~$70 a barrel crude (ii)

Two factors are moving the Energy sector higher.  The obvious one is the higher oil price during a normally seasonally weak time.  In addition, though, the market is actively looking for alternatives to IT.  It isn’t that the bright long-term future for this sector has dimmed.  It’s that near-term valuations for IT have risen to the point that Wall Street wants to see more concrete evidence of high growth–in the form of superior future earnings reports–before it’s willing to bid the stocks significantly higher.  With IT shunted to the sidelines for now, the market is not being a picky as it might be otherwise about alternatives such as Energy and Consumer discretionary.

The fancy term for what’s going on now is “counter-trend rally.”  It can go on for months.

 

As to the oils,

–a higher crude oil price is clearly a positive for the exploration and proudction companies that produce the stuff.  In particular, all but the least adept shale oil drillers must now be making money.  This is where investment activity will be centered, I think.

 

–refiners and marketers, who have benefitted from lower costs are now facing higher prices.  So they’re net losers.  Long/short investors will be reversing their positions to now be short refiners and long e&p.

 

–the biggest multinational integrateds are a puzzle.  On the one hand, they traditionally make most of their money from finding and producing crude.  On the other, they’ve spent very heavily over the past decade on mega-projects that depend for their viability on $100+ oil.  This has been a horrible mistake.  Shale oil output will likely keep crude well short of $100 for a very long time.

Yes, the big multinationals have all taken significant writeoffs on these ill-starred projects.  But, in theory at least, writeoffs aren’t supposed to create future profits.  They can only eliminate capital costs that there’s no chance of recovering.  As these projects come online, they’ll likely produce strong positive cash flow (recovery of upfront costs already on the balance sheet) but little profit.

The question in my mind is how the market will value this cash flow.  As I see it–value investors might argue otherwise–most stock market participants buy earnings, not cash generation.  Small companies in this situation would likely be acquired by larger rivals.  But the firms I’m talking about–ExxonMobil, Shell, BP…–are probably too big for that.  Will they turn themselves into quasi-bonds by paying out most of this cash in dividends?  I have no idea.

Two thoughts:

—–why fool around with the multinationals when the shale oil companies are clear winners?

—–as/when the integrateds start to show relative strength, we have to begin to consider that the party may be over.  So watch them.

~$70 a barrel crude oil

prices equity investors watch

Investors who are not oil specialists typically use (at most) two crude oil prices as benchmarks:

Brent, a light crude from under the North Sea.  Today it is selling at just about $70 a barrel.  “Light” means just what it says.  Brent is rich in smaller, less-heavy molecules that are easily turned into high-value products like gasoline, diesel or jet fuel.  It contains few large, denser molecules that require specialized refinery equipment to be turned into anything except low-value boiler fuel or asphalt.  Because it can be used in older refinery equipment that’s still hanging around in bunches in the EU, it typically trades at a premium

West Texas intermediate, which is somewhat heavier and produced, as the name suggests, onshore in the US.  It is going for just under $64 a barrel this morning.

 

What’s remarkable about this is that we’re currently nearing the yearly low point for crude oil demand.  The driving season–April through September–is long since over.  And for crude bought, say three weeks from now, it’s not clear it can be refined into heating oil and delivered to retail customers before the winter heating season is over.

Yet WTI is up from its 2017 low of $45 a barrel last July and from $57 a barrel in early December.  The corresponding figures for Brent are $45 and $65. (Note that there was no premium for Brent in July.  I really don’t know why–some combination of traders’ despair and weak end user demand in Europe.)

 

why the current price strength?

Several factors, most important first:

–OPEC oil producers continue to restrain output to create a floor under the price

–they’re being successful at their objective, as the gradual reduction of up-to-the-eyeballs world inventories–and the current price, of course–show

–the $US is weakening somewhat.

 

 

My Lighting class is calling, so I’ll finish this tomorrow.  The bottom line for me, though:  I think relative strength in oil exploration and production companies will continue.

 

EU insurance companies and coal–FAANGs the next step?

Yesterday’s Financial Times had a curious article, one with no immediate investment implications, but one that I thought was noteworthy anyway.  EU property/casualty insurance companies have decided they will no longer offer insurance coverage for new coal mining projects.  Their rationale is that ultimately they will be the ones paying out claims for damage that results from using this heavily polluting fuel.  So it makes no sense to make their situation worse by supporting the projects that lead to big loss payouts.

 

When I was looking for my first stock market job, I asked an interviewer why he had become a securities analyst and what was most satisfying for him in his work.  He replied that the best part of the job was in influencing investors through his reports to apply high price-earnings multiples to socially responsible companies (thereby making it easier for them to raise new investment capital), and low multiples to dishonest or socially irresponsible ones (making fund-raising harder).

Performing an important social service wasn’t what I’d expected to hear.  But over the years I’ve come to believe that, despite the cynical persona most professional investors adopt, very many–me included–think the way my old interviewer did.  This is one reason that tobacco companies, for example, are rarely market stars.

There may be enough problems with fossil fuels that low multiples are already permanently baked into the cake   …and that coal will continue to be a fertile ground for value investing.  I don’t think so, but who knows.

The more interesting question to me, though, is whether this thinking is being/will be applied to firms like Facebook, Google or Apple–serving as invisible anchors to the rise of their stocks.

 

IT: sector advances happen in waves

My first stock market industry coverage responsibility came in late 1978 at Value Line.  A more experienced colleague was poached by an institutional investor (nirvana for a VLer at that time).  Even though I had only a few months’ training, I became the firm’s oil analyst.

This was just as OPEC was repudiating Western colonial control of the world oil supply–the overthrow of the Shah of Iran in 1979 being a main catalyst.  Oil prices tripled.  Oil stocks shook off their typical bond-like torpor and began a raging two-year+ bull market.

The advance didn’t happen all at once, however:

–Small oil and gas exploration companies in the US, for whom rising prices had the most direct positive impact, rose first.

–Then came medium-sized, mostly domestic US-oriented, integrated firms (meaning they refined and marketed oil products in addition to exploring).  Most of these were subsequently acquired.

–Finally, the big Seven Sister-class international integrateds moved up, too.

This whole process, as I recall it, took most of a year.  The exact timing isn’t so important.  The pattern is, though, because it’s one that recurs.  In particular,  I think, it’s a useful tool to assess the massive tech rally we saw in 2017.

Wall Street then paused while it worked out whether there was more to go for.  It said there was.  And the whole three-tier process began again.

At the end of Round Two, the stocks were all fully valued by any conventional lights.  But international unrest continued   …and the three-tier process happened once more.  At that point the stocks were wildly overvalued.

Easy to say in hindsight, you may be thinking.  But there was a company back then called American Quasar that clearly signaled the excessive enthusiasm.  AQ was the exploration firm that discovered the Rocky Mountain Overthrust belt of trapped natural gas and ran tax shelters (always a danger sign) to finance their exploration.  In my view, Round One of the sector advance fully valued AQ’s reserves.  Round Two very fully valued its future exploration prospects, as well (this almost never happens).  Round Three placed a huge multiple on large prospective acreage it had just leased and had not yet drilled (which turned out to be the only parts of the Overthrust not to have any hydrocarbons).

In early 1981, the spot price of oil on commodity markets began to dip, initiating a three-year bear market in which many oil stocks lost 2/3 of their peak valuations.

 

The way I’m thinking about it, IT stocks finished Round One in late 2017.  To my mind, the sharp rise in Intel shares last September-November is like the big international integrateds finally participating back in 1979.  It signals that the valuation gap between firms exposed to the hot areas of IT and the large left-behinds had grown too wide.  Investors thought it made more sense to bet that INTC could lift its game than to buy more shares of an already high-flier.  It’s a red flag.

Now we’re in a wait-and-see period.  My guess is that there will ultimately be a Round Two.  But, as I’ve written elsewhere, IT is already about 25% of the total S&P 500 market cap.  That’s a daunting size.  My guess is that other sectors will have to rally in a way that reduces the IT weighting to, say, 20% before tech before more than the strongest tech names take off again.  But I think IT will ultimately rally.

the revamped Google Finance

I hadn’t realized how dependent I’ve become over the past ten years on the Google Finance page.  Google Finance’s debut coincided closely with my retirement from my job as a global equity portfolio manager.  I found that GF met enough of my personal money management needs that I didn’t miss my $26,000/year Bloomberg terminal much at all.  (The ability to see a company income statement dissected in a way that revealed major customers and suppliers–and their relative importance–came to
Bloomberg later.  Assuming it’s still there, that’s a really useful feature for a securities analyst.)

 

What I liked about the old GF:

–everything was on one page, so I could take in a lot of information at a single glance

–it contained information about stocks, bonds and currencies, so I could see the main variables affecting my investment performance grouped together

–there was a sector breakout of that day’s equity performance on Wall Street

–I could add new stocks to a portfolio list easily, and thereby be able to see what was going up/down for a large group of stocks I was interested in

–I could compare several stocks/indices on a single chart, and vary the contents of that chart–and its timeframe–easily.

 

The charts themselves were not so hot.  But I could either live with that or use Yahoo Finance.  (I have a love/hate relationship with charts, in any event.  My issue is that stretching the price and/or time axes can change a bump in the road into a crisis and vice versa.)

 

The new Google Finance?

well…

–All of the stuff on my “likes” list has disappeared.

–The Dow Jones Industrials–a wacky, irrelevant index whose main positive point is that it’s easy to calculate–features prominently in coverage of the US.

–The Sensex has been consistently listed as a top-five world index, even though India is an insiders market that’s extremely difficult for foreigners to access.  Same for Germany, where there’s no equity culture and little of the economy is publicly listed.  No mention of Hong Kong or Shanghai or Japan or (most days) the UK.  Yes, the UK economy is smaller than Germany’s.  But London’s significance comes from its being the listing hub for many European-based multinationals.

 

My conclusion:  the new page has been put together by people who, whatever their tech smarts, have no clue at all about what an investor needs/wants.  Its overall tone seems to be to provide information that an investor will like to hear, based on browsing history.  Put a different way, the new page strives to turn users into the prototypical “dumb money.”  Actually, now that I’ve come to this realization, maybe the new page isn’t so counterproductive after all.  Just don’t use it.

 

 

deferred taxes and corporate tax reform

I wrote a couple of posts several years ago explaining in some detail what deferred taxes are.  The short version: when a company makes a gigantic loss, the loss itself has an economic value.  That’s because the firm can almost always use it to shield future earnings from income tax.

 

The IRS and the Financial Accounting Standards Board have different ways of accounting for deferred taxes.  For the IRS, they only appear on a return when the company has sufficient otherwise taxable income to use them.  At the other extreme, financial accounting rules allow the company to recognize the entire value of these potential savings immediately.  That’s even though the actual use of tax losses may be far in the future.

An example:

A company has pre-tax income of $1,000,000 from ordinary operations.  It also closes down a subsidiary, incurring a pre-tax loss of $11,000,000.  For IRS purposes, the firm has a total pre-tax loss of $10,000,000.  Ignoring the possibility of carrybacks (recovery of previous years’ tax payments because of the current loss), the company has no taxable income.  It also has a loss in the current year of $10,000,000, which it can potentially use to shield future income from taxes.

Financial accounting presents a much rosier picture.  The pre-tax loss of $10,000,000 is the same.  But financial accounting allows the company to recognize the possibility of future tax recovery right away, as a reduction of the current loss.

The financial accounting income statement reads like this:

pre-tax loss        ($10,000,000)

deferred taxes    +$3,500,000

net loss                 ($6,500,000).

The $3.5 million is carried as a deferred tax asset on the balance sheet until used.

Auditors are supposed to certify that it’s actually possible for the company to generate enough future income to use up the tax losses during the limited period of years tax law allows.  I can’t think of a company where auditors have held a firm’s feet to the fire on this point, though.

Where does the  tax bill come in?  The tax rate assumed in writeoffs up until now is 35%.  However, from now on, the top tax rate in the US is going to be 21%.  Therefore, deferred tax assets now being held on corporate balance sheets are only worth 21/35ths (about 57%) of their current carrying value.  Because they’re clearly, and significantly,  overvalued, they must be written down.

This may well throw algorithmic value investors for a loop, since the writeoff of deferred taxes will be reductions to book value.

What sector does this change affect the most?

Major banks.

Banks took major writeoffs in 2008-09 because of speculative trading and lending losses piled up after the Glass Steagall Act was repealed in the late 1990s. These losses were gigantic enough to require a huge government bailout of the industry in 2009.

Note:  Glass-Steagall was passed in the 1930s to prevent a recurrence of the financial meltdown that triggered the Great Depression.  Banks claimed in the 1990s that they were too mature to do anything like this again.  In this instance, it took over a half-century for Washington to forget why the law was in place.  However–and oddly–Washington already appears eager to to dismantle Dodd-Frank.