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Some have remarked I have focused to intensely on oil.  A major reason for this myopicy is the close correlation between oil and equities since July 2014.  The correlation is over 90% according to Bloomberg.

It has often been written the most obvious conclusions are those which are ignored.  Many times I have compared 2014-16 to 1999; the last time oil plunged because of excess supply and shrinking demand.  In March of 1999 oil rose about 50% in 20 days and doubled by year end because of stronger demand.

Oil has rebounded about 50% since the mid-February lows and many are suggesting prices will soon again plunge.  Yesterday crude fell about 2.5% on inventory concerns.

As noted many times oil infrastructure spending has collapsed.  Since 2015 over $300 billion in projects have been shelved, a record by a margin of 2:1.

Because of this cut in infrastructure spending, the International Energy Agency (IEA) is now stating the depletion of old oil wells is expected to surpass new sources of supply in 2016.

It is a general rule of thumb that the annual depreciation rate of global oil supplies is between 6% and 7%.  These stores must be replaced.  I think it is noteworthy that the seven major global oil producers have only replaced 75% of the oil used in 2015, the first such shortfall in over 20 years.

The IEA is now suggesting during 2016 existing fields will lose about 3.3 million per day while new fields brought on line will only add 3 million barrels.

Because of lack investment, the IEA states the supply/depletion balance will further widen in 2017 as the new sources of production will rise by 1.2 million barrels in 2017 and further widen in 2018 and 2019 given the lack of “upstream” investments, investment that cannot be turned quickly around.  If demand remained unchanged, depletion would be about 2 million barrels more than supplies in 2017.

Speaking of demand, gasoline demand is rising at a rate greater than expected.  Economics 101 dictates there is no cure for low prices except low prices which stimulates greater demand.

And then there are geopolitical risks that have all but been ignored.  The Middle East is facing the greatest anarchy since the dissolution of the Ottoman Empire 100 years ago.  In my view the planned production freeze is symbolic in nature given that OPEC is already producing at capacity.

Speaking of capacity, spare global capacity is at a record low of 1 million barrels a day according to the IEA.

I ask what happens if there is a major supply disruption because of failed nation states.  Historically when a country fails, so does its means of economic production.  Libya is essentially off line producing about 200,000 barrels day down from almost 2 million in 2011.  The odds of Libya increasing production is extremely low.

And then there is Nigeria and Iraq whose annual production has dropped about 700,000 day since mid- February because of violence and lack of infrastructure spending.

I rhetorically ask what if this slump in Nigerian and Iraqi production is a harbinger of things to come?  Iraq has no money to invest in a major oil field whose production has dropped about 47% in the last eight weeks.  Will violence continue?  According to Foreign Affairs, this is the sixth Caliphate in history.  The previous five ended extremely bloody with societies—specifically Islamic societies—decimated by the warring Islamic factions.

Commenting briefly about Iran, Iran has not yet and is not expected to be a significant contributor as many has predicted because the lack of western funds to modernize its fields.

If the most obvious conclusions are truly ignored, I think the oil narrative will diametrically change by the end of the second quarter and if the oil/equity correlation maintains, stock prices should be higher.

At some juncture however rising oil prices will be viewed negatively, as a proverbial tax upon the economy.  But at this juncture rising crude is extremely closely correlated to higher stock prices.

Commenting about yesterday’s market action, equites rallied as FRB Chair Yellen’s remarks were interpreted dovish, trumping the decline in oil prices.

What will happen today?

Last night the foreign markets were up.  London was up 1.71%, Paris up 1.92% and Frankfurt up 1.73%.  China was up 3.60%,  Japan up 1.31% and Hang Sang up 2.15%.

The Dow should open moderately higher on Fed optimism and an increase price of crude, the result of a survey that suggested inventories did not rise as much as expected and increased gas usage and falling dollar.  The 10-year is unchanged at 1.82%.

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Ken Engelke

Chief Economic Strategist Managing Director

The views expressed herein are those of Kent Engelke and do not necessarily reflect those of Capitol Securities Management. Any opinions expressed are statements of judgment on this date and are subject to certain risks and uncertainties which could cause actual results to differ materially from those currently anticipated or projected. Any future dividends, interest, yields and event dates listed may be subject to change. An investor cannot invest in an index, and its returns are not indicative of the performance of any specific investment. Past performance is not indicative of future results. This material is being provided for informational purposes only. Any information should not be deemed a recommendation to buy, hold or sell any security. Certain information has been obtained from third-party sources we consider reliable, but we do not guarantee that such information is accurate or complete. This report is not a complete description of the securities, markets, or developments referred to in this material and does not include all available data necessary for making an investment decision. Prior to making an investment decision, please consult with your financial advisor about your individual situation. Investing involves risk and you may incur a profit or loss regardless of strategy selected. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. If you would like to unsubscribe from this e-mail distribution, please reply to this e-mail and indicate that you wish to unsubscribe in your response.