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.

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.

 

 

 

 

 

 

$80 a barrel oil

cartel activity

About a week ago, Saudi Arabia and Russia, two of the three largest oil producers in the world (the US is #1), announced they were discussing the mechanics of restoring half of the 1.8 million barrels of daily output foreign companies have been withholding from the market since 2016.

the objective? 

…to stop the price from advancing above $80.

To be honest, I’m a bit surprised that oil has gotten this high.  But producing countries have held to their cutback pledges to a far greater degree than they have in the past, with the result that the mammoth glut of oil in temporary storage a couple of years ago is mostly gone.  In addition, the economy of Venezuela is melting away, turning down that country’s output of heavy crude favored by US refiners.   Also, the world is worried that unilateral US withdrawal from the Iranian nuclear agreement may mean the loss of 500,000 daily barrels from that source.

On the other hand, short-term demand for oil is relatively inflexible.  Because of this, even small changes in supply or demand can result in large swings in price.   An extra 1% -2% in production drove the price from $100+ to $24 in 2014-15, for example.  The same amount of underproduction caused the current rebound.  So in hindsight, $80 shouldn’t have been so shocking.

Why $80?

Two factors, I think.  There must be significant internal pressure among producing countries to get even a small amount more foreign exchange by cheating on quotas.  Letting everyone get something may make it harder for one rogue nation to break ranks.

More importantly, a $100 price seems to trigger significant global conservation efforts, as well as to shift the search for petroleum substitutes into a higher gear.  So somewhere around $80 may be as good as it gets for producers.  And it leaves some headroom if efforts to hold the price at $80 fail.

the stocks

My guess is that most of the upward move for the oils is over.  I think there’s still some reason to be interested in financially leveraged shale oil producers in the US as they unwind the restrictions their lenders have placed on them.

 

 

 

oil right now–the Iran situation

For almost a year I’ve owned domestic shale-related oil stocks, for several reasons:

–the dire condition of the oil market, oversupplied and with inventories overflowing, had pushed prices down to what I thought were unsustainable lows

–other than crude from large parts of the Middle East, shale oil is the cheapest to bring to the surface.  The big integrateds, in contrast, continue to face the consequences of their huge mistaken bet on the continuance of $100+ per barrel oil

–there was some chance that despite the sorry history of economic cartels (someone always sells more than his allotted quota) the major oil-producing countries, ex the US, would be able to hold output below the level of demand.  This would allow excess inventories to be worked off, creating the possibility of rising price

–the outperformance of the IT sector had raised its S&P 500 weighting to 25%, historically a high point for a single sector.  This suggested professional investors would be casting about for other places to invest new money.  Oil looked like a plausible alternative.

 

I’d been thinking that HES and WPX, the names I chose, wouldn’t necessarily be permanent fixtures in my portfolio.  But I thought I’d be safe at least until July because valuations are reasonable, news would generally be good and I was guessing that the possibility of a warm winter (bad for sales of home heating oil) would be too far in the future to become a market concern before Labor Day.

 

Iranian sanctions

Now comes the reimposition of Iranian sanctions by the US.

Here’s the problem I see:

the US imposed unilateral sanctions like this after the Iranian Revolution in 1979.  As far as oil production was concerned, they were totally ineffective.  Why?  Oil companies with access to Iranian crude simply redirected elsewhere supplies they had earmarked for US customers and replaced those barrels with non-Iranian output.  Since neither Europe nor Asia had agreed to the embargo, and were indifferent to where the oil came from, the embargo had no effect on the oil price.

I don’t see how the current situation is different.  This suggests to me that the seasonal peak for the oil price–and therefore for oil producers–could occur in the next week or so if trading algorithms get carried away, assuming it hasn’t already.

 

 

~$70 a barrel crude (ii)

Two factors are moving the Energy sector higher.  The obvious one is the higher oil price during a normally seasonally weak time.  In addition, though, the market is actively looking for alternatives to IT.  It isn’t that the bright long-term future for this sector has dimmed.  It’s that near-term valuations for IT have risen to the point that Wall Street wants to see more concrete evidence of high growth–in the form of superior future earnings reports–before it’s willing to bid the stocks significantly higher.  With IT shunted to the sidelines for now, the market is not being a picky as it might be otherwise about alternatives such as Energy and Consumer discretionary.

The fancy term for what’s going on now is “counter-trend rally.”  It can go on for months.

 

As to the oils,

–a higher crude oil price is clearly a positive for the exploration and proudction companies that produce the stuff.  In particular, all but the least adept shale oil drillers must now be making money.  This is where investment activity will be centered, I think.

 

–refiners and marketers, who have benefitted from lower costs are now facing higher prices.  So they’re net losers.  Long/short investors will be reversing their positions to now be short refiners and long e&p.

 

–the biggest multinational integrateds are a puzzle.  On the one hand, they traditionally make most of their money from finding and producing crude.  On the other, they’ve spent very heavily over the past decade on mega-projects that depend for their viability on $100+ oil.  This has been a horrible mistake.  Shale oil output will likely keep crude well short of $100 for a very long time.

Yes, the big multinationals have all taken significant writeoffs on these ill-starred projects.  But, in theory at least, writeoffs aren’t supposed to create future profits.  They can only eliminate capital costs that there’s no chance of recovering.  As these projects come online, they’ll likely produce strong positive cash flow (recovery of upfront costs already on the balance sheet) but little profit.

The question in my mind is how the market will value this cash flow.  As I see it–value investors might argue otherwise–most stock market participants buy earnings, not cash generation.  Small companies in this situation would likely be acquired by larger rivals.  But the firms I’m talking about–ExxonMobil, Shell, BP…–are probably too big for that.  Will they turn themselves into quasi-bonds by paying out most of this cash in dividends?  I have no idea.

Two thoughts:

—–why fool around with the multinationals when the shale oil companies are clear winners?

—–as/when the integrateds start to show relative strength, we have to begin to consider that the party may be over.  So watch them.

oil inventories: rising or falling?

The most commonly used industry statistics say “rising.”

However, an article in last Thursday’s Financial Times says the opposite.

The difference?

The FT’s assertion is that official statistics emphasize what’s happening in the US, because data there are plentiful.  And in the US, thanks to the resurgence of shale oil production, inventories are indeed rising.  On the other hand, the FT reports that it has data from a startup that tracks by satellite oil tanker movements around the world, which seem to demonstrate that the international flow of oil by tanker is down by at least 16% year on year during 1Q17.

Tankers move about 40% of the 90+million barrels of crude brought to the surface globally each day.  So the startup’s data implies that worldwide shipments are down by about 6 million daily barrels.  In other words, supply is now running about 4 million daily barrels below demand–but we can’t see that because the shortfall is mostly occurring in Asia, where publicly available data are poor.

If the startup information is correct, I see two investment implications (neither of which I’m ready to bet the farm on, though developments will be interesting to watch):

–the global crude oil supply/demand situation is slowly tightening, contrary to consensus beliefs, and

–in a world where few, if any, experienced oil industry securities analysts are working for brokers, and where instead algorithms parsing public data are becoming the norm, it may take a long time for the market to realize that tightening is going on.

It will be potentially important to monitor:  (1) whether what the FT is reporting proves to be correct; (2) if so, how long a lag there will be from FT publication last week to market awareness; and (3) whether the market reaction will be ho-hum or a powerful upward movement in oil stocks.  If this is indeed a non-consensus view, and I think it is< then the latter is more likely, I think, than the former.

This situation may shed some light not only on the oil market but also on how the discounting mechanism may be changing on Wall Street.

 

 

 

why have oil production costs fallen so much?

rules for commodities

From years of analyzing oil, gas and metals mining–as well as watching agricultural commodities and high-rise real estate out of the corner of my eye–I’ve come to believe in two hard and fast rules:

–when prices begin to fall, they continue to do so until a significant amount of productive capacity becomes uneconomic and is shut down.  That’s when the selling price of output won’t cover the cash cost of production.  Even then, management often doesn’t reach for the shutoff valve immediately.  It may hope that some external force, like a big competitor shutting down, will intervene (a miracle, in other words) to improve the situation.  Nevertheless, what makes a commodity a commodity is that the selling price is determined by the cost of production.

–it’s the nature of commodities to go through boom and bust cycles, with periods of shortage/rising prices followed by over-investment that generates overcapacity/falling prices.  The length of the cycle is a function of the cost of economically viable new capacity.  If that means the the price of new seed that sprouts into salable goods in  less than a year, the cycle will be short.  If it’s $5 billion to develop a gigantic deep-water offshore hydrocarbon deposit that will last for 30 years, the cycle will be long.

boom and bust spending behavior

During a period of rising prices, cost control typically goes out the window for commodity producers.  Their total focus is on adding capacity to satisfy what appears at that moment to be insatiable demand.  Maybe this isn’t as short-sighted as it appears (a topic for another day).  But if oil is selling for, say $100 a barrel, it’s more important to pay double or triple the normal rate for drilling rigs or mud or new workers–even if that raises your out-of-pocket costs from $40 to, say, $60 a barrel lifted out of the ground.  Every barrel you don’t lift is an opportunity loss of at least $40.

When prices begin to fall, however, industry behavior toward costs shifts radically.  In the case of oil and gas, some of this is involuntary.  Declining profits can trigger loan covenants that require a firm to cease spending on new exploration and devote most or all cash flow to repaying debt instead.

In addition, though, at $50 a barrel, it makes sense for management to:  haggle with oilfield services suppliers;  do more ( or, for some firms initiate) planning of well locations, using readily available software, to optimize the flow of oil to the surface;  optimize fracking techniques, again to maintain the highest flow; streamline the workforce if needed.   From what I’ve read about the recent oil boom, during the period of ultra-high prices none of this was done.  Hard as it may be to believe, getting better pricing for services and operating more efficiently have trimmed lifting expenses by at least a third–and cut them in half for some–for independent wildcatters in the US.

 

This experience is very similar to what happened in the long-distance fiber optic cable business worldwide during the turn of the century internet boom.  As the stock market bubble burst and cheap capital to build more fiber optic networks dried up, companies found their engineers had built in incredibly high levels of redundancy into networks (meaning the cables could in practice carry way more traffic than management thought) and had also bought way to much of the highest-cost transmission equipment.  At the same time, advances in wave division multiplexing meant that each optic fiber in the cable could carry not only one transmission but 4, or 8, or 64, or 256…  The result was a swing from perceived shortage of capacity to a decade-long cable glut.

My bottom line for oil:  $40 – $60 a barrel prices are here to stay.  If they break out of that band, the much more likely direction is down.