more on Russian oil and natural gas

Demand for oil is relatively inelastic, meaning that small changes in supply can easily result in large changes in price. Press reports suggest that in the case of the three million or so daily barrels of Russian crude not being delivered to boycotting customers, a large amount is apparently being sold, at a 20% discount to the normal price, to countries like India and China. So, for the moment at least, the actual shortfall may be closer to one million barrels a day, not a catastrophic amount. This is also in line with what has happened during other boycotts.

Russian natural gas is a somewhat different issue. Because natural gas is a gas at the surface, it is sent to market either through a network of pipelines or, if that’s not possible, it’s frozen near the wellhead and transported in cryogenic containers–a very expensive operation to build and maintain. Russia is the largest seller of natural gas to the EU, supplying about 40% of what it uses. The EU asserts that it will cut its dependence on Russian natural gas by a third by the end of the year. Whether/how this will happen is unclear, to me at least.

The hard currency loss to Russia from the oil boycott is the sum of the reduction in volumes, maybe $90 million a day, plus discounts on volumes sold, say $20 million a day. Natural gas is a much bigger deal, amounting on average to about $1 billion daily, weighted toward the winter heating season.

I read something yesterday that suggested the clown-car performance of the Russian military in Ukraine so far is a deliberate ruse to disguise the true objective of the invasion–to seize oil and gas resources in that region, turning Russia into a Euro-Asian equivalent of Saudi Arabia.

I have two problems with this thought: I find it hard to believe the Russian army is just pretending it can’t feed/fuel itself, that its vehicle break down all the time and that it uses the equivalent of vegetable cans tied together with string to communicate with; also, Middle Eastern countries like Saudi Arabia are trying desperately to transform themselves into something (anything!) more relevant than being a hydrocarbon superpower in the renewables age that’s now dawning.

Given that the Russian economy is so dependent on foreign sales of its oil and gas, my guess is that the ultimate result of the invasion of Ukraine will be a sharp acceleration in the world movement toward renewables as the most effective way to defund this former Cold War giant.

an inverting yield curve: what it means

The primary economic goal of the US is to achieve maximum non-inflationary GDP growth. The government sets a general framework for this through fiscal policy–taxation and government spending. And, in theory as least, it stands at the ready to deal with shocks to the system. Monetary policy, in contrast, is a more flexible–and faster-acting–tool. It attempts to guide the economy through the business cycle by raising rates when the economy is running to hot and lowering them when the cooldown begins to take effect. The main rate it acts on is the Fed Funds rate, the price of overnight borrowing between the Fed and the big money center banks.

For government debt, where credit quality is presumably not an issue, the key determinant of the interest rate of a debt security is its term–the length of time before the principal most be repaid. A normal yield curve is what one would expect: the longer the term, the higher the interest rate.

When it sees the economy is growing too fast, the Fed begins to raise the Fed Funds rate to slow things down. At first, the entire yield curve shifts upward. At some point, however, holders of longer-term (say, 10-year) Treasuries make the judgment that their yields are high enough that they can ignore business cycle-related fluctuations in the price of overnight money that they think are only temporary.

If/as the Fed Funds rate continues to rise, the yield curve inverts–meaning that the yield on shorter-term securities is higher than that on longer-term ones.

Securities markets traditionally take yield curve inversion as an indicator that the Fed has gone too far in reining in near-term economic growth and that it will be unable to reverse stance fast enough to avoid at least a mild recession.

Maybe this will be the case again today, as the Treasury yield curve flirts with inversion. There are several unusual factors, though, that make the conclusion less than clear:

–although the Fed is already raising short-term rates, it continues to suppress longer-term yields by its bond buying, thereby gabling the yield curve message

–unusually, the bulk of government stimulus in this expansion is coming from fiscal spending, which has been generally absent in prior expansions. Arguably, Fed policy should be more restrictive than usual to offset this.

–longer-term Treasuries are as safe haven asset. In the first decade of this century, for example, Chinese buying pushed the 10-year yield as much as a percent lower than they would have been from domestic buying alone. Today, the war in Ukraine and the consequent weakness in the yen and euro may have caused international bond managers to shift holdings to Treasuries.

On the other hand, there’s:

–supply chain disruptions are being made worse by covid-induced slowdowns in China

–the war has reduced output from Russia and Ukraine, from wheat to minerals to coders

–the surprisingly large (to me, anyway) support for the Russian invasion from the domestic political right. There’s also the growing evidence that January 6th was not a spontaneous act, but the result of deliberate action by elected officials. Not a confidence booster for international investors.

My bottom line: it’s too early to tell whether inversion is really happening and whether it will have its usual predictive power. Something to keep an eye on, though.

Russia and oil

my more or less accurate history

When the old Soviet Union broke up thirty years or so ago, there was a wild scramble by powerful politicians and state officials (read: KGB) to seize control of valuable state-owned assets. Among these were Russia’s large but mature and decrepit oilfields.

The new oligarchs knew nothing much about oil, but they were smart enough to hire Western oilfield services companies–Schlumberger, Halliburton and Baker Hughes are the biggest–to repair and maintain the vast hydrocarbon resources they now controlled. The result was a jump in Russia’s oil output from 6 million daily barrels to the current 10 million or so.

oilfield service sanctions

The sanctions imposed by NATO are interesting, I think. The oilfield companies are allowed to continue work on existing projects but not launch new ones. What’s new and what’s existing haven’t been clarified in public announcements. The idea, though, appears to be to allow current production to continue undisturbed, thus mitigating the potential for near-term shortages that would drive the world oil price substantially higher. We already know, for example, that a lot of Russian output is ending up in India. It may also be possible for the foreign firms to further infill drilling–something that may depend on how quickly the world can shift away from oil and/or how quickly the Middle East can, or wants to, boost its output. At some point, however–two or three years down the road?–this production, Russia’s main source of hard currency, will begin to slacken. Assuming the sanctions are still in place then, and why wouldn’t they be, Russia will begin to fade away as an oil power.

Presumably, Moscow has worked this out already.

sifting through the fallen angels rubble

Robinhood (HOOD) went public last July at $38 per share. It shot up to $85 almost immediately …before beginning a downhill journey that resulted in the stock recently cracking below $10 a share.

I’ve been buying the stock recently, something I find a little surprising.

I firmly believe that the key to success for anyone in the stock market is to know more than most other market participants about the valuation and earnings prospects for the stocks in one’s portfolio. Better to know a lot about a small number of areas than end up being the dumb money in lots of places. For me, the key sectors have been Energy (where I spent my first decade as an analyst and PM–but not so useful now), Consumer Discretionary and IT.

I’ve generally tried to stay away from Financials. I’ve had colleagues who are stars in this sector, who seem to know, loan by loan, where a bank’s major exposures are and how fully (or not) it has reserved for potential losses–in the way I used to know, field by field, how a given oil and gas company was positioned. I don’t. And I’m not that willing to put in the time and work needed to make an intelligent decision.

I did open a HOOD account early on. I wasn’t favorably impressed. Nice colors. No information. Hard-to-believe easy in qualifying to trade options–sort of like a casino delivering you to the games with the lowest payout. I know that things have improved since then, but…

Still, I ended up buying HOOD. How so?

Over the past six months, the US stock market has performed as follows:

–S&P 500 +2.4%

–NASDAQ -6.6%

–ARKK -45.4%

–HOOD -69.0%.

To my mind, especially in a market like today’s where extreme valuations, both + and -, abound, it makes sense to root around among the market’s big losers to try to find low valuations. A plain vanilla value strategy, in other words.

What jumped out to me about HOOD is that it has book value (i.e., shareholders’ equity) of about $9 a share, almost all of that in working capital, meaning it can relatively quickly be turned into cash. As I’m writing this, the stock is at $12.82, or about 1.4x book.

HOOD seems uniquely able to appeal to younger traders/investors, a very desirable market that has so far eluded other brokers.

A number of discounters have been acquired over the past few years. Acquisition prices seem to have been around 2.5x book. Two remaining public ones are Charles Schwab (SCHW) and Interactive Brokers (IBKR). Both trade at about 2.8x book. The chairman of IBKR recently commented that HOOD’s return on its customer assets is 50% higher than IBKR’s.

Four thoughts:

–on a price/book basis, HOOD seems very cheap

–how could this stock ever trade at $85, or almost 10x book in a world where 3x seems pricey? Talk about crazy!

–the biggest risk I see is that the founders have voting control of HOOD through the special shares they own. So, unlike traditional value stocks, holders are highly dependent on their willingness and ability to grow the company. Here, what happens with Peloton (PTON) will be highly instructive

–why is a growth investor like me, who has written even in this post about the virtues of sticking to what you do well straying into value territory? One answer must be, whether I fully recognize this or not, is that I don’t feel comfortable adding to the tach and consumer discretionary names I already own.

after the first Fed Funds rate rise

The Fed raised the Fed Funds rate last week from basically free to 0.25%. More important, it said it would raise short-term rates six more times this year, and foresees another three or so for 2023. By New Years Day, then, overnight money will be at 1.75%, and will conceivably reach 2.5% by summer.

My sense, which isn’t worth much in the fixed income arena, is that the 15-month ahead target is a bit more aggressive than what the consensus had been expecting, Nevertheless, the stock market rose sharply on this news, signaling its approval of this more aggressive Fed plan.

What does this mean for the 10-year Treasury, the main alternative to stocks for us as investors? If we posit that the real (after subtracting inflation) yield on the 10-year should be 1.0%, this implies a nominal yield for the 10-year at 3.5% by next summer. Let’s say 4.0%, instead.

If we think the earnings yield (1/PE) on stocks and the interest yield on government bonds are more or less equivalent things, this implies the PE on the stock market should be somewhere around 25x.

Economist Ed Yardeni estimates the earnings on the S&P for 2022 will be $225/share. This would suggest the S&P at 5600, close to 25% higher than it is today. Put a different way, and assuming both that Yardeni is roughly correct and that the interest yield-earnings yield correspondence holds, the S&P is already discounting the 10-year Treasury at 5%.

For anyone caught up in the rough-and-tumble of daily stock market gyrations, Wall Street’s positive reaction to the Fed news might seem to be surprising upbeat. Three considerations:

–typically, the more bearish the market, the more willing investors are to refrain from their normal practice of acting in anticipation and to wait instead for actual events

–from the highs of late December to last Monday’s low, the S&P had dropped by about 13%. The 7% gain from then to the Friday close recovers only about half that loss and brings the index to roughly breakeven over the past half year; also,

–the most significant market damage has occurred away from the S&P. From 12/27 through last Monday, the NASDAQ was down by 18% and ARKK had lost 40%.