oil at $80 a barrel–a Saudi plot?

I don’t think so  …and if the Saudis are trying to keep oil prices low in order to drive American shale oil out of business, it’s a pretty pathetic one  (Tom Randall of Bloomberg, for example, recently wrote an otherwise excellent article in which he supports the plot view).

Here’s why:

Any oil project starts with geology work to locate prospective acreage for drilling.  The oil firm then purchases mineral rights from the owner of the land where it intends to drill.  Next comes the actual drilling, which can cost $5 million – $10 million a well.  The driller also needs some way of getting output to market, which may entail building a spur to the nearest pipeline, or at least paving the local roads so that trucks he hires can get to the wellsite.

All that outlay comes before the exploration company can collect a penny from the oil or gas that comes to the surface.

In other words, the project costs are significantly front-end loaded.  This is important.  It means the economics of the situation change dramatically according to whether you’ve already made the up-front investment or not.

An example:

I took a quick look at the latest 10-Q for EOG Resources, a shale oil driller.

Over the first six months of the year, EOG took in $6.5 billion from selling oil and gas, and had net income of $1.4 billion.  That’s a net margin of 21.5%.  At first blush, it looks like a 20% drop in prices would put EOG in big trouble.

Look at the cash flow statement, however, and a different picture emerges.  The $1.4 billion in net comes after a provision of $1.9 billion for depreciation of some of those upfront expenses and after another provision of $479 million for deferred (that is, not actually paid yet) income taxes.  So the actual cash that came into EOG’s hands during the period was $3.8 billion.  That’s a margin of 58.4%–meaning that prices could be more than cut in half and EOG would still be getting money by continuing to operate existing wells.

Yes, at $70 a barrel, new shale oil projects are probably not sure-fire winners.  But oil companies will continue to operate oil share wells, even at prices below this in order to recover capital investments they have already made.  The right time for Saudi Arabia to throw a monkey wrench in to the shale oil works would have been three or four years ago, not today.

The wider point:  once a new entrant has made a big capital investment to get into any industry, it’s very hard to get the newcomer out.  Even if incumbents make the new firm’s position untenable, the latter’s goal just shifts away from making money to minimizing its mistake by extracting as much of its capital as it can.  It will be willing to destroy the industry pricing structure if necessary to do so.




Tesco, Coke and IBM, three Buffett blowups

Warren Buffett of Berkshire Hathaway fame is perhaps the best-known equity investor in the United States.

What made his reputation is that Buffett was the first to understand the investment value of intangible assets like brand names, distribution networks, training that develops a distinctive corporate culture.

Take a soft drinks company (I’m thinking Coca-Cola (KO), but don’t want to dig the actual numbers out of past annual reports).  Such a company doubtless has a secret formula for making tasty drinks.  More important, it controls a wide distribution network that has agreements that allow it to deliver products directly to supermarkets and stacks them on shelves.  The company has also surely developed distinctive packaging and has spent, say, 10% of pretax income on advertising and other marketing in each of the past twenty (or more) years to make its name an icon.  (My quick Google search says KO spent $4 billion on worldwide marketing in 2010.  Think about twenty years of spending like that!!!)

Presumably if we wanted to compete with KO, we would have to spend on advertising and distribution, as well.  Maybe all the best warehouse locations are already taken.  Maybe the best distributors already have exclusive relationships with KO.  Maybe supermarkets won’t make shelf space available (why should they?).  And then there’s having to advertise enough to rise above the din KO is already creating.


What Buffett saw before his rivals of the 1960s was that none of this positive stuff appears as an asset on the balance sheet.  Advertising, training, distribution payments only appear on the financials as expenses, lowering current income, and, in consequence, the company’s net worth, even though they’re powerful competitive weapons and formidable barriers to entry into the industry by newcomers.

Because investors of his day were focused almost totally on book value–and because this spending depressed book value–they found these brand icons unattractive.  Buffett had the field to himself for a while, and made a mint.


This week two of Mr.Buffett’s biggest holdings, IBM and KO, have blown up.  They’re not the first.  Tesco, the UK supermarket operator, another firm right in the Buffett wheelhouse, also recently fell apart.

what I find interesting

Every professional investor makes lots of mistakes, and all of the time.  My first boss used to say that it takes three good stocks to make up for one mistake.  Therefore, she concluded, a portfolio manager has to spend the majority of his attention on finding potential blowups in his portfolio and getting rid of them before the worst news struck.  So mistakes are in themselves part of the territory.

Schadenfreude isn’t it, either.

Rather, I think

1.  Mr. Buffett’s recent bad luck illustrates that in an Internet world structural change is taking place at a much more rapid pace than even investing legends understand

2.  others have (long since, in my view) caught up with Mr. Buffett’s thinking.  Brand icons now trade at premium prices, not discounts, making them more vulnerable to bad news, and

3.  I sense a counterculture, Millennials vs. Baby Boom element in this relative performance, one that I believe is just in its infancy.




why the oil price will continue to be weak

supply and demand

In the short term (read:  for now and for some vague time into the future), demand for oil is pretty constant, no matter what the price (i.e., demand is inelastic).   People need to fuel their cars and heat their homes.  Industry needs to generate electric power and keep factories humming.

The supply of oil is similarly inelastic, for two reasons:

–major oilfields are mammoth, expensive, multi-year capital projects.  Engineers get underground oil flowing toward wells at what they calculate to be the optimal rate to drain the entire deposit.  Changing that rate once the oil is moving can mess things up so that lots of oil gets left behind–meaning having to do expensive and time-consuming extra drilling to recover it.

–a macroeconomic look at OPEC’s oil-producing countries, especially in the Middle East, is a real eye-opener.  These nations typically have large young populations and more or less no economic activity other than oil.  In my cartoon-like view, they have tons of high school graduates entering the workforce each year and nothing to offer them but make-work “jobs” funded by oil money.  Keeping the political status quo ultimately requires that the oil keep flowing.  According to the Wall Street Journal, the budget breakeven oil price for Iran, for instance, is $140 a barrel and Saudi Arabia’s is $93.  (This isn’t an immediate do-or-die thing, though.  Countries can use savings, borrow or sell assets to bridge a budget gap for a while.)

recent history

Over the past decade or more, supply and demand have been close to being in balance, with China’s strong economic growth giving prices an upward bias.

China is now trying to halt the proliferation of low value-added, energy-wasting industry, so this source of extra demand is fading.  More important, the advent of oil extraction from shale in the US has raised world oil supplies by about 6%, or 5 million barrels a day over the past five years.

Given that demand is relatively constant, the only way to get buyers for this extra oil is to cut prices.  This is what’s happening now.

revisiting the 1980s

There’s lots of ugly history of colonial exploitation of Middle Eastern oil producers in the 1970s and before.  Let’s skip over that, in this post at least.

During the 1970s, OPEC pushed the price of a barrel of oil from under $2 to around $25.  By the start of the 1980s, the association was clearly divided in to two camps.  One wanted to maintain the highest possible current price (which had risen to around $35 for the easiest oil to refine).  The other, led by Saudi Arabia, the largest OPEC producer, feared users would find substitutes for oil, diminishing the long-term value of their vast untapped reserves.  It wanted prices at, say, $15 – $20 a barrel.

Saudi Arabia decided to force its will on the other camp by unilaterally raising production to stabilize prices.  However, a long and deep global recession soon began (partly caused by higher oil prices, mostly by the Fed’s decision to raise interest rates sharply to choke off runaway inflation in the US).

Saudi Arabia then reversed course and began to cut production, again to defend its preferred price level.  Other OPEC nations agreed to reduce production as well, but by and large never did.  Prices eventually bottomed at about $8 a barrel.

The point, though, is that the Saudi attempt to act as the “swing” producer by raising and lowering its output in order to stabilize prices, didn’t work out.  All that happened was that Saudis absorbed a huge amount of the pain of the price decline, allowing its OPEC rivals to prosper, in a relative sense at least.


I think Saudi Arabia learned from its experience in the early 1980s that unilaterally reducing production doesn’t work.  Besides, unlike in the early 1980s, it needs its current coil income to balance its budget.

Shale oil production will continue to grow, if nothing else simply from projects begun a few years ago.

As a result, I think the oil price will drift lower, either until a healthier world economy increases demand, or until lower prices force high-cost oil producers to shut down.  We’re a long way from the latter happening.

Bad for oil producers–in fact, energy producers of any stripe, great for everyone else.

looking for patterns

Yesterday I wrote that the recovery that follows a sharp stock market decline is an important time to look for changes in the kinds of stocks that investors are eager to buy and the ones they’re happy to dump overboard.  I’m not sure why take place at these market inflection points, but the very often do.

Step one in trying to detect new patterns is for each of us to examine our own holding to see what’s happening with them.  We’re not just looking for under performance/outperformance during the downdraft.  We’re basically looking for two kinds of outliers:  stocks that underperformed on the downside and are continuing to underperform (bad!); and for stocks that outperformed on the way down and that are continuing to outperfrom now (very good!).

Step two is to widen our search to try to get a feel for what the overall market is thinking.  The way of doing this that I find most useful is to try to imagine the general economic situation the world is in and what kinds of stocks should be winners/losers if my picture is right.  Then I look at the stocks themselves to see whether their price movements confirm my thoughts or not.  Then I adjust if needed and repeat.

The most difficult situation is one where I’m 100% convinced I’m right but the stocks say otherwise.  This is rarely the case, in my experience.  At least someone has already picked up on a major investment theme before me.  But that’s okay.  A trend may last for years.  If I’ve missed the first three months it’s not a big deal.  Besides, being the only one in the restaurant has a kind of eerie feel to it.  If I’m thoroughly convinced I’m right, I’ll probably take a small position and prepare myself to add more quickly as other diners come through the door.

what I’m looking for now

The world is still in a slow recovery from the Great Recession.  The US is doing fine, given dysfunction in Washington.  China has structural change issues that have it growing at a “mere” 6% – 7% or so.  On the other hand, the warts in Abenomics in Japan are showing themselves and the EU is starting to look a lot like Japan of the 1990s.

Four big macro changes over the past, say, six months:

–China has been much more persistent than I had thought possible in trying to steer its economy away from low value-added export-oriented manufacturing toward higher-end businesses aimed at a domestic audience.  This changes the composition of growth, but is good, in my opinion.

–The EU is flirting with recession again.  The biggest culprit is France.  This is bad.

–Energy prices are falling–a lot.  This is bad for energy producers, great for everyone else.

–I had expected world growth developments to express themselves mostly (exclusively?) through changes in stock prices, with the US going up and the rest going sideways.  Instead, the principal expression has been through changes in currency values. This makes a difference.  A higher dollar slows economic gains in the US in much the way an increase in interest rates would; the fall in the euro acts as a (desperately needed) stimulus for the EU.

So, I expect…

1.  Slow GDP growth means secular growth stocks will do well, cyclical value stocks (much) less so.  Long Millennial/short Baby Boom ideas may be the best.

2.  Companies with costs in euros or yen but revenues in dollars stand to be big winners from recent currency moves.  So too companies with assets in the US.  Assets or earnings in the EU or Japan are now worth less in dollars than they were earlier in the year.

3.  The energy situation has a lot of moving parts (more tomorrow).  The clear winners are energy users.  The clear losers are the oil-producing countries where the deposits are controlled by national oil companies (think: Latin America, Africa).

Once I publish this, I’m going back to see if the markets are running with these ideas or not.




equity portfolio analysis to do now

Investors, even professionals, typically don’t want to look at their equity portfolios during a market downdraft.  It’s too ugly and too painful.  I’ve always thought, however, that if you can keep yourself from becoming too emotionally distraught from viewing what is after all a natural occurrence in equityland, you can get a lot of valuable insight into how the market will unfold as stocks inevitably turn up again.

Just from eyeballing charts–I’m too lazy to go back and do precise calculations–we had a particularly long and deep correction in 2011, two (maybe three, depending on how you count) in 2012, two 5%+ corrections in 2013–all before this one in 2014.

I’m pretty sure this correction has ended.  No one knows for sure until the downturn is clearly in the rear view mirror–and sometimes my native optimism gets the better of me.  I feel better  having made this disclaimer, even though there’s been enough if a reversal of form in stocks previously being pummeled (meaning most of my portfolio) to have me pretty well convinced

In any event, I think we should all do what I’m about to recommend, even if there does turn out to be another leg down.

First, two rules:

– Generally speaking, when the market declines value stocks go down less than the market; growth stocks go down more.  When the market begins to rise again after a correction, the pattern reverses itself.  We want to find stocks that are acting out of character–both good and bad.

–Often market leadership–meaning the industries/sectors that do the best–changes during/after a correction.  This change may simply validate ideas we already have  …or it may show us some economic development that we’d overlooked so far.  Either way we want to identify and ride new trends.

use a chart

For me, the simplest way to do this is graphically.  Set up a Google or Yahoo chart that will compare the performance of each stock in your portfolio with the S&P 500 from September 19th until now and look for anomalies.

Throw in some well-known names, stocks you think you might like but don’t own, volume leaders…to get a feel for what’s going on with names you don’t own.

The best case is a stock that has outperformed on the way down and which is rebounding more strongly than the market.

The worst is the opposite   …a stock that underperforms during the downturn and fails to bounce back during the rebound.  These are ones you especially want to detect and investigate.  In my book, you have to have very compelling reasons to hang on to a stock like this.  In my view, you don;t want a stock like this to be your largest position, no matter what reason you come up with.

Do this without having any expectations.  Just see what the numbers say.  Then you can begin to interpret.

Don’t make excuses in advance for stocks.  If a holding has, say, declined by a third during the correction and isn’t rebounding,  chances are that something is wrong.  Facebook (I don’t own it), on the other hand, did better than the market on the way down and continues to outperform.  Other social media stocks appear to be doing the same.

More tomorrow.



3Q14 for Intel (INTC): keeping the faith …or not

INTC reported 3Q14 results after the close on Tuesday.  Earnings per share came in at $.66, which beat the brokerage house analyst consensus by $.02.  The company’s guidance for 4Q14 exceeded analysts’ expectations as well.

The stock gained about 3% in the aftermarket   …but plunged at the open yesterday.

There are two main points at issue, as I see it:


1.  Some analysts think INTC’s outlook is too bullish.

a. Last Thursday, Microchip Technology (MCHP), a maker of a broad range of commodity semiconductors, warned that its 3Q14 would be weaker than it had previously thought.  The reason:  weakness in China in September.  The company also predicted that a general semiconductor industry downturn is now beginning.

MCHP is saying,  in effect, that it is in much better touch with end users of its products than most other semiconductor firms, including INTC.  It records revenue only when an end-user buys a chip from a distributor–not when the chip leaves the factory, which is the common industry practice.  It believes others will soon figure out they have much too much inventory floating around in their distribution systems (already booked as revenue) and will be forced to cut back production to bring them back into line with demand.  If so, MCHP is sort of like the canary in the coal mine for chipmakers.

b.  INTC recorded healthy growth in its PC business.  Third-party research services like IDC say demand was basically flat.  Is INTC inadvertently stuffing the channel?

INTC’s response to this worry is:

–it’s a specialized maker of microprocessors

–corporate demand is strong, partly because Microsoft (MSFT) has stopped supporting Windows XP, but also because corporations are beginning to replace the now-decrepit PCs they’ve been duct taping back together for a decade.  This trend will last for a long time.

–third-party researchers like IDC are fine for tabulating demand in the US and the EU, but can’t easily see the businesses of no-name computer makers in the emerging world who are strong INTC customers.

–yes, inventories are higher today than they were a year ago, but they’ve just returned to normal from extremely low levels.


2.  INTC’s mobile chip business is losing $1 billion a quarter, even as the company has become the second-largest vendor of tablet microprocessors in the world.  Can this end well?

The company has gone from a standing start to having chips in maybe 40 million tablets being made this year.  It is concentrating on low-end tablets in emerging markets, entering into long-term R&D and development arrangements with Chinese firms–and, for now at least, more or less giving its chips away to get them into machines (the reality is more complicated).

The company thinks it can begin to whittle away at those losses, beginning next year.  Profitability in 2016?  My guess is yes, but who knows?

my take

If INTC is ever going to crack the mobile market, the time is now and the company’s strategy is sound (it’s also the only one I see available to it).  Suppose it loses $5 billion on the effort and has to reassess.   Not good   …but then $5 billion represents only about 3% of the firms stock market value.  A risk, yes, but one worth taking, I think.

The cyclical downturn thesis is more worrying. When it comes down to it, though, I’m unwilling to generalize from MCHP’s business softness.  Arguably, the weakness MCHP is seeing comes from the Beijing orienting the economy away from construction and low-end commodity-like activities.  The move to higher value-added business should mean greater demand for microprocessors, not less.  So on this front, too, I’m willing to give INTC the benefit of the doubt.

The stock is trading at 15x earnings (high for it but a discount to the market) and yielding a tad under 3%.  If I had to put numbers to my thinking, I’d say that, in the absence of a serious semiconductor swoon, downside is to $25.  Upside if tablet losses begin to abate in 2015 is maybe to $45.

If I thought upside and downside were both equally probable, I should have been a seller at $35.  I wasn’t.  I’m now guessing that upside/downside has deteriorated from 2/1 to each equally probable.  But at $31, I’m still a holder.  I’m not a buyer, though.







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