Bizarro World: The Herd Has Truly Gone Mad

Bizarro economics

Evidence that the economy is sliding into recession continues to mount.

GDP is slowing. Earnings warnings issued by publicly-traded companies are at a 13-year high. The most reliable recession predictor of the past 50 years, an inverted US Treasury curve, has been in place for the past quarter.

Yet the major stock indices hit all-time highs earlier this week. And every one of the 38 assets in the broad-based asset basket tracked by Deutsche Bank was up for the month of June – something that has never happened in the 150 years prior to 2019.

It has become all-too clear that markets today are no longer driven by business fundamentals. Only central bank-provided liquidity matters. As long as the flood of cheap credit continues to flow (via rock-bottom/negative interest rates and purchase programs), keeping cash-destroying companies alive and enabling record share buybacks, all boats will rise.

So last week, the world found itself waiting for the release of the latest jobs report. And here’s how perverted things have become: investors were praying for disappointing data. They wanted to see more warning signs of the recession threat.

Why?

Because a worsening macro outlook will make it easier for Federal Reserve Chair Jerome Powell to deliver on the future interest rate cuts investors are counting on. And rate cuts should boost stock prices higher (as well as the prices of nearly all other assets, too).

In a sane world, when signs of an approaching recession are visible, stocks and other risk assets should be nowhere near all-time highs. And should recessionary warnings mount, stocks should start diving, as recession = lower earnings + higher interest rates = lower valuations.

But in today’s bizarro world, investors pray for bad data.

One day – likely soon – investors will get exactly what they’re asking for. And when the next recession arrives in force, and zero/negative interest rates fail to stem the tide of layoffs, bankruptcies and defaults, they’ll realize too late that the trade-off of artificially high asset prices today for an eviscerated economy tomorrow was a fool’s bargain.

Bizarro energy policy

Like it or not, our economy and our way of life remains incredibly dependent on fossil fuels.

Given that, reason would dictate we should treat our remaining – and finite – fossil energy deposits as national treasures, to be put to the best and highest possible use, and conserved as much as possible.

But in today’s bizarro world, we instead rush as fast as we can to extract and burn as much as we can. At an economic loss.

The decade-long shale oil revolution has yielded a staggering amount of production from America’s soils. The US accounted for 98% of global oil production growth in 2018 and is on track to hit a record 13.4 million barrels per day of production by the end of 2019.

But those volumes won’t last. As we’ve carefully explained in our Crash Course video chapter on Shale Oil, these shale basins are a short-lived bonanza given their extreme exponential decay (85% of a shale well’s lifetime output is extracted by year 3) and the fact that the most-promising plays have already been drilled. What’s left is increasingly just dregs.

But making today’s frenzied efforts to drain our shale basins even more regrettable is that we’re doing it unprofitably. We’re rushing to export our arguably most valuable national treasure and losing money in the process.

How does this serve us?

A ‘’gusher of red ink’’ For U.S. shale

Yet another downturn could not come at a worse time for U.S. shale drillers, who have struggled to turn a profit. Time and again, shale executives have promised that profitability is right around the corner. Years of budget-busting drilling has succeeded in bringing a tidal wave of oil online, but a corresponding wave of profits has never materialized.

Heading into 2019, the industry promised to stake out a renewed focus on capital discipline and shareholder returns. But that vow is now in danger of becoming yet another in a long line of unmet goals.

“Another quarter, another gusher of red ink,” the Institute for Energy Economics and Financial Analysis, along with the Sightline Institute, wrote in a joint report on the first quarter earnings of the shale industry.

The report studied 29 North American shale companies and found a combined $2.5 billion in negative free cash flow in the first quarter. That was a deterioration from the $2.1 billion in negative cash flow from the fourth quarter of 2018. “This dismal cash flow performance came despite a 16 percent quarter-over-quarter decline in capital expenditures,” the report’s authors concluded.

They argue that the consistent failure for the sector as a whole to generate positive free cash flow amounts to an indictment of the entire business model. Sure, a few companies here and there are profitable, but more broadly the industry is falling short. The “sector as a whole consistently fails to produce enough cash to satisfy its voracious appetite for capital,” the report said. The 29 companies surveyed by IEEFA and Sightline Institute burned through a combined $184 billion more than they generated between 2010 and 2019, “hemorrhaging cash every single year.”

Rystad Energy put it somewhat differently, although came to the same general conclusion. “Nine in ten US shale oil companies are burning cash,” the Norwegian consultancy said late last month. Rystad studied 40 U.S. shale companies and found that only four had positive cash flow in the first quarter. In fact, the numbers were particularly bad in the first three months of this year, with the companies posting a combined $4.7 billion in negative cash flow. “That is the lowest [cash flow from operating activities] we have seen since the fourth quarter of 2017,” Rystad’s Alisa Lukash said in a statement.

More than 170 U.S. shale companies have declared bankruptcy since 2015, affecting nearly $100 billion in debt, according to Haynes and Boone. There have been an estimated 8 bankruptcies already this year, with some $3 billion in debt restructured.

“Frackers’ persistent inability to produce positive cash flows should be of grave concern to investors,” authors from IEEFA and the Sightline Institute wrote. “Until fracking companies can demonstrate that they can produce cash as well as hydrocarbons, cautious investors would be wise to view the fracking sector as a speculative enterprise with a weak outlook and an unproven business model.”

Bizarro environmental destruction

And if the above weren’t bad enough, when we look at what we’re doing to the natural systems we depend on to simply exist, the data is downright horrifying.

A full listing of recent depressing scientific findings would read encyclopedic. So I’ll just stick to the big picture: species extinction is happening at the highest rate ever, short of a massive meteor slamming into the planet.

The world’s plants are disappearing 500x faster than they should. The global animal population has decreased by 60% since 1970. The UN now predicts a million more species will go extinct within the next few decades.

But in today’s bizarro world, there’s a perverted incentive to sacrifice biological capital for financial capital.

The scarcer the tuna become, the higher the price the fisherman will get for his catch at market. As long as commercial demand is kept artificially boosted by central banks, the economic incentive to bulldoze the next hectare of rainforest will continue to overpower the argument to conserve it.

Whoever hooks the last tuna in the oceans will get one hell of a price for it. But tell me, what will the 8+ billion humans left on earth eat then?

Adam Taggart is the president and co-founder of Peak Prosperity. He wears many hats, but his basic job is to handle the business side of things so that his fellow co-founder, Chris Martenson, is free to think and write.

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