bonds vs. bank loans: drawing down your revolver

 

A number of transport companies announced this morning that they are drawing down their revolving likes of credit with banks.  What does this mean?

bonds vs. bank loans

Bonds are fixed income instruments sold to investors.  Although, like everything else in financial markets there are myriad variations, a plain-vanilla bond is a fixed term and a fixed interest rate borrowing.  Absent the issuer violating loan covenants, holders can only get their money back before redemption date by selling the bond to someone else.  And in recent years of low yields, strong covenants have been few and far between.

Bank loans are a different animal.  For one thing, the counterparty is a bank or group of banks.  Some bank loans are fixed-term, typically with covenants that have more teeth.  Revolving lines of credit, or revolvers, in contrast, are the corporate equivalent of credit cards.  Lines can be borrowed or repaid at will and are very often used for seasonal working capital needs.

The key difference in today’s world:  a bank credit committee periodically reviews the revolver lines to make sure they’re appropriate.  I’ve seen instances, though, where the bank calls an ad hoc credit committee meeting and yanks the line because of changing economic circumstances.

why this matters

This is what I’m reading in today’s news–transport companies are afraid their credit lines will be withdrawn and are grabbing the money before banks can act.

 

an ugly day: coronavirus + oil

oil

In normal times, the world produces about 100 million barrels of oil daily and consumes about the same amount.  Small changes in either supply or demand can cause huge changes in price.  That’s because demand–autos, jet fuel, heating oil…is relatively inflexible (if seasonal).  Supply is also inflexible, because a cartel of suppliers, led by Saudi Arabia has been able to control output levels.  Their goal:  highest price possible without encouraging substitution.

A problem has surfaced, however.  A mild winter + reduced demand from airlines have combined to cause a potential supply overhang.  Negotiations between Saudi Arabia and Russia about production cuts to offset this and keep prices high broke down.  Not only that, but the Saudis have apparently decided to punish Russia (and themselves) by starting to sell large amounts of oil at about $30 a barrel, or $10 a barrel below Friday’s price.

Implications:

–the consensus view is that Saudi Arabia, radically dependent on oil exports, needs a price of $80+ to balance its budget; Russia, smaller and economically much weaker, needs $40+.  So both are it trouble.  Riyadh’s calculation must be that Moscow will soon feel the pain more quickly and will agree to production cuts

–a $30 price has two bad consequences for oil production companies in the US and elsewhere.  The lower price reduces revenues and profits.  This is an acute problem for some US shale companies, which have borrowed heavily in the junk bond market.  In addition, a standard way of evaluating natural resource companies is to compare the stock price with the per share value of the reserves they hold.  The price fall not only reduces the value of those reserves but also shrinks the amount, since some oil that’s viable at $40 becomes economically unfeasible to drill for at $30.

–if oil companies make up 4% of the S&P 500 and we say that they have lost a third of their value over the weekend, then the S&P should open 1.2% lower because of that.  Add in banks that will be in trouble and maybe that figure drops to down 2%.  Conceptually offsetting that would be the benefit to oil consumers of lower prices.  But that’s a diffuse group that is typically overlooked in a market downdraft   …and in this case prime beneficiaries like transport companies are being hit by coronavirus fears.

–as I’m writing, the S&P 500 is trading down about 5% in the premarket.  So the other 3% must be due to other factors–presumably coronavirus fears.  Those, in turn, break out, I think, into two factors:  the virus itself and the efforts of the Trump administration to prevent disease preparedness, information exchange and treatment.  To my mind, the last is the scariest part.

–if we were to posit no AI involvement in the premarket decline, this would look to me like the start of an old-fashioned selling panic.  In an AI-driven world, however, it’s not clear that that the idea of a cathartic release of pent-up fear setting the emotional stage for the next upswing still holds water.

All in all, for almost everyone a day to turn off the screen and go out in the sunshine.

Tesla (TSLA): dreaming and reverse engineering

As I’m writing this, TSLA’s market cap is around $160 billion, with the stock up 50%+ over the past week and having more than doubled in a flat market over the past month.

I have no real idea what’s behind the move  …desperate short covering?  …glitchy trading AI feeding on positive price momentum?  It looks crazy, though.

My thoughts:

–conceptually at least, we’re now living in a post-fossil fuel world.  This is much more evident in, say, Europe than in the US.  (The current administration here is clueless.  It actually favors the most heavily polluting fuels and is fighting industry efforts to keep US-made auto relevant in world markets through increasing fuel efficiency.  If this were a century ago, we’d be backing firewood.)

–the trickiest part of a car to make and maintain is the internal combustion engine.  Substitute big batteries and suddenly building is easier, manufacturing costs go down and you don’t need an extensive dealer network for sales and service.

Tesla is the leading brand name in electric cars.  There’s also some evidence that the manufacturing problems that plagued TSLA are now behind the company.

–we’re still in the “dream” or “concept” stage of TSLA’s development, so it’s very hard to gauge what the company is worth.  On the other hand, we can ask ourselves what the current share price implies must be already factored in, as follows:

—-let’s say that the market for automobiles is 100 million units/year, with 25% of those in China and 20% in the US.  Suppose TSLA can capture a 1% market share over the next few years.  That would mean manufacturing 1 million cars.  Let’s pluck numbers out of the air and say that they’ll sell for $40,000 each and have an after-tax margin of 20% (using margins is bad–never do it–but we’re just dreaming here).  That’s $8000 each, or $8 billion in total.

—-the point of this reverse-engineering is to see that the stock is now trading at 20x that annual earnings figure (market cap =$160 billion).  To buy/hold the stock at this point one would have to believe that the future for TSLA is better than I’ve just described.

—-how could that happen?:  the margin number I’m using is very high in conventional auto company history; there’s the issue of creating a network of charging stations to serve the cars; there’s also a (less important, I think) question of usability of electric cars in colder climates.  The biggest unknown, in my opinion, is how large a lead TSLA has on other would-be electric car makers.

Primary competition will likely come from Europe, where whose diesel emission cheating scandal has wrecked the market for conventional cars, thereby accelerating the move toward electric.   Their biggest impediment–ironically, a major point in favor of TSLA, is the backward-oriented posture of the administration in Washington.

On the other hand, given that TSLA has manufacturing operations in the two largest markets, maybe a 1% market share is too low.  Again, I have no idea.  But I think that’s the bet buyers today will be making, whether they realize it or not.

public utilities and California wildfires

public utilities

The idea behind public utilities is that society is far worse off if a municipality has, say, ten companies vying to provide essential services like power and water to citizens, tearing up streets to install infrastructure and then maybe going out of business because they can’t get enough customers.  Better to give one (or some other small number) a monopoly on providing service, with government supervising and regulating what the utility can charge.

The general idea of this government price-setting is to permit a maximum annual profit return, say 5% per year, on the utility company’s net investment in plant and equipment (net meaning after accumulated depreciation).  The precise language and formula used to translate this into unit prices will vary from place to place.

The ideal situation for a public utility is one where the population of the service area is expanding and new capacity is continually needed.  If so, regulators are happy to authorize a generous return on plant, to make it easier for the utility to raise money for expansion in bond and stock markets.

mature service areas

Once the service area matures, which is the case in most of the US, the situation changes significantly.  Customers are no longer clamoring to get more electric power or water.  They have them already.  What they want now is lower rates.  At the same time, premium returns are no longer needed to raise new money in the capital markets.  The result is that public service commissions begin to reduce the allowable return on plant–downward pressure that there’s no obvious reason to stop.

In turn, utility company managements typically respond in two ways:  invest cash flow in higher-potential return non-utility areas, and/or reduce operating costs.  In fact, doing the second can generate extra money to do the first.

How does a utility reduce costs?

One way is to merge with a utility in another area, to cut administrative expenses–the combined entity only needs one chairman, for example, one president, one personnel department…

Also, if each utility has a hundred employees on call to respond to emergencies, arguably the combined utility only needs one hundred, not two.    In the New York area, where I live, let’s say a hundred maintenance people come from Ohio during a blackout and another hundred from Pennsylvania to join a hundred local maintenance workers in New York.  Heroic-sounding, and for the workers in question heroic in fact.  But a generation ago each utility would each have employed three hundred maintenance workers locally, most of whom have since been laid off in cost-cutting drives.

Of course, this also means fewer workers available to do routine maintenance, like making sure power lines won’t get tangles up in trees.

the California example

I don’t know all the details, but the bare bones of the situation are what I’ve described above:

–the political imperative shifts from making it easier for the utility to raise new funds (i.e., allowing a generous return on plant) to keeping voters’ utility bills from increasing (i.e., lowering the permitted return).

–the utility tries to maintain profits by spending less, including on repair and maintenance

The utility sees no use in complaining about the lower return; the utility commission sees no advantage in pointing out that maintenance spending is declining (since a major cause is the commission lowering the allowable return).   So both sides ignore the worry that repair and maintenance will eventually be reduced to a level where there’s a significant risk of power failure–or in California’s case, of fires.  When a costly failure does occur, neither side has any incentive to reveal the political bargain that has brought it on.

utilities as an investment

In the old days, it was almost enough to look at the dividend yield of a given utility, on the assumption that all but the highest would be relatively stable.  So utilities were viewed more or less as bond proxies.  Because of the character of mature utilities, no longer.

In addition, in today’s world a lot more is happening in this once-staid industry, virtually all of it, as I see things, to the disadvantage of the traditional utility.  Renewables like wind and solar are now in the picture and made competitive with traditional power through government subsidies.  Utilities are being broken up into separate transmission and generation companies, with transmission firms compelled to allow independent power generators to use their lines to deliver output to customers.

While the California experience may be a once-in-a-lifetime extreme, to my mind utilities are no longer the boring, but safe bond proxies they were a generation or more ago.

Quite the opposite.

 

 

 

 

 

 

 

how the market looks to me today

It may be that the market downdrift we’ve been experiencing since early October started out as a bout of yearend mutual fund selling, as I’ve been writing for a while.  Maybe not.  In any event, the selling has continued for far longer than the mutual fund hypothesis can explain.

It may be that the market has been thinking that the prices of IT-related shares had gotten far too high, given their earnings prospects.  Strike out the “far” and I’d have to agree; in my mind, the big issue preventing at least a temporary market rotation away from tech has been, and remains, what other group to rotate into.

It’s also possible that the operative comparison has been between stocks and bonds.  The ongoing upward yield curve shift now has short-term Treasury notes yielding around 2.5% and the 10- and 30-year yielding above 3%.  Arguably this is a level where income-hungry Baby Boomers could feel they should allocate somewhat away from stocks and into fixed income.

Whatever the market’s motivation, however, I’m sticking with my idea that the S&P bottomed on October 29th.

 

Many times, when the market has hit a low and has begun to rebound, it will reverse course to “test” the previous low.  Also arguably, that’s what has been happening over the past week or so–formation of what technicians in their arcane lingo call a “double bottom.”  The main worry with this idea is that two weeks after the initial low is an unusually short time for the double bottoming to be happening.  Still, it’s my working hypothesis that this is, in fact, what’s going on.

The things to monitor are whether the market breaks below the late October low and, if so, whether it breaks below the April or February lows.

 

Another topic:  oil.  Crude oil and oil stock prices have been plunging recently.  Most non-US producers added extra current output to offset the assumed negative impact of the US placing renewed sanctions on the purchase of oil from Iran.  At the last minute, however, Washington granted exceptions to large purchasers of Iranian crude.  Because of this, oil has continued to flow in addition to the extra oil from OPEC.  Since demand for oil is relatively inflexible, even 1% – 2% changes in supply can cause huge changes in price.  Whether or not the US deliberately set out to deceive OPEC and thereby cause the current oversupply, the price of oil is down sharply since the US acted.

Saudi Arabia and Russia have just announced supply cuts.  Given that Feb – April is the weakest season of the year for oil demand, it’s not clear how long it will take for the reductions to lift the oil price.  It seems to me, though, that the more important question is when rather than if.  So I’ve begun to nibble at US shale oil producers that have been flattened since Washington’s action.

thinking about Walmart (WMT)

On August 16th, WMT reported very strong 2Q18 earnings (Chrome keeps warning me the Walmart investor web pages aren’t safe to access, so I’m not adding details).  Wall Street seems to have taken this result as evidence that the company makeover to become a more effective competitor to Amazon is bearing enough fruit that we should be thinking of a “new,” secular growth WMT.

Maybe that’s right.  But I think there’s a simpler, and likely more correct, interpretation.

WMT’s original aim was to provide affordable one-stop shopping to communities with a population of fewer than 250,000.  It has since expanded into supermarkets, warehouse stores and, most recently, online sales. Its store footprint is very faint in the affluent Northeast and in southern California, however.  And its core audience is not wealthy, standing somewhere below Target and above the dollar stores in terms of customer income.

This demographic has been hurt the worst by the one-two punch of recession and rapid technological change since 2000.   My read of the stellar WMT figures is that they show less WMT’s change in structure than that the company’s customers are just now–nine years after the worst of the financial collapse–feeling secure enough to begin spending less cautiously.

 

This interpretation has three consequences:  although Walmart is an extraordinary company, WMT may not be the growth vehicle that 2Q18 might suggest.  Other formats, like the dollar stores or even TGT, that cater to a similar demographic may be more interesting.  Finally, the idea that recovery is just now reaching the common man both justifies the Fed’s decade-long loose money policy–and suggests that at this point there’s little reason for it not to continue to raise short-term interest rates.

OPEC and $80 oil: last week’s meeting

$80 per barrel oil

Over the past year the price of a barrel of crude oil has risen from $50 to $80.  The latter figure is substantially below the $100+ that “black gold” averaged during 2011-2014, but hugely higher than the low of $25-minus thee years ago.

conventional wisdom upended

Two pieces of conventional wisdom about oil have changed during the past half-decade:

–effective shale oil production technology has shelved the previous, nearly religious, belief in the near-term peaking of world oil productive capacity.  More than that,

–the development of viable electric cars has won the world over to the idea that a substantial amount of future transportation demand is going to be met by non-petroleum vehicles.

new meaning for “peak oil”

The “peak oil” worry used to be about the day when demand would outstrip supply (as emerging economies switch from bicycles/motorcycles to several cars per household–just as conventional oil deposits would begin to give up the ghost).  The term now means the day (in 2040?) when demand hits a permanent peak, and then begins to fall as renewable energy supplants fossil fuels.

new OPEC solidarity

When Saudi Arabia, the most influential member of OPEC, said during the recent supply glut that its target for the oil price was $80 a barrel, I thought the figure was much too high.  Why?  I expected that the cartel wouldn’t stick to mutually-agreed output restrictions (totaling 1.8 million daily barrels) for the years needed for oversupply to dry up and the price of output to rise.  That was wrong.

I think the main reason for OPEC’s uncharacteristic sticktoitiveness (first time I ever typed that word) is the realization that petroleum is going to yield to renewables as firewood was supplanted by coal in the mid-nineteenth century and coal was replaced by oil in the mid-twentieth.

There are other factors, though.  The collapse of the Venezuelan government means that country now produces about a million barrels a day less than two years ago.  Also, Mr. Trump’s aversion to all things Obama has prompted him to pull the US out of the Iranian nuclear agreement and reinstate an embargo.  This likely means some fall in Iranian output from its current 4.5 million or so daily barrels, as sanctions go back into effect.  Anticipation of this last has upped today’s oil price by something like $10 a barrel.

adding 600,000 barrels to OPEC daily output

Just prior to the Trump decision on Iran, Russia and Saudi Arabia were suggesting publicly that the coalition of oil producers eventually restore as much as 1.5 million barrels of daily production, as a way of keeping prices from rising further.  Mr. Trump has reportedly asked the two to make any current increase large enough to offset the $10 rise his Iran action has sparked.

Unsurprisingly, his plea appears to have fallen on deaf ears.  Last Friday the cartel announced plans to put 600,000 barrels of daily output back on the market–subject, I think, to the condition that the amount will be adjusted, up or down, so that the price remains in the $75 – $80 range.

optimizing revenue

The old OPEC dynamic was Saudi Arabia, which had perhaps a century’s worth of oil reserves and therefore wanted to keep prices steady and low vs. everyone else, whose reserve life was much shorter and who wanted the highest possible current price, even if that hastened consumers’ move to alternatives.

Today’s dynamic is different, chiefly because the Saudis now realize that the age of renewable energy is imminent.  Today all parties want the highest possible current price, provided it is not so high that it accelerates the trend to renewables.  The consensus belief is that the tipping point is around $100 a barrel.  $80 seems to give enough safety margin that it has become the Saudi target.