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Oil: The Good, The Bad, and The Ugly image

Although the Dow Jones Industrial Average eeked out another new all-time high close on Friday and the NASDAQ 100 stepped lively into the Promised Land, the S&P 500, the Midcap 400 and the Russell 2000 all went the other direction, losing -0.25%, -0.80% and -1.49% respectively.

What was the reason for the disparity in returns, you ask? One word. Oil.

Crude oil futures (January delivery) dove $7.70 or -10.45% on Friday, closing at $65.99. And for the month of November, oil futures fell an eye-popping -18%. Ouch.

Looking at the U.S. Oil Fund ETF (NYSE: USO), which is an oil price proxy that is far easier for most folks to get their hands on, the devastation in the oil market becomes clear. In short, the USO fell -8.32% on Friday, -16.5% in November, and is down -35% since the recent peak in June of this year.

U.S. Oil Fund (NYSE: USO) - Daily

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While the above chart is ugly enough, taking a look at the price of oil on a weekly basis really puts the recent dance to the downside into perspective.

U.S. Oil Fund (NYSE: USO) - Weekly

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The problem in the oil market is easy enough to understand. In short, there is simply too much oil floating around the world these days and on Thursday OPEC announced they would NOT cut production of oil. And in essence, this means that the current glut of oil is likely to stick around for a while and that prices could continue to fall.

OPEC Just Says No

To anyone who has followed the markets since the 1970's, OPEC's decision should not come as a surprise. Remember that OPEC is a cartel whose sole purpose is to maintain their monopoly on the oil market.

It is also important to recall that oil prices have moved up and down in dramatic fashion many times in the past. But since prices have been relatively stable over the past five years, the current dive is attracting an awful lot of attention.

U.S. Oil Fund (NYSE: USO) - Weekly

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Why would OPEC agree to accept the 35% decline in oil prices when cutting production would almost assuredly cause the price of crude to head northward? To squeeze out the competition, of course.

You see, at $100 per barrel, there is plenty of profit margin available to the companies using fracking to produce oil from shale fields.

According to the EIA, the production of oil from shale deposits in the United States has increased by 74% in the last six years alone (from 5 million barrels per day in 2008 to 8.7 million today). And the projection is that production from shale will hit 9.5 million barrels per day in 2015.

However, the key is that getting oil out of shale is much more expensive than an old fashioned well. Therefore, the profit margins are lower. And what happens to these producers when the price of oil drops out of bed? The answer is, nothing good.

But Aren't Lower Oil Prices Good For the Consumer?

To be sure, the big decline in the price of oil is good for the U.S. consumer. This is money that goes directly to a family's bottom line. Less money spent at the gas pump means more money to spend on other stuff. And given that the consumer is responsible for 2/3 of GDP in the U.S., yes, the decline in oil is indeed a good thing for the economy of the good ol' USofA.

The Problem Is...

So, why are traders worried about a decline in oil prices? Four reasons really.

1. Jobs - The worry is that since $65 oil is not as profitable for the shale producers, job growth in this fast growing sector will suffer.

2. The State of the Oil Patch - There will undoubtedly be a ripple effect in the oil business. Thus, the decline in price will impact oil producers, services companies, and so on, and so on.

3. Deflation - The biggest worry is that the decline in oil will mean more deflation pressures in places like Europe and Japan. Without inflation, these economies may continue to struggle, which could become a nasty headwind for the global economy.

4. High Yield Default Risk - Energy companies make up between 15% - 20% of all junk bond debt in the U.S. The fear is that falling prices will cause defaults in the sector and cause new problems for the banking industry.

Yes, it is true that there are many positive arguments to be made regarding the decline in oil prices. And frankly, it is easy to see how the benefits to U.S. economy would outweigh the potential negatives relative to the global economy. But, with a stock market that is severely overbought, almost any input could easily become a negative.

So, while stocks could easily pull back a bit in the near-term on deflation fears, don't forget that the central bankers of the world remain bent on producing some inflation. As such, the pullback in oil could easily provide the "cover" needed for the ECB to start doing more than just talking about QE. And lest you forget, there is a meeting of Super Mario and friends coming up...

For now then, the cost/benefit argument for oil would seem to favor the economic bulls. But in a market that just produced a record rally, even positives could be viewed as negatives from a short-term perspective. So, stay tuned, this is going to be interesting.

Turning To This Morning

This morning's headlines are chock full of new inputs - none of which is particularly encouraging. First, despite the recent efforts by the PBOC, China's PMI data disappointed again with most of the components pointing to an ongoing cyclical slowdown. Next, Moody's cut Japan's debt rating to A1 from Aa3 citing uncertainty over the government's ability to control their deficit (think QE-infinity). Across the pond, another ECB board member voiced their opposition to a sovereign QE program and the manufacturing PMI data showed that Germany, France and Spain all fell into contraction mode. Here at home, first there is the report from the NRF that Black Friday weekend sales were down 11.3% over last year's levels. And finally, there are reports that the decline in oil will trigger junk bond defaults in the oil sector, which could produce a spillover effect and hurt the banking sector in general. Thus, it is not exactly surprising to see U.S. stock futures pointing to a lower open on Wall Street.

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

Major Foreign Markets:
    Japan: +0.75%
    Hong Kong: -2.59%
    Shanghai: -0.11%
    London: -1.04%
    Germany: -0.33%
    France: -0.44%
    Italy: -1.55%
    Spain: -0.79%

Crude Oil Futures: +$0.02 to $66.17

Gold: +$5.70 at $1181.20

Dollar: lower against the yen and pound, higher vs. euro

10-Year Bond Yield: Currently trading at 2.160%

Stock Indices in U.S. (relative to fair value):
    S&P 500: -9.46
    Dow Jones Industrial Average: -63
    NASDAQ Composite: -13.58

Thought For The Day:

When you're arguing with a fool, it is best to make sure he isn't doing the same. -Unknown

Positions in securities mentioned: None

Wishing you green screens and all the best for a great day,

David D. Moenning
President, Chief Investment Officer
Heritage Capital Research
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