Feb 6, 2017 | ETFs, GDXJ, Post of the Month, VIX, Volatility Portfolio
The most widely followed volatility measure, the CBOE S&P 50 Volatility Index (VIX), is going nowhere. The VIX, commonly known as the fear index, closed at 11.37 today, February 6 and it is stuck below both its 50-day moving average of 12.09 and its 200-day moving average at 14.01.
Which doesn’t mean there’s no volatility or no fear in the markets. It’s just not reflected in the market for puts and calls on the S&P 500.
Other measures, however, are flagging uncertainty in the financial markets. Some politically-inclined analysts are, for example, looking at the gap between the VIX and the Global Economic Policy Uncertainty Index. It’s now at its highest level on record. Others, unwilling to give up on the VIX completely, are looking at the CBOE Skew Index, which measures the price of buying protection against more dramatic moves in the S&P 500. The VIX itself may not be signaling an increase in worry but investors are willing to pay to hedge the more extreme if less likely downside outcomes in the tail of the bell curve.
And then gold. We all know that gold doesn’t go up when interest rates are expected to rise–except when expectations for inflation–which is good for gold–and worries about market uncertainty outweigh expectations for rising inflation.
And, strikingly, that’s where we seem to be now. The yield on the 10-year U.S. Treasury has climbed to 2.44% from 1.77% since the November election.
But gold, rather than wilting is showing solid strength. Gold and silver ETFs are among the best performers on a 1-month and year-to-date basis on fears that inflation in the United States and other economies, such as Germany, is showing signs of breaking out of its target bounds. Gold mining stocks tend to be more volatile than the price of gold bullion ETFs (such as GLD, the SPDR Gold Trust) since the costs of miners are relatively fixed making a change in gold prices a huge deal for their bottom lines. The Juniors are more volatile than the bigger companies in the VenEck Vectors Gold Miners ETF (GDX) because their balance sheets tend to be more leveraged and the stocks themselves are riskier. Decide for yourself how much risk you want to add to your portfolio. The VanEck Vectors Junior Gold Miners ETF was up 7.72% today. The senior ETF climbed “just” 3.67%.
Before we leave the subject of gold and volatility, however, there’s one pattern worth mentioning. Most of the time, indeed, gold falls when interest rates rise. Logical. However, when inflation fears are enough to overwhelm fears of an interest rate increase, the combination can signal a negative move in the market. Three consecutive quarters of rising benchmark bond yields and rising gold prices preceded previous market falls including the 1973-1974 bond market crash and Black Monday in 1987, Chris Flanagan at Bank of America told Bloomberg. The yield on the 10-year Treasury has climbed to 2.44% from 1.77% since the November election. Gold, which has been among the best performers in the shorter term, has moved sideways in that longer period.
Something to watch.
Jan 24, 2017 | Options, Post of the Month, Stocks
Way back on January 5 I posted that 2017 looked like a very promising year for technology LEAPS, especially for Apple (AAPL) and Facebook (FB), two technology stocks where near term volatility has created promising opportunities.
(LEAPS, Long-term Equity AnticiParticipaton Securities are long-dated options that can run for up to three years.)
I argued that LEAPS gave you a way to take advantage of the big volatility in technology stocks and get the significant leverage created by buying options instead of actual shares without having to get the timing of the tops and bottom exactly right. With LEAPS if the rally in Facebook happens in September rather than May, for example, you can still profit from the gain instead of seeing a standard May option expire worthless. Mind you I don’t think the strategy I’m about to suggest will work for all technology stocks–you have to pick stocks where the long-term trend is powerfully upwards but where the short-term road has a few major potholes. To my mind Facebook and Apple are ideal candidates right now, I wrote.
And I promised to follow up on what happened with these Apple and Facebook LEAPS as we got close to and then moved beyond the next earnings report.
So what’s happened?
As frequently occurs with long-dated options, as a big event nears–Apple’s December quarter earnings announcement on January 31, and Facebook’s earnings report on February 1, the price of the January 19, 2018 and the January 18, 2019 call options soared. A call option is the right to buy at a specific price at a specific date in the future. On January 15 2017, for example, you could have bought the call option to buy 100 shares of Facebook at $125 a share for a premium of $1275. If you bought that call, you’d be hoping that shares of Facebook moved above $125 before the option expired in January 2018. The right to buy at $125 becomes valuable if, say, Facebook shares trade at $129.37, the close on January 24. The price of those call options you could have bought for $1275 had climbed to $2217.
To simplify, the price of an option depends on three things. First, the price of the underlying stock. The value of the right to buy Facebook in the future climbed in the early days of January since the price of Facebook shares went up. Second, the time until the expiration of the option. An option is a wasting asset which will expire worthless at that specified future date. As that date gets close, the value of the option begins to decay since the time remaining for the underlying asset to make its move gets less. And, third, expectations among traders and investors that some event is approaching that will accelerate the movement of the underlying stock. Expectations for volatility are especially important in setting the price of long-dated options. Long-dated options, such as LEAPS, tend to move more in response to expectations for volatility that surround a big event than do short-dated options.
That last is the biggest reason for the increase in the price of the long-dated call options for Apple and Facebook. Heightened expectations that the earnings announcement on January 31 for Apple and February 1 for Facebook would move the shares led more traders to want to buy options on that move–which led to a rise in price for those options since traders who were selling calls (and thus giving up their right to participate in any gains in the stock) were demanding and receiving a higher price for those calls from traders who wanted to buy that right.
In the world of options that expectation that an event is about to move the price of the underlying asset–and thus the option–is measured by something called implied volatility. Implied volatility is an indication of how big a move traders are expecting in a stock and option and implied volatility increases as expectations for a big move rise. For Facebook, for example, implied volatility for those $125 January 19, 2018 calls had climbed to 22.39% by January 17.
The general rule for buying an option at a reasonable price is to buy when implied volatility is low–and to sell when implied volatility is high. That lets you buy when demand for the option–and its price–is relatively low, and sell when demand for the option is high.
Frequently what this means is that the implied volatility and thus the price of a long-dated option will climb significantly into the big event–and then decline significantly afterwards as those traders who wanted to leverage that big event move on to other trades and other options.
Will that happen this time with Apple and Facebook options?
There were signs going into Apple’s actual earnings report day that this pattern might be visible. Implied volatility on the Apple $125 January 19, 2018 LEAPS had stalled, moving down slightly from 22.39% on January 17 to 22.17% on January 24. For those of us interested in the long-term play on Apple’s introduction of the iPhone 8 (or whatever) in the fall of 2017, this is a potential trend that is potentially worth watching.
Maybe, although I think there are other trends at work, the same pattern is visible in implied volatility for Facebook $125 calls for January 19, 2018. Implied volatility for those calls had crept lower to 30.10% on January 24 from 30.50% on January 17. Remember the big event date for Facebook is still a little more than a week away.
So those are the trends that I’m monitoring. If you’re a shorter term trader than I am and rushed out to buy the options a couple of weeks ago, be sure to take a close look at the trends in implied volatility to see if you want to sell as the big earnings events for these two stocks come and go.
Full disclosure: I own shares of Facebook in my personal portfolio.
Jan 9, 2017 | ETFs, Post of the Month, Stocks
The IShares MSCI Emerging Markets ETF (EEM) is actually up 1.87% in the last five days and up 0.08% in the last month.
Which is pretty stunning given that Brazil and Mexico, two of the biggest and more consequential of developing economies, have descended into something near chaos. And the path of those two economies suggests worrying possibilities for other emerging markets such as Turkey and the Philippines.
In case you haven’t been following the news:
In Mexico the administration of President Enrique Pena Nieto raised gasoline prices by about 20% on January 1 as it ended some subsidies that had kept prices at the pump below the market price for gasoline. By the end of the year, the government says, prices will fluctuate with the markets. Mexico imports about 50% of its gasoline from the United States and with the peso near a historic low against the dollar, the cost of that imported gasoline has soared.
What the government got in response were mass protests and violent riots that seem to have caught the government by surprise. Protestors blocked roads across Mexico and took over the customs office on the border near San Diego, halting southbound traffic. Businesses have been looted with 1,500 people arrested. Five people have been killed in the riots.
Protestors, even those without cars, fear that higher fuel costs will raise the price of just about anything that travels on road to reach stores. And that higher fuel prices will force businesses from taxis to trucking companies to small stores to go out of business.
In Brazil prison riots between competing drug gangs have left piles of mutilated and decapitated corpses. At a prison in Manaus, 56 prisoners would up dead after violence blamed on the Northern Family and First Capita Command drug gangs. At another prison riot in Roraima state, in the far north of Brazil, at least 30 prisoners have been killed in what may have been retaliation for the Manaus massacre.
As in Mexico, the Brazilian government has looked on in surprise. President Michel Temer, who took over after the impeachment of Dilma Rousseff, waited three days before saying anything and then called the killings a “terrible accident.” Some government officials have gone so far as to say that since these are privately run prisons, the government has no responsibility for what has happened there.
Now I’d never ask you to accept that two points make a trend, although they do describe a line, but Mexico and Brazil do have enough points in common to sketch in a larger problem for developing economies.
Growth in the Mexican economy has been sluggish and threatens to get more sluggish if President-elect Donald Trump imposes a tariff or higher taxes on Mexico’s exports to the United Atates. For 2016 the Mexican central bank had been projecting GDP growth of 2.2% to 3.2% but it recently cut its forecast to 2% to 2.6%. GDP fell 0.2% in the second quarter from the start of the year. The central bank has been successful at keeping inflation below its 3% target but only by raising interest rates by 2.25 percentage points to 5.25% since the end of 2015. The government has succeeded in reducing the size of the budget deficit, even with a huge fall in tax revenue from oil production by Pemex, but that has resulted in cuts to social programs and in subsidies such as the recent reduction in gasoline subsidies. In short growth is slow, taxes and inflation and interest rates are up, the peso is way down, some of the country’s poorest have been hit hard, and the country faces deep uncertainties about the future from beyond its own borders.
And in Brazil? A remarkably similar picture–but replace sluggish growth with a grinding two-year recession, the deepest two-year down turn in a century.
The Brazilian economy contracted by 3.8% in 2015 and is forecast to contract by another 3.22% in 2016. The central bank raised interest rates to a stunning 14.25% before cutting them by 25 basis points on October 19. As you might expect, against that headwind growth is not looking any too rosy in 2017 with the Banco Central Do Brasil forecasting 1.23% GDP growth, down from an earlier forecast of 1.3%. Inflation is predicted by economists to fall to 5% in 2017. The government of President Temer has cut spending in an effort to bring the budget deficit under control but, even more so than in Mexico, a large part of those cuts have fallen on Brazil’s poorest–who have already seen their spending power cut by inflation, higher interest rates, and a falling currency. Any turn around in Brazil depends to a great degree in a recovery in prices in overseas markets for the country’s commodity exports.
There are other similarities too. Political leadership at this time of economic crisis is essentially bankrupt in both countries. In Mexico President Pena Nieto has rock bottom approval ratings and all levels of government are beset with deep public distrust after years of drug wars and killings, and public corruption. Unfortunately for Mexico the country won’t conduct a presidential election until 2018. Brazil doesn’t hold its next presidential election until 2018, as well, and the big question there is whether there will be any politicians left to run by then. The country’s continuing wave of corruption scandals has already taken down not just former President Rousseff, but also many of her opponents who led the impeachment fight.
The pattern here, I’d argue, is that economic hard times test a country’s political institutions and leadership. This is true, obviously, of developed countries as well–I’d argue that we’re witnessing that kind of a test in the United States, the United Kingdom, Italy, and France just to name a few current hot spots–as those in the developing world. But at this point in the current economic cycle, developing economies seem especially vulnerable to this combination of economic distress and political failure. And the risks are, that in 2017, this combination will extend to other countries in the developing world–the Philippines looks to have already headed down this path, Russia is hoping to be bailed out by rising oil price, South Africa threatens to take such a journey, Thailand’s institutions seem especially vulnerable after the death of a revered king.
China has its own problems with economic growth but at the moment the government seems to be a bulwark against the kind of unrest seen in a Brazil or Mexico. The costs of constructing and maintaining that bulwark in a slower economy are certainly clear. The Beijing government has clamped down on any institution that might threaten its control of the country. It has abandoned crucial economic reforms in favor of stability. And it has ratcheted up its most jingoistic and nationalistic rhetoric.
In the the short run that has left China as a stabilizing force in the iShares MSCI Emerging Markets ETF. That ETF is overweighted toward China and Asia with 26% of cash in Chinese assets, another 15% in South Korea (is South Korea still an emerging market?) and 13% in Taiwan (same question). Only 13% of the fund’s cash is in Latin America.
In the some whatever longer run this reliance on China’s stability understates, in my opinion, the risks of the emerging market asset class in general and of China in specific. The pressure that even 6% growth puts on China’s institutions and leadership increases the odds that China will make a policy mis-step on its currency, on its banking system, on corporate bad debt, and most likely, on its trade relations with the United States. I don’t see China going the way of a Mexico or Brazil–it’s a very different society with a very different set of political institutions. But I do think it’s important to realize that China too is feeling the pressures of slower growth, a stronger U.S. dollar, and questions about the legitimacy of its political institutions. This isn’t a time to be complacent about China and about emerging market assets.
Dec 20, 2016 | Bonds, ETFs, Post of the Month, Stocks
Where to begin?
China faces a depreciating currency, a bond market that has switched from rally to sell off, huge outflows of cash, and what looks like a resurgence of inflation.
Fixing one of these problems alone would be a huge challenge to the People’s Bank. The combination leaves the central bank with a situation where fixing one problem may just make the others worse. Increasingly the People’s Bank looks like it is rushing from problem to problem, giving the crisis-of-day a whack and then rushing to figure out what’s likely to pop up next that will deserve a bash with the mallet. As anyone who has ever played the boardwalk game Whac-A-Mole knows, this kind of frenzy usually doesn’t result in anything good.
The most recent crises that need a whack are in the bond and property markets. The 10-year government bond climbed to an 18-month high yield of 3.35% last week (remember bond prices fall when yields climb) and trading in futures on the 10-year bond was suspended briefly last week after they fell by their maximum 2% limit. It was the first suspension in futures trading since it was relaunched in 2013.
There seem to be two causes for the bond market rout. First, the decision by the U.S. Federal Reserve to raise interest rates resulted in cash flowing out of the Chinese yuan and yuan-denominated assets and into dollars. Second, the People’s Bank of China has tightened China’s money supply in an effort to damp inflation and to deflate/prevent bubbles in China’s real estate and wealth management markets.
In the real estate market central bank policies have brought housing prices to a standstill in China’s top markets. In November prices for newly built homes in Beijing, Shenzhen, Shanghai, and Guangzhou grew by just 0.1% from October. Month over month price increases had been growing by 3% to 4% recently. The result isn’t surprising since city governments had made it harder to buy second homes and increased the size of required down payments. Property developers have been prevented from borrowing to buy land. Real estate analysts are now forecasting a 5% to 10% drop in home prices in these markets.
All of which has had the un-intended effect of pushing down growth in the economy as a whole, perhaps enough to put next year’s target of 6.5% growth at risk. It has also added to the stress in the financial system as banks are now looking at increased levels of debt from property developers. Slightly further down the road, fears of slower economic growth and of China’s growing bad debt problem put more pressure on China’s currency. A slump in real estate prices would send even more cash off shore, legally or illegally, as wealthier Chinese look for safe havens for their money.
At the same time the Ministry of Finance has cut the size of its bond offerings. The last sale saw just 16 billion yuan offered when the sale had been previously announced at 28 billion.
The end of the bond rally has created ripples that have spread out across the economy. Traders and investors had been borrowing money at low rates in the money markets and then using that to buy bonds, which then rose in price, encouraging more people to pour into this trade. Since August, though, the People’s Bank has been tightening money supply in money markets and that has led to lenders asking for their money back–since the People’s Bank action had reduced their access to liquidity too. With bond prices falling as well parts of the interconnected financial and corporate sectors are starting to feel the squeeze. That’s an especially big problem in the corporate sector where many Chinese companies have loaded up on debt, raised money in the debt markets to make up for a lack of profits, or themselves traded the financial markets to make up for the cash that their core business isn’t generating.
All this has sent traders and investors–and indeed anyone with cash–scrambling in two directions. First, it has sent even more cash into managed products at banks and other investment managers. Some of this cash is actually money generated by loans from the very institutions that then invest the proceeds and those loans are often collateralized with bonds and other assets that have lost value lately. The People’s Bank has cracked down recently on these off-the-books loans and investment products in an effort to prevent China’s banks and companies from building their big mountain of bad debt even higher. Second, cash looking for returns and safety has been looking to leave China. That has led to further downward pressure on the yuan–which has forced the People’s Bank to spend more than $1 trillion in foreign exchange reserves to prop up the country’s currency. And it has led to new tighter regulations designed to slow the flow of money out of China. Those currency restrictions have severely undermined efforts by Beijing to win reserve currency status for the yuan. (And the efforts to support the yuan haven’t been totally successful. The currency is down 6.7% in 2016. Which, of course, has just added to fuel to arguments in the incoming Trump administration to brand China a currency manipulator.)
Add in a very recent uptick in inflation–producer pries haste climbed 3.3% in 2016 as of November–and the People’s Bank may be looking at having to start whacking another set of problems.
Effects from all of this for you and your portfolio to worry about? First, any slowdown in China will have a huge effect on the global economy and especially on those developing economies that rely on commodity exports. Second, China’s willingness of resort to currency controls has emboldened other development economies to consider similar moves. Indonesia, Malaysia, and India are on Wall Street’s short list for countries considering currency controls. Third, the depreciation of the Chinese yuan and of other emerging market currencies such as the peso and Turkish lira will make efforts by the Trump administration to cut the U.S. trade deficit really, really difficult–especially if those economies slow. There’s certainly a chance for an overreaction by the incoming U.S. administration.
And, there’s also an increasing chance that the People’s Bank will reverse policy again, having decided that sacrificing growth in order to prevent further deterioration in the financial system is just too politically dangerous. That has happened before. The cost is pushing off any solution to the real problems and allowing them to become bigger. Which makes them tougher to eventually address.
Dec 6, 2016 | Bonds, ETFs, Everyday Life, Options, Post of the Month, Stocks, Volatility Portfolio
It’s not like there isn’t any volatility in the financial markets, ya know.
The Federal Reserve is about to raise interest rates for the first time in 2016. The euro is tanking. The Italian government just collapsed. Oil prices have rallied on an OPEC production deal nobody really trusts. And the President-elect has managed to rile and/or confuse China and a good bit of the rest of the world–including the leaders of his own party who aren’t sure what to make of his call for a 35% tariff that could well set off a trade war.
Yet with all of this, the Chicago Board Options Exchange S&P 500 Volatility Index (VIX) continues to drop lower almost every day. It closed today at 11.79, down another 2.88% on the day. The 52-week low at 11.02, set back in August when it looked like the much more predictable Hillary Clinton was going to win the Presidential election, is just a tad lower than today’s level.
The VIX measures how much investors and traders are willing to pay for options to hedge against a drop in the S&P 500. So right now it’s safe to say no one is thinks it’s worth very much to pay up for that protection.
Why not? And what does the reason tell you about when (or if) you might want to buy options on the VIX or put some money into an ETF like the ProShares Ultra Vix Short Term Futures ETF (UVXY) in order to profit when the volatility trend turns?
I think the simple reason the VIX is so low is that this index reflects not volatility in the financial markets but volatility in U.S. stocks. And right now, while there’s a lot of volatility in the financial markets it’s all concentrated in the bond and currency markets. And not in the U.S. stock market. At the moment, I’d say in fact that no one is especially worried about U.S. stocks. They are, in fact, the asset that everyone thinks they should be buying right now.
Look at bonds in November. The Bloomberg Barclays Global Aggregate Total Return Index lost 4% in November. That’s the worst performance for this bond index since its beginning in 1990. Global bonds have lost $2.8 trillion (yep, with a “T”) in the last two months.
But they’ve lost it because of news that for the most part bodes well for stocks. The new Trump administration is going to propose a $1 trillion package to build infrastructure–that will stimulate the economy and modestly increase inflation. The new administration has also proposed a huge tax cut, which should also stimulate growth and increase inflation. Faster growth is good for stocks as is moderate inflation (since it let’s companies raise prices.) A single interest rate increase by the Fed, which is all we’re looking at right now, won’t hurt economic growth significantly (U.S. central bankers hope) and it’s even good for earnings in the financial sector.
No wonder that while bonds have slumped, stocks have climbed with the S&P 500 up 3.79% as of the close today December 6 and with that index and the Dow Industrials hitting new record highs just about every day. The Dow Jones Industrial Average, in fact, set another new record high today.
See any reason there to hedge U.S. equity positions?
Or how about looking at the dollar and currency markets if you’re looking for volatility and hedges?
The Fed’s trade-weighted dollar index rose climbed 3.9% from November 8 to November 29. That has raised the cost to investors in the yen and euro, who want to hedge against a further rise in the dollar. And this doesn’t look to get better with some investment houses predicting a dollar shortage in Asia (which means higher prices for the dollar) in 2017.
Traders don’t have to wait for volatility in the bond and currency markets to fall in order to see volatility for stocks climb. In fact, at some point volatility in bond and currency markets is likely to lead to an increase in volatility in stocks. A stronger dollar, for example, isn’t good for U.S. stocks if it gets so strong that it cuts into earnings. Higher interest rates, which produce falling bond prices, aren’t good for stocks at some level either because they raise borrowing costs and slow growth in the economy.
But as long as traders and investors see putting money into U.S. stocks as a way to escape falling bond prices and as a way to participate in a rising dollar, it’s unlikely we’ll see a significant pick up in volatility as measured by the VIX.
I don’t see the VIX falling a lot further at this point but the index is likely to remain resistant to events that might otherwise cause a pickup in stock market volatility for a while. (This is, of course, absent some geopolitical mis-step that creates a real global crisis.)
I do see that changing once Donald Trump goes from being President-elect to President. At that point he will have to deal with the reality of Congressional politics that won’t always give him what he wants on the budget, on taxes, on infrastructure, and on trade. Turning vague proposals into real numbers will itself make financial markets–including the stock market–more nervous. We’ll go from “Gee, it’s great that we’re going to put $1 trillion into infrastructure” to “I’m worried that this plan won’t make it through Congress,” and we’ll go from relief that the Federal Reserve thinks the economy is strong enough to take an interest rate hike in December to wondering how many times the Fed might raise interest rates in 2017 and thinking about the dangers of a global recession and trade wars.
My best estimate at this point is that you don’t risk seeing volatility sink a whole lot further at this point, but that you won’t make much money on volatility either (absent an unpredictable geopolitical event) until some time in early 2017. I’d peg February or March as a reasonable schedule. Betting on rising volatility right now isn’t wrong; it’s just early. In my opinion.
Dec 1, 2016 | CHK, COP, Jubak Picks Portfolio, LNG, Post of the Month, PXD, RSPP, SDRL, SLB, STO, Stocks, Top 50 Portfolio, XOM
The entire energy sector was up today–but not every stock rose to the same degree.
I think these themes defined the way that the market grouped stocks in the energy sector.
- Big gains went to U.S. oil from shale producers–and especially to producers with big positions in the low-cost Permian Basin. Pioneer Natural Resources (PXD) was up 10%; Parsley Energy (PE) climbed 15.75%; and RSP Permian (RSPP) rose 14.66%. Logic here is pretty straightforward. Companies operating in the Permian are working on a low cost geology with break-even a $30-$40 a barrel and because of new discoveries in the geology they have the ability to rapidly increase production in response to any increase in oil prices. These companies were adding drilling rigs even before today’s announcement of an agreement on production cuts from OPEC with companies such as Pioneer projecting 13% to 17% increases in production. Higher oil prices will, Wall Street was projecting today, lead to an even quicker ramp in production. The problem with this group is that they were already moving up in price before today’s OPEC news and with the jumps today the upside to Wall Street target prices is getting a bit slim. According to Yahoo Finance, the median target price on Parsley is $43.06 (shares closed today at $38.15); on RSP Permian $50.80 (today’s close $44.65); and on Pioneer Natural Resources $214.63 (today’s close $191.04.) Remember that before today’s news Wall Street was projecting that oil might climb to $55 a barrel on a “strong” announcement. West Texas Intermediate at today’s close of $49.00 a barrel and Brent at today’s close of $50.47 aren’t all that far away from that $55 a barrel projection. All these target prices, however, were based on lower oil prices and I expect that Wall Street analysts are burning the midnight oil tonight in an effort to figure out how fast the Permian Basin companies can expand production now that oil looks to be headed for $55 a barrel over the next few months. (Pioneer Natural Resources is a member of my long-term 50 Stocks portfolio where it has gained 91.4% since I added it on January 13, 2012.)
- Smaller gains went to Big Oil stocks such as ExxonMobil (XOM), up just 1.63%. The vertically integrated majors–those that are in the business of producing oil, refining it, and marketing refined products such as gasoline–aren’t as leveraged to the price of oil as the pure exploration and production companies of Group One. When oil prices are low, for example, they take a hit to oil production revenues but balance that from increased profits in refining–and their marketing arms continue to churn out revenue as long as people fill up their cars. Some integrated majors have substantial positions in U.S. oil shales but those reserves are out weighed by investments in off-shore fields, conventional international reserves, and Canadian tar sands. Today, besides ExxonMobil’s 1.63% gain, Chevron (CVX) was up 2.03%, and Royal Dutch Shell (RDS-A) climbed 4.16%. (ExxonMobil is a member of my long-term 50 stocks portfolio. The shares at up 39.16% since I added them to that portfolio on December 30, 2008.)
- All the oil drilling and service stocks were up today with the biggest gains going, oddly enough, to ocean drillers with no exposure to the U.S. oil shale sector. I think the big gains in companies that specialize in ocean drilling came on hopes that OPEC’s action would put in a bottom for these battered stocks. If day rates for rigs and the number of rigs under contract climbed, these stocks would rocket off the bottom. At least that seems to be the thinking in the 17.06% gain today for Transocean (RIG), the 24.97% rise in Ensco (ESV), and the 24.97% climb in Rowan Companies (RDC.) Even Seadrill (SDRL), the deepwater specialist that is struggling to get out from under a mountain of debt, was up 13.88% today. In my opinion, that hope is, well, a bit early. The ocean drilling sector is still working through a surplus of active rigs and there’s a substantial supply of stacked and idle rigs just waiting for a turn in the market before they head back out to sea. That means it’s going to take quite a while for increased drilling activity to result in rising day rates, especially since ocean drilling is far riskier and more expensive than drilling in land-based shale geologies. Whenever oil companies get ready to increase capital spending again, the bulk of the first wave of new money is going to go to exploration and production on land. Which is why land-drilling specialists such as Patterson-UTI (PTEN), up 16.16%, and Helmerich & Payne (HP), up 11.96%, had such good days. (An oil service company with exposure to both wet and dry worlds, Schlumberger (SLB) climbed “just” 5.17%. But that is partly because the stock–and the company’s business–had held up relatively well during the savaging of energy stocks. Schlumberger is a member of my long-term 50 stocks portfolio. Shares of Schlumberger are up 124.9% since I added them to that portfolio on December 30, 2008.) I’d also add the fracking sand suppliers to this group. If drilling activity picks up in U.S. oil shale geologies, these companies will show big increases in sales volume and price of sand used to fracture the shale in order to release oil and natural gas. Hi-Crush Partners (HCLP), for instance, gained 14.78% on the day.
Besides these main groups, I think a few “oddities” from today’s market deserve a look. Stocks that I’d put in this category include Chesapeake Energy (CHK), which is primarily a natural gas producer. It was up 9.89% today on the belief that higher oil prices would push natural gas prices higher too. (Chesapeake does produce oil too, of course.) In a similar higher oil prices mean higher natural gas prices vein, shares of Cheniere Energy (LNG), the market leader (so far) in the export of liquified natural gas from the United States climbed 4.85%. Statoil (STO), a specialist in extreme weather production and the dominant producer in the waters of Norway’s outer continental shelf, moved ahead 6.42%. ConocoPhillips (COP), which is no longer integrated since it spun off its refining operations as Phillips66 (PSX), but which has a capital structure that makes the stock very leveraged to changes in oil prices, was up 9.7%. (Cheniere and Statoil are members of my Jubak Picks portfolio. Chesapeake is a member of my 50 Stocks portfolio. ConocoPhillips is a member of my Dividend portfolio.)
So how do you handicap these three groups and “oddities” after today’s surge?
Let me list the downside and then upside.
The downside includes the possibility that the OPEC agreement will either fall apart before its scheduled renewal in May or be rendered meaningless by the kind of rampant cheating on quotas that has characterized OPEC in the past. Either alternative would mean that the agreement would not remove as much supply from the market as traders and investors assumed today. There’s also the extremely likely possibility that U.S. oil shale producers will ramp up production so quickly that they will cancel out OPEC’s production cuts. Continental Resources (CLR), for example, said today that it will put some of its 175 drilled but uncompleted wells into production after OPEC’s agreement. The U.S. oil shale industry has responded to OPEC’s pressure on oil prices by driving costs out of its operations–which means that many oil shale producers don’t need to see $60 oil before increasing production. That added supply, of course, makes it less likely that oil will hit $60 and stay there. The drive to cut costs hasn’t been limited to oil shale producers either. The result has been that even some older resources, such as the fields in the North Sea, are now profitable at levels far lower than $60–or even $50. For instance, estimates put operating costs in the North Sea at $25 a barrel for some producers. Oil producers have aggressively pursued a policy of high-grading production projects so most companies now have a very good idea of what projects turn profitable at what price points. And finally, higher oil prices won’t fix the reserve problems at some of the majors that have been struggling to find enough oil to replace what they’re currently pumping out of reserves. (Higher oil prices will, indeed, fix the accounting problems at some of the majors since they won’t have to write down the value of reserves that aren’t viable at oil prices in the $40s.)
The upside includes, well,obviously, the fact that oil companies will make more money if oil prices move up. The biggest winners from any price increase that sticks for weeks or months will be companies that can quickly increase production–which means U.S. oil shale producers. Service companies that provide the immediate supplies for increased drilling activity–fracking sand for instance–will benefit from any quick increase activities designed to complete wells. Higher oil prices will be the biggest relief at debt-strapped producers, such as Chesapeake Energy, and service companies, such as Seadrill, since the improved cash flow will enable these companies to reduce and restructure debt. For some energy companies, cuts in oil production and any consequent rise in drilling, is relatively unimportant. Cheniere Energy’s fortunes, for instance, are tied more closely to the company’s ability to get added trains on line at its Sabine Pass and Corpus Christie LNG plants.
So where would I be putting money now–if I were to put any to work–given the current mix of risk and reward?
The obvious winner from OPEC’s action is the U.S. oil shale sector. In that sector I’d go with Pioneer Natural Resources because of its large position in the low cost Permian Basin. The company is the largest producer in the Permian Basin’s Spraberry/Wolfcamp geology with a potential reserve of 11 billion barrels of oil equivalent and 20,000 horizontal drilling locations. I think there’s easily another 30% in the stock. I’d also look at one of the fracking sand producers. Hi-Crush Partners was still slightly below its 52-week high after Wednesday’s surge. It may take land-drilling companies Helmerich & Payne and Patterson-UTI a little longer to get rolling since the collapse of drilling in the United States has left a lot of idled drilling equipment on the market. But improvements in power at newer rigs give them a cost and efficiency edge over older equipment that should make the existence of some part of this inventory of older equipment irrelevant.
A lot of the “when” here depends on how the market reacts over the next week or so to today’s huge move higher. 15% or 20% moves in a day are an over-reaction to an OPEC agreement that doesn’t include cuts big enough to bring supply and demand immediately back into line. So we could get some profit taking in the next session or two–or we could get a rush to buy from investors worried about being left out. I’d try to avoid overpaying here because there’s no doubt in my mind that increased supply from U.S. oil shale producers will make this agreement seem less important a few months down the road.
