The Fed's latest victim: energy

Energy stocks have been summarily punished over the past year and a half. And it hasn't been a minor selloff. Now that the Federal Reserve has begun the tightening process, it will likely further cloud the outlook for the sector. Why? Because energy prices won't stabilize until we approach an equilibrium point at which energy supply meets energy demand. The Fed's normalization process will likely lead to further gains in the dollar, and therefore more downside volatility in the prices of energy and energy stocks.

The S&P 500 energy index is down about 38 percent from its high in mid-2014 (not including dividends). Perhaps more stunning, the S&P 500 energy index now comprises just 6.6 percent of the S&P 500 after peaking out at an intra-year high of over 16 percent in mid-2008.

Global economic growth is weak and may be getting weaker. China, the source of almost insatiable demand for energy and other commodities over the past couple of decades, is now experiencing a significant deceleration in economic growth. Nobody knows the true magnitude of the growth deceleration as Chinese economic data are notoriously unreliable. Some say China is now growing well below the government's stated target of 7 percent. In any case, the uncertainty is causing a "shoot-first-ask-questions-later" mentality, and so prices across the commodity complex have plummeted in response.

But the economic weakness is not confined to China. Europe and Japan remain weak, and the emerging markets (except China) are suffering from massive capital outflows due to economic stagnation, overinvestment, falling currency values, and their heavy dependence on the commodity markets. Meanwhile, the variance in economic growth between the U.S. and the rest of the world is contributing to strength in the U.S. dollar, which further pressures commodity prices in the global marketplace.

But the collapse in the energy prices (and therefore the energy sector) is not solely due to sagging demand. The sector is also suffering from the aftereffects of a supply-side shock, itself the result of many years of easy money.

During the past 6-plus years of ultra-loose monetary policy in the U.S. and beyond, credit has been cheap and abundant as investors frantically sought acceptable returns on their money. The easy money led to massive investments in energy exploration and production, which created a massive boom in energy production both within and outside the U.S.

The biggest production gains, though, came in the U.S. where new technologies like horizontal drilling and hydraulic fracturing created an energy renaissance not unlike the 1990s boom in Silicon Valley. The widespread adoption of these new drilling techniques was made possible by easy access to cheap credit. The result? A massive increase in the supply of energy.

The effects of both the positive shift in supply and the negative shift in demand can be seen below. Either one in isolation would have caused pricing pressures for energy. But both forces moving together had an amplified effect. Now you know why oil is trading below $40 per barrel.

Now that interest rates are set to rise (we still aren't convinced of meaningful increases) and oil prices seem likely to remain at low levels, companies operating in the energy sector are finding credit access much more restricted. They are also finding that the cost to borrow or refinance existing loans is becoming prohibitively high. It seems highly likely that some of the weaker enterprises that were made possible by loose credit will not survive the crash in energy prices.

The weakness in energy is also spreading to other sectors as bond managers sell their more liquid holdings in order to meet redemptions. The situation has led to "spread widening" across the high-yield bond markets, which is generally not a harbinger of good things to come for equity investors.

The problems now surfacing in the energy sector are the direct result of ultra-loose monetary policy. Easy money led to massive investment in energy exploration and infrastructure. Many of these projects made little economic sense in a world of sub-$40 oil and/or normalized levels of interest rates. But the pain that energy investors are now experiencing is all too familiar. For the past 20+ years, the Fed has repeatedly propagated these boom-bust cycles that always end in severe pain for investors.

Whether it be the tech bubble, the housing bubble, the energy complex, high-yield bonds, or stock prices, the Fed's largesse has consistently put us in these predicaments. They say that the definition of insanity is doing the same thing over and over again and expecting a different result. Well, now that the Fed is raising interest rates, its policy is now contributing to the turmoil in the energy sector. The most likely outcome is that the dollar will continue rising, which makes the bottom for energy stocks less visible.

Commentary by Michael K. Farr, president of Farr, Miller & Washington and a CNBC contributor. Follow him on Twitter @Michael_K_Farr.