China’s Yuan Devaluation Creates Profit Play

When the People’s Bank of China (PBOC) cut the value of the yuan by 2% on Tuesday, it was the biggest one-day drop for the currency in more than 20 years.

Crude oil and stocks sank on Tuesday, as well, with oil scraping six-year lows.

[ad#Google Adsense 336×280-IA]Tuesday’s action would have been enough… but then the yuan plunged all over again on Wednesday, despite PBOC efforts to prop it up, triggering even more volatility.

This means the U.S. oil sector is in for another painful period, but that pain is going to give rise to some irresistible profit opportunities that we’re getting ready for now…

China’s Move Was Hardly Drastic, Even If the Impact Was

The yuan announcement was a shocker. It’s a signal that Beijing has decided to shore up its slackening exports.

It’s all but certain that other Asian economies will follow suit in the “race to the bottom” that’s the hallmark of currency wars.

Technically, the PBOC move amounted to a change in the way the central bank calculated the value of the yuan against the U.S. dollar by revising the way in which the daily midpoint is determined. Now it will result from market makers’ quotes and the previous day’s closing price.

Making one’s currency cheaper against major outside trading currencies effectively reduces the price of exported goods. They are now produced by cheaper domestic payments that allow outsiders using hard currency to reduce their payments for what is produced.

More broadly for oil, this is seen as a sign of further weakening in Chinese industrial demand for energy.

That prognosis may be a bit premature (since there will be no figures to sustain a judgment either way for at least three months), but nonetheless it will feed into the current market’s penchant for overreacting emotionally to each new development.

Since this news follows major declines on Chinese stock exchanges, pundits will now bang the drums for a Chinese-led restraint on oil prices.

Yet all this means just one thing for Chinese authorities…
It means they’ve actually lowered artificial manipulation practices with the nation’s currency, moving closer to allowing the foreign exchange market to determine the actual value of the yuan.

The direct connection between Chinese exports and energy needs has always been a debatable issue. There is no doubt that industry in general is a heavy user of imported oil, and a decline in production for export would have an impact on oil imports into China.

However, it is the rising domestic market that will be fueling the brunt of oil needs moving forward.

It is here that the perceived decline in domestic economic expansion looms.

Yet even here, the pundits are overreacting…

Chattering Pundits Are Missing the Opportunity

A continued 7% annualized expansion rate in China is neither realistic nor desirable.

The dislocation and inflationary pressures incumbent on such an overheated environment are counterproductive. As long as there had been domestic slack to absorb the expansionary pressures, it could be discounted.

But these days, moving the expansion “down” to around 5% provides greater stability – for both the rapidly accelerating Chinese middle class and the more market-oriented currency.

Nonetheless, expect the ripples from this week’s yuan devaluation to be the topic of hotly contested conversation on commodity prices over the next few days.

The more serious effect on the American oil and gas-producing sector will be coming from further deterioration in the energy debt market.

Most U.S. producers have been “cash poor” for much of the past decade. Their operations have cost more than the proceeds of production.

In normal pricing environments for oil and gas, this does not mean very much. U.S. producers could easily roll debt forward to cover capital expenditures. They could reserve cash in hand for benefits to shareholders (dividends, share buyback programs, etc.).

However, today the situation is very different.

Energy debt comprises the highest stratum of what is termed “high-yield debt.” This is not investment grade and is usually referred to as “junk bonds.” The yields are higher because the risk is worsening.

Here’s the rising problem in a nutshell…

The spread between investment grade and junk bonds has been widening, with an additional premium being required for the highest risk associated with energy. Today, new rollover bonds require annualized interest payments of almost 14%. That rate will increase as we move into the third quarter.

In addition, banks will restructure debt portfolios by October and again toward the end of 2016’s first quarter. On both occasions, energy debt will become even more expensive.

A return to $70 a barrel oil prices and $4 per 1,000 cubic feet for natural gas would change the picture considerably – but neither is likely until the end of this year or into 2016. The debt picture will get worse before it evens out.

And that means the cycle of smaller company liquidations and broader M&A activity will intensify.

That’s bad news for some vulnerable companies, but good news for us.

There will be a fire sale involving choice wells, drilling locations, and leases.

And we will have some nice pickings in an exceptionally oversold sector.

— Dr. Kent Moors

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Source: Money Morning