Edge and Odds

The enemy of knowledge is not ignorance, it’s the illusion of knowledge (Stephen Hawking)

It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so (Mark Twain)

Edge and Odds

Invest with smart knowledge and objective odds

BOTTOM FISHING IN THE OIL POOL? THINK AGAIN!

This chart from Ed Yardeni will likely alert the value investor in you. It sure made me work!

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Natural resources investors Goehring & Rozencwajg provide more bait to wet your appetite for undervalued sectors in this overvalued equity market:

In the thirty years we have been investing in global natural resource markets, we cannot remember seeing greater value than we do today in the global oil markets. With both crude
and oil-related securities, the price action appears to have completely divorced itself from underlying fundamentals.

By any measure, oil and oil-related securities are radically undervalued. Over the last 120 years, we estimate it took 17 barrels of oil on average to buy one unit of the S&P 500. Today it requires over 53 barrels. The only time it has taken more was during the parabolic dotcom blow off–incidentally an excellent time to become an oil investor. At the same time, energy-related
equities now make up a mere 4% of the S&P 500 by weight. Not only does this represent the lowest level in at least 20 years (when our records begin), it is 75% below the peak levels reached in 2008 at which point energy stocks made up 16% of the S&P 500.

In particular, the bear market in oil exploration and production companies has created value that can hardly be believed. We analyzed the universe of all US-listed E&P companies with market capitalizations over $100 mm and proved reserves that are at least 50% oil. We then compared the current stock price to the net-debt adjusted SEC PV-10 measure from their 2018 10Ks. As you may recall, a company’s PV-10 measures the discounted cash flow of all proved reserves at the prevailing oil and gas prices. Under normal market conditions, E&P stocks trade at a premium to their SEC PV-10, reflecting the expected value of any future reserves not yet “booked” in the reserve statement. However, due to the overwhelming bearishness among energy investors, the average company now trades at a 12% discount to its net-debt adjusted SEC PV-10 per share value. While we have seen individual companies trade at a discount, we cannot recall a time when the industry average was less than its SEC PV-10 value. We should point out that the price used in most companies’ SEC PV-10 analysis for 2018 was $55 per barrel, not materially higher than today’s price.

We also computed the discounted value of the companies’ proved developed producing reserves (PDPs). This represents the most conservative possible measure of value: a company’s
discounted cash flow from currently producing wells only. As you might imagine, it is very unusual for an E&P company to trade at a discount to this most conservative measure. Today, we estimate that twelve of the twenty-nine companies in the universe are trading at a discount to their PV-10 value using only their PDP reserves. Furthermore, the average premium to PDP PV-10 value across the entire industry is now only 7%. Once again, we have never seen anything remotely like this before. Investors often act irrationally at the bottom of long, drawn-out bear markets and we believe that is what we are witnessing today. (…)

In past cycles, as energy prices fell and E&P stocks sold off, two groups of investors would begin to accumulate positions: natural resource specialists and value investors. Our analysis tells us that natural resource funds continue to suffer material redemptions as investors look to reallocate capital away from the industry. We estimate that nearly 25% of the industry’s assets under management are flowing out through redemptions each year and this figure shows no sign of abating. As a result, resource fund managers are constantly forced to sell positions to meet redemptions, instead of stepping in to take advantage of the deep value. Value managers are also suffering net redemptions. After a difficult ten-year period, growth continues to outperform value and investors continue to chase the momentum of the former by selling the latter. In past cycles, value investors could be counted on to buy during extreme bear markets. but today they are either on the sidelines or liquidating positions to meet redemptions as well. In fact, active managers in general are seeing capital being allocated away into passively managed index funds. As we mentioned earlier, energy now makes up its lowest ever weighting in all the major indices. Therefore, as capital gets redirected from actively managed funds towards passive index funds, energy shares end up being liquidated.

There are no natural buyers for natural resource stocks in general and energy stocks in particular. This has allowed the sell-off to be more severe than past cycles and resulted in unprecedented value for those able to invest in this most contrarian space.

Goehring & Rozencwajg go on to demonstrate that equity markets are totally missing the point on energy stocks, that oil demand is stronger than statistics suggest and that supply, particularly from U.S. shale areas will prove materially less than expected.

Spending one’s working life analysing and investing in natural resources companies is a constant challenge trying to keep pace and understand the large number of low-visibility macro and micro variables impacting these industries, making forecasting in these industries an exercise akin to shoveling clouds.

If you are inclined to bottom fish energy equities, also consider these factoids unexplored by the above quoted duo:

It does take about 50 barrels of Brent oil to buy one unit of S&P 500, making oil seemingly cheap compared to some other periods, but I hardly see any meaningful point in this relationship, certainly not a clear high/low pattern one can secure a valuable hat on. The fact is that the economy needs less and less oil to grow.

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Price to Book for the median U.S. energy stock is currently 1.2, near the very bottom of its 25-year 1.0-3.0 range. Trailing ROE, measuring the return on said Book Value, was 4.3% in 2019, also near the low end of its 0-18% range. Unless ROE can recover meaningfully, the low P/B is justified by the current low return on book.

Energy sector ROE has historically been intimately tied to oil prices which rose from $13 in 1994 to their current $66 with flares exceeding $120 in 2008 and 2011-12. As this CPMS/Morningstar chart illustrates, the problem is the constant decline in the energy industry’s ROE per dollar of oil prices (red line):

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The industry’s trailing 12-month cashflow margin is 17%, at the low end of its 25-year range of 15-30%. But when oil prices averaged $65 in past years, cashflow margins were 19% (2015), 22% (2010), and 25% (2007). This industry clearly has a cost (or efficiency) problem that, to this day, shows no sign of abating. Lower cashflow margins reduce funds available for production and exploration, even more so when oil prices are low.

The median energy company has a debt/equity ratio of 0.7, at the high end of its 25-year range and nearly double its 2006 level when oil prices were also $65. Critically, higher leverage has not translated into higher ROE. The average D/E ratio is 1.0, down from 1.3 at the end of 2015 but well above its 0.8 high between 1993 and 2014. Some large companies are highly leveraged.

As recently revealed by the WSJ, North American oil-and-gas companies have more than $200 billion of debt maturing over the next four years, starting with $41.2 billion in 2020, reaching $68.1 billion in 2022 according to Moody’s Investors Service. It is not clear whether the apparent asset values quoted above fully take this high debt leverage into account.

Energy equities are currently selling at 17.0 times forward EPS per Ed Yardeni’s numbers. The 6.6% discount to the S&P 500 P/E of 18.2 is nowhere near its 30% level of 2000-01, just before Energy’s strong outperforming decade, and hardly compensates for the uncertainty inherent to the sector’s macro variables and its poor, deteriorating fundamentals:

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Forecasting oil prices has been an elusive and slippery activity, even for full time seasoned analysts like Goehring & Rozencwajg. Good luck if you buy energy stocks on a rising oil price forecast. If you are right, you are still invested in a leveraged sector with poor cost control and numerous moving macro parts offering very limited visibility. If you are wrong, you find yourself holding a sharp, oily knife.

While I do not pretend to be part of a typical family (though not very far from it), I can only notice that of my 9 immediate family households, five recently changed one of their cars and four opted for either a hybrid electric vehicle (1) or full EV Teslas (3). One of our sons bought a Model X and we and a nephew each now drive a Model 3. Frankly, these are truly unique and really great cars, totally redefining the car ownership/driving experience with unique, efficient software that gets regularly updated to constantly improve the car efficiency, safety and driving/owning pleasure. Of my immediate family’s combined 12 cars, 3 no longer need to visit a gas station, ever, and one only very occasionally.

In many respects, Teslas remind me of the cellular phone in the early 1990s. Early adopters bought Blackberries and IPhones for their portability. When people started to realize/understand the power of the software embedded in these little boxes, they wanted/needed them for their various and ever expanding functionalities. Cellphones went from portable telephones to increasingly convenient, efficient and evolving software in the pocket. It may not be long before people realize/understand what owning a Tesla really means: beyond being a great electric vehicle, a Tesla is convenient, efficient and evolving software on wheels. This disruptive trend is there to stay and accelerate.

This chart from Ed Yardeni shows world oil production’s relentless rise…

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…while this chart, using the U.S. EIA numbers, illustrates how production keeps outrunning world consumption.

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The truth is that oil has a growing demand problem that some producing nations attempt to offset with complicated and elusive controls of a pool of supply that is becoming more and more marginal. Meanwhile, technology keeps reducing production costs for the marginal barrel, dragging down commodity prices along with margins for this high legacy costs industry.

In such a context, it is difficult to see who will be the next “natural buyers of energy stocks”. Certainly not the increasingly environmentally conscious young investment managers and their increasingly environmentally conscious clients, and certainly not the growing cohort of Tesla owners.

THE DAILY EDGE: 3 JANUARY 2020: Manufacturing PMIs

Happy and Healthy New Year

Posted December 30: THE RULE OF 20 STRATEGY GOES ALL CASH
DECEMBER MANUFACTURING PMIs
USA: Manufacturing output continues to recover amid further new order growth

December data pointed to a further recovery in operating
conditions across the U.S. manufacturing sector. The sustained
improvement was supported by a solid rise in new business and
a further upturn in production. Output expectations remained
historically muted, however.

Meanwhile, rates of both input price and output charge inflation
quickened amid higher cost burdens and the ongoing impact of
tariffs.

The seasonally adjusted IHS Markit final U.S. Manufacturing
Purchasing Managers’ Index™ (PMI™) posted 52.4 in December,
down slightly from 52.6 in November and in line with the flash
figure. The latest data indicated a modest improvement in the
health of the U.S. manufacturing sector. The final quarterly
average of 2019 was in fact the strongest since the opening
three months of the year.

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Output growth across the sector softened from November’s
recent peak, but was moderate nonetheless. The expansion was
linked to greater client demand and a rise in new order volumes.
The rate of increase was still well below those seen at the end of
2018, however.

New business received by manufacturing firms grew at a solid
rate in December, and one that was the second-strongest
since April. The sustained rise in client demand was partially
attributed to the acquisition of new clients and reviving export
sales. Goods producers reported a third consecutive upturn in
new export orders.

The overall rate of expansion nevertheless faltered somewhat
in December and remains well below that seen this time
last year, suggesting producers are starting 2020 on a softer
footing than they had enjoyed heading into 2019.

On the price front, cost burdens rose at a solid pace at the end of
the fourth quarter. The rate of input price inflation accelerated
to a nine-month high as firms stated that higher supplier costs
and tariffs had driven prices up.

The pace of output charge inflation also quickened to the joint-fastest since February and was solid overall. Companies commonly attributed the rise to the partial pass-through of
higher costs on to clients.

Despite an increase in client demand, output expectation
towards the coming year remained relatively muted at the end
of 2019. Nonetheless, the degree of confidence picked up from
that seen in November, with optimism reportedly stemming
from new product development, new client wins and investment
in new facilities.

Meanwhile, a further upturn in new business drove firms to
expand their workforce numbers in December. Employment
growth was the second-fastest since May, with firms stating
the increase largely stemmed from greater production
requirements.

Strain on capacity was also reflected in a further accumulation
of backlogs of work. That said, the rate of growth in the level
of outstanding business was only marginal and eased from that
seen in November.

Finally, input buying rose for the third month running amid
efforts to stockpile raw materials. Post-production inventories
were little-changed, however, as sales from stock weighed on
growth.

China: Operating conditions improve again in December

The health of China’s manufacturing sector continued to improve in December, with firms registering a further strong rise in output. However, the rate of new order growth eased to a three-month low, and export sales rose only slightly. At the same time, confidence towards the 12-month business outlook remained relatively weak, and staffing numbers stagnated. Nonetheless, a further rise in new work prompted firms to expand their purchasing activity and inventories, which in turn placed further strain on supply chains. Operating expenses rose for the fourth month in a row, albeit marginally, which underpinned a renewed increase in selling prices.

The headline seasonally adjusted Purchasing Managers’ Index™ (PMI™) posted 51.5 in December, down from 51.8 in November. The latest figure remained consistent with a modest improvement in the health of the sector, with conditions now strengthening in each of the past five months. That said, the latest PMI reading was the lowest seen since September.

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Weighing on the headline index was a softer upturn in total new business at the end of the year. The rate of new order growth was modest, having eased to a three-month low. Panel members suggested that demand both at home and abroad had improved, though export work continued to rise only slightly overall.

Domestic demand expanded, but less quickly than in the previous two months. While the subindex for total new orders fell further in December from its high in October, the gauge for new export orders fell more slowly, suggesting growth in domestic demand is slowing more rapidly.

The sustained rise in new orders underpinned a further increase in production volumes during December. The rate of expansion remained strong overall, despite edging down for the second month in a row.

Staffing levels were unchanged in December, as a number of firms mentioned efforts to contain costs and boost efficiency. As a result, the level of outstanding business rose again, albeit at a weaker pace.

Purchasing activity rose for the sixth month in a row, though the rate of growth cooled from November. This, in turn, led to an increase in inventories of purchased items. Inventories of finished goods also expanded at the end of the year, which some companies linked to expectations that demand conditions will improve in the months ahead.

Firmer demand for inputs placed further pressure on supply chains, with average lead times for purchased items lengthening again in December.

At the same time, manufacturers registered a further rise in operating expenses, which was attributed to greater raw material and staffing costs. However, the rate of input price inflation was marginal and much softer than the series average. Nonetheless, the further increase in costs led companies to raise their selling prices for the first time since June, and at a modest rate.

Although Chinese goods producers generally expect output to rise over the next year, concerns over ongoing trade tensions, environmental protection policies and intense market competition meant that overall sentiment remained weaker than the historical trend.

Eurozone: Manufacturing downturn deepens during December

Having reached a three-month high in November, the
IHS Markit Eurozone Manufacturing PMI® lost
momentum in December. Posting 46.3, down from
46.9 but slightly better than the earlier flash reading of
45.9, the PMI remained below the crucial 50.0 nochange
mark for an eleventh successive month.

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Highlighting the continued underlying weakness in
sector performance, the PMI averaged 46.4 in the
final quarter, unchanged on the previous quarter’s
near seven-year low.

Market groups data indicated that manufacturing
underperformance was centred on the intermediate
and investment goods sectors, with the respective
PMIs remaining well inside negative territory.
Conversely, marginal growth was recorded in the
consumer goods category for the first time since
August.

image_thumb20There was a broad-based softening of PMI figures during December, with seven of the eight countries covered by the survey recording weaker PMI numbers compared to November (the exception being Austria,
which registered an unmoved reading).

Germany was again the weakest-performing country,
whilst the deteriorations seen in Italy and the
Netherlands were the sharpest in over six-and-a-half
years. Conversely, growth was sustained to a solid
degree in Greece, whilst a marginal gain was seen in
France.

Both production and new orders continued to
deteriorate markedly during December. Latest data
showed output falling for an eleventh successive
month and at a rate that matched September’s 81-
month record. Levels of incoming new work also fell
at a sharper rate. That was despite the weakest
reduction in new export sales since the start of the
year.

With new work continuing to fall, manufacturers were
again able to make notable inroads into their existing
contracts. Backlogs of work declined for a sixteenth
successive month, and at a faster rate compared to
November. Spare capacity subsequently weighed on
employment, which declined during December for an
eighth successive month. Moreover, the rate of job
losses was the sharpest recorded by the survey since
the start of 2013. In line with recent trends, job
shedding remained centred on Germany. Greece, in
contrast, saw strong employment growth, with France
the only other country not to record lower employment
during the month.

Further evidence of general manufacturing
retrenchment was provided by purchasing and
inventory data. The volume of inputs bought by
manufacturers declined during December for a
thirteenth successive month, whilst inventories of both
inputs and finished goods continued to fall.

With demand for inputs deteriorating, supplier delivery
times again improved to a historically marked degree
at the end of 2019. Vendor performance has now
strengthened for ten months in succession.
Further highlighting supply-side slack was a further
fall in input prices, the seventh in consecutive months.
Although the weakest since September, deflation
remained marked and provided further room for
manufacturers to lower their own charges. Latest data
showed output prices falling again in December, as
they have done in each month since July.

Finally, confidence about the future continued to
steadily improve at the end of 2019. Having hit its
lowest in over six-and-a-half years during August,
expectations about output strengthened to a six month
high during December. Except for France and
Greece, sentiment improved across the region.

The survey is indicative of production falling by
1.5% in the fourth quarter, acting as a severe drag
on the wider economy. (…)

Only households provided any source of improved
demand in December, underscoring how the
consumer sector has helped keep the economy out
of recession in recent months. The ability of the wider
economy to avoid sliding into a downturn in the face
of such a steep manufacturing contraction remains a
key challenge for the eurozone as we head into
2020.

U.S. Initial Claims for Unemployment Insurance Edge Down by 2,000

Initial claims for unemployment insurance decreased 2,000 in the week ended December 28 to 222,000 (-3.9% y/y) from the prior week’s 224,000, which was revised upward by 2,000. The four-week moving average of initial claims rose to 233,250 from 228,500. (…)

The 4-w m.a. has crossed above its 2-year range…

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