Houston, we have an OIL PROBLEM! But do we know the whole story?

This is no news to most, but plunging oil prices have been devastating for energy businesses across the United States, to say the least.

At the close of 1/15/16, the WTI crude oil was priced at $29.42, which is down 72.6% since the high of $107.26 on 6/20/2014. Prices are down 18% in 2016.

This eruption has not only been heard on the oil fields and drilling sites but also around the world in various areas.  We have been told that the massive debt and currency devaluation in China as well as the oversupply of oil being pumped worldwide with the Sheikhs and shale boom keeping supply at high levels. However, these issues are just parts of the problem. Let's look at the true cracks causing huge earthquakes in the energy sector for the last year and a half.

1. Junk bonds - Right now we are experiencing a replay of the 2008 Housing Crisis but now it's the 2015-2016 Oil Crisis. Similar to the mortgage collapse, may energy companies made investments post 2008 with the recent shale boom in America and new opportunities in opening oil plays. However, a lot of the loans made out to the companies were junk status (a bond that is rated BB or below) and the banks were writing loans to the energy firms with their eyes closed without anticaption of falling prices, just like the banks writing mortgage backed securities in the 2000s.  But who cares, all this debt accumulation helped push the price of oil. So what is the main component that makes these bonds go bust? Freaking Derivatives.
2. Derivatives Contracts- You may or may not know how this works. Derivatives are basically a security betting if an investment in an asset will go up or down. Energy companies place these bets to maximize returns and/or hedge against crude oil prices. The problem is a lot of the companies that had action in the shale boom need oil prices to remain at least $60 to be profitable. Therefore they held many of their derivative contracts through 2015 and to expire in 2016. So with the big banks being on the other side of those trades, the losses can and will be catastrophic. Just as the big banks didn't anticipate housing prices to fall and implode mortgage backed securities, I don't think they were that prepared for oil prices plummeting and oil junk bonds tied to these derivatives going bust. It is possible at least a third of the oil companies will go out of business.
3.  Stagnate demand - The mainstream media constantly hammers us with supply, supply, supply which is true. Supply is running at fast levels with world production increasing from 93.33m bpd (barrels per days) in 2014 to 95.71m bpd in 2015. On the other side, demand has been lackluster as of late. Global demand didn't feel the same with world consumption rising from 92.44m bpd to 93.77m bpd. World consumption should pick up in 2016 according to the EIA forecasts, but we shall have to see the actual results as the uncertainty of the global economy continues.     
4.  Commodities Deflation - Oil, coal, copper, gold, coffee, lumber, wheat, gold, silver. You name it, it's going down. Commodities are getting crushed and this does not appear to be a short term trend. A great deflation is taking place which will continue hurting emerging market countries while strengthening the dollar. 
5.  Geopolitical Tension - Russia, Turkey, Iran, Saudi Arabia, the U.S., Syria, I mean half the world is flexing right now. We could not leave this incremental section out of this read. The U.S. is still fighting to control of the oil war so it can continue trade off king petrodollar. The Iranians are continuily testing the waters of nuclear power, oil prominence, as well as handling tensions with the highly unsettled Saudi Arabia who has much at stake from there control in their global oil presence, regime of power with the House of Saud, and currency pressure with the U.S. dollar. Russia has solidified itself as a big kid on the block again helping Syria strike back in a major way against ISIS and has truly flexed their muscles on the global scene since the beginning of this oil collapse.  Be on the look out for any possible black swan to come out of the many events intensifiying in the eastern hemisphere.

So where is oil going from here? How will this affect the financial markets and overall economy? 

No one can be sure for certain, but people get paid the big bucks to be able to predict and make investment decisions based on where the cycle is moving and what the music will sound like in the future. I wouldn't call myself a hot shot making the big bucks but i do a lot of research and investigating on financial markets so why not try? Therefore as I stated in my last article, "Is 2016 2008's Big Brother?" 2016 will be a volatile year for the financial markets as a whole. To extend on that, I believe this year is the beginning of the deflationary period for many assets. 

In the next article, I will dive deeper into real economics issues in the U.S. including paramount cracks that you aren't being told and reveal where I think we are in the business cycle. 

Your Contrarian,

Joshua C. Taylor