how low can the crude oil price go?

This is my response to the comment of a regular reader.

There’s no easy answer to this question.  I have few qualms about putting a ceiling on the oil price.  In round terms, I’d say it’s $60 a barrel, since this is most likely the point at which an avalanche of new shale oil production will come on line.  Also, for investing in shale oil companies this number doesn’t matter than much, so long as it’s appreciably above the current price.

A floor is harder.

a first pass through the issue

We can divide the source of oil production into three types.  I’m not going to look up the numbers, but let’s say they’re all roughly equal in size:

–extremely low production cost, less than $5 a barrel, typified by production from places like Saudi Arabia

–very high production cost, like $100+ a barrel, which would be typical of exploration and production efforts of the major international oil companies over the past decade or so, and

–shale-like oil, with production costs of maybe $35 -$40 a barrel.

In practical terms, there’s never going to be an economic reason for the low-cost oil to stop flowing.

Shale oil is basically an engineering and spreadsheet exercise.  The deposits are relatively small and the cost of extraction is almost all variable.  So shale will switch on and off as prices dictate.  We know that at the recent lows of $25 or so, all this production was shut in.

The very high production cost is the most difficult to figure out.  Of, say, $100 in production expense, maybe $70 is the writeoff of exploration efforts + building elaborate hostile-environment production and delivery platforms.  This is money that was spent years ago just to get oil flowing in the first place.  What’s key is that for oil like this is that the out-of-pocket cost of production–money being spent today to get the oil–may be $30 a barrel.  From an economic perspective, the up-front $70 a barrel should play no role in the decision to produce oil or not.  So, dealing purely economically, this oil should continue to flow no matter what.

second pass

First pass says $30 – $35 a barrel is the low;  $60 is the best the price gets.

Many OPEC countries (think:  Saudi Arabia again) have economies that are completely dependent on oil and which are running deep government deficits.  Their primary goal has to be to generate maximum revenue; the number of barrels they produce is secondary.  If so, they will increase production as long as that gives them higher revenue.  Their tendency will be to make a mistake on the side of producing too much, however.  Their activity will make it very hard to get to a $60 price, I think.

On the other hand, shale oil producers who can make a small profit at, say, $35 a barrel may tend to shut in production at $38 – $40, on the idea that if they exercise a little patience they’ll be able to sell at $45, doubling or tripling their per barrel profit.

third pass

Second pass argues for a band between, say, $40 and $55.

Bank creditors don’t care about anything except getting their money back.  They will force debtors–here we’re talking about shale oil companies–to produce flat out, regardless of price, until their loans are repaid.  This was an issue last year, and what I think caused the crude price to break below $30 a barrel.  I don’t think this is an issue today.

There’s a seasonal pattern to oil consumption, driven by the heating season and the driving season in the northern hemisphere.  The driving season runs from April through September, the heating season from September through January.  February-April is the weakest point of the year, the one that typically has the lowest prices.

If the financial press isn’t totally inaccurate, there are a bunch of what appear to be poorly -informed speculators trading crude oil.  Who knows what they’re thinking?

my bottom line

This is still much more of a guessing game than I would prefer.  I see three positives with shale oil companies today, however.  Industry debt seems more under control.  Operating costs are coming down (more on this on Monday).  And seasonality should soon be providing support to prices.




why are higher interest rates good for banks?

There are two factors involved:

behavior of bank managements:  To a considerable degree, commercial banks are able to use changes in interest rates to their money-making advantage.  When rates are declining, banks immediately lower the interest they pay for deposits but they keep the rates they charge to borrowers high for as long as they can.

When rates are rising, as is the case in the current economic environment, banks do the opposite.  To the degree they can, and given that most loans are variable-rate that is considerable, they raise rates to borrowers immediately.  But they keep the interest rate they pay for deposits low for as long as they can.

A generation ago, banks had a much greater ability  than they do now to maneuver the interest rate spread.  That’s because money market funds were in their infancy.  There were no junk bonds to serve as substitutes for commercial loans.  There was even a Federal Reserve rule, Regulation Q, that prevented banks from paying interest on checking accounts and put a (low) cap on what they could pay to holders of savings accounts.

Nevertheless, especially as rates are rising, spreads still can widen a lot.

economic circumstances:   bank lending business tends to tail off in recession, since most companies don’t want to take the risk of increasing their debt burden during bad times–even if the potential rewards seem enticing.  The credit quality of existing loans also worsens as demand for capital and consumer goods flags.

The opposite happens during recovery.  The quality of the loan book improves and customers begin to take on new loans.

stock market effects

The market tends to begin to favor banks as soon as it senses that interest rates are about to rise.  Wall Street was helped along this time around when perma-bear bank analyst Mike Mayo turned positive on the group for the first time in ages last summer.

After the anticipatory move, banks have a second leg up when the extent of their actual earnings gains becomes clear.  It seems to me the first move has already come to an end   …but the second is still ahead of us.

the wobbly crude oil price

Over the past week or so, the world crude oil price has dropped by about 10%–although it is rebounding a bit as I’m writing on Wednesday morning.

I have several thoughts:

–this is the weakest part of the year for crude oil demand, since the winter heating season is over and the spring driving season is yet to begin

–the surprising aspect of recent crude oil prices is not that they are weak, but rather how strong they have been in January and February in the face of a rising rig count in the US and a milder than average winter in heavily populated areas around the world

–hard as this may be to believe, the price drop suggests to me that many traders in the crude oil market are new to the game, and for some reason haven’t filled themselves in beforehand on the basic characteristics of the commodity

–since there’s a direct relationship between the price of oil and the price of oil exploration and development stocks, the current odd price action in the crude market makes evaluating and trading in the equities more difficult

–I’ve built a small position in e&p stocks over the past couple of months, so I’m sitting on my hands.  If I owned nothing, I’d be tempted to buy something–although I’d be more comfortable if crude had been gradually declining in price over the past month, rather than exhibiting the panicky behavior of the past week.  This is also predicated on the idea that what’s driving crude is thoughts #2 & #3.

three steps and a stumble?

That’s the conventional wisdom (read: old wives tale) about Fed rate hikes and the stock market.  The idea is that the market absorbs the first two hikes in any rate rise series as if nothing were going on   …but reacts negatively on the third.

The third in this series of rate hikes will almost certainly come tomorrow.

The problem with this particular old saw is that there’s very little evidence from the past to support it.  Yes, there may be an immediate knee-jerk reaction downward.  But in almost all cases the S&P 500 is higher a year after a third hike than it was on the day of the rate rise.  Sometimes, the S&P has been a lot higher, once in a while a percent or two lower, but there’s no third-hike disaster on record.

Generally speaking, the reason is that rate rises occur as a policy offset to the threat of the runaway inflation that can happen during a too-rapid acceleration in economic growth.  As financial instruments, stocks face downward pressure as higher rates make cash a more attractive investment option.  On the other hand, strong earnings growth exerts contervailing upward pressure on stock prices.  In most cases, the two effects more or less offset one another.  (Bonds are a different story.  With the possible exception of junk bonds, all the pressure is downward.)

Of course, nothing having to do with economics is that simple.  There are always other forces at work.  Usually they don’t matter, however.

In this case, for example:

–I think of a neutral position for the Fed Funds rate as one where holding cash gives protection against inflation and little, if anything, more.  If so, the neutral Fed Funds rate in today’s world should be between 2.5% and 3.0%.  Let’s say 2.75%.  Three-month T-bills yield 0.75% at present.  To get back to neutral, then, we need the Fed Funds rate to be 200 basis points higher than it is now.

I was stunned when an economist explained this to me when I was a starting out portfolio manager.  I simply didn’t believe what she told me, until I went through the past data and verified what she said.  Back then, I was the odd man out.  Given the wholesale layoffs of experienced talent on Wall Street over the past ten years, however, I wonder how many more budding PMs are in the position I was in the mid-1980s.

–the bigger issue, I think, is Washington.  I read the post-election rally as being based on the belief that Mr. Trump has, and will carry out, a mandate to reform corporate taxes and markedly increase infrastructure spending.  The Fed decision to move at faster than a glacial pace in raising interest rates is based to a considerable degree, I think, on the premise that Mr. Trump will get a substantial amount of that done.  If that assumption is incorrect, then future earnings growth will be weaker than the market now imagines and the Fed will revert to its original snail’s pace plan.  That’s probably a negative for stocks …and a positive for bonds.




The kinks of financial journalism

This is the tile of a 2014 paper by Prof. Diego Garcia of the University of North Carolina, in which heanalyzes the relationship between recent behavior of the stock market and subsequent reporting in financial newspapers.

Conventional wisdom holds that reporters’ articles mirror and perhaps intensify the tone of the recent past.  That is to say, they are unduly bearish when the stock market has been making losses, and similarly unduly bullish when it has been making gains.

Prof. Garcia, studying Wall Street as reflected in the Wall Street Journal and the New York Times from 1920 to 2005, draws a different conclusion.  He writes:

“…the asymmetry of journalists’ writing is pervasive: it has barely changed from the 1920s to the 1990s, and virtually all authors exhibit the same pattern, emphasizing negative returns, ignoring large positive market moves.”

Why should financial reporting have a negative bias?

The first thing that comes to my mind is television and radio weather people, who have a strong tendency to predict more precipitation than the US Weather Service, the government body from which they derive their data, says will happen.  How so?  Media weather people know that talking about looming bad weather has more entertainment value than a more benign forecast.  Also, viewers/listeners feel relieved if the forecast is for rain and the day is sunny instead.  They only get angry if the forecast is for fair weather and it ends up pouring.  Therefore, media weather people have every business/career reason to shade their forecasts heavily toward more precipitation rather than less.

John Authers, a reporter from the Financial Times from whom I learned about Prof. Garcia’s paper, gives more or less the same rationale for the similar phenomenon with newspapers.

my thoughts

–if the default position of a newspaper writer is to write a negative story, then we probably get no investment information from it.  On the other hand, if the story is positive, it’s unusual enough that we should look into the company or industry being reported on as a possible investment idea.

–Mr. Authers illustrates the risks to a journalist of making a positive recommendation.   Better, he says, to recommend not buying Amazon and watch it double than to run the risk of a loss.  Suppose the positive recommendation turn out to be Enron?

Of course, anyone in his right mind who read the Enron financials would have stayed as far away from that company as possible (yes, a couple of less-skilled colleagues at my last firm were, incomprehensibly to me, quite eager to buy the stock just before it imploded–and, yes, I did buy a stock certificate before it was delisted at $.80 or so as a souvenir–but that’s another story).  Reporters are trained journalists, however, not securities analysts.  They typically don’t have the economics, accounting or finance background to do analysis (although Mr. Authers does have an MBA from Columbia).  Nor do they have the time.  So the risk they run by saying something positive about a company is enormously high.

–An aside:  oddly enough, one of the first steps in training a growth stock analyst is to question this common sense attitude that avoiding all possibility of loss is the highest virtue.  For growth investors, finding a stock that can triple is.

–this study is only of US newspapers.  In my experience, reporters for the Financial Times are much more highly skilled than their US paper counterparts.



Employment Situation, February 2017

This morning at 8:30 est, the Bureau of Labor Statistics of the Labor Department issued its Employment Situation report for February 2017.

The Bureau estimates the economy added 235,000 new jobs last month.  This is a very strong result.  However,it is most likely influenced by unseasonable warm temperatures in February, which typically allow outdoor construction work to get started earlier than  usual.  So maybe the “real” figure should be 200,000–which would still signal significant economic strength.

Revisions to the prior two months’ data were +9,000 positions.  Most other data–like the labor participation rate, the number of long-term unemployed…–were relatively unchanged.

The unemployment rate fell to 4.7%, a level that twenty years ago would have set off alarm bells warning of incipient wage inflation.  Nevertheless, wages grew at the same steady yearly rate of +2.8% we have been seeing for a while, and are showing none of the acceleration that labor economists fear.

We know from the BLS’s Job Opening and Labor Turnover (JOLT) survey that the number of current job openings is more than 20% higher than at the pre-recession economic peak in 2007.  This makes the lack of wage acceleration look even more peculiar (more about this on Monday).

Nevertheless, the Fed has made it clear that it thinks there’s nothing further that maintaining emergency-room low interest rates can do to stimulate the economy.  That ball in in the court of fiscal policy, the province of Congress and the administration, where it has resided unmoved for several years.

Especially given Mr. Trump’s promises of corporate income tax reform and renewed infrastructure spending, the biggest economic hazards lie in not continuing to normalize interest rates.

So I think we can pencil in three hikes of 25 basis points each in the Fed Funds rate both this year and next.



$4.95 trading commissions: a good deal?

Yes, both for you and me and for Fidelity, which initiated the move down from $7.95.  Fidelity has quickly been followed by other discount brokers.

The reason for the reduction is the increasing popularity of ETFs with individuals who have been traditional buyers of no-load mutual funds–and who, because of this, aren’t used to paying commissions.  (Yes, the functional equivalent of trade commissions end up being deducted from mutual fund results through administrative expense charges, but people generally don’t notice this.)   Apparently, though, $4.95 is an acceptable number.

Fidelity, as a market maker in ETFs, will also earn a bid-asked spread on transactions.   In addition, the reports I’ve read suggest that the sponsor of an ETF can earn as much as 0.5% of assets annually through stock lending.  So forfeiting $3 on each trade won’t dent Fidelity’s bottom line, especially if this stimulates sales of in-house ETFs.

I think the main results of the move will be to lower our costs modestly and to hasten a bit the demise of traditional brokers.