4Q15 earnings for the S&P 500

A few days ago, Factset published a note analyzing 4Q2105 earnings for the two-thirds of the S&P 500 that had reported as of that time.  It wanted to find out two things:

–how the sharp decline in the price of energy, especially oil and gas, had affected revenue and earnings of the S&P, and

–how the strength of the dollar affected the results of companies with substantial overseas revenues, earnings and assets.

Three observations (from me):

–the oil and gas figures, which show a general collapse in earnings, are a mix of operating results and writedowns of long-term investments in what are now no longer viable exploration/development projects (in plainer words, the balance sheet cost of finding the hydrocarbons exceeds their market value).  Factset doesn’t separate operating earnings declines from writedowns—which would be a pain in the neck to do—even though the distinction is important

–companies may have hedged either currency or oil/gas price fluctuations.  If successful, these hedges would have meant the reported results were better than unhedged would have been.  If unsuccessful, the opposite would be the case.  (Even farther afield, companies typically disclose unsuccessful hedges, thinking investors will focus on the unhedged results; no one calls attention to successful hedges, for the same reason.)

–products and services sold abroad are typically priced in local currency.  When that currency falls against the dollar, the dollar-denominated results for a US-based company fall as well.  As a matter of course, the US company can raise its local currency prices.  But the general rule of thumb is that they can be boosted by, at most, the local inflation rate—and with a time lag, as well.  In the case of the euro, which is the currency of most concern to the S&P 500, there is no inflation at present.  So (ex hedging, if any) current results show the full brunt of the euro’s decline against the greenback.


The Factset numbers:

–for all S&P companies, revenues fell by 3.7% during the quarter.  Earnings fell by 3.6%.  For companies with more than half their sales in the US, revenues were up by 0.8% and earnings by 2.7%.  For firms with more than half their business abroad, revenues were down by 13.0%; earnings were off by 11.2%.

–for the S&P 500 ex Energy, sales were up by 0.5%; earnings for non-energy firms rose by 2.5%.  Domestically oriented companies ex Energy, had revenue gains of 3.9% and an earnings increase of 6.9%.  Sales for foreign-oriented firms fell in dollar terms by 7.4% and earnings by 3.2%.


My thoughts:

–I think the euro has already bottomed against the dollar.  If so, ex hedges, 2016 results may be surprisingly good for S&P firms with significant EU exposure.

will an oil cartel cut production and raise prices?

As I argued yesterday, the oil cartel can cut oil production to a degree that will raise prices significantly, because the gap between supply and demand is relatively narrow.  Whether it will, however, is another matter.

The announcement on Tuesday of an agreement among Saudi Arabia, Russia, Venezuela and Qatar is a case in point.  The Saudis and Russians together account for about a quarter of world oil production.  Venezuela and Qatar each account for about 2%.  The four declared three days ago, after what was widely rumored to be a meeting to discuss production cuts, that they had agreed not to raise production further.  Given that the Saudis, Russians and Venezuelans are all running flat out–Qatar may be, too, I just don’t know–this was an incredibly weak statement.

Of course, consuming nations don’t want prices to rise.  Sunni countries don’t want Shiite countries to have more money and vice versa.  The rest of the world would worry that extra funds in the Middle East will find its way into jihadist hands.

There are also important economic considerations, concerning the character of OPEC and the differing motivations of Saudi Arabia and the rest of the cartel.

First, OPEC as a cartel:

Economic theory and practical experience both conclude that economic cartels never work.  That’s because members always violate any production reduction agreements they come to.  At one time, OPEC, founded in 1960, was an exception.  That’s because, in my view, in the early days OPEC was a political organization–formed to combat colonial exploitation of resource-rich third world countries.  During that period, the organization displayed remarkable cohesion.  OPEC’s nationalization of the oil companies’ interests in the 1970s, however, transformed the organization from a political detente to a garden-variety economic cartel, subject to the same garden-variety cheating problem that other commodity producers suffer from.

On top of that:

Saudi Arabia possesses vast oil reserves, enough to continue production at current rates for, say, 100 years.  Since the oil shocks of the 1970s,  Saudi Arabia’s biggest economic concern has been to maximize the value of this asset   …that is, to make sure the world is still using oil and has not substituted other forms of energy for the next century.  The main threat to accomplishing this goal is very high prices.

By and large, the reserves of other OPEC countries are much smaller–enough to last, say, 20 years.  These nations couldn’t care less about long-term substitution of other fuels, because they will have run dry before that can happen.  Having the highest possible oil price in the here and now is the most important objective.  So they have a strong incentive to cheat rather than adhere to production cuts OPEC agrees to.

Also, for the past several years, the Saudis have had to worry about the emergence of large amounts of oil extracted from shale.  That has been enough to tip the oil market into oversupply.  The expansion of shale oil output undermines the ability of the Saudis to stabilize prices, too.

In practical terms, what do these factor imply?

–although the rest of OPEC would be willing to agree that Saudi Arabia should cut oil production to stabilize/increase prices, other members are unlikely to reduce output themselves.  They’re much more likely to boost it.  We saw this clearly during the oversupply years of 1982-86.  During that time, Saudi Arabia reduced its oil production in steps by about seven million barrels a day without putting a dent into oversupply.  That’s because other OPEC nations, which had promised to cut back their output, upped it instead, barrel for barrel with Saudi Arabia’s cuts.    All the cutbacks did for Saudi Arabia was to lose it market share–which the kingdom found very hard to win back when supply and demand came back into balance.  There’s every reason to expect the same outcome would happen again.

–at a $30 a barrel market price, shale oil production in the US is gradually starting to shrink.  If oil prices remain at the current level for another year or two, shale oil firms will start to go out of business.  This means that skilled workers and technical knowhow will be lost–making it more difficult and time-consuming for shale oil production to start up again.  Arguably, this is Saudi Arabia’s main objective.  After all, if the Saudis had not increased its oil output over the past year or two, world oil supply and demand would be roughly in balance today–and prices would, I think, be significantly higher.


What does “significantly” mean?  When oil prices were at $100+ per barrel, shale oil producers had no need to be efficient.  They made a profit almost no matter what their costs were.  So they concentrated on maximizing production.  Estimates at the the time were that shale needed a price of $60 a barrel to be economic.  In today’s world, where shale oil drillers have got to concentrate on keeping costs in line, I think the breakeven price is closer to $40.  So even in the unlikely event that OPEC agrees on production cuts–and nobody cheats (fat chance!)–$40 a barrel is probably a price ceiling.


can the oil cartel raise prices by cutting back production

cartel action in the offing?

That’s the rumor that has been supporting the oil price over the past week or so, despite this being the weakest season of the year for petroleum demand.  The story is that OPEC and Russia are having discussions right now about withholding output from the market in order to push prices up.

How likely is this to happen?

How likely is it that prices will rise if OPEC and others take action?

Supply/demand data

–world oil demand is about 95 million barrels a day, according to the International Energy Agency.  That figure has been growing at about a 1.5 million daily barrel clip over the past few years.  The IEA forecasts growth in demand to drop to a gain of 1.2 million in 2016, due to economic slowdown in China and the EU.  But demand will still likely be 96 million barrels/day by December.

–world oil supply is about 97 million barrels daily, according to the IEA.  That’s about 3 million barrels higher than at the end of 2014, due to increases in output from the US (2 million), Iraq (1 million) and Saudi Arabia (1 million-), partly offset by a bunch of production declines elsewhere.

–of the 97 million barrels of output, 39 million come from OPEC and about 14 from the former Soviet Union (11 million from Russia).  The rest come from oil consuming areas like the US, the EU and China.  These producers are, in my view, highly unlikely to cut output except when the selling price falls below the out-of-pocket costs of getting oil to the surface.


What I find fascinating about oil–and maybe this is just me–is the figures above show the gigantic fall in price since mid-2014 has been caused by a difference between supply and demand of only about 2%.  In fact, the IEA is forecasting continuing downward pressure on the oil price even though it thinks that the excess supply will be reduced to about 300,000 barrels daily, about 0.3%, by yearend.

It’s also important to note that demand for oil is relatively insensitive to changes in price over periods of a year or two or three.  Greater fuel efficiency of cars, substitution of natural gas or alternative energy, better insulation against heat and cold in construction, high taxes on fossil fuels in most developed countries (ex the US), are among the reasons.  What’s key for this discussion is that higher prices are very unlikely to make a dent in demand.  That’s a strong reason in favor of cartel action.

So, what would OPEC + Russia have to do to create a supply deficit?

…remove 2 million barrels of oil daily from world supply.  Let’s say 3 million, just to be on the safe side.  Given that OPEC + R control output of 53 million, that would mean each member reducing production by about 6%.  Assuming that increasing supply from US shale oil would only become economic at $40 a barrel, implying that’s the highest sustainable level prices are likely to achieve, OPEC + R could reap an almost immediate 25% increase in revenue by trimming output by 6%.  That’s a powerful incentive for economies radically dependent on oil sales and running short of cash.

Could this happen?

More tomorrow.



the weird relationship between stocks and oil

Over the past several months, there’s been a strong correlation between the movement of the crude oil price with the movement of stock prices around the world.  Oil goes up, stocks go up; oil goes down, stocks go down.

Until last week, there has been a certain logic to the link–a logic I think is incorrect, but a logic nonetheless.  Traders seem to be observing, correctly, that when economic activity is weak the demand for oil declines, both because consumers economize and industry uses less.  When that happens, the price of oil falls.  Therefore, traders say (incorrectly), the sharp drop in the oil price over the past 20 months is evidence that the world economy must be weaker than we think.  So low oil price = sell, or short, stocks.


Two problems with this line of thought:

–this is a little pedantic (actually, just skip over this paragraph), but logically “weak economy ⇒ falling oil price” doesn’t imply the converse, “falling oil ⇒ weak economy”.  It implies “not weak economy ⇒ not falling oil price.”  It’s like if you’re standing out in the rain, you get wet.  But if you’re wet, it doesn’t mean you’ve been standing out in the rain.  You may have been taking a shower.  Put a clearer way, the fact that a falling oil price is a symptom of economic weakness doesn’t mean it causes it.

–global demand for oil is, in fact, rising, not falling, according to the International Energy Agency.


Nevertheless, whether it makes sense or not to me, oil and stocks have been going up and down in lockstep.  So it makes sense to someone else–actually, a lot of someone elses.  And, like when it makes no sense but you see the train is barreling down the track at you, the best course of action is to step off the rails and out of the way.

That’s not the real weirdness.  Here’s where that comes in:

Over the past few days, oil and stocks have been going up on the rumor that a number of big oil producers, including OPEC and Russia, are talking about cutting back their production in order to prop up prices.

This would obviously be good for them.  If they’re getting $30 a barrel now and can move the price to $40 by reducing output by, say, 10%, their revenue goes up by 20%.  If the price got to $50, they’d be 50% better off than today.

However, this doesn’t make the world as a whole better off, nor does it stimulate the global economy.  It’s a transfer of money from oil consumers to oil producers.  It’s good for Saudi Arabia, Russia et al, but it’s bad for the US, Europe, Japan and China.  In the parts of the world the S&P 500 represents, it helps about 10% and hurts the other 90%.  So a rising oil price caused by cartel manipulation is a big net minus for the S&P.

Despite this, stocks soared yesterday, in robotic fashion according to the rule that stocks move in the same direction as oil.  Go figure.

the yen and the unraveling of Abenomics

Last week the Tokyo stock market had two days in which the benchmark Topix index fell by more than 5%.  For the week as a whole, the market declined by 12.5% (the quirky Nikkei 225, the Japanese equivalent of the Dow, fell by 11%).

This has little to do with worries about the oil price or about a global economic slowdown, in my view.  This is all about Abenomics.

The three “arrows” rhetoric aside, the idea behind Abenomics has been to create extraordinary short-term economic stimulus in Japan through huge depreciation of the currency, large increases in government deficit spending and a big expansion of the money supply.

It has been clear from the outset that all three of these actions will leave deep permanent scars on the Japanese economic landscape.  However, their purpose has been to buy time and space for export-oriented Japanese industry to restructure and modernize.  That would, in turn, allow these firms to hire more workers and increase wages for all.  In the eyes of Abe boosters, the benefits brought by a revitalized industrial base would more than offset the body blows caused by depreciation, inflation and an increase in already gargantuan outstanding government debt.

It has also been clear that Abenomics can’t take infinite time to work. Shock-and-awe stimulus is temporary; waves of it are progressively less effective.  Theory and practical experience both say that without substantive changes an economy tends to revert to its previous torpid state after a few years   …except there’s higher inflation.

In Japan’s case, industry hasn’t voluntarily restructured.  Government continues to protect recalcitrant corporate managements from outsiders skillful enough, wealthy enough and willing enough to take on the modernizing task.  So far, then, Abenomics has all been jam tomorrow, as Lewis Carroll put it.

Since the beginning of this month, early in the fourth year since the launch of Abenomics, the yen has risen by about 7% against the US$, 8% against the renminbi and about half that against the €.

This strength is a bit surprising, since it comes immediately after further stimulus by the Bank of Japan in the form of negative interest rates.  Investors in Tokyo are reading the currency strength as the first sign that the window of opportunity for Abenomics to succeed is starting to close.

I’m not sure this interpretation is completely correct.  But, having been an Abenomics skeptic from day one, I won’t argue that it’s wrong, either.

For people like me, who continue to watch from the sidelines, Japan is important to the rest of the world as a tourist destination, but mostly as a cautionary tale about the limits of monetary policy and the dangers of special interest politics determined to defend the status quo.