thinking about 2016: oil

Regular reader Chris commented about yesterday’s post that we may be in the early stages of a decade+ downcycle in the oil price.  I thought I’d elaborate on that thought today.

base metals–gold, too

I think the situation with base metals is very clear.  Capacity is typically added in very large increments, and by all parties in the industry at once, creating the top of the market.  The mines can be shut down, but the orebodies don’t disappear.  Neither does the machinery.  So operations can be restarted fairly easily.  As a result, the market only comes back into balance as economic growth slowly expands, eating into the oversupply overhang.  Last time around, in the early 1980s, this process took well over a decade.

oil

Th case of oil is slightly different.  The petroleum industry is far bigger and more important than metals.  In most cases, there are no good substitutes.  Use for heating and transportation can’t be postponed.

Discovery of new reserves is a much more important factor in production.  The ability of oilfields to extract output without significant new drilling can deteriorate sharply if wells are shut down, interrupting the underground flow of oil to them.  Because of this second factor, very small differences between supply and demand can have dramatic.

 

At the last oil peak in 1980-81, two factors conspired to stretch out in time the fall in prices needed to restore supply-demand balance.

–The US, the world’s largest petroleum consumer, enacted a byzantine series of price control laws to prevent higher oil prices from being passed on to consumers.  This delayed conservation into the 1980s, when the regulations were dismantled.

–Saudi Arabia, then the largest oil producer in the world, decided to cut its production in an unsuccessful attempt to prop up prices.  It went from 10+ million barrels per day in 1980 to just over 3 million in 1985.  Although other OPEC members also agreed to curtail production, widespread cheating (typical cartel behavior) undermined the supply reduction effort.  The oil market finally bottomed at around $8 a barrel (the high was $34 in December 1980) when the Saudis got fed up and began to restore production in 1986.

 

This time, neither factor is present.  The only residual of 1970s efforts to promote oil use in the US is the country’s relatively low level of tax, by world standards, on gasoline.  Saudi Arabia, having learned a bitter lesson from the 1980s, has actually increased production slightly.

 

I think this means that the bottom for oil will come much more quickly than in the 1980s.  It may be happening now.

I don’t think there will be a quick rebound, however, even though the excess supply now present in the world may only amount to 2% – 3% of total demand.  That’s because:

–demand is growing more slowly than experts have been predicting

–hydraulic fracturing is proving less vulnerable to lower prices, as frackers streamline their procedures to lower costs (no one worried about efficiency when oil was $100 a barrel)

–removal of economic sanctions on Iran will give a one-time boost to supply of about 500,000 barrels a day (on world production of roughly 90 million bbl/’day).

my thoughts

If I had to guess, I’d say that fracking has permanently changed the supply/demand situation in oil.  New capacity can be added quickly, in lots of small increments, at around $60 a barrel.  I think this puts a (permanent?) ceiling on the oil price, or at least one that lasts for longer than we as investors need to worry about.

The bottom is harder to figure out.  If we were back in 1980, when world demand was about 60 million barrels a day and almost half came from ultra-low-cost sources in OPEC, revisiting the 1986 lows might be an ugly but realistic option.  However, with production now around 90 million and the Middle East closer to an afterthought than a real price-setting power, enough output is being curtailed at current prices that I think we’re probably in the bottoming process now.

At some point, aggressive investors will sift through left-for-dead small exploration companies to find survivors.  I’m sure industry experts are already doing so.  I’m not an expert any more.  I’m not doing so yet.  My inclination is to look for consumer or tech companies that stand to benefit from the boost to economic activity created by lower oil.

 

thinking about 2016: commodities

commodities

In the broadest sense, commodities are undifferentiated products or services.  Producers are price takers–that is, they are forced to accept whatever price the market offers.

Commodity products are often marked by boom and bust cycles, that is, periods where supply exceeds demand, in which case prices can plummet, followed by ones where supplies fall short and prices soar.

 

For agricultural commodities, the cycle can be very short.  For crops, the move from boom to bust and back may be as little at one planting season, or three-six months.  For farm animals, like pigs, chickens or cows, it may be two years.

 

For minerals, which right now is probably the most important commodity category for stock market investors, cycles can be much longer.  Base and precious metals have recently entered a period of overcapacity.  The previous one lasted around 15 years.  One might argue that prices for many metals have already bottomed.  I’m not sure.  But I think it’s highly unlikely that they will rise significantly for an extended period of time.

 

Oil is a special case among mined commodities.  Lots of reasons

–the market is huge, dwarfing all the metals other than iron/steel.

–there’s a significant mismatch between countries where oil is produced and where it’s consumed.

–there’s one gigantic user, the US.

–for many years, there was an effective cartel, OPEC, that regulated prices.

To my mind, the most important characteristic of oil for investors at present is the wide disparity in out-of-pocket production costs between Saudi crude ($2 a barrel) on the one hand, and Canadian tar sands ($70? a barrel) on the other.  US fracked oil ($40? a barrel) is somewhere in the middle.  The lower-cost producers have gigantic capacity, and the potential to ramp output up if they choose.  This wide variation in costs makes it very difficult to figure out at what price enough capacity is forced off the market that the price will stabilize.  For example, Goldman, which has an extensive commodities expertise, has argued that under certain conditions crude might have to fall to $20 a barrel before it bottoms.

 

The oil and metals situation is important for any assessment of 2016, because:

–about 25% of the earnings of the S&P come from commerce with emerging markets, many of which depend heavily on exports of metals and/or oil for their GDP growth

–the earnings for about 10% of the S&P 500–the Energy, Materials and Industrials sectors–are positively correlated withe the price of metals and oil.

–a low oil price is a significant economic stimulus for most developed countries, meaning margins expand for companies that use oil as an input  and consumers spending less on oil will have more money left to spend elsewhere.

As a result, one of the biggest variables in figuring out earnings fo the S&P next year will be one’s assumptions about mining commodities prices, especially oil.

 

More tomorrow.

 

 

thinking about 2016

At present, world stock markets appear to me to be obsessively focused on the smallest details of the here and now.  This may be fine for short-term traders, but getting caught up in this mindset is the surest recipe for trouble for us as long-term investors.  Our biggest advantage against professional traders is taking a longer view.

So it makes sense that we should be shifting our focus toward the new year, even though (actually, because) I think the markets have yet to do so.

My thoughts (which will be presented in more detail in my yearly strategy posts in a few weeks):

interest rates

Rates will be somewhat higher a year from now than today.  The Fed, however, has made it clear that the journey back from emergency-low rates to normal–that is to say, from zero to perhaps 2% for overnight money–will take years.  In theory, higher rates make fixed income relatively more attractive to investors than stocks, mimplying that the stock market suffers price-earning multiple contraction.  I’ve written a number of times, and I still believe, that virtually all of this contraction has long since been factored into today’s stock prices.  Even if this is incorrect, next year’s rise is going to be quite small.  Absent a crazy panic, the potential headwind from PE contraction is likely to be extremely small.  

world economies

–the US will continue to be strong

–the EU has bottomed and will gradually strengthen, so next year will be better than this

–China ‘s transition from export-oriented growth to expansion led by domestic consumer spending is happening at a satisfactory pace.  While traditional economic indicators, which are generally speaking all focused on exports (the wrong place to look), continue to be ugly, overall economic growth next year will be at least as good as in 2015

–natural resource-producing emerging countries will continue to have troubles.  The main issue will not be lower commodity prices.  It will be dealing with excessive debt taken on when companies/governments believed in a perpetual commodities boom, and adjusting private/government spending downward to deal with lower levels of commodity income.

 

More tomorrow.

merger mania in the computer chip business: why?

This year has been market by a spate (like that word?) of mergers/acquisitions in the computer chip industry, the latest being the potential combination of stodgy Analog Devices with Maxim Integrated Products.   Why is this happening now?

Three reasons:

–cheap financing, even though not necessary in all cases, is still plentiful.  This may not continue to be the case as interest rates in the US rise

–the cost of creating and fabricating new generations of products is becoming very expensive, to the point that some firms can no longer afford to stay independent and remain in the game

most important, though, is the emergence of mega-customers like Apple and Samsung, or Acer and maybe even Asus, which has changed the competitive structure of the industry.  The situation now is that these few large buyers of components can play one supplier off against another to get better prices.  The only way suppliers can get any market clout is to combine.

 

One might think that this is evidence of the overall tech industry maturing, meaning that we’re entering a period of slower industry growth.  While that may be true, maturity isn’t the sole, or even the main, reason for consolidation.  When the EU was created, for example, cross-border mergers became feasible for the first time.  Small national supermarket chains combined to become EU-wide powerhouses.  For a while, food suppliers remained as small as before.  But the mammoth size of EU-wide purchase orders from the big supermarket chains became so enticing that food suppliers offered unusually high discounts to get the business.  These firms soon realized that they needed scale, both just to get the big supermarket orders and fulfill them and to streamline operations and lessen profit-destroying discounting.  The large scale of the customers forced the suppliers to scale up as well.

The economics works in the other direction, too.  Large scale on the suppliers’ part forces customers to scale up.

In the case of chip companies, I don’t see an easy way to make money right away from ongoing consolidation.  Many of the actors remain unattractive on a stand-alone basis, in my view.  Also, the general rule is that half of the combinations won’t work out, either because the principals can’t get along post-merger or an acquirer pays too much for a target.  Better to let the dust clear and try to assess the combined firms, say, next Spring.  Having said that, I do own Intel and Avago, two consolidators.

the Fed’s rate rise dilemma

It’s looking more and more to me as if the Fed is being paralyzed into inaction by worries about two possible negative effects of beginning to raise rates now.  The dilemma is that the current zero interest rate policy is playing a large role in making each situation worse.

 

The IMF is arguing that economies in the emerging world are too fragile at present to withstand even a small rate rise in the US.  The agency points out that many emerging economies are very dependent on dollar-denominated natural resources, and therefore are being hurt badly by the current slump in demand for minerals.  In addition, many have borrowed heavily in US dollars to finance industrial (read: natural resources) capacity expansion.  Even a small rise in US interest rates, the IMF says, could spark a sharp upward spike in the value of the dollar against other currencies.  This would further dampen demand for natural resources.  At the same time it would make the local currency cost of dollar-denominated loans skyrocket, possibly into impossible-to-repay territory.  In other words, the Fed could trigger an emerging market crisis similar to the one in smaller Asian countries in the late 1990s.

Of course, what made natural resources firms so foolish as to create wild overcapacity?   …one big reason has been the availability of cheap (by historical standards) dollar-denominated loans.   What has prompted (and continues to prompt) US investors (among many others) to take the risk of lending crazy-large amounts of money for projects in places they know nothing about and for projects they didn’t understand   …years and years of low interest rates on Treasury securities and other safe alternative caused by the Fed’s intensive-care low rates.

 

The Fed has carefully studied the failure of Japan in the early 1990s to reignite economic growth after its economic meltdown in late 1989.  The key factor there, in the Fed’s view (mine, too, for what that’s worth) was that the country tried to remove policy stimulus too soon.  The Fed knows that it has already used up all its economy-healing power, so the country would be reliant on Washington for fiscal stimulus to rescue us in the event it makes a similar mistake.  But we all know that Congress has a poor track record for corrective action in crisis and is particularly dysfunctional now.  So the price to the economy of acting too soon could be very high.

How is it, though, that Congress has been able to ignore its economic responsibilities for so long?  …it’s at least partly due to the fact that the Fed continues to cover for lack of legislative action by running a super-easy monetary policy.  The Fed is an enabler.

 

my thoughts

Neither threat to policy normalization–the potential effect on emerging markets and the lack of an economic backup–is going to go away.  Arguably, the situation will deteriorate the longer the Fed waits.  I think the Fed should start the normalization process now.

3G acquiring Heinz, Kraft, Anheuser Busch, SAB Miller: the common denominator

What attracts Brazilian takeover specialist 3G to mature companies in low/no growth industries?

Three features are right out of a finance or marketing textbook:

–the target firms are priced at modest multiples of earnings in the stock market, that reflect the consensus assumption that earnings growth will be hard to come by.  So there’s money to be made if 3G knows that assumption is too pessimistic.

–in an industry that has two giant competitors with, say, 25% of the total market each, and then a bunch of firms with no more than 5% each, the two leaders will continually knock heads with one another.  Both have large absolute market shares but no relative market share advantage against one another.  If 3G already owns one (as is the case with Kraft and SAB Miller) and the two combine, even if they are forced to divest assets to avoid antitrust objections , the post-merger industry structure will be something like one 40% giant and a (possibly larger) bunch of 5% midgets.  The one giant will have 8x the market share of its nearest rival–a huge competitive advantage.

–in mergers like Kraft/Heinz and AB InBev/SABMiller, there’s lots of duplication in SG&A that can be eliminated

 

There’s a fourth reason that doesn’t get talked about much, but which I think is much more important than the other three–

–at the end of WWII, victorious troops returned to the US and began fashioning the “modern” American corporation, the structure that most mature publicly traded enterprises still maintain.  A basic building block was the idea of span of control, or the maximum number of people who any manager could effectively supervise directly.  That number was seven.  So if a firm had 7,000 workers performing essential company tasks, they would need 1,000 first-line supervisors.  Those would, in turn, require 70 second-line supervisors, who would be controlled by 10 third-line managers…

Of course, that was in combat.  And that was before copiers, fax machines, television, cheap landlines, personal computers, cellphones or the internet   …and when most workers had far less training/education than today.

In addition, in the army, a lieutenant would be in charge of 30 people, a captain 150, a lieutenant colonel a thousand.  So it was an easy conceptual step to associate importance in the company hierarchy with the number of people under a manager’s purview.  But this means that if a manager opts to run a department more efficiently with fewer people he risks losing status in the firm.  So no one does this.  Instead, managers want to have more subordinates, even if they’re underutilized.

So these companies tend to be bloated with non-productive labor.

 

To address again the question of what 3G does

…it looks for companies that still cling to a seventy five-year old business model that internal bureaucracy keeps in place, and modernizes it.  It looks for the 15% – 20% extra people the target firm employs and lays them off.  It also sells the corporate art collection or the polo club a former chairman persuaded the board to allow him to buy.  It installs zero-based budgeting, meaning managers are required to justify all expenses each year, not just new ones.  By this time, it doubtless has a good idea going in of where to look for fat.

To my mind, the surprising thing is that this pre-technology corporate structure has lasted so long past its sell-by date.  3G is willing to be a catalyst for change because it sees the immense profits that can be made by doing so.

 

what’s wrong with Tesla (TSLA)?

On September 21st, TSLA traded at $270+ per share early in the day.  Yesterday it closed at $215    …and is sliding again in pre-market trading as I’m writing this post.  That’s a loss of almost 20% during a period when the S&P is up about 2%.  What’s going on?

TSLA is an early-stage car company that is still spending money faster than sales revenue is coming in.  That’s why it is forced periodically to raise new capital on Wall Street.  Officially, TSLA is still projecting that it will sell 50,00 cars this year, a figure that would bring it to breakeven on a cash flow basis–meaning sales revenue would be sufficient to cover all its spending.  Recently, however, the company has been making noises that it will fall short of that figure, mostly because it’s having more trouble than it thought with reprogramming its machine tools to handle producing two models on the same assembly lines.

Let’s say TSLA falls 5,000 cars short of its 50,000 goal.  At first blush, this doesn’t sound too bad. But figure that each car would retail for, say, $120,000.  If so, a shortfall of 500 means $60 million less in the bank than anticipated.  It also means that TSLA won’t reach cash flow breakeven until sometime in 2016.

Something similar happened to TSLA this time last year, when bad weather and sales weakness in China made 4Q14 look ugly, however. TSLA has also been hinting for months that the 50,000 goal may be out of reach, even though “officially” it has not changed its production figure.  So this isn’t exactly new news.

I think two other factors are behind TSLA’s weakness.

–Up until about a month ago, Wall Street brokerage house analysts have been writing super-bullish reports on TSLA.  This amped-up enthusiasm is always what happens in advance of a capital raising (in August, TSLA issued about three-quarters of a billion dollars in new shares).  Now, analysts are, as usual, toning down the rhetoric, and conceding that TSLA might indeed be still cash flow negative at yearend.  Par for the course.  Yet this new analyst narrative is causing the stock to fall, in my view.  This suggests research reports are being processed in larger than normal measure by robots who believe everything they read.

–Investors may also be becoming more cautious about speculative stocks like TSLA because they are finally convinced that the interest rate cycle has turned and that rates are on the cusp of a multi-year upward course.  One enduring market metaphor for stocks is that they are a funny kind of bond.  That is, that they can be evaluated by calculating the present value of future cash flows (this is much, much easier said than done).  A speculative stock is somewhat like a zero-coupon bond, with all the value far in the future.  As discount rates rise, the present value of securities like these erodes the fastest.

This is by no means a fatal flaw in the TSLA story, in my view.  It just suggests to me that trading may mimic the pattern of a year ago for a while.  What’s more interesting is the possibility that the stock market is finally beginning to factor into prices the idea of higher interest rates.