Will We All Be Victims of Cheap Oil?

OILEarlier this year we wrote that Russia’s economy was fundamentally weaker than Europe’s and that their decision to start a trade war in retaliation for economic sanctions over the Ukraine would hurt Russia far more than Europe. As it happened Russia has suffered that fate and had a helping more. The collapsing price of oil was a mortal wound to the soft underbelly of the Russian economy, leading to a spectacular collapse in the value of the Ruble and an estimated 4.5% contraction in their economy for 2015.

The Ruble’s earlier decline this year had already made the entire Russian stock market less valuable than Apple Computers, but as the price of Brent oil continued to slide below $60 (for the first time since 2008) investors began to loose confidence that Russia could do much to prop up the currency, prompting an even greater sell-off. That led to an unprecedented hike in the Russian key interest rate by its central bank, moving it from 10.5% to 17% yesterday. Moves like that are designed to reassure investors, but typically they only serve to ensure a full market panic. The Ruble, which had started the year at about 30 RUB per dollar briefly dropped to 80 before recovering at around 68 to the dollar by the end of trading yesterday.

The Russian Ruble over the last year. The spike at the end represents the last few weeks.
The Russian Ruble over the last year. The spike at the end represents the last few weeks.

Cheap oil seems to be recasting the economic story for many countries and millions of people. The Financial Times observes that oil importing emerging markets stand to be big winners in this. Dropping the cost of manufacturing and putting more money in the pockets of the growing middle class should continue to help those markets. The same can be said of the American consumer, who will be benefiting from the sudden drop in gas and energy prices.

The Financial Times always has the best infographics.
The Financial Times always has the best infographics.

Losers on the other hand seem easy to spot and piling up everywhere. Venezuela is in serious trouble, so is Iran and the aforementioned Russia. Saudi Arabia should be okay for a while, as it has significant foreign currency reserves, but as the price drops other member states of OPEC will likely howl for a change in tactic. But along with the obvious oil producing nations, both the United States and Canada will likely also be victims, just not uniformly.

Carbon Tracker Initiative
Carbon Tracker Initiative

Manufacturers may be breathing a sigh of relief in Ontario, but Canadian oil producers are sweating it big. Tar sand oil requires lots of refining and considerable cost to extract. Alberta oil sands development constitute some of the most expensive projects around for energy development and a significant drop in the price of energy, especially if it is protracted, could stall or erase some future investments. This is especially true of the Keystone Pipeline which many now fear isn’t economically viable, in addition to being environmentally contentious.

This chart was produced by Scotiabank
This chart was produced by Scotiabank

Saudi Arabia has continued to allow the price of oil to fall with the intention of hurting the shale producers in the United States. This price war will certainly claim some producers in the US, but it will difficult to know at which point that market will be effectively throttled. Certainly new projects will likely slow down but the continued improving efficiency of the fracking technology may make those producers more resilient to cheap energy.

But there is one more potential victim of the falling price of oil. That could be all of us. I, like many in the financial field, believe that cheap energy will enormously benefit the economy. But our biggest mistakes come from the casual confidence of things we assume to be true but prove not to be. A drop in energy should help the economy, but it doesn’t have to. If people choose not to spend their new energy windfall and save it instead, deflationary pressure will continue to grow. As I’ve previously said, deflation is a real threat that is often overlooked. But even perceived positive forms of deflation, like a significant reduction in the price of oil, can have nasty side effects. The loss to the global economy in terms of the price of oil is only beneficial if that money is spent elsewhere and not saved! For now confidence is that markets will ultimately find the dropping price of oil helpful to global growth, regardless of the early losers in the global price war for oil.

Canada’s Problems Are More Severe Than You Realize

house-of-cardsOn December 10th, the Bank of Canada released it’s Financial System Review for 2014. It outlined numerous problems that continue to grow and potentially undermine the Canadian economy. Globally this report attracted a great deal of attention, not something the BoC is used too, but with a rising concern that the Canadian housing market is overvalued, an official document like the FSR gets noticed.

Screen Shot 2014-12-14 at 10.56.42 AMTo understand why Canada is growing in focus among financial analysts around the world you need to turn the clock back to 2008. While major banks and some countries went bankrupt, Canada and its banking system was relatively unscathed. And while the economy has suffered due to the general economic slowdown across the planet, the relative health of our financial system made us the envy of many.

Screen Shot 2014-12-16 at 10.39.42 AMBut the problems we’d sidestepped now seem to be hounding us. Low interest rates have helped spur our housing market to new highs, while Canadians in general have continued to amass debt at record levels. Attempts to slow the growth of both house prices and improve the standard of debt for borrowers by the government have only moved loan growth into subprime territory.

If all this sounds familiar, it’s because we’ve been talking about it for sometime, and sadly the BoC hasn’t been able to add much in the way of clarity to this story. While we all agree that house prices are overvalued, no one is sure quite how much. According to the report the range is between 10% to 30%. Just keep in mind that if you own a million dollar home and the market corrects, it would move the price from $900,000 to as low as $700,000. That can make a considerable dent to your home equity and its too big a swing to plan around.

Screen Shot 2014-12-16 at 10.39.06 AMOn top of this is the growth of the subprime sector in the market. Stiff competition between financial institutions and an already tapped out market has encouraged “certain federally regulated financial institutions” to increase “their activities in riskier segments of household lending.” This is true not just in houses but also in auto loans, where growth as been equally strong.

The Financial System Review also goes on to talk about problems growing in both cybersecurity and in ETFs (both subjects we have written about). It also talks about some of the positive outlooks for the economy, from improving economic conditions globally and support for continued economic activity. But its quite obvious that the problem Canadians are facing now is significant underlying risk in our housing and debt markets. These problems could manifest for any number of reasons (like a sudden drop in the price of oil, a significant slowdown in China, or a fresh set of problems from Europe), or they may lay dormant for months and years to come.

For Canadians the big issues should be getting over our sense of economic specialness. As I heard one economist put  it “Canadians feel that they will be sparred an economic calamity because they are Canadian.” This isn’t useful thinking for investors and as Canadians we are going to have separate our feelings about our home from the realities of the market, something that few of us are naturally good at. But long term investor success will depend on remaining diversified (I know, I link to that article a lot), and showing patience in the face of market panic.

Concerned About The Market and Recent Volatility? Contact Us!

Only Time Gives Clarity to Investors

The reality of the 21st century is that finding clarity in world events for investors is almost impossible. Take the recent price drop in oil, which has been hailed as both a good and bad thing. And as the new lower price of energy slowly becomes the norm, everyday news reports come in about its respective benefits and unintended negative consequences.

https://twitter.com/Walker_Report/status/540161044786589698

Those seeking to know what those events mean and what guidance headlines should give will only be frustrated by the almost endless supply of information that seeks to empower decisions but leaves many scratching their heads in wonder about the future.

Screen Shot 2014-12-03 at 8.36.05 PM

A big reason for this is the sheer volume of information that we can now rely on. Since the advent of computers and the more recent rise of high-speed communication and networking we have found that the core truth of an event still isn’t apparent until after something has happened. In other words it’s almost impossible to predict corrections before they happen despite an almost inconceivable amount of data and endless ability to process it.

This is true no matter where we look in the world of investing. Consider Black Friday, the end all and be all day in shopping in the United States. This year Black Friday seemed to fizzle. Sales were down 11% year-over-year and that got people nervous. Yet Cyber Monday, the electronic version of Black Friday, sales were up 17% and topped $2 billion for the first time. Combined with the longer sales period leading up to the weekend, many suspect that total sales were actually higher.

All of this data conflicts with each other, which for investors means sometimes you will be wrong. Small things sometimes prove to be big things, and what initially appears simple turns out to be surprisingly complex, and much of it you simply won’t predict. This points investors back to some dull but surprising truths about investing.

1. Not much has changed when it comes to determining what makes a company worthwhile to invest in. Corporate health, sound governance and healthy cash flow still tell us more than loud hype about potential new markets, new products and new trends.

2. Time is a better arbiter than you about investing. The old line is time in the market, not timing the market, and that still appears true. Many Canadians are likely wringing their hands about the sudden drop of oil and the impact it is having on their portfolios. But the best course of action maybe not to abandon their investments, but make sure they are still sensibly invested and well diversified. The market still tends to correct in the long run and immediate volatility (both up and down) are smoothed out over time.

Screen Shot 2014-12-04 at 2.48.01 AM
The S&P 500 over the last 50 years. From Yahoo Finance

Not every sensible investment will work out, but a portfolio of sensible investments over time will. For investors now wondering about the future and their investments in Canada, the best thing to do is understand the logic behind their investments before choosing a course of action.

 

America Is In Great Shape; Be Afraid!

markets_1980043cAll year people have been expecting a correction in the US Markets. For most of the year I have listened to portfolio managers discuss their “concern” about the high valuations of American companies. I have also listened to them point out that America remains the strongest economy and the most likely to see significant growth in the coming year.

Flash forward to late-September, early October and the markets have finally had their corrections. At the bottom every market was negative, including the TSX which had given up all of its YTD high of 15%. That was the bottom. The recovery was swift, money flowed back into the markets, and hedge fund managers managed to make a mockery of some otherwise nervous DIY investors. Now the markets look strong again, with the S&P 500 reaching new highs. Nobody is happy.

All of this comes on the news that US GDP was up 3.9% in the third quarter, a full .5% above analyst expectations (that sounds small, but it’s worth billions) while energy prices continue to decline, manufacturing is highly competitive and US consumers look poised for a significant Christmas bonanza. So what’s wrong with this picture? Why are both the Globe and Mail and the Financial Times worried about the US stock market?

https://twitter.com/Walker_Report/status/537581249440014337

FullSizeRender

The answer is a combination of fear, data, and the insatiable need for stories to populate the media everyday. First is the fear. Stocks are at all time highs. The problem is that “all time high” isn’t some automatic death sentence for a stock market. The stock market always hits new highs all the time, and a by-product of that is that corrections can really only happen after a high is reached. Look at the history of the S&P 500 since 1960:

Screen Shot 2014-11-26 at 11.02.50 AMAs you can probably tell, there are a lot of “new highs” that had occurred over the last 40 years, but each new high did not automatically translate into some automatic correction. There were legitimate reasons why the economy could continue to grow, and in the process make those companies in the stock market more valuable. That isn’t to say that the stock market can’t be “frothy” or that their aren’t problems in the stock market today. It merely means that setting a new market high isn’t proof of an impending collapse.

The second issue is data. We live in an age of Big Data. Data is everywhere and there is so much it can be hard to separate the useful data from the useless. Some of the data is concrete, but much of it takes time to understand or even become clear. The first analysis of the higher than expected GDP numbers seemed great (more economy, Yay!) but upon closer inspection, there are reasons to be cautious. While the GDP was higher than expected, it was largely due to growth in government spending, not consumer spending. In fact consumer spending was lower quarter over quarter. In addition there are a number of concerns about how corporations are spending their profits and whether that is sustainable. Many of these concerns, when taken in context, seem to be the same from earlier in the year.

The third factor is the insatiable need to write something. Content is king in the news world and providing insight (read: opinion) means that you must constantly produce new stories to publish. That means that there is a need to be constantly suggesting that things are about to go wrong (or more wrong than they already have) to create a compelling story. It isn’t that these stories are wrong, just that constantly saying the stock market is going to go down isn’t insightful, since at some point we can expect the stock market to correct for one of a number of reasons.

So is America frothy? Are we poised an some kind of financial collapse? I don’t know, and nobody else does either. We are no more likely to correctly know when the market might correct again than we are to guess the future price of gas. The best response is to diversify, and remember some core elements of investing. Buy low and sell high. With that in mind sturdy investors should probably start giving the beat-up and maligned Europe a second look…

The Failure Of Google Glass Is A Useful Warning To Investors

Google_Glass_with_frameLast week Google announced that it would not be proceeding with another round of Google Glass for 2015, meaning that the most ambitious experiment in wearable technology had come to an end. Google Glass has many failings, ranging from looking stupid to attracting angry mobs of people, but it did seem to be the vanguard of wearable technology. Wearable tech has attracted a great deal of attention, both from consumers and investors, but I have a feeling that it’s rise may be overstated.

For the most part wearable technology is a subset of the “internet of things“, the growth of cloud computing, mobile sensors and high speed communication between stuff. The most beneficial forms of this could be about smart city grids communicating with cars to smooth traffic flows and reduce congestion. In reality it is largely counting how many steps you take everyday.

Looking past the incredible number of terrifying elements about our privacy and data mining that go along with these devices, by and large most wearable technology hasn’t really taken off. Google Glass may be a high end flop, but the vast amount of wearable devices on the markets today have yet to win over big audiences. They remain largely niche devices with a high drop off rate. Where as people adopted smartphones on mass, many people have just shrugged their shoulders and moved on, while those that do buy into wearable tech often stop using it after a few months. This suggests that there is a disconnect between understanding what smartphones get right and wearables get wrong.

That gap is clearly frustrating tech companies, and it will be interesting to see whether Apple’s first wearable device, the Apple Watch, is able to change the pattern. But for investors the allure of the new as a reason to invest should be tempered, and excitement over the prospect of “the next big thing” and the importance of getting in on the ground floor may prove financially costly.

Take for instance TESLA Motors (TSLA: Nasdaq). Tesla may be a car company, but it is treated like a technology company on the stock market, meaning that it is currently trading with a ridiculous P/E ratio, close to 130x next years earnings. Put simply, if Tesla were to pay out all of its earnings to its shareholders it would take 130 years (given current earnings) for you to receive the equivalent value of what you paid for a share. That gives Tesla, a company that sells cars by the thousands a market cap similar to General Motors, a company that sells cars by the millions.

That’s crazy, but normal for the tech world. This has been exceptionally true social media sites like Twitter, Linkedin and Pinterest. All of them also trade well and above “normal” valuations, especially given that they don’t make anything.

The lesson for investors is to be cautious about technology companies. They come with a host of pitfalls and unique qualities that are frequently glossed over in the excitement of the new. Investors have been swept up before with the prospect of some great new device that can’t go wrong, but with some notable exceptions much technology often finds itself on the scrapheap of history. Or maybe we will all start carrying around smart glasses for every beverage

 

Russia’s Entire Stock Market is Worth Less Than Apple Computers

Let's just call this what it is. Awkward.
Let’s just call this what it is. Awkward.

A few days ago a bizarre inversion took place. A single company was suddenly worth more than the entire investable market size of a major economy. While I like Apple a lot and applaud the incredible profitability of the company, this is more a story about how badly the Russian economy is doing.

Back when Russia was first inciting dissent inside the Ukraine following the ouster of the quasi-dictator running the country, it had banked on the idea that it’s continued escalation inside the borders of a sovereign nation would go unchallenged as few countries would wish to risk a military skirmish over a single, marginal country in Europe.

Vladimir Putin miscalculated however when he didn’t realize how precarious the Russian economy was. Sanctions were implemented and what followed was a largely hollow trade war that did more to identify Russia’s weakness than strength. But the most recent blow to Russia has been the change in the price of oil.

Screen Shot 2014-11-21 at 12.31.04 PMNow that the price of oil is under $80, Russia is suffering severely. Like many oil rich nations, oil exports substitute for taxes. This frees autocratic rulers to both pursue generous social programs while not having to answer to citizen complaints about high taxes. It’s how countries like Saudi Arabia  and Iran get by with little democratic input and a relatively passive population with little to no public disobedience about democratic rights (mostly).

This relationship though means that there are actually two prices for oil. First the breakeven price for extracting oil from the ground, and second break breakeven social price of oil. Those prices are different in every country. In Alberta for instance, tar sand oil is usually quoted at $70 a barrel for breakeven. But to cover the costs of running the government the price is much higher. For Russia the slide in price from $109 a barrel to $80 has meant wiping out it’s current account surplus.

Combined with the falling rouble (now 30% lower than the beginning of the year) and the growth of corporate debt sector, Russia is now in a very precarious situation. I’m of the opinion that energy, and energy companies have been oversold and a rise in price would not be unexpected. But whether the price of energy will bounce back up to its earlier highs from this year seems remote.

This is a stock photo of a guy thinking. Could he be thinking about where to invest his money? He could be. It's hard to tell because he was actually paid to stand there and look like this and we can't ask him.
This is a stock photo of a guy thinking. Could he be thinking about where to invest his money? He could be. It’s hard to tell because he was actually paid to stand there and look like this and we can’t ask him.

Over the last few months I’ve been moving away from the Emerging Markets, and while the reasons are not specifically for those listed above, Russia’s problems are a good example of the choices investors face as other markets continue to improve their health. If you had a dollar today that could be invested in the either the United States or Russia, who would you choose? The adventurous might say Russia, believing they could outlast the risk. But with more Canadians approaching retirement the more sensible option is in markets like the US, where corporate health is improved, debt levels are lower and markets are not subject to the same kind of political, economic and social instability that plagues many emerging economies.

 

How To Invest In Energy When You Hate Volatility

***This post will refer to both a mutual fund company and a particular fund. This post should not be construed as endorsing that fund. We always make sure that we cite our sources and in this instance our source is a fund company, and we are not suggesting in any way that you should invest in or purchase this fund. If you are interested in any fund, please consult with your financial advisor first for suitability, especially if that financial advisor is us!*** 

frackingSince the price of oil dropped there have been lots of reasons to be excited. First the price of gas at the pumps is so low that I don’t hate going there anymore. Second, investments in energy have suffered since oil lost close to $30 in value.

WTI price over the last 6 months. From NASDAQ.com
WTI price over the last 6 months. From NASDAQ.com

And while energy stocks have recovered somewhat from their low points, they are still way off where they were earlier in the year. I’m not going to get into the finer points about the nuances of energy producers and the various types of oil and  costs of production. It’s a worthwhile article, but will take up too much time here. Instead I wanted to focus on a different way that Canadians can participate in the energy sector.

Commodities can be volatile but also a valuable element of a portfolio. So how can Canadians play the energy sector while being mindful of the risks associated with it?

The answer may be by investing in what is called “Midstream MLPs”. Midstream MLPs (Master Limited Partnerships) are American operators that transport energy from the producers to the consumers. It’s a capital intensive business that is federally regulated but traded on the stock market. It therefore provides consistent cash flow while offering liquidity to investors. But Canadians already have opportunities for energy infrastructure, so why should they care about this in the United States?Midstream2The answer has everything to do with the rising levels of oil production in the United States combined with what federal regulators are willing to do to encourage new growth.

That brings us to the growth of the shale revolution in the United States. Newly discovered reserves (of significant size), improved technology and a dropping costs of production have set the US on a course to be the largest global energy provider in the coming years. This combination of efficiencies means that the United States is going to continue to increase its oil production over the next decade, while dropping the cost of extraction for each additional barrel. But each barrel produced has to go somewhere.

Projected Oil Growth in the United States
Projected Oil Growth in the United States

In the United States, Midstream MLPs are responsible for moving that oil. But it’s a sector that also must grow. Infrastructure to move oil efficiently from shale producers doesn’t exist yet, and regulators are eager to get MPLs in place with new development. New infrastructure is costly, and while the business model for an MLP doesn’t require a high price for energy to be profitable, it does need assurances about the consistency of the volume of oil to be moved. To encourage that growth regulators are allowing the price that MLPs charge to rise at a rate faster than inflation. Why are they doing that? Much of the shale oil is having to be shipped via rail to get to its right home. This causes price disparities that reduces producer margins and rankles federal governments.

 Pipelines in the US. Most of the pipelines direct energy to Texas, which isn't set up to handle the ultra light crude from shale projects. that energy, coming out of North Dakota, needs to get to New Jersey. The lack of pipelines means it is being shipped by rail to Chicago and then via pipeline.

Pipelines in the US. Most of the pipelines direct energy to Texas, which isn’t set up to handle the ultra light crude from shale projects. that energy, coming out of North Dakota, needs to get to New Jersey. The lack of pipelines means it is being shipped by rail to Chicago and then via pipeline.
The various prices of oil. Oil from Canada is sold at a discount while Brent crude is sold at a premium to WTI. Improving infrastructure would rectify this problem and equalize prices. (The WTI price is listed from the summer). Click on the image to see it larger.

 

Currently there is only one fund option in Canada that we are aware of for investing in MLPs. We had an opportunity earlier this week to meet the managers of this fund and were greatly impressed by what they had to show us. I am already a big believer in the growing Shale Revolution, and am particularly pleased by the arrival of new opportunities for investment. Growth in the Canadian and American energy sectors is good news for not just investors, but also citizens. Russia, Saudi Arabia, Venezuela and a host of other despotic and semi-despotic regimes have been able to get by on the high price of oil. Now they are feeling the pinch of a decreasing price that has the benefit of bringing jobs back to North America while weakening their influence. In all, this is a good story for everyone.

Want to talk oil? Send us a message!