Today, it begins

Around the same time every winter I have the great fortune of getting together with a small group of ex-colleagues/friends from Hedgistan in an undisclosed mountain location for skiing and the best hot chocolate on the planet. And market talk. Lots of market talk.

It always ends up bearish. I don’t know if it’s the calendar or some kind of perverse self-selection process, but by the time we’re ready to head home it seems that the end of the world is always nigh. And, just as regularly, the trip is usually followed by a short-term market bottom. Let’s hope that happens again this year–or I’m going to have get a bigger bunker.

Market topics this year ranged through the ones you’d expect: Chinese capital flight, profit margin reversion, US recession/no recession, income/wealth inequality, technology and globalization. Honestly, fun and stimulating though it was, we came away with no iron clad answers. Except one.

As you’d also expect, we talked a bit about oil as well. What would end the bear market? Would Saudi and Russia combine forces and reduce supply? How quickly can shale producers turn production on and off? But on this subject we came away with an answer, something wiser (not smarter, wiser) market types have been susurrating for several months: the supply pressures won’t stop until debt-financed production becomes equity-financed production. It really is that simple.

The reasoning is clear: We know you can’t hold back production to get higher prices later if you have debt to service. Only equity financed production has that luxury.

The process is also clear: The highly leveraged producers drown each other with supply in an attempt to be the last man floating, but ultimately all sink. The equity holders get wiped out and the bond holders become the new equity holders in exchange for writing off their debt claims.
Sometimes the new equity holders sell their claims to others in the process. Sometimes they hold on. But either way the new owners have made time their friend instead of their enemy.

This debt for equity swap is the sine qua non for swing production to begin the long awaited, over forecast pull back in supply.

Did you see what just happened to the stock prices of Chesapeake Energy and others producers of its ilk?

The process started today.

NB: I am not saying buy oil today, that oil will be a moon shot, or that the process will be rapid or clean. In fact, the ability of shale producers with today’s technology to ‘turn the spigots back on’ very quickly should dampen any large upward thrust in the price of crude. ‘L’ is still more
likely than ‘V’. But at least it begins the process. And maybe with it we can hope against hope that the correlation between crude oil and other risk assets can begin their process of reverting to their means.

Bring on the bankruptcies.