Wednesday, March 30, 2016

Monetary Policy Review

Yesterday at an event hosted by the Economic Club of New York, local economists were fortunate to hear the Federal Reserve Chairwoman Janet Yellen speak about monetary policy. After a dovish conclusion to the March meeting, remarks from Fed members such as Bullard, Lacker, Williams, Lockhart, and Evans confused the markets when they provided a more hawkish outlook. The conflicting comments highlight the ambiguity of the Fed's monetary policy which often proves to be discouraging for investors. Unlike the impressive show of coordination during the financial crisis in 2008, central banks across the globe have settled for a fragmented approach to monetary solutions in the current global slowdown. The ECB continues to expand its quantitative easing, the Bank of Japan experiments with negative interest rates, all while the Federal Reserves tries to find ways to raised the Fed funds rate. Amidst the chaos, Janet Yellen's speech sought to clarify the Fed's unkempt thought processes using her eloquent Fedspeak.

The cautious FOMC once again reiterates that only gradual increases in the Fed funds rate are due this year because of low inflation and high volatility. Yellen repeated a phrase often used by her committee, "expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate," in hopes that the markets will settle. In reality, the Fed's median projected GDP growth this year is 2.2 percent only 0.3 percentage points higher than last year. Prospects for growth don't actually improve either. For the years 2017 and 2018, the median projected change in GDP drops 0.2 percentage points to a measly 2.0 percent. To wait for such a minuscule amount of growth to raise rates is very dovish, and, in my opinion, a very dangerous move.

This low-interest environment that was discussed in Monday's article and now in Yellen's speech suppresses the yield on the bond, encourages debt, and spoils the chance for an American to save. Think about this metaphor. Imagine the economy is on a giant slingshot, and the Fed has the ability to pull back the strap to launch it and relieve the tension. Every meeting that interest rates aren't increased, the slingshot inches back and tension on the strap increases. There will be a point in time where the Fed can't pull back anymore and must let go. The tighter the slingshot, the faster the economy will crash into something and relapse back into the hands of the central bank.


With all the tension, equities have shown incredible growth during the period of low-interest rates as businesses were more than happy to take advantage of cheap capital. But the growth in stocks came at the suffering of U.S. treasury bond yields, one of the safest securities on the globe. Yields initially grew when investors' money exited these safer assets for the equities that were maintaining a recovery, but large-scale quantitative easing headed by the Federal Reserve pushed the yields down even further as the economy started to recover and credit markets stabilized. During 2010 and 2011, the economy appeared to be in a calmer condition with the exception of unemployment still running at about 9%. These years, with equities 40% higher, would have been ideal periods where the Fed could have at least considered gradual rate hikes before treasury bonds became almost useless in 2012 and 2013.

In her speech, Yellen reported the Fed's desire to "respond to the economy's twists and turns so as to promote, as best as we can in an uncertain economic environment, the employment and inflation goals." This statement confuses me. In the past five years, the S&P 500 has been skyrocketing up 50%, 60%, 70, and eventually 80 to 90%, a remarkable recovery from the financial crisis and, by anyone's definition, an economy with little "twists and turns" to navigate, minimal volatility, and healthy inflation. Why weren't rate hikes ever seriously discussed then? Instead, a low-rate environment has turned from being a solution to creating a problem that feels like it should have been preventable.


The chart above shows VIX since the beginning of the zero-bound interest rate period. Clearly, the Federal Reserve had plenty of other stretches with lower volatility where the Fed funds policy could have been changed, especially during a stretch in 2012, 2013, and early 2014. During these years, GDP and inflation were showing modest growth with unemployment dropping every year both trends better than they were now.

Low oil prices, low treasury yield, low inflation, and low output all define the environment in which the Federal Reserve is forced to raise rates, a place no conventional monetary policymaker would want to be. To make matters worse, central bankers are looking at energy prices and low inflation that they have no power over (and, really, never had power over). The weapon they should have to fight the downtrend was drained in 2009, and the economy and its investors are paying the price. Because treasury yields are so low, investors will want to skip out on investing in those bonds because stocks could increase and provide a higher yield in a short time frame. As money flowed out of equities, markets froze and planned to wait out the low oil prices.

And their's the disconnection. The misunderstanding. Every individual who planned on waiting out the oil glut didn't plan on it lasting into 2016. The Federal Reserve might have been in the same boat and their persistent reiteration that inflation "will move up to 2 percent" gives me the impression they were waiting to raise rates when energy prices stabilized. As a result, real interest rates grew because of deflation, as reported by the IMF, and the economy contracted further.

What are the ways forward? Even though the Federal Reserve missed  periods more appropriate for gradual rate hikes, the Governors should restart the campaign for higher interest rates in April. The oil price misunderstanding due to illicit expectations can only be ameliorated by a stabilization in prices, and investors confronting low oil prices for longer head on. In addition, central banks across the globe should begin to support treasury yields and softly encourage saving which will improve financial confidence and lead to a recovery in personal consumption. These adjustments will also be accompanied by a shift in expectations that will prepare investors for the new environment they will be trading in. Yellen's comment that "the return to 2 percent inflation could take longer than expected and might require a more accommodative stance of monetary policy than would otherwise be appropriate" is an ideal start to the acknowledgment that the Fed screwed up and the recognition that a different kind of solution is necessary for this situation.

Sources: Yellen Speech, Fed Projections

Monday, March 28, 2016

Oil Prices and Real Interest Rates: An IMF Paper

One of the great economic conundrums of today that continues to stump economists across the globe is the failure of low oil prices to spark a consumption-based boom. Lower prices are supposed to stimulate more demand from the average consumer and lift economies with a boost in sales. Across almost all sectors, firms see their input costs decreasing, especially the transportation and industrial sectors. Consequently, the availability of extra capital allows business and residential investment to increase and offset the losses in the energy industry. Finally, the total gross domestic product rises. This theoretical flow-chart can be followed by most college economic students and has much power for policymakers across the globe.

The question still stands, though, why hasn't the low price of oil supported growth? Average quarterly global GDP growth slowed to 1.98% in 2015, down from 2.50% in 2014 and 2.46% in 2013. The average yearly price of crude oil in both of those years was significantly lower compared to 2015. A glut slashed the WTI spot price by about half from $97.98 and $93.17 in 2013 and 2014 to $48.66 just last year. The data refutes the economic framework first discussed while introducing a fresh inquiry into the dynamics of energy prices and growth. Almost eight months after a staff discussion at the International Monetary Fund forecasted growth in GDP because of the low oil price, their economists have written a paper as to why they were wrong. The aptly named article, "Oil Prices and the Global Economy: It's Complicated," appears to be the answer that economists were looking for with an explanation not easily scripted in a fancy headline as most would hope it to be.

Click here to access the IMF article.

The paper starts out introducing the glut, something that the articles on this blog do often. WTI and Brent price trends including how far they have dropped from June 2014 are cited, but the IMF paper mentions a currency-adjusted price decline. Because of the "20 percent dollar appreciation," the real price change lingers around $60, still a significant sum. Nevertheless, there still remains an interesting currency dynamic that should be analyzed. The price weakness coupled with the dollar appreciation has resulted in emerging, oil exporting markets to be hurt more than usual. From their perspective, their revenue has been discounted while the real value of their debt increased.


The stronger dollar could also be blamed for intensifying the bearish trend of oil prices. As foreign currencies were being devalued, they could afford less and less oil because most of the commodity were being sold on markets with a dollar-denominated price. Nevertheless, the economic downturn cannot be blamed solely on the appreciation of the dollar. The trend only exacerbated the effects of the glut on the price of oil and deflation.

The authors at the IMF continue to reinforce their belief that low oil prices should be a "net plus" for the world's economy because "consumers in oil-importing regions such as Europe have a higher marginal propensity to consume out of income than those in exporters such as Saudi Arabia." This point makes sense, especially in a low-interest-rate environment. The average citizen of a Western country like the United States or a euro nation has an incentive to spend now because they will not earn as much interest on their savings. The only problem with this statement is that it fails to consider the United States as any less of an oil importer despite its new status as the third largest world producer. The low oil price destroyed the stock price of many energy companies who had recently gone shopping for cheap loans. The junk bond market, composed of this debt, saw a decline as a result. The IMF economists, perhaps, underestimate the effect that a faltering energy sector had on the U.S. and the global economy. Cuts of billions of dollars in the United States were part of a 22% drop in global oil and gas investments in 2015. Rystad Energy also predicts another 12% drop in 2016.

Their first chart describes the bearish relationship quite well and corroborates the argument that business investment had a significant effect on the economy. The blue line shows the correlation between the WTI spot price and U.S. equities.

Oil.chart1

The article doesn't stop to blame a drop in business investment and continues its discussion with interest rates. Compared to past periods of supply shocks, this glut that began in 2014 was unique because of the low-interest rate environment in which it formed. The next few paragraphs discuss the trend in demand for oil exporters and oil importers. Nothing seems out of the ordinary as oil exporters are forced to cut investment spending with rising risk. Oil importers are set to wait for an increase in consumption and, consequently, a jump in demand to remedy the low oil price. But that jumpstart never came, and oil firms are looking at less demand and more supply for awhile. Here's why.

The problem is that "falling oil prices, this time, coincide with a period of slow economic growth—so slow that the major central banks have little or no capacity to lower their monetary policy interest rates further to support growth and combat deflationary pressures." As my macroeconomics professor says, "The Fed doesn't have enough water in their squirt gun."  These explanations adequately sum up the disparaging situation global macroeconomic leaders find themselves in, but a deeper analysis is more beneficial

The authors mention Michael Bruno and Jeffrey Sachs who showed that oil supply shocks cause stagflation when prices go up. Conversely, the IMF economists say that lower prices should do the opposite "lower production costs, more hiring, and reduced inflation." So what did the central banks do wrong this time?  The deflationary pressure that is caused by shrinking oil prices indirectly raises real interest rates. This follows from the formula for real interest rates which is calculated by subtracting inflation from the nominal interest rates (interest rates set by central banks). In short, deflation can act as a rise in interest rates if the central banks do not adjust nominal interest rates down as well. This time around, they cannot because rates are already at zero (or sub-zero if you're Japan). Higher interest rates, as a result, have a pro-cyclical effect on the global economy where "compressed demand" and "stifled output and employment" are the result. The observation is not too complicated but operates on a rule found deep in a macroeconomics textbook.

And that's really the gist of it. The drop in oil prices has had a pro-cyclical macroeconomic effect as a result of an inability to reduce interest rates. The IMF authors conclude saying that "the current episode of historically low oil prices could ignite a variety of dislocations including corporate and sovereign defaults." The dangers are real and could change the landscape of the energy market. Higher real interest rates explain the failure of the junk bond market, and why investors sold off debt in 2015. Companies that need new funding will now have to deal with higher risk premiums, including Exxon-Mobil which has recently seen its AAA rating in danger. The solution seems dim. Because interest rates are so low, central banks have no choice but to let the cycle continue without cushioning it. Then, interest rates will go up rapidly. The Fed clearly acknowledges this real interest rate increase as the problem and continues on its path of waiting.

My brief analysis of this IMF paper is just the tip of the iceberg. I encourage all my readers to read the primary source and continue researching the ideas from the paper. The research is excellent and, for the most part, eye-opening. An understanding of the underlying macroeconomic trends in this interesting economic environment can only help an investor in the long run.




Friday, March 25, 2016

Fundamental Friday: 25 March 2016

Crude oil: Production of crude oil dropped by 30,000 b/d this week accelerating a trend that appeared to have flattened in the past month. The decrease in output is accompanied by a drop in refinery inputs by about 180,000 b/d. The current pattern reflects a peak of refinery inputs, which almost reached 16 million b/d, quickly giving way to the maintenance season. The drop in production is most likely oil firms' response to less demand for their immediate, extracted crude. Look for inputs to fall more as refineries close and weekly production to continue to respond in tandem.

Stocks of crude oil grew by about 9.4 million barrels from last week. The gains were sharper this week because of the reduction in inputs forcing more crude oil into storage. The trend continues to be bearish on price, but the retraction of the export ban could release some of the pressure on growing stocks. In an Energy Information Agency report, U.S. petroleum exports increased by 467,000 b/d over the 2015 year. If this trend holds for the 2016 year, U.S. producers could find supply problems soften as their oil finds more foreign customers. Finished products accounted for most of the growth in exports, but a lifted ban will allow crude oil exports to significantly contribute to the increases in foreign shipments.

After prices peaked at about $41 last week, trading brought the WTI spot price lower to $39.46 by the end of this week. For Brent crude, spot price trading stopped at $41.05




Natural gas: Unlike crude oil, production of natural gas appeared to increase with total operating rigs jumping to 92 this week. With these extra rigs coming online, natural gas rigs now account for 19.8% of total active rigs. Stocks grew in tandem with the rig trend. The EIA estimated that 15 bcf of gas was added to underground storage last week.That gain puts stocks 68.9% higher than last year and 51.4% higher than the five-year average.

Overall, the EIA surmises that daily weekly supply in North America increased by 1.35% from last week. In the same report, an estimation of last week's demand growth came in at 8.7%. Most likely, this trend is being encouraged by the new popularity of natural gas for electricity generation. The leading energy agency in the U.S. expects gas to become the dominant input for generating power. An exact forecast has natural gas accounting for 33.3% of 2016 electricity, topping, for the first time, coal which will account for 32.0%. Because of these expectations, demand for natural gas should steadily rise. Producers should build and maintain stockpiles above the 5-year trend as the price starts to stabilize and slowly rise.

Henry Hub contracts opened above $2.00 at the beginning of this week. Five straight losing trading sessions dropped the spot price $0.13 to $1.882 by the end of the week. Supply and weather trends still weigh on sentiment.


Gasoline: Stocks of finished motor gasoline fell by over 600,000 barrels this past week reflecting the drop in outputs that comes with the maintenance season. Component fuels doubled the losses of last week with a 4 million barrel decrease this week. Both stockpiles continue to drift well above historical averages due to the impending glut. Finished gas production dropped by about 400,000 b/d after growing by the same magnitude the week before. Product supply, a crude estimation of consumption, remains stable with a small gain of about 140,000 b/d. Demand still seems quite robust with the product supplied 3.74% higher than a year before.

Regular and diesel gasoline prices finally reach $2.00 a gallon this year. The growth in price is mostly supported by the average price in PADD 5 (West Coast) reaching $2.480 a gallon. The overall U.S. reached $2.007 a gallon, still down $0.45 from a year ago. Diesel prices only grew $0.02, or half of what regular prices did. The spread between regular and diesel prices continues to shrink amidst supply concerns.




Wednesday, March 23, 2016

Terrorist Attacks and the Stock Market

Just months after tragic events in Paris, the city of Brussels is attacked by Islamic State-inspired terrorists. On Tuesday, two bombs blasted the a Belgian airport and later a train in the capital's metro station. Authorities across Europe remain on high alert as they continue to search for one of the three attackers on the run. The death toll has reached 31 with 270 wounded in the explosions. The attacks raise questions about the ability of counter-terrorism agencies in Europe as well as adding more tension in the debate over Syrian refugees. The Islamic State claimed these assailants as their own soon after, heightening the urgency surrounding the war against ISIS.

This terrorist attack comes only four and a half months after a massacre in the capital of France. A death toll of about 130 with hundreds more injured was the first sign of danger from ISIS after the Charlie Hebdo attacks. The response from the authorities and the population were aimed at ensuring the safety and moral of the nation despite the lingering danger. The three teams of terrorists in Paris were also claimed by the Islamic State soon after the attacks on November the 13th.

The brutality of both of these attacks is used as a long-term psychological weapon which attacks the safety and security of everyday life by instilling fear and uncertainty. The attackers are not aiming to kill as many people as they can. Instead, they plan explosions in open, public places so that that country's population will feel unprotected and terrorized. If the Islamic State can scare innocent civilians without relentlessly attacking them, they have augmented their effect and taken a step towards achieving their goal of intimidation.

The economic condition of a country is no less a target. In fact, if a terrorist can crimp the financial well-being of a nation, it can add uncertainty and instability to a social and political setting. One of the best barometers of psychological effect during a terrorist attack is the movement of the stock market during the event. Because large amounts of emotion accompany a tragedy such as what occurred in Paris and Brussels, one can observe the spillover effect where individuals let significant amounts of emotion affect decisions or thoughts that may not be related to the initial feeling. In addition to a flood of emotions, an unexpected crisis can increase the perceived uncertainty of an investment. The fresh memory of a terrorist event can cause cautious behavior and a reevaluation of risks that might not have ever occurred. In the United States, there was a large political backlash against Syrian refugees after the Paris attacks in response to an evaluation of the risks and uncertainty of allowing these immigrants into the country.

To assess the effect of terrorist attacks on the financial setting of a country, the local (where the attack took place) stock market and the global markets will be analyzed. A comparison of the trend immediately before the attack will allow the effect of the tragedy to be singled out. The analysis will look at three periods over the past 28 years. The events selected are all located in either Europe or the United States because attacks in these locations have a larger emotional effect than the countless that occur in nations deemed "high-risk," for that reason, are more expected and have a smaller emotional effect.


The Pan Am 103 crash in 1988 is the first event to be analyzed. About 240 passengers died as the plane crashed near London, England after an explosion downed the plane. Because most of the casualties were American, the S&P 500 will be used to assess losses. On the day of the event, the major index stayed mostly flat with no deviation from the trend that had developed over the past month. Investor sentiment around airline stocks was the most affected that day with two major equities associated with the airline industry falling on December 21st, 1988. The Boeing drop appears to match the trend that had been developing, but the losses established a new bottom for the two months shown and could represent some emotional trading from the attack. Similarly, Southwest Airlines saw a brief drop in their stock that day, interrupting a clear bullish trend that was developing.


Next is the Oklahoma City bombing in 1995 which targeted a federal building in the United States.The bomber acted alone and was quickly executed for the terrorist attack. The effect on equities was not very strong as the attacker's intentions were most likely not to intimidate and terrorize. Even so, on the day of the bombing, the S&P 500 traded lower all day with an intraday low significantly lower than the settlement price. This could represent an emotional spike but may actually reflect the pattern created by the losses earlier in the week. Similarly, the next week's sentiment recovered to resume the bullish uptrend.


Although the bombings of U.S.embassies in 1998 were events that occurred outside of the country, the financial implications were real at home. Over 200 people were killed in two different African nations due to simultaneous car bombs on August 7th. On that day, stocks fell from a two-day gain earlier that week. Once again, the intraday trend shows a large gap between the low and the high which hints at heightened volatility due to the terrorist attacks. It's unclear, though, whether the losses were due to a trend of volatility that already existed before the bombings. The MSCI Emerging Markets Index (black line) also fails to present any interesting deviations. It is possible that leftover emotions from the event caused the market to fall under uncertainty in the next month. Nevertheless, it appears that the location of the bombing diluted the psychological effect it had on those it targeted.


There is no stronger evidence of the psychological power of terrorist attacks on financial systems than the attacks on the World Trade Center on September 11th, 2001. By taking control of three planes, al-Qaeda operatives were able to destroy the two largest buildings in New York City and kill over 3000 people in the process. It was a truly tragic day for the nation, and the markets weren't even open to show it. Due to panic and the potential for an enormous sell-off, the New York Stock Exchange closed on the 11th and didn't reopen until the 17th of September. Then, the sell-off began. Over the next five sessions, uncertainty and negative emotion extended a bearish trend that had begun in August. The NYSE Arca Airline Index fared worse losing almost half of its price in the same period. Despite the fact that increased security and counter-terrorism tactics would be installed immediately, a bearish trend in airline stocks set in with the attacks fresh on investors mind. The S&P 500, on the other hand, makes a moderate recovery showing the resilience of equities outside of the airline industry.


These next two attacks occurred within a year and a half of each other over the years 2004 and 2005. On March 11th, 2014, multiple train bombings in Madrid killed dozens of innocent civilians and dealt a major blow to the transportation infrastructure. On July 7th, bombings interrupted Long transportation systems with explosions on the metro and a double decker bus. Both attacks elicited bearish trading that seemed to deviate from the local trend. The Madrid attacks caused a more sustained loss that eventually turned to a bullish trend by the end of the year. The effects of the London attacks were very brief but strong. The spike downwards looks out of place in the uptrend that had developed over the past two months. However, the MSCI Transportation Europe Index did not deviate from the major market indexes. The psychological effect of both events was broad-based, quick, and temporary.



The next five terrorist attacks come in a span of a year and a half again with two in the United States and three in Europe. All but one were a result of Islamic State fueled rhetoric and ideas. The first attack in Paris had little effect on the stock market in Europe or the United States. The Charlie Hebdo bombing was more centered around a political argument and appeared to have a specific target. For this reason, the economic effects seem to be negligible, although, uncertainty would start building. The next three attacks occurred in less than a month with casualties in both the United States and Europe. The Paris attacks alone lead to a significant loss from the S&P 500 and the STOXX 600. Both recovered until two more shootings in the United States caused a tense market to plunge downward. On the day of the San Bernardino attacks, equities sold off and began a bearish trend that led into the new year. There's no denying that the weak global economic condition  was the main cause of the plunge moving into 2016, but security concerns that smelled of fresh terrorist attacks the month before only added uncertainty and negative sentiment on an already weak market. The Belgium attacks come when markets are starting to make a comeback, distancing themselves from a troubling 2015. The bombings this year will only remind investors of the risks that still exist even if equities in Europe and the United States stayed afloat.

The analysis in this article is just a start of a larger investigation that could be done concerning the effects of terrorist attacks on the stock market. In conclusion, most equities are hurt, even if only slightly, by the negative emotion that comes from an attack. Depending on the trend that had developed, a brief loss could be reversed the next day or send push a bearish build-up through the floor. There was a clear correlation between terrorist attacks using planes and the performance of airline stocks that day. While that supports evidence that sell-offs occur in the industry most affected, the performance of transportation indexes during the Madrid and London bombings says otherwise. If there's one thing to take from this short little study as an investor it is that uncertainty and emotion already existing in a financial system can lead to sudden sell-offs if exasperated by an unexpected brutal event like a terrorist attack.

Monday, March 21, 2016

Book Value Analysis of the Energy Sector

One of the most popular, timeless types of security examination is the cut-and-dry view provided by fundamental analysis. Investors who subscribe to this school of thought find buy and signals in the data of the financial statements. This form of investing, often called value investing, looks to find the best bargain on the market. Because quarterly statements only come out every three months, most trades made using fundamental analysis are long positions in the long-term. But these decisions aren't impulsive or speculative, instead, loads of data and valuation techniques can be packed behind a buy or sell signal. For this reason, it is extremely helpful to visit this perspective even if it's not an investor's specialty.

Today, we're going to be value investors and analyze energy stocks using one of the most popular tools of fundamental analysis. The book value alone represents what a potential shareholder is buying into. To calculate it, look at any balance sheet and take total liabilities from total assets. Most of the time, a company's financials will have a cell that lists the total equity or total shareholders' equity which is just another name for the book value. This number, the total equity or book value, represents the amount of money left over if a business is liquidated. Businessmen in the early to mid-20th century used this amount to measure how much they could earn if a company was taken over or taken apart for its assets. This valuation technique became slightly antiquated as traders started to focus on analyzing earnings potential for quick growth and increasing dividends.

But this isn't a throwback article, book value valuation can still be pertinent today in an analysis of the balance sheet of a company. The book value per share figure allows investors to get a general idea of how much a company's individual share is worth by dividing the stakeholders' equity over the outstanding shares. Growth (or loss) of this value over time shows how successful a business is in optimizing the use of their assets and minimizing the liabilities that take away from total equity. If book value increases, the core valuation of the company is increasing from an objective point-of-view.

An even more powerful number incorporates the objectivity of book value with the subjectivity of the group trading the market price. The market-price-to-book-value ratio compares the current share price on the market with what the financials of the company suggest a share should be worth. The ratio can also be shortened to price-to-book ratio and is used by most, if not all, fundamental value investors. There are three things to look for when calculating price-to-book ratio:

  • Price-to-book ratio is equal to 1.When this is the case, the market considers a company to be worth exactly what its financials suggests. While this will almost never happen, anything near 1 represents the idea that a company's asset is worth the dollar amount that its given. No additional earnings potential value is assigned to the firm.
  • Price-to-book ratio is less than 1. With this result, investors are told that the market values the company's assets at less than what they are worth. Typically, a value of less than 1 communicates the expectation that the company will run a loss in the future, and shareholders' equity will be taken away. This case can also accompany a buy signal if the analyst thinks that the firm is undervalued and will grow in the future.
  • Price-to-book ratio is greater than 1. Whenever a share is trading above its book value, the market is assigning extra value to a firm's asset to account for the earnings potential of the assets. There is no limit to how high a price-to-book ratio can be. A company with impressive growth potential, like Apple or Google, will typically trade at a price way beyond their book value.  At the same time, this case can generate a sell signal if an analyst believes that a market price overvalues a share.
As the stock market grew to include millions more investors and thousands more businesses, price-to-book ratios became chaotic with a high variability making large-scale comparisons relatively difficult. Now, the valuation technique is most useful when comparing individual companies within an industry. Today, a price-to-book analysis of the S&P Energy Sector will be used to show the performance of oil and gas companies over the past year. With this data, investors can see which stocks are overvalued and undervalued as well as which oil and gas firms have actually benefited their shareholders amidst the low price environment caused by the glut. 


The preliminary findings aren't exactly surprising. Of the 39 companies that were analyzed, only nine showed book value growth over the year 2015. On average, S&P oil and gas companies were worth $38.63 a share at the beginning of 2015. By the end of the year, the book values had dropped to $31.10 per share on average. That represents a change of -19.48% of shareholders' equity in the 39 firms. Investors punished this loss of fundamental value with a harsher drop in the market price. Only six companies had market share prices that were higher by the end of 2015, five of which increased their book value. On average, the market valued S&P oil and gas shares at $60.78 a share, and by the end of 2015, the same market valued them at $46.34 a share, a loss of -23.76% over the year. Already, one can see the disparity between the objective book price and contrived market price even though the difference is only about 4%. In fact on average, investors devalued these stocks at just about the same rate by which the shareholders' equity was falling. Finally, a total of eleven companies saw their price-to-book ratio rise by the end of year. The average for the 39 oil and gas companies was 1.86 and decreased to 1.74, a seemingly inconsequential change. The year change was -6.72%, which shows how investors devalued market price in tandem with book value losses.


The overall trend is only moderately interesting with losses in assets as the clear culprit of the drop in book values across the industry. Because companies are required to evaluate their assets using the current commodity spot price, the book value of these assets fell relative to what they had been valued at. On top of that, firms in need of cash to pay off short-term liabilities might liquidate assets at prices below their worth which would show up as a loss in book value. Similarly, low oil prices deflated expectations for higher earnings and caused investors to discount the shareholders' equity by over 20% on the open market. But overall, an optimistic outlook about the price of oil can be seen in the movement of the price-to-book ratio over the year. The ratio never dropped below one or came close to it. On average, traders valued the assets of oil and gas companies at 1.74x their value which seems pretty reasonable given the +50% loss in WTI contract price.

An interesting observation in the data for price-to-book ratios explains why the mergers and acquisitions scene in the oil and gas industry never erupted in 2015. Large companies shopping for cheap assets were never able to find a deal on the market because, on average, they would have been paying an extra 74-86% for any of those assets. Acquisitions don't totally make sense until a firm's price-to-book ratio drops to one or less. If that does happen, it can be bought up and liquidated for extra cash by a large firm. That result, of course, considers just averages, so individually, some companies may be undervalued and targets for a takeover.

To end, a list of interesting data points will be noted below along with what the values suggest. None of the following comments are endorsements for buy or sell signals as more research behind the data would be necessary.

  • With a 620.2% increase in its price-to-book ratio, Apache (APA) saw their book value fall by over -90%. The upside for shareholders' in this company is very limited as the market price seems overvalued. Apache will be looking to increase assets or decrease liabilities this year as a price-to-book ratio of 6.55 does not accurately represent their earnings potential. A suggestive sell for sure.
  • Cameron International (CAM) was one of four firms to increase their book value, market price, and price-to-book ratio. Shareholders' equity has only grown 2%, but its market value grew by 24%. Investors definitely have a favorable opinion of this stock and a 2.65 multiple may be a fair evaluation of its earnings potential. Look for its first quarter report for more analysis of its earnings potential. Not necessarily a suggestive buy now but could be.
  • Chesapeake (CHK) is an interesting mid-cap equity with debt problems. Its price-to-book ratio was below one for a part of 2015, but its market value tanked and stabilized it at 1.40x. Watch this company's first quarter report. It may prove to be undervalued and a good suggestive buy in a favorable price scenario.
  • CONSOL Energy (CNX) which specializes in coal and consumable fuels is very undervalued with a price-to-book ratio of 0.38. This equity is definitely a suggestive sell, though, as coal assets are beginning to lose their earnings potential.
  • After a price-to-book change of -64.1%, Kinder Morgan (KMI) is trading at a multiple below 1. Meanwhile, its shareholders' equity changed by only -1.8%. The earnings potential of this stock may be understated. The low market price translates to a suggestive buy signal.
  • Newfield Exploration (NFX) is in a situation similar to Apache. Major book value losses have led to a price-to-book multiple jump of 302.7%. This equity is very overvalued and a suggestive sell.
  • Tesoro Petroleum (TSO) and Valero Energy (VLO) are both firms who saw increases in all three categories. Shareholders' equity grew modestly with heavier gains on the market. The price-to-book multiples, both and around one and a half, represent favorable earnings potentials in an upside with the possibility of large jumps in market price. Not a suggestive buy yet, but a suggestive hold for sure.

Friday, March 18, 2016

Fundamental Friday: 18 March 2016

Crude oil: For the week ending March 11th, U.S. production shrunk by 10,000 b/d week over week. After a slight gain the week before, a 0.1% change showed the continuing pressure of low oil prices on domestic producers. Over the past month, production power of 67,000 b/d has gone dormant reflecting the current trend of supply tightening. Daily output level now sits at 9,068,000 b/d. The last time wells were pumping this much, the weekly WTI spot price had fallen to $78.42 for the week ending November 7th, 2014.  Keep an eye out for the 9 million b/d mark which might be identified as a signal of building momentum.

Stocks of crude oil in the United States grew by about 1.3 million barrels last week with companies still looking to store crude while waiting for higher prices. A jump of 1.6%, or about 20 million barrels, for the past month shows the constant pressure on storage and refinery capacity. With every weekly increase, total stocks of crude oil (excluding SPR) sets a new all-time record, weighing heavily on WTI prices. The newest weekly estimate, an all-time record, currently sits at 2.042 billion barrels.

Production drops currently support the positive trend in WTI spot price this week (gains of 3.50%), but crude oil stock date keeps downside risk around. Today, contracts traded as high as $41 then settled at $39.35.



Natural gas: Baker Hughes reported that the amount of rigs producing natural gas dropped by 5 to 89. from last week in the United States. In Canada, natural gas rigs fell by 13 to 57 total. That count is 48% lower than the 110 rigs that were running a year ago. Despite both countries showing a decrease in rig utilization, production has remained stable "indicating that drilling has become more effective," per the Energy Information Agency. They reported a 5.4% growth in production last year and projected a flatter 0.9% this year. The oil and gas split in the rig count in North America widened to 81.3% crude oil and 18.7% natural gas. Next week will mark two months since natural gas rigs accounted for 20% of the total. Diversified energy companies appear to be leaning towards a bet on a crude oil rebound.

Like crude oil, stocks of natural gas continue to rise at frustrating rates. For the week of March 11th, gas underground storage in the United States decreases by just 1 billion cubic feet to 2,478 billion cubic feet. This year's withdrawals are significantly less than the 81 billion cubic feet used last year. Total storage across the country remains saturated with a 67.4% increase since March 11th, 2015. The oversupply is mostly blamed on an HDD deviation of -31.2% from the normal U.S. winter. 

Lower consumption and a warmer winter have kept natural gas spot prices low through the winter, but a recent recovery has lifted it to $1.893, a 5-day jump of 4.76%.



Gasoline: Stocks of the blending components in motor gasoline fell by just over 2 million barrels in the past week with the RBOB blend stock dropping 309 thousand barrels alone. Finished motor gasoline grew by almost 1.3 million barrels in the same period. As energy companies enter the refinery maintenance season, the proportion of component gasoline stocks to finished gasoline stocks will get higher. This will magnify the already oversupplied markets where component stocks in the second week of March 2016 are 8% higher than the same time 2015 and 21% higher than 2014. Similarly, an already reduced finished gasoline stock that is 7% less than the 2015 total and 29% less than the 2014 total will face more downward pressure.

Regular gasoline prices across the country have increased slightly in response to the seasonality trend. Week over week, the average U.S. price per gallon grew 6.5% to $1.961. Diesel prices grew as well but at a slower 3.9% to $2.099 a gallon. RBOB contracts fell -0.8% to $1.43 this week, but the one month trend remains at a bullish 18.7% following its complementary, crude oil.


  • Supply, gas price, and production data from EIA
  • Rig count data from Baker Hughes
  • Spot price data from WSJ

Wednesday, March 16, 2016

Why Shale Producers Will Never Stop Pumping

This week in crude oil, prices sit in the high $30's after three straight losing sessions are erased by a 6.14% gain in WTI price today. While the worst appears to be over, analysts still assert that an excess of supply will dominate growth in demand. Those from Citigroup blame institutional investing and bets on short-term trends for the rebound that has occurred over the past month. Data from the large investment bank shows a record number of bullish bets that hedge and pensions funds have placed on a rebounding Brent. The current market "equilibrium" feels wedged between the unrelenting force of a saturated market and strong, short-term volume behind WTI and Brent gains.

Scheduled maintenance that is expected to start soon will limit the demand for crude in upstream operations. Despite the fact that this shutdown period occurs every year, this year the seasonality trend could disrupt a critical point on the timeline of the glut. The Energy Information Administration actually reported that stockpiles grew by about 3.3 million barrels last week, a clear indicator that downside risks still remain. The market finds itself, once again, chasing its own tail after it briefly thinking it had caught it.

Volatility in the WTI price trend


As troubling as the volatility is, investors have been coping with the fluctuations by shorting after a rally, a strategy proven to be very profitable. The table above describes the kind of false hope that technically driven gains elicits from the markets. Measuring from weekly tops and bottoms over the past year and a half, one can extrapolate rebounds and retreats that represent erratic the sentiment changes exhibited by traders. Right around this time of last year, a bullish rally briefly encapsulated the market with gains of 12.9% in over two weeks, but news that production wasn't being crimped caused extremely bearish consequences. A similar resurgence occurred in late-August with hopes of ending the year at about $60 a barrel fresh on the lips of mavens everywhere. Those projections were quickly proven wrong as the second week of the new year showed prices in the $20's including a record low of 12 years.

Because of all the extreme fluctuations, oil and gas companies can't efficiently hedge against prices in the future. The exchange for commodity contracts was not meant for speculative trading. Vendors of raw materials and large-scale businesses formed the market with the goal of uniting the needs of both sides of the supply chain. Speculation in the commodities market is an enemy of businesses who hope to secure the best prices for their assets or find a bargain for materials needed as inputs. Trends that promote uncertainty, like the one described in the chart above, results in cloudy long-term market expectations making hedge trading less effective. If firms can't extrapolate a reasonably clear trend, they'll look to sell (or buy) the most recent, secure contract, the spot price. That's what we're seeing in the crude market now.

In 2015, the volatility wasn't as harmful because shale producers were cutting shale expense and increasing revenue without having to hedge for the future. For that reason, output stayed high, a trend that was underestimated from the start because analysts just assumed turning wells off was the only way to save money. In 2016, shale producers find that costs can only get cut so much; the exhaustion of technological advancement finally slowed the trimming of excess expenditures. Last Friday, the International Energy Agency forecasted a decline of 530,000 barrels a day in the U.S. for 2016. This data was part of the month-long rebound of over 20% beginning in the middle of January.  Production is just now being forced downward meaning firms will have to be successful on the commodities exchange if they want to get top dollar for their oil.

So then what's next? In the first week of March, prices appeared to have peaked again preparing for another retreat if it were to follow the recent historical pattern. A Wall Street Journal agrees that there is immediate downside risk because of the slightly higher prices. The article says that "higher prices will likely encourage shale producers to ramp up output again." Why will they go back to pumping? It surely beats the alternative of shopping in the volatile WTI  supermarket. Think about it this way. If the price of milk at Wal-Mart changed 10% every month with an accumulated change of 70% over the course of a year and a half, would anyone shop there? Probably not. The best price on the market continues to be the spot price with such diverse expectations for the future.


Included in these expectations for the future is the rise of demand for alternate energy sources like solar and wind power. An index following global representatives of that industry beat the oil exploration and production industry by over 40% against the S&P 500. The Paris agreement, signed and endorsed by President Obama, is just the first signal of waning desire to expand oil and gas capabilities in the United States. Current energy companies must discount this loss of market share when making projections over the next 10 years. Fossil fuel-based companies are beginning to realize that the end of the supply glut may be the beginning of the clean energy era. In fact, low prices now may be the only thing increasing demand for oil and gas, and thus, firms in that industry should be working to keep their products competitive. Pumping oil is not just a something that producers should do, it is a must. Analysts should stop imagining WTI and Brent prices over $60. That era ended with the fragmentation of OPEC.

Investors should stop lamenting over the death of the oil cash cows, and, instead, appreciate the price trend as their only way to survive. Relentless pumping leads to cheaper inputs for business and lower gas prices for consumers. Both support business investment and personal consumption thickening the economy in the long run. It resolves the problem of opaque expectations as a true market price emerges with no cartel looming over market participants. In order to stay competitive, unproductive wells would be ignored which leads to a slimmer, more versatile industry. Freezing output is no longer an option in this newfound free market. Pumping oil and doing it now is a requirement, and investors should expect that trend to emerge in shale producers, the most efficient drillers in the industry.

Sources: WSJ (1), WSJ (2)

Monday, March 14, 2016

Emerging Markets Are The Key

Most investors and financial analysts keep their eyes locked on the U.S. and European markets in order to take the pulse of the global economy. Shares on the New York Stock Exchange and the London Stock Exchange are among the most traded in the world, drawing money from every continent in just about every currency. The DJIA, S&P 500, and the FTSE 100 are the most popular indices in the world, representing constituents that make up trillions of the globe's wealth. But what if I told you that something's driving them? That developed economies are being driven instead of driving?

By 2030, ExcelFunds reports that emerging markets equities are expected to represent 55% of the global market capitalization by 2030. China's will, by itself, account for 28%. There is no questioning the power of developing economies. Their businesses and governments become power hungry vacuums demanding infrastructure, cheap services, construction, and just about every kind of raw material out there. If the particular country is not consuming, its revenues often become linked to the mass amounts of raw materials it produces, creating resource economies that grow robustly. In the same report, emerging economies' stock market performance beat the developed world by a whopping 5.5% over the past 15 years. The ravenous appetite of these countries allows investment opportunities to flourish, but when things turn sour, the world grimaces. 

Emerging Markets lead Dow Jones Industrial Average

During this particular economic period defined by low oil prices and low-interest rates, emerging markets have shown why they matter. There are many points in the beginning of 2015 where one can observe the emerging markets index leading indices from developed countries. We will use a comparison with the Dow Jones Industrial Average. Due to inclement economic data from developing countries, especially China, risk grew in their capital markets which caused investors to reevaluate their assets in U.S. and European equities. The green circle identifies a position where emerging market weakness (mostly caused by Chinese stock bubble) lead the losses in the Dow. Major equities in emerging countries also saw much larger losses over the same period of time. In fact, in just 3-months the deficit between the Dow Industrials and the GSCI Emerging Markets Index was more than 10%. The difference between the two held when they rebounded in early 2016 as well. Emerging markets recovered about 3.5% of their price back during the recovery. 

The chart above clearly shows that investors have been betting heavily on these markets to lead the way. With low-interest rates set by the Federal Reserve, U.S. investors have been more than happy to flood the developing capital markets with money, expecting a higher yield with minimized risk. Through the selling of corporate  bonds and sovereign debt, governments and corporations in the developing world have amassed an astounding $1.6 trillion worth of liabilities to be settled in between 2016 and 2020 as reported by The Globe and Mail. The report also cited a projection where that debt amount grows about $100 billion a year in that same time period. Most individuals would shake their head at this gargantuan bill that was created out of thin, but why wouldn't growth-hungry businesses take on such cheap debt. The bonds and debt didn't become a problem until expectations for interest rates changed. As money was supposed to get more expensive, the risk premiums on bonds in emerging markets scared off investors who promptly took as much money as they could and looked for something safer (and ironically, the T-bill provided safety and a higher expected yield).

Notable Developing Countries' GDP Growth Rate
from Trading Economics

But why should that trigger losses in the developed markets? The debt overload, higher risk premiums, and capital outflows created two things that directly affected developed markets. The first is lower demand from developing countries as a result of slower growth rates. The chart above shows the slowing of some of the largest emerging markets in the world. The second largest economy in the world in China slowed to growth rates below its targeted 7% (though some doubt the government's data). Both Brazil and Russia's growth rates dropped into below zero as it shed some of the girth of their economies in a global diet. Because the world's total economic growth relies so heavily on emerging markets, even these slight drops affected developed trade, investments, and currency dynamics. Financial Times said that the spread between emerging markets growth and developed markets growth was at a low 2.1% which hadn't been seen since 2000. It was almost as if a family of four sat down to eat dinner, but the father never showed up. That brings in the second reason, the leftovers. With demand from developing countries shrinking, commodities took a huge hit as businesses, which usually devoured them, went on a diet. The year 2015 will always be known for its huge losses in commodities which were most evident in the crude oil market. Developed inventories remained high with trade deficits growing because of less foreign demand. With prices dropping and the most loyal customers falling away, revenues started to be affected which cause equities to drop as well. 

For any investor still wondering why emerging markets are still the key to a sustained rebound, the answer's hidden in a change of psychology. The Federal Reserve has openly forecasted their wariness going into the upcoming meetings, meaning interest rates will most likely stay lower for longer. That translates to a debt environment that continues to be friendly to emerging markets who'll have to pay less interest. Many of the readers are now probably asking, "Rates have to go up eventually, right?" Probabilities calculated using the Fed Fund futures have assigned a mere 43% probability to rates increasing from 0.50% to 0.75%  in September of 2016. These projections don't really matter, though, because the Fed has already told us emerging markets are safe. Traders and economists shouldn't expect another hike until inflation has risen to a comfortable level and the threat from low oil prices has subsided. This will only occur when a broad-based commodity recovery has occurred, a signal that businesses in emerging markets are back at it again. The low-interest rate environment and stronger energy sector will then allow developed equities to return to safety as well. 

That's why emerging markets are the key because every economist at every central bank and investment firm is waiting for them to come back. Their rebound not only signals lower risk but the ability of traders to earn a higher yield in a low-interest rate environment.

Sources: The Globe and Mail, Financial Times, Excel Fund

Thursday, March 10, 2016

Introducing Black Gold Disease: Predictions

Black Gold Disease is beginning its journey into the world of prediction where mathematical models and precognitive ability are often mistaken for each other. Most articles on this blog have addressed the current economic or financial situation of an entity with suggestions of what the future could look like. The BGD: Predictions page will focus on something different with a different structure and purpose. A visitor there will see a long list of links that connect to predictive tools along with explanations of each. The information found on those links will be open for anyone to use with downloadable Excel spreadsheets a goal for the future. Currently, only two links are listed (Deviation Moving Average), but more indicators and models will be uploaded over time. 

I ask everyone who reads my blog to at least come check out those tools to support the blog and the information it offers. Getting feedback and traffic are what keeps the additions coming. Any interest in collaborating or adding to this or the Predictions page will be welcomed. Just send me a message or comment on any post so far. This blog has come so far already, and I can't wait to see it grow more. 


I'll also be starting an internship at the Borgen Project as a writer for their blog. In addition to writing, a fundraising goal of $500 has been set for me personally. So please, if there's any way to support, come donate at the link below and list me as the inter you're supporting.


Cheers!
Jacob Hess

Wednesday, March 2, 2016

Earnings Review: EOG, Marathon, and Continental

With the fourth quarter and annual earnings reports coming out, analysts are able to get a better look at the oil and gas production scene in the United States. Crude oil sits at just over $34.00 today after a small bullish boost lifts it from the high $20's of last week. Just about a year and a half ago, oil executives and energy analysts might have called someone crazy if they had predicted those prices in 2016. Bewilderment aside, oil and gas firms have actually proven to be quite resilient under these sudden bearish conditions.



At the peak in 2014, prices as high as $107 prompted large revenue streams to flow into the coffers of oil and gas companies just beginning to reap the benefits of the new develops in shale technology. New discoveries in North Dakota, Eagle Ford, and the Bakken fields became more viable as fracking allowed deeper and more unorthodox ways of drilling. During these days, equities like Exxon-Mobil and Halliburton's common stock were among the most traded in their industry, and they certainly proved their worth. Fast-forward almost two years to record lows that bottomed out around $26 with losses up to 75.8% over that time period. Just now, analysts are claiming a relative stabilization has been reached with U.S. producers projected to cut and OPEC reduced to capping output. It's no secret that earnings reports have been low points for the energy sector which dropped -34.3% of its sales in the United States. FactSet projections have another -16.1% of sales in the current year. In the same time period, production of oil and gas per day increased 6.4%.

In order to get a closer look at what some companies are expecting out of 2016, the investors reports of three important shale producers will be reviewed: EOG Resources, Marathon Oil Corporation, and Continental Resources. An article from Wall Street Journal recently referenced these three entities as some of the leaders in the industry that have elected to reduce production in the coming months. Here is what they have to say.