Yearly Archives: 2015

what would $20 a barrel oil mean for stocks?

September 17, 2015 By in Energy, oil and natural gas, Portfolio management, stock market, Strategy Tags: , , , , , Leave a comment

Yesterday I wrote about the recent Goldman report speculating that oil might fall to $20 a barrel.

What would this mean for stocks?

a $40 ceiling…

To my mind, the most important observation is the simplest–the potential price fall would be caused by more oil being supplied than the world wants or needs or is able to store profitably for future use.  The price would decline to force marginal production off the market.

In other words, there’s significant oversupply at $40 a barrel.  Therefore, $40 becomes the new ceiling for oil, which would presumably bounce between it and the floor of $20.  The $60-$70 a barrel level, which markets now believe to be the near-term price ceiling, becomes a pipe dream.

…that would be hard to break through

Yes, demand for oil has been showing a trend rise of about 1% per year, and a lower price will encourage higher use but since the extent of oversupply is hard to know for sure, the safest assumption, I think, is that it would take a looong time to break through the $40 ceiling.

substitutes are hurt

A lower oil price makes substitute forms of energy–from coal and natural gas to nuclear to wind and solar–relatively less attractive.  In the US, we’ve already seen demand for automobiles is shifting away from fuel efficiency to gas guzzling because of $40 a barrel oil.  This trend to would likely accelerate if oil falls more.  Of course, by spurring more profligate use of oil, this trend should sow the seeds for future oil price increases.  Still, my guess is that upward price pressure takes a long time to develop.

producers vs. consumers

countries

Lower prices would be a boon for oil-consuming nations.  For developing countries dependent on oil production for economic growth, however, lower prices would force significant–and possibly very politically messy–structural change.  We’re already seeing this in Saudi Arabia, for instance.

industries (in the US)

Financially strapped oil producers would be in worse trouble than they are now.  Bad, too, for oil-related junk bonds.  The same for regional lenders specializing in oil and gas loans.

Seen from 30,000 feet, the US is a complex economic case.  Shale oil has allowed the country to displace Saudi Arabia as the #1 oil producer in the world.  On the other hand, the US is nevertheless a huge importer of foreign oil (per capita, we use twice as much oil as anyone else on earth).  While oil-producing regions–Alaska, Texas, Oklahoma, North Dakota…–would suffer from lower oil prices, the rest of the country would have its already low oil bills cut in half.

stocks

the minus column

oil producers

producers of other forms of energy

companies located in oil-producing regions

the plus side

US auto firms

oil refiners

transport companies, like airlines and truckers

consumer companies, helped by the boost to disposable income from less spent on petroleum products

??strip malls, Wal-Mart, resort destinations, other firms consumers typically drive to

businesses serving less affluent customers, who would have the greatest percentage boost to disposable income

 

 

 

 

 

 

$20 a barrel oil?

September 16, 2015 By in Energy, Industry Analysis, Mining, shale oil, shale oil and gas Tags: , , , Leave a comment

Last week, Goldman Sachs released a research report to clients in which it observed that if the world oil market develops in a less favorable way (to oil producers) than it currently anticipates, the crude oil price might plunge to as low as $20 a barrel before enough production is removed from the market for prices to stabilize.

This “doomsday” scenario has, naturally enough, captured all the press headlines.  I haven’t seen the GS report, but I do know the factors involved.  They are:

forces for price stability around $40 a barrel

  1.  Under normal conditions in a commodity market, when oversupply develops prices fall to a level below the out-of-pocket production expenses of the highest-cost producers.  This eventually causes them to stop generating output.  The reduction in supply stabilizes prices.  If producers mothball their operations and fire their workers, that itself may be enough to start prices rising again.
  2. Even for producers who are still profitable at lower prices, decreased cash flow leaves them less money to invest in project expansion.  Price uncertainty may cause them to hesitate, as well.  For those who have borrowed heavily, contracts with their lenders may force them to divert cash away from operations toward debt repayment.

forces against stability

  1. Many members of OPEC, which accounts for about a third of world oil production, have relatively simple economies that are heavily dependent on oil to fund government spending and to provide money to ordinary citizens.  Where the textbook economic response to lower prices may be to produce less, in order to maintain government plans and services (keeping citizens happy) the only response from OPEC is to produce more to generate more income.  This is arguably self-defeating   …and makes the problem worse.  Still, OPEC has raised production by about 2 million barrels a day over the past months.  And Iran is saying that once sanctions are lifted, it will begin to sell 100,000 barrels of oil a day, with presumably more in the offing.
  2. At, say, $100 a barrel, producers of petroleum from oil sands or shale have had no pressing incentives to hone their techniques.  At $40 a barrel and facing potential shutdown, they’re becoming much more inventive.  So they are finding ways to lower their costs to keep delivering output to market.

oil storage

We know that the world is now being supplied with more oil than it needs because oil inventories are rising.  Middlemen continue to be content to buy from producers because they can immediately sell for future delivery at a profit through derivatives and store the stuff in the mean time.

My experience is that although the markets have a rough idea of how much storage capacity there is–in giant storage tanks, barges, tanker ships…,  the reality is that there’s always more capacity than the consensus suspects.

What happens when every storage container is full?    …no one buys oil that comes on the market because there’s no place to put it.

the doomsday scenario

Three parts:

–shale oil producers lower their costs so that their production doesn’t fall by the 500,000 barrels/day that the market expects

–storage gets all filled up

–OPEC keeps on increasing production because it needs the money.

Middlemen turn the stuff away.  Prices plummet.

probability?

I’m not worried, so I guess I think it’s low.  In reality, no one knows.

Goldman has credibility in this field not only because it has strong commodity trading operations, but also because years ago it predicted $100+ per barrel oil when no one else thought it was possible.

Tomorrow, consequences of doomsday, were it to happen.

 

risk parity

September 15, 2015 By in Uncategorized Leave a comment

risk parity

Risk premium parity or risk parity is an academic idea that has made its way into institutional investment management, particularly among hedge funds.

The main idea, which has many variations, is this:

Let’s say an investor has his portfolio allocated 50% to bonds and 50% to stocks.  If we use the academic definition of risk as volatility, we observe that maybe 75% of the risk in the portfolio is represented by the stocks in it.

We can reduce the risk of the portfolio, and thereby provide protection against loss, by shifting the asset allocation away from stocks and toward bonds.  Let’s do so until the riskiness of the two components is equal.  That would be at 2/3 bonds and 1/3 stocks.  At this point, both portfolio elements are in risk premium parity.

If we do so by selling bonds to buy stocks, we’re reducing the profit potential of the portfolio.  Let’s not do this.  Instead, let’s borrow and buy more bonds to increase that weighting.  If the original portfolio was $50 in stocks and $50 in bonds, the new result is $50 in stocks, $100 in bonds and ($50) in margin debt.

This reconfigured portfolio should have lower volatility than the original, but superior return potential from the positive spread between the coupon earned on the bonds bought on margin and the cost of the margin debt.

a viable strategy?

Theoretically, yes.  In practice over an extended period of time, yes.

Worries?

Yes!!

There are three about risk parity:

  1.  We’ve been in a thirty-year bull market in bonds, as the Fed aggressively attacked incipient runaway inflation in the early 1980s and has been lowering rates since then.  Is the success of risk parity a result of superior portfolio design or simply having a huge leveraged cocktail of bonds in the mix?  …or is the academic endorsement of risk parity simply a distraction from the fact that the outperformance comes from the large size of the bond holdings?  Put another way, is the risk parity bond strategy a disaster waiting to happen in a rising interest rate environment?
  2. Lots of institutional money is in the risk parity strategy.  That’s because success breeds imitation.  It’s also because pension funds love portfolio strategies implemented by computers and based on academic theories–which they believe insulates them from reliance on (fallible) human judgment.
  3. Other than perhaps on the run Treasuries, bonds aren’t the most liquid of investments.  This illiquidity is in part the reason for bonds’ low volatility, since professionals realize the scope for trading is limited.

What happens, then, if bonds start to perform badly, risk parity managers begin to rebalance toward stocks and institutional clients begin to pull their money out?  No one really knows.  This is not only a worry for holders of risk parity portfolios.  It’s a potential problem for the bond market in general–and by extension for other financial assets as well.

risk and volatility

September 14, 2015 By in risk = volatility, Uncategorized Tags: , , , , , 1 Comment

risk

I think that defining what risk is is the most difficult topic in finance/investing.

I’m not sure there’s one answer that fits everyone and everything.

We do know that individuals’ perception of what risk entails changes as they age or as their wealth increases; they become more conservative.  We also know that appearances can be deceiving.  A model with a perfectly proportioned body may be clumsy or a terrible athlete.  Experience counts for something, as well.  Situations that appear risky when a neophyte is in control, like in doing brain surgery, may in fact be relatively safe in the hands of an expert.  Information is important, too, like having enough data or experience to know who is the beginner and who is the well-trained seasoned pro.

risk as volatility

Academic finance, and following its lead, pension consultants and their pension fund clients, have all chosen to reduce this complexity to a single concept, risk = volatility.  In other words, the magnitude of day to day price changes in securities. This can be expressed either in absolute form or relative to some benchmark, and may be measured over differing time periods.

Defining risk as volatility has three big advantages:

–easy data availability

–quantitative form

–simplicity.

In a world where no one runs with scissors or texts while driving, or where there’s never a flood, a tornado or huge food items falling from the sky (like in Chewandswallow), that would be enough.

In practice, however, volatility isn’t such a hot measure.

On a very abstract level, there’s no recognition of the issue that philosophers have been pondering for the past two centuries or so–that groups may not be connected by every member having a single thing in common.  One alternative is the possibility of “family resemblances” popularized by Ludwig Wittgenstein over a half-century ago.  So maybe there isn’t one common factor that constitutes risk.

On a more practical level, in the real world not everyone has the same information.  History also shows that markets periodically become highly emotional, either wildly optimistic or deeply pessimistic.  My conclusion, based on decades of experience, is that the results of daily trading don’t constitute infallible indicators.  Quite the opposite–most often one should take the evidence of daily trading with a grain of salt.

…but does it trade?

To my mind, though, the most striking failure of volatility as a risk measure is that it doesn’t take liquidity into account.

An example of what I mean:

In the mid 1980s, I came across for the first time academic articles that touted real estate as the most attractive of major asset classes.

How so?

The argument was that since the end of WWII real estate had not only a higher annual rate of return than stocks or bonds, but it also had the lowest average price volatility of the three.  Not only did real estate deliver the highest absolute gains, but adjusting for its low “risk” property ownership looked even better.  This was an odd result, because one typically thinks that reward and risk are directly correlated, not inversely.  But no one questioned it.

real estate

Anyone who has owned a home over an extended period of time, to say nothing of owners of commercial or office real estate, knows this is loony.  In bad times, bank finance disappears and, along with this, so too transactions.  During 1981-83 in the US, when I experienced this phenomenon first-hand, houses could only be sold at extremely steep discounts to pre-recession prices–or to owners’ notions of fair value based on rental equivalents.  Potential buyers made very low-ball offers, prospective sellers took their homes off the market, and no transactions happened.  In the very narrow sense, therefore, volatility was low.  But that was because there were no sales to demonstrate how the market had deteriorated, prices were stable.  You just couldn’t sell.

junk bonds

The collapse of the junk bond market in the late 1980s demonstrated the same idea.  Junk bonds had been touted as having “all the rewards of stocks with all of the safety of bonds.”  The safety part proved an illusion.  The apparent stability of the net asset values of junk bond funds ended up resting in large part on the fact that the bonds they held seldom traded.  So every day the funds priced themselves using more or less the last trade, which might have been weeks ago–and which might not reflect current circumstances.  This idyll lasted until funds began to have net redemptions, forcing them to sell bonds at real market prices, which were often way below their carrying value on  fund books.

 

Jim Paulsen on the US stock market

September 11, 2015 By in Constructing a Portfolio, Current Market Thoughts, inflation vs deflation, Inventory Cycle, margins, Portfolio management, Recent Market Action, stock market, Strategy Tags: , , , , , , , , 3 Comments

Yesterday’s Financial Times contains a guest column by Jim Paulsen, strategist for Wells Capital, a part of Wells Fargo.  I find Mr. Paulsen’s work to be orignal, thoughtful and, for me, thought-provoking.  On the other hand–a warning–he and I share the same generally optimistic view on markets and have tended to agree on most basics.

Here’s what he has to say:

–the current market swoon may have been triggered by worries about the Chinese economy, but its real cause is to be found in the dynamics of the US economy/stock market

–US stocks were, and still are, trading at an unsustainably high price-earnings multiple.  The final bottom for stocks in this correction will be around 1800 on the S&P 500, or about 3% below the low of a few days ago.  That’s where stocks will be on a more reasonable 15x PE

–full employment in the US, i.e., where we are now, creates a series of problems for the economy and stock market.  Employers wishing to expand are forced to find new workers by bidding them away from other firms.  Since inflation in advanced economies is all about wage increases, poaching creates inflation.  In the short term at least, a higher wage bill means lower margins–and therefore lower profit growth.  The Fed responds to the inflation threat by raising interest rates, which exerts downward pressure on PEs

–investors don’t get this yet.  They’re “more calm and confident than at any other time in this recovery.”

–the combination of high PE, higher interest rates and slowing growth mean that equity investor focus will shift from the US to more fertile fields abroad.  These areas are more prospective because, unlike the US, they don’t face the need, caused by achieving full employment, to rein in the pace of domestic economic growth. I presume, although Mr. Paulson isn’t more specific, that this means the EU (it may also mean US stocks with high exposure to non-US economies).

my thoughts

Mr. Paulsen is in touch with institutional equity investors every day.  So he has a much better sense of the current thought processes of US professionals than I do.  He seems to feel his customers are only beginning to believe that the set of issues that come with full employment are at our doorstep–and are only now starting to discount them into stock prices.  Hence the correction.  While it’s risky to think you know more than the other guy–in this case, that the other guy slept through his elementary economics classes–I’m willing to go along and say it’s true.

Mr. Paulsen has previously made the point that interest rates are going to rise in an economy that doesn’t have much business cycle oomph left in it.  Therefore, he argues, past instances of cyclically rising rates, during which stocks generally were flat to up, may not be good guides to what will happen today.  I look at the situation in a different way.  If we ask where long Treasuries will be at the end of Fed tightening, the answer is that they’ll likely be yielding less than 4%.  If we think that the yield on Treasuries and the earnings yield (1/PE) on stocks should be roughly equivalent, then the implied PE on the S&P is 25x.

One might argue that the idea of the equivalence of earnings yield and interest yield arises from a long period in which Baby Boomers preferred stocks to bonds.  As Boomers have aged, that preference has reversed itself, meaning that yield equivalence between stocks and bonds may be too rosy a view for stocks.  If we assume that stocks trade at a 20% discount to this yield parity, however, the implied PE at the end of rate hikes is still 20.

Both results are a long way from the 15x that Mr. Paulsen proposes for the S&P.

It’s often the case that a significant drop in stocks often signals a leadership change.  I think it makes a lot of sense to reverse portfolio polarity away from an emphasis on earnings coming from the US to profits generated abroad.  How exactly to carry this idea out is the key, though.