2022 Predictions Review

2022 

That was one hell of a year. And not in the “it was totally rad” sense of hell. No, actually it was hell in the sense of hell. Or maybe not. My year was actually all right considering everything that is going on. I shouldn’t complain. Pain is relative. My country wasn’t invaded by Russians. I didn’t lose money in FTX. I’m not in an Iranian jail for breaking the dress code. I didn’t die from Covid. Will Smith didn’t slap me on national TV while hosting the Oscar. The FBI didn’t raid my house for classified documents. I didn’t waste $44 billion on Twitter. I didn’t get ban from Twitter. And despite a tough year in the market, my portfolio didn’t lose as much as the market. I remain optimistic. In chaos and disorders, there are opportunities. The attitude and mindset you bring when you approach a problem matters. You can decide to be a victim or not. That’s a choice.

Let’s go back to my 2022 predictions. First, let me say straight up that it’s a fool’s errand to predict anything. I knew that and I know that. But I thought it would be fun to try and see how it held. It’s the time of the year where you get to read about “experts” predictions. I read some stuff, try to stay informed and all of that. But did you ever notice how they never go over their past predictions? But I will go over mine and let’s see how embarrassing it is.

Second, I remember spending maybe 5 minutes making predictions, because I figured it was a total crap shoot.

Third, I had to go back to my 2022 post because I didn’t remember what I predicted.

The first thing that jumped at me was the date of the post. February 22, 2022. Two days before Russia invaded Ukraine. More on that war prediction at the end.

Source: Me last year. And I just noticed a typo.

Let’s review,

S&P 500 2022 prediction: Target: 4500

Wrong. Really wrong. The S&P finished at 3832. I was off almost 15%. In hindsight, it was a very stupid prediction knowing that 1) interest rates were going up and 2) the S&P just had a massive 26% return in 2021, and 16% in 2020 based on massive stimulus that was going away. Looks like I wasn’t the only one that’s wrong: The 2022 consensus for the S&P 500 was 4,800 at year end 2022.

Interest Rate 2022 prediction: Interest Rate, 5 rate hikes max. The 10-year T-Bill will finish at 2.5%.

Wrong. 7 rate hikes and the T-bill finished at 3.8%. The Federal fund rate is at 4.25%.

Inflation 2022 prediction: Inflation will come down in the 2nd half.

I’m giving myself a “W” for that one. I nailed the trend. But the inflation number is higher than I expected.

Oil 2022 prediction: The classic safe answer of “between $50 to $100 per barrel”. The narrative is that market dynamics will keep pushing prices higher, well above current levels around ~$93 a barrel. I’m going to go against the grain on this one.

This one makes me laugh. It’s a win that doesn’t feel like a win. The WTI ended the year at $73. Yeah I took the contrarian bet, but the journey! I feel like Apollo in Rocky I. Yes Apollo won, but it didn’t feel like a win. 12 rounds and a beating for the win. Oil hit a peak of $123 a barrel and analysts said that it was only the beginning. And yes energy was the only sector that performed well in 2022, and oil is 50% off its peak and trading at a 52-week low. 

Gold 2022 prediction: Gold will finish the year below $2000/oz. Why? The central bank will raise interest rates and “restore” a little bit of trust in the dollar.

Win. Gold finished at $1800/oz. Goldman Sachs called for a $2500/oz by the end of 2022. I crushed Goldman Sachs. I don’t know how to value gold. It was a lucky guess. With everything that’s going on in the world, war, inflation, and the money printing, I don’t know why gold is not higher.

Cathie Wood 2022 prediction: More carnage for ARK

Nailed it. The ARK Innovation ETF was down -69% (-80% at peak). I tried to remember why I made a prediction on Cathie Wood, or why would I even care. I wrote:

As a valuation professional it’s frustrating to watch. People have invested their retirement money and their kids’ education money in her ETFs.

Look I don’t like to see somebody losing money. It can happen to anybody. But there’s a little bit of “I told you so” in ARK’s debacle. We have seen this tape played many times in the past. Her MO is concentrated investments in companies with neat ideas and zero earnings, with astronomic valuations (if they can be measured at all). This is a recipe for disaster because 1) when companies don’t live up to their prospects (e.g. Peloton, Roku…) and  2) when rates rise, and they will, it will hurt the present value of future cash flow. And all of Wood’s investments rely on the future profits in years to come.

At the end of the day valuation matters. Fundamentals matter. Cash flow matters. Profit matters.

I still stand behind that statement.

Russia-Ukraine War 2022 Prediction: Russia won’t do a full invasion of Ukraine. The cost is too high. Instead it will support the separatist regions and will never stop harassing Ukraine through different means (cyberwar, coup, rigged election, propaganda etc…). (Update, a few hours after writing the previous lines Russia sent troops in the breakaway regions of Ukraine. I still don’t think a full invasion will happen.)

Really wrong with brutal timing. And not like I would had I wish Russia invaded just to be right. I still can’t believe Russia invaded. Nobody gave Ukraine a chance. Russia was so confident that the first wave of troops arrived with dress uniforms ready for a victory parade and without nearly enough food. The Ukrainians stood and fought. The Ukrainians have proven themselves.

Record: 4 wins, 3 wrong. It’s not bad. Because I didn’t remember what I predicted, I thought going in that it was would have been a disaster.

As for 2023, I may or may not make predictions. Not because I’m afraid to be wrong. But because I had fun last year making them. It’s impossible to predict the future. But you can plan for it.

We will see.

The Gas Tax Holiday is An Expensive Gift

On June 22 President Biden asked Congress to suspend federal gasoline taxes for three months. It’s a fixed tax, 18.4 cents per gallon. At over $5 a gallon, it’s less than 4% of the current price. It goes without saying that the motive is to give drivers a small break during the summer driving season.

I get it. This is the first normal summer in over two years. I don’t know many people that are changing their summer vacation plans in what seems to be the first normal summer in over two years. I myself plan on driving a bunch and yeah, high gas prices sucks.

Now that I stated the obvious, let me state the non-obvious. If Biden’s plan is to fight inflation, his solution could backfire.

It’s Political

We all feel the pain. I understand what Biden wants to achieve. I understand that he wants to take some of the pain away from the consumer. I understand that he wants to give families a little bit of breathing room. I understand that he wants less inflation. Of course inflation is deeply unpopular heading towards an election.

But it’s also about the politics. The Democrats are going into the midterm election deeply unpopular and they need to show something. They need something tangible that says “hey we provided relief from gas prices”.

If Biden and the Democrats were serious about fighting inflation and high gas prices, they would focus the real issues behind high prices and not just try to apply a short-term band aid for political gains.

Biden’s solution is not going to fix the high gas prices. A temporary reprieve from the federal gas tax will make the problem worse. Maybe a lot worse.

• The problem behind high gas prices is supply. Not demand. We don’t need more demand. We need more supply.
• Dropping the gas tax will boost demand for gas. It’s supply that needs to be address.
• How are you going to meet that extra demand when supply is already stretched? This mean one thing: Higher gas prices.
• Even if you pump more oil out, you still need the infrastructure to support it. You need to distribute it and you need to refine it.
• Refineries are even more constrained now so supply is nearly fully inelastic. There’s supply capacity but it’s in Russia. And that’s no-go.
• If it takes 10 years to build a refinery, and another 10 years to break-even, in a context where there’s no social acceptability for these projects, you can see why nobody wants to build one.
• How much really will be passed to consumers? Retailers can simply raise the base price of gas to make up the difference.
• The federal gas tax is 18.4 cents per gallon, less than 4% of the current gasoline price. Plus, a break on a fixed rate looks even worse if gas just keeps getting more expensive. The tax is fixed, so as the price of crude oil rises, the tax accounts for a proportionately smaller share of the total retail gas price. The more expensive gas gets, in other words, the less a tax break matters.
• Cheaper prices, if any, will encourage more driving and as a result more pollution.
• And what happens once the “holiday” is over and prices goes back up. Or will they extend the holiday. Governments are notorious for extending popular programs from “temporary” to the “permanent”.
• Removing the tax will turn out to be expensive. The tax provides an important source of funding for road construction. Expect road quality to take a toll. It’s also part of the bi-partisan infrastructure bill. They haven’t mention how to will make up for the short-fall.
• Other measures to curtail rising gas prices, such as releasing oil supply from U.S. reserves, haven’t worked.

I’m not a “tax” guy. I like paying less taxes as much as the next person. But this is not area where cutting the tax will do more good than harm. In the end, you might end up with higher prices. The oil industry is as complex machine. Removing a tiny tax is not going to solve the problem. There’s no easy fix.

Like I said, the solution is more supply. It’s often say the solution to high prices is high prices. There’s some truth to that. High prices forces consumers to change their behavior. Maybe drive less. Take the smaller car. Walk or bike more. Car pooling. Buy an EV. High prices leads to demand destruction. Higher prices also result in producers pumping more oil.

The Biden approach reminds me a little bit of the 70s. I wasn’t around during that time but I know people that were. I also read on the subject. Inflation was a major problem back then. And politicians kept throwing band-aid to the problem. Things like rent-control and price control were introduced. Nixon imposed a 90-day freeze on wages and prices in order to counter inflation. Then I think it went on for two years. On the surfaces the measures sounded good and they were politically popular but they were disastrous. It was called the Nixon shock. It didn’t go well. Inflation rose. There was an major economic failure (73-75). A recession. The problem became worse. People became poorer.

This tax holiday thing is a gimmick (Even Obama dismissed it as a gimmick in 2008 when he ran against McCain). This is coming from a President that canceled the Keystone XL pipeline expansion on his first day in office. And now he’s begging Saudi Arabia to drill more.

What’s needed is a serious plan to address energy security. Democrats and Republicans need to figure this out. They need to hit reset and work on a serious energy supply plan. Not just something to get past the next election.

The government’s role to set the conditions for the market to provide energy. Not picking winner and losers. We need a all-hands on deck approach. Oil, natural gas, wind, solar, hydro, and nuclear.

Of course the perfect solution would be to use no oil. But we are not there yet. The transition to renewable will take time. Nuclear has to be part of the picture. It’s a carbon free.

The main question with renewables is: Can the world dramatically scale up green energy to power the economy as well as alleviate climate change—bridging the tension between energy security and climate security?

In the end, there’s no perfect solution, only trade offs.

Predictions

I wanted to publish this in January and I never got to it. There’s eleven months left until 2023. Better late than never. My figured my crystal ball can’t be much worse than the experts.

I would hate to be a financial strategist. Expectations are sky-high. At the beginning of each year you have to make ridiculously precise predictions about indexes, commodities, and provide some wisdom on how to achieve world peace. How do you keep a job like that?

I’m always reminded, when I read previous expert predictions, of just how hard it is to predict the future. Two years ago, none of us predicted Covid. Last year, no one predicted the levels of inflation that we’re seeing now, although some of us talked about the risk of inflation.

It’s important to be humble. Here’s the takeaway: Making predictions about the future is a fool’s errand, planning for the future is not.

For the purpose of fun, I’m going to give it a shot.

S&P 500

Target: 4500. Yes I think the market will finish in the positive (~4325 now). But it won’t be a smooth ride. 

The Fed is taking the punch bowl away. The pandemic-era party appears to be ending. Stocks, bonds, crypto, you name it—almost every asset class has hit a rough patch since the beginning of the year.

I think the market will “correct” from rate hikes and recover towards the end of the year.

Why 4500? Estimated earnings of $225 with a multiple 20x = 4500. The genius: I like round numbers. So expect some big ESP surprises.

Interest Rate

5 rate hikes max. The 10-year T-Bill will finish at 2.5%. It might trend higher during the year but will probably trigger a negative response and withdraw. Inflation should also normalize (come down) in the 2nd half of the year. More on that later.

If the Feds are too aggressive they risk inverting the yield curve, which would flash warning signals about a looming economic contraction. They don’t want to kill the recovery and some inflation is welcome.

Inflation

The key question was “Will the inflation be transitory, or can the Federal Reserve still rein it in?” Well you don’t hear the word ‘transitory’ anymore.

My sense is that inflation in the second half of the year is going to come down more rapidly than the typical media reports suggest.

Many of today’s headlines are just wrong. They take an overly simplistic view of what is happening. The inflation data, for one, overstate what’s going on. Of course I recognize that there has been an increase in core inflation, and that wages are rising. I shop and buy groceries like everyone. My bills are not going down.

But we have to recognize that much of the increase in measures like the government’s CPI comes from factors that are one-time events. There has been a huge increase, for example, in the price of used cars. Well, families don’t buy cars every year. There has also been an increase in home prices, but homes are not recurring purchases. 

Remember inflation is a year-over-year phenomenon. If oil goes from 50-100 in a year, that is +100%. If it stays at 100 the second year that is 0.0%. We are going to see inflation data come down. 

The best starting point from which to consider this is the bond market’s current expectations, which are for the Fed to indeed stick the landing; in other words, the market thinks that inflation is most likely to recede over the coming years and be close to 2-3% annually in five years. Perhaps it is the huge collection of assets sitting on the Fed’s balance sheet providing the market comfort that a path to quickly remove liquidity exists if need be.

Oil

I want to go with the  classic safe answer of “between $50 to $100 per barrel”. But that’s no fun. My job is not on the line here. I’m not on TV or popular magazines. It’s a blog. My blog.

The narrative is that market dynamics will keep pushing prices higher, well above current levels around ~$93 a barrel. Some analysts are saying $100 oil is just the beginning. The thesis is there’s simply not enough oil being pumped and demand is growing fast.

I’m going to go against the grain on this. Being an oil contrarian has paid off in the long term. Oil prices is one area where it seems that all the experts agree and that’s scary. I’m not an oil expert, so I think oil prices will go down by the end of the year. The thesis: Not supply and too much demand, is already incorporated in the price.

Traditionally speaking producers respond to high oil prices by over producing, which hurts oil prices. That’s why the cure to high oil prices is higher oil prices. Normally, a US$100 a barrel typically would spark a frenzy of new drilling. Producers get greedy and flood the market. It’s true that producers haven’t responded to high oil prices like in the past because of ESG concerns. 

They are also more disciplined. Because of past boom and bust energy producers are more conservative and preach disciplined capital allocation. Companies have committed to higher production. Not the kind of increases you would have seen in the pre-covid past, but a more measured production raised. Producers care more about having a decent return on their capital than trying to win market share at any cost. Cash flows will go back to investors through dividends and buybacks instead of more CAPEX. A balance market is better long term. A bust brings too much damage. But producers will eventually respond to the market. These prices are too good to pass up and the more they go up the more it weakens their discipline. It just will take a little longer.

There’s a failure of the analytical community to look at what’s happening on the ground, to look at projects that have been reaching final investment decisions, to look at where the efficiency of capital is. 

Capital spending levels don’t reveal very much. After the last oil crash companies have gotten much more efficient, reducing the cost of finding and development by more than half in the past few years. So every dollar they spend is going a little further, meaning production can rise without very much spending. 

Oil is a wild card. Analysts are calling for $100 oil. I wouldn’t be surprised if it hits it and goes higher. However I think it will trend downward. Yes the amount of CAPEX to pump oil out of the ground is down compared to other peaks. But I think what the market underestimates is how much more efficient they have gotten since 2014 and how much costs have come down. 

$100 oil is possible. Will it stay there? I doubt it. Expect supply of 101m-102m barrels of oil per day and demand to match it. But I think  that U.S. companies will boost production by more than 1 million daily barrels a year and the rest of the planet will respond. Prediction: $70! But of course a war or some black swan event is on the menu.

(Update, a few hours after writing the previous lines Russia sent troops in the breakaway regions of Ukraine. Fear of disruption in the energy market sent energy prices way up)

Gold

I have no clue on how to value gold. There’s no cash flow and there’s an esoteric feel to it.

We are in a period of “high” inflation, unrestrained government spending and the debt pile is getting higher. Central banks have been virtually “printing” money. Yet, the price of gold hasn’t responded. It has been trading sideways for over a year. The traditional thesis of 1) Inflation protection and 2) Alternative to the debasement of fiat currency is not working. You can also add geopolitical tensions and potential war to the mix. I’m not sure if I get it. 

My suggestion is to avoid the commodity directly (unless you are buying jewelries) and look at producers and royalty companies. They make good money at this rate.

My bet: Gold will finish the year below $2000/oz. Why? The central bank will raise interest rates and “restore” a little bit of trust in the dollar. 

Cathie Wood

This part is more opinion than a prediction.

Cathie Wood, the star fund manager and chief executive of ARK Invest, is the investment icon of the pandemic era. She crushed it in 2020. She was the winner of the pandemic. ARK’s seven ETFs returned an average of 141% in 2020. She was the toast of Wall Street.

But Wood has had a tougher time in recent months. The ARK Innovation ETF (ARKK) is down 31% in 2022. It has lost more than 56% since its peak a year ago. And most of her investors haven’t done so well because they piled in at the peak of her performance.

Why am I bringing her up?

As a valuation professional it’s frustrating to watch. People have invested their retirement money and their kids’ education money in her ETFs.

Look I don’t like to see somebody losing money. It can happen to anybody. But there’s a little bit of “I told you so” in ARK’s debacle. We have seen this tape played many times in the past. Her MO is concentrated investments in companies with neat ideas and zero earnings, with astronomic valuations (if they can be measured at all). This is a recipe for disaster because 1) when companies don’t live up to their prospects (e.g. Peloton, Roku…) and  2) when rates rise, and they will, it will hurt the present value of future cash flow. And all of Wood’s investments rely on the future profits in years to come. 

At the end of the day valuation matters. Fundamentals matter. Cash flow matters. Profit matters.

Prediction: More carnage for ARK.

Russia-Ukraine War

Russia won’t do a full invasion of Ukraine. The cost is too high. Instead it will support the separatist regions and will never stop harassing Ukraine through different means (cyberwar, coup, rigged election, propaganda etc…).

(Update, a few hours after writing the previous lines Russia sent troops in the breakaway regions of Ukraine. I still don’t think a full invasion will happen.)

Summary

The market could be in for a wild ride. At least for the first half of the year. The Fed indicated that it was heading for earlier, faster interest-rate increases and an eventual reduction of its balance sheet.

In a world of zero interest rate, it’s the more speculative of the speculative that worked. I sat that out. Why? Because valuation matters. The price you pay determines your future return. Now the tide is turning.

With rates rising I see a big shift coming in the investment narrative from a focus on the central bank’s balance sheet to a focus on companies’ intrinsic value. Cash flows, business fundamentals, and valuation considerations will be a greater driver of returns as the Fed potentially contracts the balance sheet. 

Wall Street and the financial media are fixated on the Fed. Business owners and Entrepreneurs view things differently. They say, “If I can’t make money with all this liquidity and super low interest rates, I should go out of business.”. Focus on the businesses.

The Big Shift: The Future of Renewable Energy

Covid-19 is the current global crisis taking center stage and we will prevail. However there is another global crisis that has been decades in the making and that is climate change. Climate change is one of the world’s biggest, if not the biggest problem that we are facing. And it’s coming real soon to a theater near you. Climate change is hard to quantify and with so many variables it’s quasi impossible to predict any events. However we don’t need another study to remind us the “once in a century fire” is now the “once a multiple times a year fire”. The “fire season” is now a permanent part of the calendar. Climate change impacts everything. From the food we have on our plate every day, the air we breathe, our quality of life, and our national security. It’s a generational challenge with no quick fix.

On a more positive note we are closer to responding effectively to it. This post is about the notion that the oil era is winding down and that renewable energy would soak up the bulk of the entire energy industry’s investment dollars. The trend to move away from fossil fuels is real. And it’s renewable energy that’s taking shares of the pie. The global shift to renewable energy is a big step in the fight against climate change. Renewables are a form of “disruption” and I apologized for using a word that has been so overused.

Producing clean energy is not a novel topic. Thanks to innovation we are at a turning point. The technology has improved and cost has fallen. Innovation solves problems. Economics is central. Great innovations see their cost decline over time, creating real demand. The cost to produce renewable energy has fallen dramatically in recent years, to the point where it has become attractive next to fossil-fuel generating assets, particularly coal and oil. According to Lazard, the costs of solar panels and batteries have dropped by more than 89% in the past decade. Solar is substantially cheaper than it was even five years ago. The wind and solar power in Arizona that Fortis generates now costs less than 3 U.S. cents per kilowatt hour.

Insights on Oil

It’s not breaking news that the energy sector has been a disaster zone this year, as the coronavirus pandemic has decimated global oil demand. There’s an assumption that anyone looking to invest in energy stocks, and oil stocks in particular, is an idiot, and that assumption appears pretty reasonable—if you’re looking in the rear-view mirror. There’s might be better days ahead for the industry. But “when” is the key question. There’s an old saying in the oil industry: The cure to low prices is low prices. I expect more carnage in the short-term before it gets better. Companies will be destroyed. There will be survivors that come out on the other side looking stronger. Their shares are pretty attractive right now. But who will survive?  Energy is essential. Although demand is down right now, the world is going to need more energy in the future. Low-cost energy will help to boost the global economy.

But it’s my opinion and I have no money on it, no skin in the game. The sector is too insane for me. It’s driven by too many large actors with non-economic motives (e.g. Saudi-Arabia). Anyway I’ve been reading a lot news of the sector and here are a few insights I picked up. Sometimes in carnage there’s glimmers of hope.

• I can’t think of an industry in recent time where even though things could get worse, they got really bad. Predicting a massive drop in oil prices, sure. Predicting negative oil prices? That’s a job losing proposition. Investors in oil have been suffering for a long time.
• The market is efficient at pricing in risk. Oil prices have collapsed twice in the past six years. That would tell investors there is a greater likelihood of that happening again. If you’re an operator, this means you might require a higher return than in the past because the risk is greater. If you’re an investor, you require a higher rate of return before you’re willing to invest. Thus, when demand comes back and oil prices recover, the commodity price might be a little higher than it otherwise would have been, depending on how high you need it to be to get that marginal barrel produced.
• The world is still highly reliant on hydrocarbons. Renewable-energy sources are growing, but long-term demand for oil and natural gas is growing faster in percentage terms.
• The May futures contract for WTI crude turned negative in April (-$37 a barrel), as demand plummeted and storage capacity ran out. That seemed to be an unusual set of circumstances with open futures contracts and perhaps some unsophisticated investors who got stuck. The lesson: Don’t hold financial contracts that you can’t honor as expiration approaches. With limited-to-no storage capacity available at the delivery point for the WTI oil-futures contract on May 19 (Cushing), so holders of financial contracts will need to sell prior to expiration. If open interest remains high as we approach expiration, then negative oil prices are possible again.
• Negative oil prices were an anomaly—a function of a timing mismatch between the pace of demand reduction and that of supply reduction.
• You need to break down the oil industry in two players: Producers and refiners. In between you have the pipeline, storage, and the infrastructure (mid-streamers). In normal times, good news for producers would tend to be bad or neutral for refiners, because refiners have to buy from the producers.
• The hope is that the oil market rebalances and every part of the industry improves — oil and gas producers make more money selling crude, refiners sell more gasoline, and pipelines see more activity.
• Refiners have been cutting back on processing crude because there are too few buyers. No one is driving as people stay at home to stop the virus, and gasoline is normally the number one use of crude in the U.S.
• U.S. oil prices have jumped 99% in just the past week, an incredible performance that has made energy a top performing sector after months of under performance. Investors bet that companies in the beaten-down sector can come back from a historic rout in the first quarter. Even with the latest surge in stock prices, it should be noted that nearly all energy stocks are down by double-digit percentages for the year. Crude is up for two reasons:
  1. One is that investors now expect demand to return for major products like gasoline and diesel as countries start loosening lockdown orders imposed to stop the spread of the coronavirus.
  2. That oil companies have gotten more serious about reducing supply. U.S. oil production has already declined by almost 1 million barrels a day since it peaked in March, according to Rystad Energy.
• The Texas and the U.S. responds to market prices, not government or OPEC. Earnings releases from U.S. oil companies show they’re prepared to make dramatic cuts.
• The idea of the Russia-Saudi Arabia price war is to drive U.S. producers out of business. It might work to a certain degree. That playbook employed in 2014 with limited success. Now S-A is trying again with a weaker hand. You might end up with zombie companies like in 2014, where U.S. producers pump just enough to cover interests on the loan.
• Mass bankruptcies look unlikely, at least in the short term. And if riskier companies can hold out until oil prices rebound, they are likely to be in a position to produce better cash flow next year. Oil futures a year out are projecting West Texas Intermediate crude at $33.
• For companies to produce oil profitably, Brent needs to trade around $50 a barrel. Back in December, with the Brent at $60, companies with the right structure could thrive and  cover their dividends fully. Oil companies were buying back stock with excess cash flow. They could compete with the S&P 500 on a cash-flow-yield basis. Today the math doesn’t work at current prices.
• I was surprised to learn that energy stocks now account for a measly 3% of the S&P 500 index, thanks to a terrible decade and massive technology companies. It’s much higher than that in Canada. I know it was at least a third of the index at one point but I don’t know if it’s still that high now.
• Most oil and gas producers, including the majors, will lose money in 2020 or barely eke out a profit, and most of those still paying dividends will have to borrow to cover the cost.
• They key for oil companies is reducing production, slashing costs, and conserving cash. These steps are likely to pay off in higher oil and gas prices over the next two years—and stronger operations and balance sheets for the industry’s survivors.
• Royal Dutch Shell Plc. (RDS-A, RDS-B) cut their dividend for the first time since WWII, to 16 cents a quarter from 47 cents for a 66% cut. For a company that seems to want to be around for a long time, it’s the prudent move. Most companies, including Exxon, BP, and Chevron should cut but won’t. Instead they are delaying capital expenditure. You can only do that for so long before it bites you in the butt.
• Take Exxon for example. Analysts think that Exxon will generate $2 billion of negative free cash flow this year, with a $15 billion dividend commitment. The company recently issued $18 billion of debt, which could cover this shortfall, but one could definitely question how long it makes sense to do so.
• I think Shell is the most anti-oil oil producer. Shell is thinking about the long-term transition away from fossil fuels. Shell leads big oil in the race to invest in clean energy. Shell has this “Sky” scenario plan that highlights the transition toward a clean energy world by 2070. It’s much later than the U.N. 2050 plan and is probably more realistic. 
• Everybody talks about the negative impact on U.S. producers. That Russia and Saudi Arabia are trying to drive them out of business and that Saudi Arabia wants to regain the crown of world’s largest producer. But there are other major global impacts that won’t go unnoticed. Low prices will hurt or destroy many countries dependent on oil. This can’t be good for enemies of the U.S. that are not under their political and/or military control, such as Venezuela and Iran (also Saudi-Arabia’s rival/enemy). This can’t be good for Russia also but I think they have enough foreign reserves to withstand the storm in the short term.
• OPEC++++ agreed to cut production by nearly 10 million barrels a day, starting this month, to help to rebalance the market. I’m very skeptical it will work. First the math doesn’t work. For the near term, it’s too little, too late. The cuts agreed to are starting from a base level in October 2018, when OPEC was producing at a higher level, so the effective cut is more like 7.1 million barrels. Balance and supply is out of whack by way more than 10m a day. Second, if you look who the countries who signed the deal, how many of these countries can you trust? OPEC alone has had time keeping their members from cheating. The whole thing almost fell apart because of Mexico. This is not an easy agreement to implement. Here’s an headline: Iraq faces problems cutting 1 mln bpd of crude output -sources

Here’s an interesting take to wrap up things:

Oil: Help!

Crude Oil Prices – 70 Year Historical Chart

Oil – It’s The 1860s All Over Again

This is my latest article published on Seeking Alpha. I tried to put the current oil crash in historical context. I found some very striking resemble with the problems of today’s oil industry and the ones in the late 19th century.

I also want to take the occasion to wish everyone a Merry Christmas and Happy Holidays. May 2016 bring good health, prosperity, success and peace.

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I’m currently reading Titan by Ron Chernow. This is an excellent book about the life of John D. Rockefeller Sr. (July 8, 1839 – May 23, 1937, Obituary from the New-York Times). Mr. Rockefeller was known as the co-founder of theStandard Oil Company and was the world’s richest person. Adjusted for inflation, his fortune upon his death in 1937 stood at $336 billion according to Fortune (in 2008 U.S. dollars). Chernow does a great job shining a light on the secretive mysterious John D. Rockefeller. The biography is fair. Unlike other works about Rockefeller, Chernow doesn’t demonize or canonize Rockefeller in his book.

I’m writing this article because of the striking resemblance with today’s oil industry and the one in the book. I’m referring to the late 19th century. I want to share with you some insights between back then and today. You will get the feeling that you were reading today’s oil news. I believe that history repeats itself and there are lessons to be learned. And since this boom and bust cycle are not new, it might also provide some understanding on where we are heading. I hope you enjoy.

Let’s Go Back In Time

To understand where this is going, it’s important to understand how we got here.

Source: Public Domain. A Pennsylvanian oil field in 1862.

In the 1850s the whale fisheries had failed to keep pace with the mounting need for illuminating oil, forcing the price of whale oil higher and making illumination costly for ordinary Americans. Only the affluent could afford to light their parlors every evening. There were many other lighting options such as lard oil among others but no cheap illuminant that burned in a bright, clean, safe manner. George Bissell, considered as the father of the American oil industry, had the intuition that oil that was plentiful in western Pennsylvania could be a first rate illuminant. The slimy liquid was so ubiquitous that it tainted well water and plagued local contractors drilling for salt. In 1855,Professor Benjamin Silliman from Yale produced a report that vindicated Bissell’s hunch that oil could be distilled to produce a fine illuminant (like kerosene), plus a host of other useful products. As a result, Bissel and his company, Seneca Oil Company (formerly the Pennsylvania Rock Oil Company) needed to dispatch someone to Pennsylvania to look for large pools of oil. That man was Colonel Edwin Drake, known as the first to successfully drill for oil. Drake arrived in Titusville, Oil Creek Valley. Oil was known to exist here, but there was no practical way to extract it. Its main use at that time had been as a medicine for both animals and humans. Natives used it for war paint and for soothing skin liniment. It took a couple years but Drake struck oil in 1859. This was the beginning of a pandemonium. Bands of fortune seekers and speculators streamed into Titusville and other oil-related businesses quickly exploded on the scene. I guess you can call this the Klondike of oil.

Boomtowns appeared briefly, witnessed frantic activity, and then vanished as abruptly as they had appeared. In a short-time after oil is struck, a sleep frontier settlement is transformed into a hectic town filled with hotels and saloons. Pithole, Pennsylvania is an example of that boom to ghost town phenomenon. In 1865, after oil was discovered Pithole became a boomtown with thousands of people rushing in. Then after the oil was gone, Pithole was left with just six voters. The book talks about a $60,000 hotel, the fancy Bonta House hotel, that was sold for $600 for the lumber and doors. Back then nobody knew how much oil there was and it looked as if the oil would be more than a transient phenomenon. The worries that the Pennsylvania oil wells would dry up consumed a lot of energy. In the late 1860s there were stern prophecies about the industry’s impending demise. Today we know that we are not running out of oil anytime soon but how many times are we reminded of the Peak Oil Theory?

To a much lesser extreme, this reminds me of North Dakota and Fort McMurray in Alberta. Fort McMurray has a lot of oil left for a few decades but the recent oil crash has brought a lot of pain including a housing bust. Just like western Pennsylvania at the time the potential money to be made in Fort McMurray and North Dakota was irresistible, whether in drilling or in auxiliary services; people could charge many times the asking rate.

The oil industry was unruly and turbulent. From its first days, the industry tended to oscillate between extremes: gluts so dire that prices plummeted below production costs or shortages that sent prices skyward but raised the even more specter of oil running dry. Prices back then were volatile with the supply-demand equation shifting radically each time a new gusher came in. It was never clear where prices would settle or what constituted a normal price. When this expanded supply led to lower prices and deflationary bust, it set the pattern for the rest of the 19th century, which experienced huge economic advances, punctuated by treacherous slumps. Lured by easy profits, legions of investors rushed into a promising new field and when big gluts developed from overproduction, they found it impossible to recoup their investment. In 1861 a barrel of oil fluctuated between $10 and 10¢ a barrel! And that’s not a typo. In 1864 a barrel fluctuated between $4 and $12, and then fell to $2.40 a barrel after the Civil War. Does this remind you of today’s boom and bust environment? Below is a chart of the history of crude oil prices.

(click to enlarge)Source: Goldman Sachs. Data up to 2014.

By the late 1860s, there was a slump in the oil industry, keeping it depressed for the next five years. Low kerosene prices, a boon to consumers, were catastrophic for refiners, who saw the profit margin between crude and refined oil prices shrink to a vanishing point. In 1870 total refining capacity tripled the amount of crude oil being pumped and most refineries were in the red. Now the downstream businesses will feel the pain of a slump in refining margins. Refining margins are starting to slump. Barclays’s benchmark puts average margins in the fourth quarter about 45% lower than the prior quarter.

Worse, the oil market wasn’t correcting itself according to the self-regulating mechanism described by neoclassical economists. Producers and refiners didn’t shut down operations in the expected numbers. John D. Rockefeller said “So many wells were flowing that the price of oil kept falling, yet they went right on drilling.” Rockefeller tirelessly mocked those “academic enthusiasts” and “sentimentalists” who expected business to conform to their tidy competitive models. According to the standard model of competition, as oil prices fell below production costs, refiners and producers should have shutdown. But the oil market didn’t correct itself in this manner because refiners and producers carried heavy bank debt and other fixed costs and by operating at a loss they could still service some debt. Each refiner, pursuing his own self-interest, generated collective misery. Does it sound like today’s news? The U.S. drilling activity didn’t slow down as much as expected and a lot of producers are still pumping oil to avoid defaulting on their loans.

The Oil Regions of Pennsylvania created many millionaires and left many more paupers. Many who had made easy fortunes in oil found themselves bankrupt. Now how many people have lost their shirt in the latest oil crash? People are losing their jobs, loans are defaulting, fortunes have melted, income going to retirees is gone, oil dependent countries are falling apart, and the carnage continues. People who succeeded believed in the long-term prospect of the business and never treated it as a mirage that would soon fade. That’s what John D. Rockefeller and Standard Oil did.

The violent price swing created an urgent need for certainty, stability, order, and predictability. The solution back then was forming a cartel with the leading producers. In 1869 and 1870 are the years cited by Rockefeller as the start of his campaign to replace competition with cooperation. On February 1, 1869, the Petroleum Producers’ Association was created to curtail production and lift prices. According to Rockefeller the industry needed to be tamed and disciplined since it was struggling with excess capacity and suicidal price wars. That’s almost hundred years before the Organization of the Petroleum Exporting Countries (OPEC) that was formed in 1960. Standard Oil ran “running arrangements” with its rivals in which Standard Oil guaranteed them a certain level of profits if they accepted a ceiling on their output. This caused the problem all the cartels face: How do you prevent cheaters. Whenever refiners with running arrangements exceeded their assignment allotment, Standard Oil, as the swing producer, curtailed its own output to maintain prices. This is exactly the situation Saudi Arabia has been facing since the 1970s. Cheaters are not the only problem for the cartel, it also had to grapple with the “free rider” problem. That is opportunistic refiners outside the cartel who enjoyed the higher prices it produced without being bound by its production limits. In the end the agreement crumbled because producers couldn’t enforce discipline in their ranks. High prices lead to producers to pump more leading to another major glut in the market. In today’s world, the biggest free riders are Russia, the U.S., and Canada among others. They benefit from OPEC’s output restrictions and counted on the organization to curb output to support price. Well that mutual belief fell apart and so did the floor that the oil price was standing on.

A year ago OPEC, influenced by Saudi Arabia, decided to defend market share instead of cutting output, ultimately hoping to drive high-cost producers such as U.S. shale firms out of the market. OPEC’s decision last Friday in Vienna is escalation of that policy. OPEC will not limit oil production. OPEC says it shouldn’t have to cut output alone and there’s really no appetite to cut, especially from Iran. OPEC historically functioned for so long because they were able to coordinately restrict supply and therefore influence oil prices. Now they have dropped their founding mission to operate in a free-for-all ceilingless production environment in an already oversupplied market.

“Everyone does whatever they want” – Iranian Oil Minister Bijan Namdar Zanganeh

As a side note, most of the stuff refineries produced back then was kerosene. This was years before the introduction of the automobile. Nobody knew what do to do with the light fraction of crude oil known as gasoline and many refiners let this waste product run into the river. Rockefeller said “we used to burn for fuel in distilling oil and thousands and hundreds of thousands of barrels of it floated down the creeks and rivers, and the ground was saturated with it, in the constant effort to get rid of it.” And because the industry was so out of control and that voluntary association didn’t work, John D. Rockefeller wanted to bring the industry to heel under Standard Oil control. As for Pennsylvania, oil production peaked in 1891, when the state produced 31 million barrels of oil, 58 percent of the nation’s oil that year. Standard Oil became a monopoly and the world’s first and largest multinational corporations. The Federal Government dismembered Standard Oil in 1911 into dozens of constituent companies.

Summary

The oil market is disconnected from fundamentals. The oil industry is a victim of over production at any cost. Producers are focusing on protecting market share even if that means selling barrels below cost. Others are still filling up inventory space just because they need to pay interest on their loans. The market, instead of acting on fundamentals, is trading on momentum. Low prices are the excuses for lower prices. We are never at the center, or in equilibrium. We are always to the left or to the right of the pendulum. And when the market corrects itself it shoots past equilibrium and goes straight the other way.

The latest oil boom is responsible for the recent bust as it happened in the late 19th century in Pennsylvania after discovering a new big gusher. With high prices and sky-high profits, the field had soon grown overcrowded. Supply didn’t follow demand. When oil prices were high, capital expenditure exploded and producers drilled everywhere. The feeling was that oil prices were only going to go up. Oil booms and busts happened frequently in the past, except today we though that “time is different”. The thesis was the age of cheap oil was over because of the ever growing oil thirst of China and the rising demand in emerging markets. Well the thesis is still more or less relevant, it addressed the demand side of the equation. The issues are on the supply side of the market and latest developments set up for more price wars in an already heavily oversupplied market.

We might be in 2015 and we might think of ourselves as smart and sophisticated. Our society doesn’t look anything like the wild one described in the 1800s. However, even if our society is more advance, our behavior didn’t evolve and as a result we repeat the same mistakes of the past. When you think things couldn’t get uglier, they do. As for me, I will try to finish that 774 page oil brick.

Oil World Demand and The Cost of Production for Different Countries

Low oil price is the one financial headline that doesn’t go away. Some weeks the news focus on Greece, or China, or the U.S. budget but oil is always there. Other days we hear about the Federal Reserve and interest rates but oil is also right there. You can’t go a do without hearing about oil.

Below is an interesting graph provided by the International Energy Agency. It breaks down the average cost of production for the different oil producing countries. Saudi Arabia has the lowest cost per barrel at around ~$20 and the Canadian oil sands is the most expensive to extract at over $70 a barrel. None of this is breaking news. I just like to see in way where it’s comparable among regions.

Below are two tables. One on of the rising demand for oil displayed quarterly and the second one is world supply. You can see that the demand for oil has increased significantly with the drop in oil prices. Demand is also expected to hit 96.8m/bpd by Q4-2016. Now supply has to keep up. Because of low oil prices capital expenditure has been slashed the most in twenty years and is still expected to drop in 2016. That could cause an eventual supply shortage or a “rebalance” from excess oil to not enough oil to meet demand in the future. Oil is a depleting resource so if we don’t actively drill for new sources supplies will decrease. And the current production from oil wells is always declining due to natural depletion. That means a well produce less oil year after year and you need to keep spending money to find oil. So there’s a lot of production/supply constrain. First you need a lot of money, then you need to find oil, then you need to drill, maybe you find some, maybe you won’t, if you need do you need to extract it and find a way to ship it out and refine it. There are other intermediaries between the well and your gas tank. Plus you need to navigate the fragile regulatory and political environment that can change at any time. It seems that the cure for low oil prices is low prices. According to the IEA, demand is expected to exceed supply in Q3-2016. If the market is under supplied and demand is increasing, well we have a situation where oil prices have one way to go.

My point is you can’t get too comfortable with low oil prices. We hear so much about low oil prices that we feel like it’s the “new normal”, that its there to stay forever. Remember that not too long ago the consensus was the high oil prices weren’t high enough. Oil prices can turn around and shoot up like a rocket just like it came crashing down like a house of card.

For more info on oil you can read the IEA Oil Market Report. It’s a great resource on a resource.

Source: IEA September 2015

So You Were Wondering About Oil

I’m often asked the question “what do I think about X (oil, Ukraine, China, interest rates etc…)” I can talk about oil all day long but it’s totally different if you are going to go out and invest you hard earned money. Below is my answer.

Question: I’d be really interested to know what you think about oil. There are some very beaten down names…. What’s the strategy here? Is this an opportunity for a long term buy and hold play, or is the consensus that there’s more carnage to come?

Answer: Hi Hank (may or may not be his real name to protect askers identity),

Thanks for reaching out. I follow the oil sector in a general sense but I’m not going to pretend that I’m an oil guru. I’m also not a fan of cyclical investments, such as commodities. You can make a lot of money in that sector but it’s just not my game. You only need to look at the last year or so to see how rock “n” roll prices can be. You can make money really fast and you can lose it even faster. Having said that, I always look for opportunities. Oil is probably the most important and strategic resource we have. Oil’s influence plays a central role in our everyday economy and lives. Regarding oil as an investment, I think I can answer that question in two parts. The first part is your own personal view on oil and the second part is the investment merit of the oil & gas companies.

Part One – View On Oil

It’s very difficult to determine the value of a barrel of oil, or any commodity such as gold because you don’t have a cash flow. At least with securities you have a framework for valuing things. For example, a bond is easy to value because it distributes a fixed cash coupon. An ounce of gold just sits there or on a finger. Oil at least has a functional value to society (In gold’s defence, if you watch reruns of Glenn Beck’s show it’s never worth enough). So how much is a barrel of oil worth? I have no idea. Non-income producing assets are worth what buyers will pay for them. For a while the cost of production was a reference for the lowest price possible for a commodity but now we are seeing producers below cost (including some gold producers). One of the main reasons why there are so many companies producing oil below cost or at break-even is because they have to service their debt. It’s pretty much the bank telling them to pump oil because the bank doesn’t care about the economics or fundamentals of oil. As a piece of advice, I would ignore talking heads’ price target on oil. It’s too easy to get sucked in by the fancy sophisticated analysis. The thing is if you listen enough there are so many contradictory targets. Before the oil crash Goldman Sachs was saying oil was going north of $150. Then they changed their mind to $48 a barrel after the crash. You hear so many different numbers being thrown around. What’s insane is that all these analysts have access to the same data bank as everybody else. Basically it’s all noise and those price targets go up and down like the tide. To answer a part of your question regarding if there is more carnage to come, well my answer is how long we will continue to see a decline in the price of oil is anyone’s guess. You really need to develop your own independent opinion with minimal advisory input.

My personal view on oil is that it’s bound to go up eventually. My opinion is not scientifically researched and I don’t have eye popping charts to show you. I also don’t subscribe to any conspiracy theories. My view on oil is simple and easy to defend. You could probably find the same view out of a 6th grader school notebook. In the short-term it’s impossible to know if the barrel of oil is going to $80 or $20. I heard intelligent cases for both side. If your idea of investing in oil is speculating on the price of oil in the next months or years, good luck. I can’t help with that and anybody pretending to is taking you for a ride. If your idea of investing is finding companies or assets trading below its perceived intrinsic value then I can steer you in the right direction.

My case for higher oil is a simple one. Now remember that it’s just an opinion. Demand worldwide should grow modestly over the next couple years. As a society, we still have a lot of work to do before we can switch to a reliable alternative energy source. Basically, what I’m saying is that we are not getting off our oil addiction anytime soon. I love clean energy and it’s definitely the way to go but I’m not giving up my pickup truck anytime soon for a bicycle (However I heard a company called Tesla is up to pretty amazing things with cars).

I do think that low prices is the cure low prices. The lower the price, the higher the oil consumption. (You can also make the case that higher prices is responsible for lower prices) On the supply side, producers just can’t keep operating at a loss forever. According to the IEA, supply will outstrip demand by 2m barrel per day (bpd) for the rest of 2015 and should equilibrate sometime in 2016. It sounds like a lot but it’s not. During Q2-2015, demand was at ~93.5m bpd and supply is at ~96m bpd but some analysts believe the demand side number will be revised upward with demand for gasoline stronger than expected. According to the Federal Highway Administration, the number of miles travelled on U.S roadways rose to the highest level ever in June. It’s easy to disrupt supply. War, geopolitics, a break down in the infrastructure, a problem at a refinery or with a pipeline, issue with transportations are just a fraction of the potential problems that could disrupt supply. Any problem with supply would therefore result in a rapid draw down of oil inventories. Plus you have millions of barrels that need to be replaced every year just because of depletion. Low prices also impact the economics of drilling, reducing additions to supply. What we are seeing right now is that producers are cutting production or leaving oil in the ground. So there’s a lot of pressure on supply. There’s obviously a lot more to oil than what I just mentioned. If you want to learn more about oil I suggest reading letters by Andrew Hall from Astenbeck Capital. That guy knows his stuff but keep in mind he’s a huge oil bull. A good resource is the IEA Oil Market Report. The U.S. Energy Information Administration also post weekly data on oil and energy.

Part Two – Investing in Oil

Just being bullish on oil shouldn’t be a reason alone to go all in and invest. Yes there are a lot of beaten up names out there and it looks very tempting to snap a couple shares here and there. The first thing I do is that I go right to the financial statements and start asking questions. Is the balance sheet strong enough for them to survive? Do they have enough cash to meet their debt obligations? In the crappiest environment, how long can they survive? What are the debt covenants? What’s their netback? How much capex do they need and how are they going to fund it? Any shareholder dilution? How long does it take to convert capital to cash flow? Do the math and invest for the maximum risked return.

Depending on how much time you have and knowledge you can poke at different part of the capital structure of a particular company. Distressed debt can be an interesting segment to look at. I would also look for companies that take advantage of the drop in oil price to review their cost structure. For some O&G companies, a drop in commodity prices can be a constructive county cyclical investment strategy which is designed to take advantage of lower activity level and lower service costs to deliver higher returns on invested capital. It’s an opportunity to lock-in suffering service providers at a lower cost. Basically low prices 1) helps weed out the strong ones from the weak ones and 2) and provide an opportunity for companies to plant the seeds of the future if oil prices turn bullish. If they can operate profitably in such a disastrous environment, the rest is upside.

While the upstream (exploration and extraction) side of part of the industry is in pain, the downstream industry which includes pipelines and trains that transport oil is making a killing in this low price environment. As an example, Phillips 66 (NYSE:PSX) and Valero Energy (NYSE:VLO) are pure refiners. As oil dropped, refiners and retailers are acquiring oil on the cheap which leads to margin expansion.

Integrated O&G companies definitely deserve to be looked at. These companies are involved in many aspects of the oil industry, such as upstream, midstream, and downstream. Companies like Exxon-Mobil (NYSE:XOM) and Suncor Energy (NYSE:SU) have their hands in exploration, refining, and retailing. With an integrated oil company, the business is not overly reliant on the price of oil. What they lose in the upstream part of the business, they make up in the downstream sector, so long as gasoline prices stay high.

You can also look at companies that have zero commodity exposure. Usually these companies have a fee based revenue, like pipelines. Kinder Morgan (NYSE:KMI) and TransCanada (NYSE:TRP) are among the companies that operate oil transportation infrastructure. These companies usually have exposure to volume, not price. What they charge is largely independent of oil prices and they are utility like.

Conclusion

If I can resume all of that, I have no clue what oil is worth and what is going to happen. I suggest you develop your own independent opinion. Take a long-term approach and ignore the noise. Wall-Street is not your buddy, pal, friend, or advisor. Basically don’t invest solely on what I just wrote or others. Don’t just snap up shares just because the sector is beaten up. Take a rational, analytical approach to all decisions. Always do the math and invest for the maximum risked return. Act like a crocodile, wait patiently for the right opportunities and take bold action when the time is right.

How many glaciers can your oil company melt?

Humble Energy, now part of Exxon, bragged about how many glaciers it could melt in 1962. Imagine if that was an actual performance metric. How many glaciers does your company melt?

I know it’s hard to read, in the ad it states that Humble Energy is able to melt 80 tons of glacier each second! That’s insane. I know I’m looking at the ad in insight, but imagine a cigarette company ad in the 50s claiming that their product gives you cancer faster.