they stand helplessly watching oil plunge under $50 a barrel and oil and gas exploration companies handing out pink slips.

“The principle difference between a good and a bad diagnostician is usually a matter of thoroughness and method. Brains count, of course, but the man who has not collected his facts has but little chance to use his brains.” - Holmes

All of which is  horrible for the oil sector but as Sherlock might ask, what does it do to our whole economy and the future earnings growth for the S&P 500 for the rest of 2015 and next year?

Observe the following: Last Thursday, GDP came in at a 2.3% level for the second quarter of 2015.  A disappointing number overall. CNBC reported it would have been closer to 3%  if it had not been for the $29 billion drop in U.S. oil  and mining activity. 

Our sluggish economy may soon get a lot more sluggish. 

And who or what caused all this ? Let's NOT start with the obvious,  namely the Saudi Arabians and their desire to drive the U.S. frackers out of business. (And now we will soon have the Iranians joining in that cause.) No, the situation is far more complex requiring some real digging into the facts.

Make no mistake about it: This sell-off in oil will have far-reaching effects into the US economy, hitting both investors and workers. 

Layoffs at the three biggest big oil & gas service companies total over 60,000. And some say more will follow beyond what Exxon  and Chevron  have already announced.

And what will the ripple effects be? How many of the newly unemployed will soon have to put their houses on the market as they will no longer be able to pay off that mortgage?

What about all the property taxes local governments will lose because of the loss in wages and property taxes? 

And what about all the banks now struggling to unload a mountain of bad oil loans?

Citigroup Inc., Goldman Sachs Group Inc., UBS AG and others will see millions of dollars in losses on loans they made to energy companies last year.

The banks intended to sell the loans to investors but have struggled to unload them even after cutting prices, thanks to a nine-month-long plunge that has taken Nymex crude futures to their lowest level since 2009.

Investment banks helped fuel the oil-and-gas exploration boom of the past decade by making loans valued at about $1 trillion to companies in the energy industry, most of which they sold to investors.

Junk bonds in the US energy sector are getting crushed, after a boom that peaked in 2014. Energy companies sold $50 billion in junk bonds through October of last year. That's 14% of all the junk bonds issued in the full year. But junk-rated energy companies trying to raise new money to service old debt or to fund costly fracking or off-shore drilling operations are now running on empty.

And the leveraged loans, the poor cousins of junk bonds, caused Janet Yellen to single them out recently in her report to Congress since they involve banks and represent risks to the financial system. Regulators are investigating them, and trying to curtail them through austere means, such as cracking down on banks, as opposed to raising rates. And what the Fed has been worrying about is already happening in the energy sector: leveraged loans are getting mauled. 

So far, we see this plunge is oil rocking the sector, and  the US economy overall and the banks, but as we "Sherlocks"  dig even deeper, we ask, what will it do to the stock market? 

Exxon earnings reported on Friday  were a whopping 50% lower than this same quarter last year. Sales were down 33%. 

So  here's the bottom line. There are 29 oil companies in the S&P 500. That's a lot of energy weight in the Index. Here's a dire prediction from an analyst at RBD Capital Markets: for every 10% drop in oil, S&P 500 earnings are cut by 1%.

That means if  oil is off  50% from its high we could see a 5% drop in S&P 500 earnings. If you use a 17x multiple, that comes out to $6 a share or  100 points.

Not one for nasty surprises, Sherlock would not be surprised to see a 5% drop in your portfolio due to the effect of this current oil situation.

Luckily, so far this earnings season the non-energy companies have been beating estimates for the most part. And if oil prices begin to recover, we could see earnings estimates improve too.  

“A wise man sees as much as he ought, not as much as he can.” - Holmes

So are there any bright spots in this dour picture? Well, actually there are.There is one small clue that has been unlocked recently that points to a possible improvement in the oil patch. 

Baker Hughes (BHI) recently reported their rig count. For more than 70 years, this company  has been issuing rotary rig counts for the United States and Canada every week. And for the the last 40 years, the company has also issued a monthly international rig count. According to them, the rig counts are a barometer for the drilling industry . They act as a leading indicator of demand for products used in drilling, and producing and processing hydrocarbons.

As of Friday, they reported that the United States came in at 874 active rigs, down from 876 a week ago and from 1,889  a year ago.

However, they announced that Canada's rig count had surprisingly surged from 200 to 215, and although that number is still down from a year ago, it is a ray of hope in the present oil situation.

In the immortal words of Mr Holmes, remember, 

“The value of experience is not in seeing much, but in seeing wisely.”