Oil futures curve finally flipped

The following is an extract of the WTI oil futures curve:

The price of current-day (spot) crude is about 1% cheaper than the price of oil half a year out.

Let’s run a refresher course on the basic mechanics of futures pricing.

All things being equal, a clean futures curve will price the interest rate curve into forward prices, minus storage costs.

For instance, if today you can buy a barrel of oil for $100 and tomorrow you can sell it for $110, you would want to dig the trench in your backyard and store the oil there for a day so you can sell it for 10% profit. (You can do the math on an annualized return over a day!).

Ignoring storage costs, if you have to chew up $100 of capital to hold your oil, there is an implied carrying cost to holding that oil instead of selling it immediately to put into risk-free securities. This is a function of interest rates.

So a theoretical market would reflect this opportunity cost loss.

Let’s pretend your interest rate is 5%.

One would be indifferent to a $100 spot price today vs. $105 a year from now, again, emphasizing no storage costs.

For financial futures, other than a few electrons, there are no storage costs. This is why you see S&P 500 futures pricing up roughly a percent for each three months of the contract duration. Sophisticated funds can arbitrage by buying the index today and selling the future 3 months out, and pocket the spread – don’t forget about those equity dividends! This is a very roundabout way of investing in a 3 month interest product.

However, for commodities, there are storage costs and also the ebb of projected supply and demand characteristics of the underlying. An example from the natural gas market – the blowup at the Freeport LNG facility (which is still under repair) had their futures project, quite rapidly, increased supply over a limited time frame. When the promises of an early repair date evaporated quicker than LNG at room temperature, the futures curve adapted accordingly.

Another variable concerning physical commodities is that physical ownership might convey some other benefits that come with income – such as gold leasing.

Going back to crude futures, this is the first time awhile where the spot month is exhibiting a “normal” sloped curve, at least for the first half year or so. The “peak” of the curve is in October 2023 and then the price slopes downward again. This is an unusual situation.

It’s been clear to me since the June peak that the game has changed from one of scarcity to one of much more conventional metrics – can you identify the firms that will survive in a lower price environment? Do you actually want to be in a space that might potentially be a “grind to the bottom” again as companies increase capital investing and have balance sheets to sustain potentially unprofitable production?

We went through that in 2014, where supply really accelerated and crushed the crap out of the oil and natural gas market.

The question here is whether supply is nearly as constrained (either for ESG reasons or geological reasons) as the narrative would suggest.

Cash ETFs – Revisited

With the increase in Bank of Canada interest rates:

Cash ETFs:
(TSX: CASH) – gross yield 479bps – MER 13bps – net yield 466bps
(TSX: CSAV) – gross yield 396bps (November 24 distribution * 12, note not adjusted for recent rate increase(s)) – MER 16bps – this should be roughly in-line with the others
(TSX: HSAV) – gross yield 475bps – MER 12bps – net yield 463bps – CAUTION: trading above NAV, do your calculations accordingly
(TSX: PSA) – net yield 459bps

IBKR will give 368bps above CAD$13k.
HISA rates (one example): Home Trust gives 365bps.

Low duration, low risk, liquid:
(TSX: ZST) – 6 month effective duration – YTM 490bps – MER 16bps – net yield 474bps (November 30, 2022 numbers, note roughly 2/3rds investment-grade corporate debt here)
(TSX: XSB) – 2.7yr effective duration – YTM 410bps – MER 10bps – net yield 400bps

Sacrifice liquidity for yield:
GIC Direct is reporting 550bps rates (1 to 5 years).

US Dollar:
(TSX: HISU.U) – Cash ETF – MER 15bps
(TSX: PSU.U) – Cash ETF – MER 15bps
(NYSE: IBTD) – 0.58yr effective duration – YTM 454bps – MER 7bps – net yield 447bps – matures end of 2023
(NYSE: VGSH) – 1.9yr effective duration – YTM 460bps – MER 4bps – net yield 456bps

Bank of Canada raises interest rates

Bank of Canada link.

I was expecting a 25bps raise, but they did 50bps instead, which wasn’t entirely out of the realm of possibilities. The short-term bank rate is now 4.25%, while 10-year government debt yields 2.78% – extreme inversion.

The second to last paragraph of the relatively terse Bank of Canada announcement says (with my bold-font emphasis):

CPI inflation remained at 6.9% in October, with many of the goods and services Canadians regularly buy showing large price increases. Measures of core inflation remain around 5%. Three-month rates of change in core inflation have come down, an early indicator that price pressures may be losing momentum. However, inflation is still too high and short-term inflation expectations remain elevated. The longer that consumers and businesses expect inflation to be above the target, the greater the risk that elevated inflation becomes entrenched.

This “entrenchment” of inflation expectations is the key variable. As long as people believe in inflation, demand will continue to be high. Run through this thought experiment – if you think the purchasing power of your money is going into the toilet, what do you do? Buy more stuff while you can.

Also, we’re in the tail-end of what I will call the “covid effect”, namely after suffering from two years of lockdowns and general malaise, people are spending money because they haven’t been spending for the previous two years. This Christmas is probably going to be the end of it. In early 2023, I’m expecting a sobering-up period and this will probably be sharper than most expectations.

The last paragraph:

Looking ahead, Governing Council will be considering whether the policy interest rate needs to rise further to bring supply and demand back into balance and return inflation to target. Governing Council continues to assess how tighter monetary policy is working to slow demand, how supply challenges are resolving, and how inflation and inflation expectations are responding. Quantitative tightening is complementing increases in the policy rate. We are resolute in our commitment to achieving the 2% inflation target and restoring price stability for Canadians.

The “will be considering” is a very different change of language than “will need to rise” to describe the next interest rate action.

Finally, quantitative tightening is a slightly misleading term at the moment simply because there is only a billion dollars of Canada Mortgage Bonds due to mature on December 15, and then the next tranches of maturities is not until February 1st (with a $17 billion slab of near zero-coupon debt due for maturity). Reserves at the Bank of Canada continue to be around the $200 billion level and have not moved for the past 6 months or so:

Those banks are very happy to keep their money at the Bank of Canada and earning 4.25% – you’re certainly not going to give a sketchy customer a leveraged unsecured loan at 6%! The reserves will get bled out as QT resumes in February and concurrent with the Federal government doing what it does best – deficit spending.

My prediction for the January 25, 2023 announcement is a 0.25% rate increase to 4.5%. The expectations for retail sales during Christmas season might be even better than expected – especially given that we still aren’t very good at mentally adjusting the “same-store-sales” numbers down 10% to account for inflation!

Lumber and cyclical markets

You could mistake the chart above for a technology company’s stock, but indeed it is the spot price of lumber per thousand board feet (about 2.4 cubic meters).

From a peak of $1,700 to $400 today represents a 76% drop.

What happened after Covid is now well known – demand for lumber went through the roof as people decided to focus on home improvement, while supply was curtailed due to labour issues.

As a result, 2020 to 2022 were record years for most lumber producers. We will use an example of Western Forest Products (TSX: WEF):

For the 12 months between Q4-2020 to Q3-2021 they made 56 cents per share.

Given that their stock was trading at around $2/share at the end of that period, you were looking at a price-to-earnings of 4, and even less on a price-to-free cash flow basis.

Four times past earnings looks like a very cheap valuation metric. However, had you invested in the stock at the end of Q3-2021 ($2.20/share), today you would be sitting on a loss of nearly 50%.

News is still not very good. Increasing interest rates, a moderation in the supply chain, and also the fact that nobody wants to work on their outdoor deck three years in a row has contributed to prices going back to ambient pre-Covid averages.

A few days ago, Western Forest announced:

Western Forest Products Inc. (TSX: WEF) (“Western” or the “Company”) today announced plans to temporarily reduce its lumber production output for the remainder of 2022 by approximately 20 million board feet to manage inventory levels to current market conditions.

Basically they’re taking most of December off. Hopefully the workers will have a good Christmas, but 2023 will bring more uncertainty. Uncertainty results in decreased prices.

Five analysts have put the 2023 fiscal year at an averaged estimated EPS of $0.22/share. At today’s stock price of $1.13, that would still be at a P/E of 5.

Despite the P/E expansion (going from 4 to 5 is a 25% increase), an investor at the cyclical top has lost a considerable amount of capital.

I also suspect that the 2023 estimate is still high.

It’s really difficult to sell something when you see the P/E at 4, but it was the right choice. My final sale was in May of 2021 at $2.25/share.

Investors in other commodities should be given caution. The tempo of commodity equities varies with the commodity, but universal to them all is the cyclicality. Time it well.

Federal Reserve – “moderate the pace of our rate increases”

In today’s edition of “everybody has to be a closet macroeconomist to invest in this market”, we have the following speech from the Fed with the following payload in the last paragraph, and the bold-font is my own:

“Monetary policy affects the economy and inflation with uncertain lags, and the full effects of our rapid tightening so far are yet to be felt. Thus, it makes sense to moderate the pace of our rate increases as we approach the level of restraint that will be sufficient to bring inflation down. The time for moderating the pace of rate increases may come as soon as the December meeting. Given our progress in tightening policy, the timing of that moderation is far less significant than the questions of how much further we will need to raise rates to control inflation, and the length of time it will be necessary to hold policy at a restrictive level. It is likely that restoring price stability will require holding policy at a restrictive level for some time. History cautions strongly against prematurely loosening policy. We will stay the course until the job is done.”

This is the so-called “pivot” that everybody was waiting for and markets exploded in reaction – the fed funds curve shot down, long-term bonds went up (yields down), “risk-on” stocks ramped up (check out AMC!), etc, etc.

This likely means that the December 14 Fed announcement will involve a rate hike from 3.75-4.00% to 4.25%-4.50% and perhaps another quarter point up on February 1st. At this point, the statement of “moderate the pace” does not really matter since January 2022 to today has been the sharpest interest rate acceleration for nearly 40 years.

In Canada, the December 7 announcement will likely involve a quarter point increase to 4% from 3.75%.

There is this implicit notion that stamping down on demand through the monetary policy levers will result in decreased inflation.

My question is on the supply side. Skilled labour, land titles, and imports of stuff from China (aside from the common discretionary goods that you typically see at the entrance of Costco – let me tell you those 60 inch televisions are damn cheap!) are not increasing in quantity.

You can actually infer this from a couple places.

One is walking into the dollar store. While $1 is now a distant memory of the pre-Covid era, what you can get now for $1.25 at the local Dollarama (TSX: DOL) is even less than before. Mind you, there is a reason why they’re trading at nosebleed valuations – customers will still pay up because they can’t afford it anywhere else!

The second place to make some inferences is Amazon. I’ve noticed the typical bulk re-marketed imports from China (ones that aren’t destined for Dollarama, an amazing retailer that Amazon-proofed itself) becoming significantly more expensive than a few years ago. A good example is reasonable-quality bike lights. There are plenty of others.

Of course, going through Costco or Amazon is not representative of a whole economy, but they are two small data points to consider. It leads to the narrative-breaking question of – what if monetary policy cannot cure consumer price index inflation? What if the central banks level off their interest rates, and wait for the effects to come in, and inflation does not wane?

I’m not saying this will happen, but rather that the narrative of the central banks once again going into a loosening mode to cause the markets to skyrocket in value might be premature.

There are a few other cross-currents I would like to illustrate.

One is challenging the assumption that higher interest rates will stomp down on demand, especially on consumer goods. The Bank of Canada has made considerable efforts as of late to try to avoid ‘entrenched inflation expectations’, especially around avoiding the wage inflation spiral. However, if the mentality of inflation is already in the minds of many, logically speaking this would mean to purchase real goods before the price of it increases… due to inflation. Every time I walk through Costco (always a mad-house), I wonder how much purchasing goes on with this psychology in mind.

Another item missing from the equation is the effect of quantitative tightening. While banks still have plenty of reserves stored up in central banks, there is a slow and steady liquidity withdrawal from the market. One positive tailwind is that government fiscal situations have improved with the inflation and hence there is less competition for financing when the governments to go the bond market to roll over their debt.

Finally, the omnipresent yield curve inversion. It is extremely inverted.

30-Year Canadian yields peaked at 3.7% back in October. Today they are at 2.9% (an investor in a long-term bond ETF like XLB would have made a quick 15%). However, today, a fixed income investor has to decide whether to get 4.3% out of their 1-year money (or even higher if you go GIC shopping) versus a lower long-term rate.

This reminds me of the scenario in the early 80’s where an investor had a choice of taking 20% for 1-year money, or 15% for 30-year money. Emotionally it feels very difficult to take the lesser 15%, but these people would have made out very, very, very well with that decision.

Something makes me think that today is a similar situation.

However, 2.9% is a really low, and nominal, rate of return. The game has fundamentally changed since the early 80’s and we are forced into the asset market casino to keep up with inflation instead of being able to rely on fixed income for sustenance. In the early 80’s if you invested a million dollars in those 30-year government bonds, you have a $150k cash stream for 30 years, plenty enough to live on even after taxes. Today, that same investment yields $29k/year, which in terms of purchasing power, can’t even buy you a Toyota Corolla these days.

This is not a good sign. It is a sign of an economy that is really struggling to make returns on capital. It is why banks have such gigantic reserves at central banks at the moment – it is too risky to lend.

There are a lot of cross-currents and this is confusing me. Normally for investing you want to ensure that your sails are facing the macroeconomic winds and right now I have a limited read on the situation. In terms of portfolio action, I am comforted that cash once again is giving something, but my appetite for risk at the moment is quite muted.