A crude awakening for energy stocks

Market forces suggest energy stocks really don’t like lower long-term bond yields.

With payrolls in the US not coming in as high as expected, one expects quantitative easing will continue for the foreseeable future.

Consequently assumptions can be drawn about the actual state of the US economy, independent of current equity prices.

Overnight US equity markets climbed higher once again and the one-year yield on US Treasury Notes retreated to levels not seen since July, with even lower yields in sight. In fact, the yield on US Treasury fell over 3 per cent – it was a convincing response to the implied future of monetary policy in the US.

It has been celebration after celebration for the US equity markets since long-term interest rates have been held artificially low by stimulative monetary policy. While Australia is slowly catching up, it hasn’t been an even contribution from all asset classes and nor will it be moving forward.

Any investments displaying bond-like characteristics such as real estate investment trusts (REITs) will do well. Lower bond yields push the actual asset price up, which is a relationship that still holds true for this sector.

Not sharing the same fortunes as REITs is the energy sector. Over the past three years, the domestic energy sector (yellow line) has been wedded to movements in the Australian long-term bond yield (white line), which mirrors movements of the US Treasury Note.  

Implications from a weaker jobs report coming from the US has the energy sector fearing there will be less demand for oil from the world's biggest consumer. For domestic producers, lower oil prices negatively impact future earnings expectations and, in turn, share prices.

Forces that helped push energy prices higher at the end of August have disappeared. Geopolitical tensions have abated and tapering so far has only been a talked-about event. Since the market has put these events long behind it, energy prices have lost steam.

It is feasible oil could find lower ground yet, as it is expected that US stockpiles will increase further. Concerns also remain over the state of US political affairs. Tomorrow, the Energy Information Administration reports oil inventories, with market experts expecting an increase.

Continuation of quantitative easing has the implicit assumption the US recovery is still battling strong headwinds, leading to lower energy demand than predicted. The fundamentals suggest domestic oil producers could be in for a rough ride.