Dead Stocks Walking

The day of reckoning is just under a week out, but markets don't seem to be focusing too much on the potential for interest rate changes during the FOMC meeting. Instead, all eyes rest on movements in the commodity market where oil has recently dropped to a 7 year low and other commodities continue their trend of low prices. WTI stooped to a low of $36.51 which mirrored levels that defined the global financial crisis. The international Brent benchmark fell to a low of $39.80, also a low for the years since 2008. On the whole, stocks are moving quite differently than their commodity counterparts as pared gains represent buying across most of the sectors. The S&P 500 is up 0.51% and the NASDAQ up 0.43%. The Dow Jones Industrial Average is up about 0.64% with gains from Exxon and Chevron leading the index. The Euro STOXX 50 also shows some growth at 0.22% for the day. As lagging in energy becomes the biggest financial issue, look for broad-based movements to follow the sentiment coming from that sector. The last four trading sessions have more or less mimicked energy investors. Two of the companies leading the small rebounds are Glencore traded on the London Stock Exchange and Chevron. Both companies reported significant restructuring maneuvers in order to fight the commodity rout. Glencore, dealing with metals, promised a large reduction in debt by the end of 2016 with a decrease in capital expenditures. Chevron, responding to new lows in oil, has introduced a 24% decrease in capital expenditures as it highlights paying its dividend as its first priority going into the next year. GLEN (LSE) is currently seeing an 8.27% increase in their stock price by about midday fighting a whopping -69.70% YTD performance, and CVX has jumped 2.70% in the same period, looking to reverse a YTD trend of -19.93%. If this isn't a hint to what commodity-based firms and energy companies should be doing, I don't know what is. Investors are looking to reward austerity measures in these industries as we have seen here today. Chevron has shown an impressive amount of intelligence when it comes in investor relations. They realize that traders will irrationally sell their stock at the sight of any bad news. In order to quell the negative sentiment, a proclamation of what the investors want to hear works every time. These capital expenditure cuts aren't set in stone; in reality, they provide a rebuttal to bearish investors that Chevron has a plan if low prices are sustained. In the situation that prices suddenly increase, they can easily reverse the changes they made with reason and new expectations for growth. In stock trading, it is important to recognize that buying and selling are not based on the present; instead, investors typically trade on their expectations. If a firm can adjust the expectations, it can improve the emotions in smaller investors looking to trade. At this point, smaller crowding can signal health and institutional buyers in the end. This process could prove to be useful for large- and some mid-cap stocks with the ability to be flexible in their cash flow statements and balance sheets. On the other hand, smaller ventures with higher debt may not be able to make such a change to entice investors. These small-cap projects with low levels of revenue and high start-up debt are named, by a Rigzone article, "zombies". Many of these entities face the real danger of defaulting on their loans if prices do not recover soon. Some of the names in the article include small firms like Comstock Resources, Goodrich Petroleum, and SandRidge Energy. And yes, there's a reason you've never heard of them because their production can almost meaningful to the grand scheme of things, sometimes as low as 10,000 barrels a day. With the absence of diversification in their plays, small-cap companies have no choice but to either produce profitably or sell their play to someone who can absorb the losses. Reuters has a great chart which describes some of those in danger. A high debt to EBITDA ratio can be dangerous as over-leveraged oil and gas projects cannot take on too much loss.

High Yield Bond ETF and WTI Crude Oil

This chart shows exactly why this trend exists. In blue, we have the all too familiar trend line showing the demise of oil prices, and consequently, the deterioration of amount of revenue from extracting the commodity. In black, an exchange traded fund following high yield bonds ironically labelled JNK is plotted in comparison. Although the categories they represent seem different, the year 2015 has brought them together. In the past six months or so, the two values have been moving together with general similar trends, but in November and December, the movements are almost the same. These "zombies" referenced above have most of their debt under this "junk bond" category where risk premiums are exceptionally high. In fact, the Rigzone article states that "at least 25 U.S. exploration and production companies are rated by Moody's at B3 or better." This rating signals a very speculative project with significant risk involved. There's no coincidence that WTI and JNK are moving together. Energy companies are leading this category of debt downwards and are in peril of crippling the small-cap group of a whole sector. In my opinion, larger corporations will start to eye these smaller plays turned "zombies" as price begins to stabilize. Once the larger corporations have saved themselves from danger, small-cap operations will be put up for sale like an auction. In the end, the supply glut is going to consolidate the oil and gas industry and turn out to be incredibly profitable for large-caps. While this may be what OPEC had wanted at first, shale technology will only get cheaper and more efficient. Depending on the advancement of climate change policy, the next five or ten years in the energy sector will be dominated by the largest cash flow statements and most adaptive capital structures.