daily volatility, non-correlation …and beta

My wife and I are in the process of hiring a financial planner.  While I think this is important to do, our search has brought me back into vivid contact with some of what I consider the nonsensical jargon of academic finance.  I want to write about the general idea of “non-correlated assets,” but I’m going to start by writing about beta.

beta…

In the early days of computer-driven finance, just after WWII, economist Harry Moskowitz proposed beginning to assess the risk of a portfolio by analyzing the interrelationships among individual stocks in it.  That task proved too daunting for the computers of the day for anything but small numbers of stocks.  Others suggested correlating everything to one standard, an index like the S&P 500, for instance, instead.

The regression that would do this has the form of y = α + β(S&P).  This is how beta, the correlation between a given stock’s price movement and that of the market, was born.

So far, so good.

…and gold stocks

One day, people discovered that there was a class of stocks–gold stocks, in particular– that had a beta of 0.  This spawned the idea, encouraged by the gold-bug prejudices of the day, that one could lower the beta of a portfolio just by adding gold stocks.  One could add, say, technology stocks with a beta =2 and offset the risk by adding gold stocks in the same amount.  Simple math said the combination had a beta = 1, or risk exactly equal to that of the market.

Some institutional investors actually bought the theoretical argument about the “magic” property of gold and altered their portfolios in the way I just described.

By doing so, they exposed themselves to the 20-year bear market in the yellow metal that lasted from 1950 to 1970.  They lost their shirts.

They realized only afterward that a beta of zero did not mean that the asset in question had no risk.  It meant instead only that the zero-beta asset did not rise and fall in price in line with the stock market.  In this case, the “uncorrelated” price went straight down during a period when the S&P gained 500%+.  So much for non-correlation.

More tomorrow.

 

 

 

thinking about 2016: oil

Regular reader Chris commented about yesterday’s post that we may be in the early stages of a decade+ downcycle in the oil price.  I thought I’d elaborate on that thought today.

base metals–gold, too

I think the situation with base metals is very clear.  Capacity is typically added in very large increments, and by all parties in the industry at once, creating the top of the market.  The mines can be shut down, but the orebodies don’t disappear.  Neither does the machinery.  So operations can be restarted fairly easily.  As a result, the market only comes back into balance as economic growth slowly expands, eating into the oversupply overhang.  Last time around, in the early 1980s, this process took well over a decade.

oil

Th case of oil is slightly different.  The petroleum industry is far bigger and more important than metals.  In most cases, there are no good substitutes.  Use for heating and transportation can’t be postponed.

Discovery of new reserves is a much more important factor in production.  The ability of oilfields to extract output without significant new drilling can deteriorate sharply if wells are shut down, interrupting the underground flow of oil to them.  Because of this second factor, very small differences between supply and demand can have dramatic.

 

At the last oil peak in 1980-81, two factors conspired to stretch out in time the fall in prices needed to restore supply-demand balance.

–The US, the world’s largest petroleum consumer, enacted a byzantine series of price control laws to prevent higher oil prices from being passed on to consumers.  This delayed conservation into the 1980s, when the regulations were dismantled.

–Saudi Arabia, then the largest oil producer in the world, decided to cut its production in an unsuccessful attempt to prop up prices.  It went from 10+ million barrels per day in 1980 to just over 3 million in 1985.  Although other OPEC members also agreed to curtail production, widespread cheating (typical cartel behavior) undermined the supply reduction effort.  The oil market finally bottomed at around $8 a barrel (the high was $34 in December 1980) when the Saudis got fed up and began to restore production in 1986.

 

This time, neither factor is present.  The only residual of 1970s efforts to promote oil use in the US is the country’s relatively low level of tax, by world standards, on gasoline.  Saudi Arabia, having learned a bitter lesson from the 1980s, has actually increased production slightly.

 

I think this means that the bottom for oil will come much more quickly than in the 1980s.  It may be happening now.

I don’t think there will be a quick rebound, however, even though the excess supply now present in the world may only amount to 2% – 3% of total demand.  That’s because:

–demand is growing more slowly than experts have been predicting

–hydraulic fracturing is proving less vulnerable to lower prices, as frackers streamline their procedures to lower costs (no one worried about efficiency when oil was $100 a barrel)

–removal of economic sanctions on Iran will give a one-time boost to supply of about 500,000 barrels a day (on world production of roughly 90 million bbl/’day).

my thoughts

If I had to guess, I’d say that fracking has permanently changed the supply/demand situation in oil.  New capacity can be added quickly, in lots of small increments, at around $60 a barrel.  I think this puts a (permanent?) ceiling on the oil price, or at least one that lasts for longer than we as investors need to worry about.

The bottom is harder to figure out.  If we were back in 1980, when world demand was about 60 million barrels a day and almost half came from ultra-low-cost sources in OPEC, revisiting the 1986 lows might be an ugly but realistic option.  However, with production now around 90 million and the Middle East closer to an afterthought than a real price-setting power, enough output is being curtailed at current prices that I think we’re probably in the bottoming process now.

At some point, aggressive investors will sift through left-for-dead small exploration companies to find survivors.  I’m sure industry experts are already doing so.  I’m not an expert any more.  I’m not doing so yet.  My inclination is to look for consumer or tech companies that stand to benefit from the boost to economic activity created by lower oil.

 

more on gold

just to clear the air

I was interviewing a prominent tycoon in Hong Kong  in the mid-1980s when the topic turned to gold.  He told me that he had long since sold all the gold bars he had once used to store his wealth.  He was now holding currency and currency derivatives instead.  I soon found that this was the norm among the rich and powerful in what had once been the center of gold bug-dom.

This was akin to travelling to southern California and seeing budding cultural trends in the US.  That’s when I began to realize that gold that had lost its function universal function as a store of wealth.  Yes, gold retains this function in third world countries like India, where people don’t trust or can’t afford banks, but–in my view–nowhere else.

As fun as it might be to elaborate on this theme, I want to write more about the mechanics/quirks of the gold market–mostly about production–than about popular delusions.

about supply

–Inventories, held either as gold bars or in jewelry, dwarf production.  As decision of holders in the three biggest markets–India, China and central banks– to liquidate can have a significant effect on price.

–Gold mines typically have pockets of ore that are very rich in gold and others that are relatively thin.  Industry practice is to aim for maximum sustainable mine life.  This means mining larger amounts of relatively poor ore are when prices are high and shifting the mix toward richer ore  when prices are low.  One practical consequence of this practice is that actual production cost figures from the past few years of high prices are going to overstate the cost of production in today’s lower price world. Another is that production amounts tend at least initially to expand when prices fall.

–When mines get in financial trouble they begin to “high grade,” meaning they produce exclusively from their richest ore deposits and they cut the amount they usually spend on maintenance and on developing newer areas to mine.  This is ultimately destructive of a mine’s long-term prospects, but it ups near-term cash flow–and it can go on for an extended period.

–When I began studying gold mining companies in the late 1970s – early 1980s, gold miners were very financially conservative because they understood clearly that their industry was subject to violent ups and downs in price.  Their number one rule was to have no debt and a large cash reserve.  That’s no longer the case.  Heavy borrowing urged by CFOs with academic finance training but little industry experience has meant that mines need to generate enough cash to service debt as well as pay operating costs.  This intensifies the need to generate maximum cash flow, even at the expense of diminishing long-term mine viability.

–Bankruptcies may help the orebodies.  But because they remove the burden of debt service, they make the near-term supply situation worse, not better.

my conclusions

The gold price can go lower, and stay depressed for a longer period, that I think most people expect.

oil and gold: finding the commodity cycle bottom

I got my first couple of portfolio manager jobs in the 1980s because one of my industry specializations as  a securities analyst was natural resources.  Back then, there were an enormous number of mining analysts in an information industry based in London.  The large size and vitality of the analyst community were partly because there had been an enormous spike in the prices of gold and oil in the late 1970s-early 1980s. So investors were willing to pay handsomely for information and interpretation.  Also, the prevalent economic theory of the day, since proved to be woefully incorrect, held that a necessary condition for global economic growth was a continuously expanding supply of mineral resources.

When the Chinese economic expansion-driven commodities boom began a decade and a half later, I found that, unsurprisingly after 15 years of no one being interested, the entire stock market information infrastructure for metals had disappeared.  There were still the odd steel or oil analyst around eking out a living and staggering toward retirement, but little else, either in London or New York.

As far as I can see, from an information perspective the situation is at least as bad today.  In the perverse way that Wall Street works, however, that lack itself is the basis of the positive thesis for mining in general.

industry characteristics

Mineral extraction industries are very capital-intensive.  This means that projects typically require large amounts of up-front money. But they can often continue, once up and running, for long periods without new funds being put in.

Mining projects often have very long lives.

Very often, projects are also huge.  This is partly the nature of the beast, partly a function of the temperament of the people who run minerals companies.  This means that new supply is often added in gigantic chunks.  New supply almost invariably arrives in amounts way above the increase in demand and typically, therefore, marks the high water mark in terms of price.  Boom and bust, boom and bust–the rhythm of these markets.

finding the bottom

Falling prices indicates that there’s more supply than demand.  In theory, that situation can be reversed either by demand expanding or by supply contracting.  In practice, the first rarely happens.

What establishes the bottom for these markets, in my experience, is a price decline that’s deep enough to force high-cost capacity to close.  This does not mean the price at which companies stop earning a financial reporting profit.  That price is too high.  That’s because it includes as an expense a non-cash allowance for recovering the money spent to open the project.  A company can also be compelled to sell at unfavorable prices by creditors.

What actually matters is the point at which the out-of-pocket cash cost of getting output out of the ground is less than what it can be sold for.  That’s the point at which projects begin to shut themselves down.  They may not do so immediately.  They may continue to bleed in the hope of an imminent turnaround.

For gold, the relevant figure is around $850 an ounce, I think.  Oil is a bit more complicated, but the magic number is likely about $40 a barrel.

More tomorrow.

 

 

uncorrelated returns: hedge funds as the new gold

Every stock market person knows what beta is.

It comes from a regression analysis, y = α + βx, where y is the return on a stock and x the return on the market).  It shows how a given stock’s past tendency to rise and fall is linked to fluctuations in the market in general.  A stock with a beta of 1.4, for example, has tended to rise and fall in the some direction as the market, but move 40% more in either direction; a stock with a beta of 0.8 has tended to exhibit only 80% of the market’s ups and downs.

The professor in a financial theory course I took in business school asked one day what it meant that gold stocks had, at the time, a beta of zero.

The thoughtless answer is that it means they aren’t risky, or that they don’t go up and down.

A consequence of this thinking is that you can lower the beta, and therefore the risk, of your investment portfolio by mixing in some gold stocks.What’s interesting is that in the early days of beta analysis that’s what some institutional portfolio managers actually did with their clients’ money.

That didn’t work out well at all.

What should have been obvious, but wasn’t, is that the zero beta didn’t mean no risk–or that gold stocks are/were a good investment.  It meant what the regression literally indicates–that none of the movement in gold stocks could be explained by movements in the stock market in general.

The riskiness of gold stocks is there, but it came/comes in other dimensions, like:  how mines develop new supply, the ruminations of the gnomes of Zürich (in today’s world, Mumbai and Shanghai), the potential for emerging country craziness, the propensity of the industry to fraud.

Why write about this now?

I heard a Bloomberg report that institutional investors as a whole are upping their exposure to hedge funds, despite the wretched performance of the asset class.  Their rationale?   …uncorrelated returns.

It sounds sooo familiar.

Admittedly, there may be a deeper game in progress.  It’s impossible to say your plan is fully funded by projecting a gazillion percent return on stocks or bonds.  But who’s to say that a hedge fund can’t do that?

 

 

natural resources and economic growth

I ended up with my first stock market job, more or less by accident–and without any finance experience or training–in the late summer of 1978.  A few months later, the firm’s oil analyst was headhunted away and I took his place.  Within a couple of years (an MBA from NYU at night along the way) I had picked up a bunch of metals mining companies, too, and was in charge of the firm’s natural resources research.

The oil industry was (and still is) really non-intuitive–more about my early adventures tomorrow.  Today I want to write about the mining industry, which is a little more straightforward.

natural resources in the 1970s

I started out by reading the annual reports and 10-Ks of the major base metals mining companies for the prior five or six years.  What stood out clearly was that all the firms held very strongly a series of common beliefs, namely:

1.  that global economic growth would continue to be strong for as far into the future as one could imagine,

2.  that the availability of all sorts of base metals–lead for batteries, copper for wiring and tubing, iron ore for steel, and so on–was a necessary condition for this growth

3.  that, therefore, demand for base metals would grow at least in lockstep with GDP increases.

Implicitly, the companies also assumed that:

4. that oversupply was highly unlikely,

5.  that substitution among raw materials–like aluminum or PVC for copper–wouldn’t be an issue, and

6. that, because of 4. and 5., the selling price of output from future orebody discovery/development would never be a concern.

CEOs’ conviction was buttressed by reams of computer paper containing economists’ regression analyses “proving” that all this stuff was true.

a massive investment cycle…

Naturally, the companies, not risk-shy by nature, went all in across the board on new base metals mine development.

As I was reading these documents in 1979-80, the first (of many) massive new low-cost orebodies were coming into production.  This wave turned out to have been enough to keep most base metals in oversupply–and a lot of mines unprofitable–for the following twenty-five years!!!  Miners were also in the midst of a massive switch to exploring for gold, where high value deposits could be developed quickly and at low-cost–causing, in turn, a twenty year glut of the yellow metal.

…that didn’t work out

The mining CEOs turned out to be wrong in a number of ways:

–like any capital-intensive commodity business where the minimum plant size is huge, industry profits for base metals are determined by long cycles of under-capacity followed by massive investment in new mines that causes long periods of over-capacity

–although it wasn’t apparent in the 1970s, substitution of cheaper materials has been a chronic problem for base metals.  Take copper.  There’s aluminum for heat dissipation and wiring, PVC for plumbing, and glass/airwaves for audiovisual transmission.

–Peter Drucker was writing about knowledge workers as early as 1959.  Nevertheless, the mining companies and their economists weren’t able to imagine a world where GDP growth might not require immense amounts of extra physical materials.

I’ve been looking for a sound byte-y way to put this all into perspective.  The best I can do is a gross oversimplification:

–real GDP in the US has expanded by 245% since 1980.  Oil usage is up by about 10% over that period; steel usage is down slightly.  The supposed dependence of GDP growth on increased use of natural resouces simply isn’t true.

Why am I writing about this today?

…it’s because I continue to read and hear financial “experts” say that weak oil and metals prices imply declining world economic activity.  To me this argument makes no sense.

 

 

 

natural resource production companies: accounting quirks to watch for

mining

Mining is mostly about how a company develops resources that have already been discovered, sometimes very long ago.

1.  Metals orebodies can vary considerably from one part ot the next in the proportion of valuable minerals they hold.  Standard practice is to mine the highest-grade ore when prices are low, and the lowest-grade when prices are high.

Not a lot of operating leverage this way.  But the idea is to enable the mine to stay open even during the inevitable cyclical downturns.  Doing the opposite, which will likely boost the stock price in good times, can lead to disaster during the bad.  There’s no easy way for an outsider to tell, except by the reputation of company management.  In the case of gold, we may find out who’s been prudent and who’s been reckless when the 2013 financials are published.

2.  Same thing with site preparation.  Standard, and prudent, practice is to routinely spend money on things like removing overburden (layers of dirt covering the ore) in places where the company is not mining today, but plans to in the near future.  This activity can be quite expensive.  But it’s necessary.  On the other hand, a firm can make short-term profits look considerably better by not doing so.

oil and gas

Oil and gas is much more involved with finding new deposits, and how to account for those costs, than metals mining.

1.  Companies have two ways to account for the costs of buying mineral rights and doing exploratory drilling.  They are:

–successful efforts, where, as the name suggests, only successful fields are put on the balance sheet and gradually written of as oil and gas is produced.  The costs of unproductive areas are written off as expense as soon as they’re incurred.

–full cost, where all exploration costs, both for productive and non-productive projects, are capitalized and written off against production.

Successful efforts is more conservative, but normally results in lower earnings.

2.  Accumulated costs are written off pro rata as each unit of oil or gas is produced.  The amount expensed against the revenue from each unit is its proportionate share of the total cost of finding and developing all oil and gas (it’s a little more complicated than this, but this is basically what you need to know).  That proportion, in turn, is calculated based on periodic estimates by petroleum geologists’ of the total size of reserves.

Big oil companies use their own geologists; smaller ones hire outside consultants.  The important point is that this estimate–and therefore the amount of cost written off per unit produced–can vary a lot, depending on the particular consultant hired.  It may also depend on the tone, conservative or aggressive, company management sets.

Just as important, as I mentioned yesterday, oil and gas price changes can alter the size of total reserves.  The cost of recovery doesn’t change, but the amounts of hydrocarbons that can be brought to the surface at a profit can be.  Lower selling prices can raise the per unit amount expensed;  higher selling prices can lower the unit amount.  Potentially, lots of operating leverage–that’s completely out of management’s control.

3.  A minor clarification of #2:  subject to some limits, the company decides how to group reserves and associated costs into different “cost pools” for figuring out depreciation and depletion.  Artful grouping of these pools can help disguise an extended run of bad drilling luck.  Not usually a worry, except with small firms with limited history.

4.  As with any other capital construction project, when oil and gas companies explore and develop with borrowed money, they can capitalize (that is, put on the balance sheet rather than expense immediately) the interest expense on that borrowing.  The interest expanse becomes part of the general costs that are written off against oil and gas production.  For smaller companies with an ambitious drilling program, this can sometimes create the peculiar (and potentially disastrous) result that it shows positive earnings while it is suffering cash outflows.  This is because interest is being paid to creditors but these payments basically don’t show up on the income statement.  Check the cash flow statement!!