Thursday, October 30, 2014

Impact of lower oil prices -- its not all good, right?

First off, understanding the impact of dropping oil prices is complex, because the law of unintended consequences applies.  There is no doubt that falling oil prices is good for business and good for consumers.  Because it increases, directly, income (and profits), so the impact at first blush is positive.  At the end of the day, the impact of oil price drops is good in terms of inflation expectations (down) and to growth to the economy.

The fall in oil prices is caused by a change in the supply demand equation (either figure can shift):

  1. First, the supply picture has changed enormously over the past decade.  In 2004, fractioning margin (refining process) carried negative price.  Oil company could not pass on the cost (necessary) of refining the oil they produced.  The impact was under-investment that has translated into compressed supply (at the very least limited search for new oil reserves).  The massive boost in price from $35/bbl to $100/bbl had the obvious impact on supply -- it rose. America today produces more oil and gas than it did at any other time (we are going back to the 1950s here!!!).
  2. Demand has shifted over the past few months.  Starting in 2013, Europe's growth started to falter -- the periphery first (not talking about Greece here) but now more central with France and Italy in recession and now even Germany feeling the impact.   Japan's experiment with "new economic theory" is failing (spectacularly) with both consumption and income dropping, and China is finally facing the reality of large numbers -- its a lot harder to grow at 10% when you are the world's second largest economy.  So growth everywhere is slowing. 
The juncture between supply (that has risen) and demand (that has slowed) is for marginal price to drop -- oil supply is, in the short term, very inelastic.  So prices dropped from 105 to 80 in 160 days!  

Now, for producers (especially the new guys on the block -- like Shale oil) the $80 price is bad news, because extraction cost are high.  At $105 this was a profitable endeavour, at $80.89 (price of WTI light and sweet) the price of synthetic oil (which is what is produced by shale oil) is much lower, and the break-even level is close by -- some would say that break even is around $85/bbl. 

That means less exploration -- no doubt that fields are that are already operating will keep on going but new stuff will be delayed -- that will result in a future shift in the supply complex.  

For producing countries that situation is entirely dependent on where they stand in the price complex. Saudi Arabia -- considered the cheapest producer at $20/bbl has the most latitude -- they have recently reduced production -- keeping their oil in the ground for when price rise again (banking into the future the profit from sales).  But for countries like Venezuela the drop in oil prices is nothing short of catastrophic.  Their oil revenues are fully spoken for in terms of government expenditure.  Venezuela one of the largest producers in the world is facing massive dislocation.  Canada is a middle ground player.  With oil sands and classical oil (less now), but the new finds are expensive -- news should transpire soon on "delayed" projects.  The impact on those economies could be important.  After all, its their core growth that is affected.

For Canada, a weaker economy and a weaker currency -- will be harsh on Canada's 2014/15 prospects.  But and this is important the global commodity market is in a slump, and has been for the past 12 months.  Since about 1/3 of Canada's economy is ressource driven... its a problem. Politically, its also a problem for the sitting government that will see election in Q2/2015 -- by law!  It may be tempting (despite the recent poor polling) to go a get a new mandate before the economy slows more dramatically.

For renewable energy, the drop in oil prices is bad news.  Because people always look at the option of choosing renewable energy Vs. oil&gas with the low price point as a reference guide.  Solar energy that was 10 years ago, prohibitively expensive is now cheap enough to be roughly comparable to oil & gas, but only when oil is around $100/bbl.  Some would say that the world has moved so far along the renewable side of the equation that a short term shift in oil price will not really alter people's long term energy generation decision... maybe, but again its far from certain that the same kind of capital will be deployed for renewable energy when oil prices are in the $70/$80 zone rather than the $95/$110 zone.

That's the law of unintended consequence, the impact of renewable energy, the reduction in green gas emission will be further delayed...

Saturday, October 25, 2014

America, the Richest, well maybe not for the bottom 72%

-39 percent of American workers made less than $20,000 last year.


-52 percent of American workers made less than $30,000 last year.


-63 percent of American workers made less than $40,000 last year.


-72 percent of American workers made less than $50,000 last year.

No additional comment needed!

Tuesday, October 21, 2014

Energy costs, CAD level and inflation expectations

Oil prices are crashing, from a peak of $105 per bbl its down to $83, a massive 20% drop in the price of energy in the last 4/5 months.  First, the world is awash with oil (granted not cheap oil) but oil nevertheless is plentiful.  From the Montana Bakken fields to Libya production has outpaced faltering demand for oil.  For the American producers, the headache is that production costs are high. According to some analysts, fracking production costs are in the upper 80s  which means that light and sweet crude at $83 is a massive problem for the producers of this "synthetic" oil.

Even up here in Canada, oil at $83/bbl is a problem, because some of the more recent oil sand projects have exploitation costs that are near that level (older projects are apparently producing at around $40/50 per bbl).  I've said it here, and I said it often, Canada is a bit of an oil play.  Canada accounts for nearly 20% of America's oil consumption.  An addiction that many Americans would like to break -- although I am not so sure that Canada's oil sands are much worse than America's fracking business...

At any rate for Canada lower oil prices is a double edged sword!  The currency drops -- importing foreign inflation -- as trade is a massive component of Canada's economy -- also stimulating exports; Canadian exporters in the past 2 years (since the CAD has dropped from parity to $0.89), and lower energy prices have translated into a more competitive environment.

Canada's economy while not on fire is doing well... just look at all the illegal immigration from  -- France!  The headline numbers:

  1. Inflation at 2%
  2. GDP growth:  2%
  3. GDP growth (July) 0.0% 
  4. Unemployment:  6.8% -- its like 1% to 1.5% lower if we use America's scale
The economy is not exactly on fire, but North America is doing a lot better than Europe or Japan -- that's something.  

The big question in Europe is:  Deflation is it a problem here?  Deflation like inflation can be a good thing -- but of course its a question of scale.  The problem with deflation is that its like inflation; it can easily get away from you if the conditions are right.  Currently, inflation risks are low:  why because the economy is working somewhat below potential.  This is changing with a shift in Canada's labour pool -- like the US, Canada's aging demographic will reduce potential GDP growth.  As we get closer to potential GDP growth level, inflation trends could re-emerge.

There are no signs of deflation in Canada -- none!  Although everyone is expecting the 11 year old housing boom to come to an end...soonish.  The reality is that Canada has more of a tendency to import trends -- it is a much more open economy, and while we import from the entire world, the reality is that Canada's southern neighbour accounts for nearly 3/4 of all trade activities.  The reality is that America is not, has not, and is unlikely to face deflation pressures.  

The current dislocation of America's wage market is not creating those pressures -- nothing will. Although most people focus on Average wages, the more telling figure is Median wages.  America's Median wage is around $53,000, while for Canada its around $80,000.  The average wage is greatly influenced by wage disparity -- a more important feature of the US economy (in fact, Canada is ranked 8th while the US is ranked 17th).  

Canada's economy is a second degree play for investors -- if you like energy, primary ressources (mining, metals and agriculture) its a very interesting investment play.  Energy costs are important but not as much as commodity prices.  The CAD at 0.89/USD is fairly well priced -- and a good representation of the two countries "Big Mac index"

Thursday, October 16, 2014

doubting Europe's creditworthiness!

La grande correction?  I don't know.  Generally, you only know that a big move is afoot once its all over.  Dragi could once again put forward the "plunge protection team" at work and prove that everything is fine, by buying every bond in sight.

But the reality of core/non-core Europe is serious.  First off, Germany is exporting to the rest of Europe, and still works on the premise that its client's inability to pay their bills is not its problem (right).  France is starting to behave like a non-core (that may be temporary) yields are rising fast in France:

But that's northing compare to Greece that saw a 200 bps yield rise in the past week.  (Hurray to all the French and German banks that sold off their Greek exposure to ECB over the past 36 months).   Don't know how many Macro funds went bust this week -- my guess is that its going to take a few weeks/months before the blood bath there emerges fully, but these leveraged hedge funds are simply not equipped to take that kind of price movement in the bond market.

US 10 years treasury trade with a yield of 1.99% and for Germany (similar instruments) the price is 0.79%.  If Germany cannot have a roaring economic growth when interest rates are as low as they are now -- compare to 7% in 2007, its an indication that even in Germany, not all is well.

I am still far from certain that Europe has done everything it can to delay the inevitable.  Clearly, with correcting stock markets, a wild ride bond market its getting more and more difficult to make the problem go away.  There was also a rather dramatic "tiff" between France and Germany after Sapin was told by Schaeuble (their country's respective minister of finance) that more stimulus was out of the question.

Add to all this that the wheels are coming off in Japan.  Abe's plan of fiscal stimulus, easing money and structural reform is not working out as planned.  Japan's GDP is shrinking fast -- 1.8% in the second quarter (7% annualized...).  Take home pay in Japan is shrinking by 3% per annum.  

China's own challenges are forcing it to re-energize its drive to slow property prices; a massive challenge when you consider the strength of the entrenched forces to maintain the status quo (never mind the current, and very public, mess that is Hong Kong).  China cannot be counted on to be a helpful force.

America is in the middle of a Ebola crisis mid term election cycle.  If the GOP is successful in taking over the Senate they have a real chance at miring what is left of Obama's presidency into irrelevance. More Bengazi enquiries more votes to defund the ACA (ObamaCare to the rest of the word).  Overall drive the economy down.  Just watching Fox News (GOP propaganda organ) its clear that the mission of the right's media outlet is to cause mayhem and fear in the heart of all Americans.  In other words, the usual politicking before a critical election -- that may shut down the US government over the next two years (not that much has been achieve of late anyway). 

Back to Europe, things could still work out for savers (temporarily anyway) if Dragi decides (with the help of Germany and France) that they need to push the correction into the future.  The question is how long can they afford to to this?  In the end, its a question of will on the part of Germany and France to make the ride continue.  There no elections for either Germany or France within the next 18 months (that matter) and it may be a good (as any) time to allow for correction to occur.  Despite's Dragi's very public statement that everything is fine in Europe, he is fully aware that Europe's economy is not well.  

Monday, October 6, 2014

Markets are topping -- Should I care?

Well, personally I have had the opinion that the markets were near their peak about 4 years ago! Got that wrong!  However, now the consensus is that the markets are near their peak (there's always a consensus that support your views/opinions).

How did we get to such high levels -- today earnings as a percentage of GDP are at a historical high (12% of GDP).  Companies are sitting on mountains of cash (granted most of that cash is offshore and will not be repatriated for tax reasons.  Companies continue to do well, and yet all earnings are directed to either dividends or stock buybacks.  Paying dividend is rational (some would disagree) and in many low growth sector essential.  But stock buybacks are another story: either funded by free cash -- or via more debt (debt is always cheaper than equity -- and has been incredibly cheap recently).  The CEO's decision to buyback his company's share are driven by a number of factors:

  1. Increase earnings per share (smaller number sharing the income pie)
  2. Increase the price of shares (as a management goal -- think CEO compensation)
  3. Better allocation of capital:  That's the worrying one!
In general, companies are well aware of the impact of share buybacks on executive compensation.  Maybe 10/20 years ago the wool could be pulled, but in reality the decision by management is often driven by an inability to find attractive investment opportunities -- and aside from keeping cash for acquisition (and making the company attractive to raiders).  the reason to buyback shares is driven by short term goals (not abnormal for  companies that change CEO every 4 years).  The reason that CEO prefer buybacks is that they cannot find (or fathom) attractive investment opportunities.  This has been a growing trend over the past few years.

This inability to find productive use for their capital, is telling with regards to future economic growth.  The engine of growth (job and GDP) is entirely driven by the growth of companies.
When these prefer returning capital to its shareholders it is an indication of a deep malaise.

This is a reason I work almost entirely with private companies.  They too have their blind spots (trust me it can be harsh too), but their investment horizon is very different.  In conversations, it is clear that a return horizon is not 36/48 months, but 72/96 months.  They understand that they are building a business for the long term.  What I mean is that they will invest with a view to making a long term return that may take some time to generate profits.  Historically they have been more conservative (although listed companies are simply not investing -- and have not for several years), but this is no longer the case.  They are conserving cash now, looking for opportunities the next time there's a correction.

As I recently explained you should only care about correction if you need to money tomorrow.  Those who stayed calm after 2008 now look at their portfolio as unchanged (with some exceptions -- looking at you Blackberry).  But it remains that calm is the best option.  Obviously some sectors suffered permanently -- Citibank was trading at $540 per share in 2007,  it trades around $50 today! That's been a permanent impairment.  But GE that was trading around $35 is now around $28 -- and you got lots of dividends.  If you bought the DOW in 2007 at 13,000 its now at 17,000.  Not a bad trade a 30% increase is 7 years!

If you need the cash in 20 years there is no reason to take a short term view of the market.  Your broker (whoever he may be) is right.  You may want to get out of certain sectors, but as a whole the market has been a good (if not great) investment.  Income has not risen, but earnings from capital is doing well!

No position in Citibank, GE, Blackberry or DOW