Two Bearish Trades Take Advantage of Temporary Highs

Freedom Financial Archive | Originally posted Jan 25, 2023
  • Time to leverage these highs into big gains to the downside.
  • One is an exploration and production company that, while good, is wildly overvalued.
  • The other is a railroad holding company that’s going to stop when the economy slows down.

Dear Reader,

Markets are currently in their own little bubble as hopes for a Fed pivot once more dominate investor sentiment. What markets don’t see is the daunting economic indicators that show the pain of a recession coming down the tracks and a major economic slowdown in 2023.

This favorable market sentiment is a perfect setup for overvalued stocks that we will take advantage of with the two bearish trades below. The temporary highs of these stocks will benefit you as a “hard landing” takes place in markets in the coming months.

Let’s go over these trades in detail:

Opportunity #1: A Good Company with An Overinflated Stock Price

Many factors come into play when considering the profitability of a company that derives value from a commodity. Source rock, location, differentials, type of product… so many things to evaluate.

There are various trading centers for different types of products.

One you will hear us talk about often is Waha as activity in the Permian Basin increases.


Henry Hub is the uniform place where people quote natural gas prices, but there are various pricing centers for natural gas that will adjust the profitability of a company.

There are many issues facing Waha, but the two biggest are:

  1. increases in volume and
  2. bottlenecks on takeaway.

What do I mean by “bottlenecks on the takeaway?”

There is a shortage of pipelines taking natural gas out of the region while a large part of U.S. completion activity takes place in the Permian.

Companies exposed to Waha will make less money than exploration and production companies (E&Ps) that can sell product at Henry Hub or Perryville or Transco. See the difference in pricing in the above chart.

The Permian is in a prime spot for crude oil takeaway, which remains the biggest factor for the region.

Natural gas isn’t the focus, but it can become a headwind for companies that produce “lighter” crude.

This typically results in an increase of natural gas that has to be sold, and the Delaware basin has a high liquids level.

As wells age, the oil gets “lighter” and more natural gas is produced.

Devon Energy Corp. (NYSE: DVN) is a perfect example of a company that is going to struggle because of its own success.

They are ramping production in liquid-rich areas and have a growing amount of natural gas that is getting sold at a steeper and steeper discount.

Natural gas liquids (NGLs) will be a great place to be over the long term.

But in the near term, we’ve had a surge in production with falling demand. The discount for natural gas liquids has increased with petrochemical utilization dropping significantly.

We’re also heading into a growing global recession that will inherently pull down broader oil demand.

When we layer in manufacturing data, you can see that as activity dips so does the demand for petroleum products; specifically, distillates.

As refiners cut runs, it will leave more crude in the market and drive up storage in many key regions.

One of those regions happens to be PADD 3 (Gulf of Mexico) where Devon sells the lion’s share of its ultra-light, sweet crude.

Saudi Arabia and Russia are competing to sell crude in Asia, which will drive down the demand for U.S. flows into the region.

We will see volumes remain competitive into Europe. But as refiners slow activity along seasonal lines, it will create a slowdown in demand.

The U.S. just reported the second most crude in PADD 3 storage going back to the last 30 years, and we see more builds rising over the next month and a half.

The only time PADD 3 had more crude in it was 2021. Based on the import patterns and seasonality, we will likely outpace 2021.

Another big headwind is the drop in refining activity as demand wanes. We will likely see some additional recovery of refining activity back to about 90% utilization rate, but that will still fall far below the “normal” levels of activity.

Devon is seeing more competition from local producers in the region, pricing pressure on key takeaway regions, and an unfavorable macro backdrop.

They are also facing a rise in completion costs driven by labor, equipment, and material shortages. Steel prices are still at record levels by a wide margin as the availability of horsepower remains hindered.

Completion crews are also harder and harder to come by as equipment shortfalls remain pervasive across the U.S.

There are only about 315 crews available to work, but they are also dispersed across the U.S.

The Permian is much closer to fully sold out, which causes a bidding war to have oilfield service companies come to your acreage.

Even after the seasonal slowdown, Permian activity remains near the highs, and there will be a continuous shortfall of equipment well into 2024/2025.

The limitations on takeaway capacity from the Permian keeps product stuck in the region with limited pricing power.

As supply remains elevated and demand wanes, realized prices will come under more pressure.

Mont Belvieu a key pricing point for natural gas liquids saw a nice bump in the near term, but we see additional pressure on pricing in the near term.

There is usually a seasonal bump that benefits the region, but petrochemical demand still remains well below normal.

The rise in supply and drop in demand has resulted in a multi-year high storage backdrop for propane and will impact pricing over the next several months.

WTI crude pricing is going to remain range bound, and right now we are at the top of the range.

The market “narrative” is built around a reopening China boosting total crude demand.

The problem with this thesis is the general volumes building up in the market.

China increased the import quotas with a sizeable bump between 2022 and 2023, but a lot of the crude was purchased ahead of the announcement.

Supertanker purchases surged last year and have so far maintained a normal trajectory in the new year.

There was a lot of hope put on the Lunar New Year, but so far, we have seen a weaker-than-normal travel schedule.

It’s well above 2021 and 2022, but still well below the “normal” spike in activity.

This is happening at a time when China has a near-record amount of crude and refined products in storage.

The level of activity is going to keep much of that product locked up in storage and promote additional exports into the market.

The government has released 18.99 million tonnes of quotas to cover mostly gasoline, diesel, and jet fuel exports, up 46% versus 13 million tonnes allotted a year earlier, reported by consultancies JLC and Longzhong, both of which have closely tracked Beijing's fuel quota policy in recent years.

The increase in exports was meant to promote an increase in refining activity to balance their markets.

This offers an opportunity for refiners to fill a rise in internal demand and export the excess to balance out storage better.

China had a bump that faded quickly as fewer people travel as COVID cases keep movements limited. This will push more product into the export market and result in another spike in storage within key markets.

There will be at least 600,000 barrels a day of Russian diesel that will have to find a new home.

European purchases surged as they absorbed as much as possible before sanctions kick in on Feb 5th.

These barrels that were initially purchased by Europe will now flow into Asia and the Middle East pushing up storage and putting pressure on local crack spreads.

According to Bloomberg:

Diesel-type fuel cargoes originating from Russian ports are set to fall to about 637,000 barrels a day this month. The drop in Russian flows is likely to be outpaced by an increase in supplies from the Middle East and North America, a trend that probably will deepen after Feb. 5 when the EU bans almost all imports of Moscow’s oil products as a punishment for the war in Ukraine. Mideast arrivals in Europe in January are set to reach a three-month high at about 397,000 barrels a day. Imports from the Americas, mainly the US, are set to surge to more than 164,000 barrels a day, the highest since October 2020, according to Vortexa Ltd. data.

“Early indications for the first half of January show that Europe will be well supplied with seaborne diesel imports despite a drop in volumes from Russia since December,” said Pamela Munger, a senior market analyst at Vortexa.

These shifting flows are going to reverberate throughout the system as Russian volume displaces normal trade channels and results in builds.

Asia is facing an increase of Russian and Chinese exports that will put pressure on crack spreads and result in economic run cuts in Asia.

This will reduce crude demand in the region so even if Chinese demand increases- it will be offset by a reduction in demand for the rest of the area.

This is an opportunity to buy puts on a company that is experiencing rising costs and a capped hydrocarbon price that will pinch margins.

We’re not saying that Devon is going bankrupt or that they are a terrible company. Instead, we’re saying they’re overvalued. A large part of the E&P sector is experiencing something similar, but we believe the end markets for Devon are in must worse shape given their structure and liquids/natural gas-rich portfolio. The market continues to “ignore” recessionary fears, and now is a time to capitalize before it’s too late.

BUY DVN Jan 2024 $60 Puts Up To $9

Opportunity #2: The Economic Slowdown Will Halt This Great Railroad Company

China is reopening under a weakening economic backdrop. It’s something much different than the other times lockdowns ended.

The last time China reopened, the market was experiencing one of the worst inventory shortages in our history resulting in a massive surge of new orders.

The shipping/trucking market skyrocketed, and exports shifted higher.

We’re now in an environment where inventories are considered too high, global trade is slowing, and the global consumer is spending less.

When we look at key leading indicators on exports, we can see a big shift in flows… and this is still at the very early stages of the decline!

The key data points below are a warning signal that fewer products are moving into the market, but more importantly, fewer will be coming to the U.S.

As less stuff comes to our ports, it means that shipping, trucking, and rail companies will have a reduced number of containers to move throughout the United States.

Even as some of the consumer confidence data finds a floor, it’s still at the lowest level going back to the 1970’s. Yes, even below the 2020 Covid Flash Crash and the 2008 Financial Crisis.

When you layer the OECD data with recent U.S. economic information, we are still at the embryonic stages of consumer pressure and slowing retail sales.

It’s important to not be fooled by recent price action causing some of the biggest names on Wall Street to “pivot” to the view that we will have a “soft landing” or “no recession at all.”

January flows are normally positive even as the economic data deteriorates to the point that a recession is already in progress.

I think Nordea does a great job of highlighting how Europe and the U.S. are still in a steep contraction even if stock prices jumped.

If anything, it provides a great entry point to short, overvalued names or cyclicals relying on the consumer or housing… or in our case- both.

Retail sales as a whole declined in December more than estimates, which is also a peak time for buying given the holiday season.

December retail sales -1.1% month-on-month vs. -0.9% estimate & -1.0% in the prior month (rev down from -0.6%); sales ex-auto -1.1% vs. -0.5% est. & -0.6% prior (rev down from -0.2%) … control group -0.7% vs. -0.3% est. & -0.2% prior.

While the top line number missed estimates, it’s important to note that the control group also missed by a wide margin. These are sales that aren’t as “flexible” and are key to the consumer’s everyday life.

Control-group sales used to calculate gross domestic product — which exclude food services, auto dealers, building-material stores, and gasoline stations — declined 0.7% in December.

The consensus expected a 0.3% pullback. They were up 1.9% on a quarterly annualized basis, far weaker than 7.4% prior.

No matter how you slice the data, it’s showing an ugly shift in the consumer and one that will weigh on economic activity throughout 2023.

When you adjust core sales for inflation, it gets even worse. Instead of being down 0.7%, it’s down 1%.

The chart below puts into perspective how high core services have gone in comparison to the headline data, while core goods have been the driver of the decline. Sticky inflation is bigger than flexible inflation.

It's also worth noting that the miss was also broad based and helps support the view that this isn’t some one-off driven by a declining in a specific area. Instead, it shows that the consumer is pulling back across all facets of their spending.

Logistic companies also have to move product for industrial companies and general manufacturing. All of them took another turn lower with some of the slowdowns now accelerating.

December industrial production -0.7% m/m vs. -0.1% est. & -0.6% prior (rev down from -0.2%) … manufacturing production -1.3% vs. -0.2% est. & -1.1% prior (rev down from -0.6%).

Even with these reductions, we are still at very elevated levels and are only starting to see a pivot to the downside.

We’re on track for three straight quarters of declines in retail sales alongside two successive negative production numbers, which only happen in a recession.

The ISM data in services and manufacturing is already showing data points well below 50, which is a signal of contraction.

The current data is showing a reduction in economic activity. You may be thinking, “What about the leading indicators?”

Well, new orders have rolled over further with U.S. manufacturing orders showing another decline to the downside.

It doesn’t matter what type of leading indicator your use. They are all telling the same story.

Each one might have a different pace or varying depth of the slowdown, but they are all telling a very consistent story. We aren’t on a strong footing when it comes to economic growth.

I’m sure you have heard the commentary that the U.S. consumer is flush with cash and sitting on a massive amount of savings.

My question is this: Are these the type of data sets that show a strong cash position? We have a surge in revolving credit (credit card debt) while savings rates have imploded. Essentially, people are using credit cards for a record amount of purchases.

You can see from the above: savings down big; credit card debt, way, way up.

Outstanding credit is increasing at every income quintile, with the biggest increases from the 40th up to the 99th percentile. This is the area quoted as having the largest savings cushion, but yet their outstanding credit card debt is increasing. Something is askew.

If a person has so much money in savings, why would they increase outstand credit card debt with the highest interest rates in history?

We just took out the 1985 peak for credit card interest rates!

Here is another look at the increase in credit cards or loans:

We have car loan delinquencies at the highest level since 2009, which is being driven by a record amount of car loans, while the car itself has seen its value collapse.

The consumer is clearly feeling the pain, and the issues aren’t going to go away when you look at inflation. It’s important to discern the difference between headline numbers and core/sticky inflation. The consumer is still feeling pain as core inflation rises further and sticky prices drive higher.

So even though there was a small decline month-on-month in the headline number, the core number is still driving higher: December headline CPI -0.1% m/m (largest monthly drop since early 2020) vs. -0.1% est. & +0.1% prior … core CPI +0.3% vs. +0.3% est. & +0.2% prior.

When we look at other measures of inflation, you can still see further appreciation of inflation. FRB Cleveland Median, Trimmed Mean, and Sticky all point to core CPI still moving higher.

The biggest drive of the decline in CPI has been “commodities” or “physical goods” while services has been driving much higher. The issue is this: 70% of household spending is on services and not goods.

We had a surge in the purchase of “stuff” when the government was pushing out cash. But as the government has turned off the spigot and wages drift lower, that has dropped through a floor.

The problem is service pricing is “sticky” while commodities/goods is “flexible.”

This is going to keep prices for the consumer and the core/sticky calculation very elevated and a huge problem for many consumers.

All of these factors are impacting spending and the most recent data in January pointed to a continued slowdown, which is inline with our expectations.

This is being confirmed by a shift higher in inventories.

We’re back to the average from the pre-pandemic.

All the while wages are starting to slip lower, but it’s happening much slower driven by lack of job participation rate.

The slowing economy will pull down wages.

But it will be at a much slower pace given the lack of job seekers, which will in turn keep inflation elevated.

The question becomes, “What drops first, inflation or wages?”

If inflation drops first, it will be a benefit for the consumer because real wages will rise and spending power grow.

If it’s the opposite or they fall simultaneously, the consumer still loses their purchasing power with more headwinds to spending.

Here are some charts showing compensation. Things have fallen but at a slow pace and from all-time highs.

Job switchers continue to find increase in wages, which is also driven by the lack of job-seeking activity.

We have seen some improvement in real wages, but you can still see it’s firmly in negative territory.

I think this chart really helps drive home that inflation and quality of labor remains a huge driver of problems for all businesses, especially small companies.

We have hiring plans slowing. But it remains difficult to fill jobs, which will keep wages higher.

The US Labor Force Participation Rate is still far below pre-covid levels, which is a big problem for the Fed. It will keep rates moving higher, while creating headaches for companies.

This is all culminating in a broad slowdown across the U.S. The weakness in manufacturing has spread across the broad sector as inventories rise and consumers slow.

The first round of Fed regional data is showing the issues: January Empire Manufacturing Index plunged to -32.9 vs. -8.6 est. & -11.2 prior; new orders sank to -31.1.

All of these indicators will bounce around, but they are heading in the same direction with little pivot into expansion.

All of this is going to drive down the need for intermodal activity within the U.S.

We see more downside risk to the intermodal world as well as chemical shipments dropping through a floor.

Coal, grain, base metal, and petroleum products will remain strong, but companies exposed to intermodal will get impacted the most. Cyclical companies in general will come under increasing pressure as the economy finds little footing in the near to medium term.

Port calls into the U.S. continue to weaken, and we see extensive pressure to Union Pacific (UNP).

UNP benefited from a surge in activity across intermodal and automotive flows, but those two key drivers are coming down and falling quickly.

The pressure on earnings is growing exponentially and the comps are very difficult given the spike in activity throughout COVID. The consumer has shifted away from goods, and you are seeing the impacts across the manufacturing sector.

Flows are set to drop considerably as inventories are saturated and consumers slow their spending.

We believe this is an excellent opportunity to capitalize on the economic slowdown that is gaining traction.

Housing has fallen again, which will also result in less “stuff” traveling by rail and truck.

Cyclical companies are going to see pressure and now is the time to jump into some puts!

BUY UNP Jan 2024 $185 Puts Up To $12.75

Good hunting,

Freedom Financial News