The financial world vs. the physical world

The Federal Reserve and Bank of Canada’s desired effect right now is to deflate the asset markets, creating a ‘reverse wealth effect’ which will hopefully stamp out some amount of inflation.

We are already seeing this rush for liquidity. It’s been going on for months now, but it’s getting to the threshold where it is actually being noticed by most people as they check their brokerage account balances.

As funds start to face redemption orders as people continue to want liquidity and demand US dollars to pay off their debts, we see asset prices drop as a result, across the spectrum (especially “stablecoin” Luna holders!). Very little gets spared in these market situations.

Companies that have long track records of producing cash are taken from a higher multiple to a lower multiple. A company that was previously trading at a (truly!) stable 15 times earnings will be re-valued at 12 times – that’s a 20% haircut in price. You haven’t lost value in the company – it will still continue earning the amount of cash it has been earning, but instead your capitalized value of it has been re-rated so if you want the entire sum of those cash flows today you will be receiving less money.

Lower prices bring higher returns for reinvestment. That company previously trading at 15 times would give you a 6.67% return – today those same dollars would give you 8.33%. The company can then look at its ledger for reinvestment opportunities. In a perfect world, it will invest capital externally in those projects that can earn better than 8.33%, and if it can’t, it will buy back shares (or give it to shareholders as a dividend). Real world conditions are never as black and white or clean, and hence a market exists.

We look at another real-world situation where a company like (TSX: CNQ), at US$107/barrel oil, trades at 4.7 times free cash flow (21%). The opportunity for them is obvious – buy back their own shares – and in a day like today, they will easily be able to post a bunch of bids and get hit as their stock is down 3%. Will the market take them down 20% to 3.8x (27%)? If so, it will make their buyback program that much more accretive – if you take the assumption that this commodity price environment will continue.

This price environment cannot be and is not assumed to last by many, hence the very low price to cash flow multiple given to these companies. Indeed, a big destruction of demand would cause commodity prices to tumble and will correspondingly take down equities with it.

There is also a propensity by many to take gains on stocks trading at 52-week highs – either to cut down your percentage allocation (anybody with fossil fuels in their portfolio have most certainly seen them bloat to high percentages) or as a manner to ‘take chips off the table’, perhaps to invest in beaten-down technology companies.

These are financial considerations. You can make these transactions by clicking buttons in front of a computer. The real-world physical market is a different story.

With the physical commodity environment showing few signs of retreat (Russia’s oil and gas exports will surely drop in the upcoming months, and US strategic petroleum reserve releases do not appear to be making any dents on US crude inventory levels), for now, it appears that the physical environment is favourable for continued high prices. Coupled with massive amounts of cash flows being poured into share buybacks, should put a limit to the downside of the fossil fuel complex. Indeed, investors should be cheering on price drops as moments where more shares can be taken off the open market when the physical market is still showing great demand in relation to supply.

The physical environment of a relatively inelastic commodity is very telling. It is best illustrated with an analogy.

Let’s pretend that we have an island of 100 people, a food factory, and cash. Initially this island produces 110 meals per day of food, and this food is of the non-perishable variety, so you can store it somewhere for rainy days. Everybody is happy, the price of food is low, and everybody can go and watch Netflix since there is nothing else to spend your capital on in the island other than buying food and maintaining the food factory. Netflix makes a fortune since they can raise their prices continually, although there is a fraction of people that prefer to just watch the waves crash against the beach. However, over time, there is a belief out there that the food factory causes a slowdown of video streaming resolution, so many of the island residents manage to pass a policy framework that chokes maintenance investment in the food factory. Initially this doesn’t have much of an impact as food production went to 105 meals a day, but over the past few years, it has slipped below 90 meals, but there was a sufficient surplus to keep people fed.

Indeed, there was a disease that struck the island that caused residents to eat half as much as normal for many months, but they slowly managed to recover from this disease, and now are back to normal eating levels. The surplus of meals that was built up by the food factory that is now producing 80 meals a day was immense, but that surplus is now running low, and residents are starting to get fearful that they will not be able to purchase food much longer. The price of the meals slowly starts to climb as this awareness creeps in, and now that this surplus is approaching critical levels, prices on this inelastic good is very, very high and everybody on the island is now noticing the price of food, and talking about how we need to subsidize people to purchase food. There are also talks about how the food factory is unfairly engaging in price gouging, and how the factory should be “islandized” to ensure a fairer equitable distribution of food. Nowhere is it mentioned that capital should be invested into the food factory to increase its output – as this would slow down people’s video streaming resolution (no way you can watch those videos at 1080p when you’ve been watching it at 4K all your life!).

Hence the situation we are in today. It doesn’t end very well.

The Crypto crash – Luna!

(Update, May 14, 2022: Lots of educational comments given to this article – much thanks everybody)

Long-time readers of this site know I have not been a fan of cryptocurrency.

This might be a bit of sour grapes on my part since I’ve been writing about Bitcoin since 2011 (yes, when it was still US$10/coin) and wasn’t a fan back then, and still am not today other than strictly the amusement factor of seeing people attempt to trade it.

Back in 2011 when Bitcoin was the only game in town, I wrote the following:

There is also the issue of “counterfeiting”, even if the bitcoin system is technically secure. One problem is that you can create an identical digital currency and call it something different. So in this essence, counterfeiting is a very relevant concern – not direct counterfeiting, but copy-catting. Bitcoin does have a “first mover advantage” which may mitigate against this.

I try not to pay much attention to the sector, but I have been amused to know that many asset managers out there consider cryptocurrency to actually be an asset class that one should keep in their portfolio at some low fraction of assets, like the arguments one would make for holding precious metals. There have also been other developments such as the concept of “stablecoins”, and crypto algorithms that apparently guarantee payouts, etc. I have not kept up to speed on the specifics of the developments and have generally tried to quarantine my brain from it, similar to how I would regarding the trading of Gamestop equity.

But this one really caught my attention – the demise of this cryptocurrency called Luna.

It is my understanding that Luna was tied to another cryptocurrency called Tether (May 14, 2022 edit: Terra), which itself is apparently backed by actual US Dollars in some bank somewhere (audit confirmation pending!). The difference is that Luna apparently pledged that you can get a 20% return by investing it in. Please be warned I could have gotten this completely incorrect, but if it is the case, wow.

So I dredged up a chart of Luna and saw the following:

At one point in the history of Luna, they had a market capitalization of US$775 trillion. Wow. Just wow! Am I reading this correctly? Somebody please educate me in the comments! (May 14, 2022: It wasn’t in the trillions, but in the few tens of billions. Apparently the high number of coins outstanding were automatically created by its algorithmic link to Terra)

What the heck am I doing investing in stocks? Time to go fully into crypto for the next Luna – whether this will be long or short, who knows!

Bank of Canada speech – headline vs. reality

Globe and Mail: Interest rate trajectory will depend heavily on housing market, Bank of Canada deputy governor says

Bank of Canada: The perfect storm

Quite the difference!

Read the speech itself, and THEN the Globe and Mail article – by reading the news article first, you expose your brain to potentially getting swept away into some narrative which may or may not be a reflection of the intended communication.

Going to the speech:

As a result, we expect the recent increase in commodity prices to boost the level of business investment in Canada by less than half of what our models generally predict based on historical relationships.

All in all, the commodity price shock is expected to generate a modest positive impact on the growth outlook for Canada—smaller than we have seen in the past.

The Bank of Canada is surprised that commodity companies are contributing less in capital investment despite the price environment. I wonder why!

More importantly, a slowdown in growth does not have to mean high unemployment, which was the hallmark of the stagflation period of the 1970s. Right now, job vacancies are very high, which means employers are trying to hire still more workers from a declining pool of labour. By cooling overall demand, we can reduce the demand for labour and the degree of labour shortages in the economy. Employers could stop looking for new workers but keep the ones they have—with little impact on the unemployment rate. That is a scenario that delivers a soft landing.

Good luck! This is like the macroeconomic equivalent of trying to thread a needle while wearing heavy-duty construction gloves.

First, what might lead us to pause our policy rate increases as the rate enters our estimated range for neutral of 2% to 3%?

Now we will get to what caused the Globe and Mail headline to print:

Another factor that might lead us to pause is that many households have taken on more debt to get into the housing market. At the end of 2021, the household debt-to-income ratio was 186%, above the pre-pandemic level of 181%. And rising interest rates are designed to slow the economy by making borrowing more expensive. That tends to slow sectors like housing. But this slowing might be amplified this time around because highly indebted households will face high debt-servicing costs and will likely reduce household spending more than they would have otherwise. Our base-case scenario includes a slowdown in housing activity. But we could see a larger-than-expected slowdown due to higher indebtedness and unsustainably high housing prices.

There were a whole bunch of reasons rates will level off at the “neutral rate”, and reasons why rates would continue to rise, but the Globe and Mail cherry-picked this paragraph for their desired headline.

I’ll leave it up to you to digest the rest of it. The important signal of this speech is that we will see central banks give out this “Well, there is going to be a limit to rate hikes” mantra which will attempt to stop what has been a slow motion stock market crash in recent months. The Federal Reserve is likely to follow suit with their forward guidance (‘speeches’).

The reach for liquidity

The Federal Reserve has raised 75 basis points since last March and the markets have already gone into a liquidity seeking mode, purely on the basis of setting expectations of increasing interest rates. There is an implied expectation of another 200 basis points worth of increases in the next year but this expectation has already traded down as the markets have tanked.

Recall that the amount of cash in the system does not materially change in any given day. Only the asset price changes on any given day.

When participants want to pay off their debts, they have no choice other than to seek liquidity in their assets – convert the asset into cash. Globally, this has been reflected in the mass depreciation of other currencies, including the Euro and Japanese Yen:

The Canadian dollar, by comparison, has had limited depreciation, presumably due to our trade links and also commodity export:

The underlying point is that the markets are seeking liquidity, and specifically US dollar liquidity. This has had a negative effect on the entire market, including precious metals (Gold and Silver have been sold down during this process – people want the US dollars and not the shiny metal stored in their safes!).

The one commodity that has exhibited signs of stability has been energy – oil and gas has retained most of their value during this market meltdown. This may not continue – if the rest of the market causes consumption of fossil fuels to decrease beyond the ability to supply them to market, then energy prices will drop. There is a huge amount of margin of safety in energy equities at the moment (e.g. Suncor at half of the current price for spot oil is still profitable with dividend intact) but clearly a continued high commodity price environment coupled with low equity prices is the formula to accelerate returns through cheap share buybacks.

Most technology companies, especially unprofitable ones, have been slammed in the past half year. Most of them, even the ones trading 75%-80% below their November 2021 peaks, in my estimation still have rich valuations. That said, markets are volatile beasts and there could be a lot of “regression to the mean” type of investors coming up given the carnage seen in the marketplace. I don’t have much commentary other than that if you were leveraged long on companies like Palantir from last November, chances are at around this point you would have been cleared out of your margin account. Don’t even get me started on the amount of leveraged capital that must have been present and taken a severe bruising in the cryptocurrency space!

First quarter review of oil and gas – and a look at Suncor

This is a brief review of the companies that have reported their quarterly results to date in the oil and gas space – specifically the ones in the Divestor Canadian Oil and Gas Index. (ARX, CNQ, CVE, MEG, SU, TOU, WCP have reported).

When your spot commodity exposure charts look like this, you know things are looking good:

The amount of bullishness out there in the previous week was a bit nuts and ripe for a correction. When markets ascend for this much time for this duration, there is a natural process where momentum and technical analysis players get cashed out, regardless of any fundamental underpinnings.

The financial market moves much, much, much faster than what goes on at a glacial pace in reality. While the amount that has evaporated out of my portfolio in the past week is impressive, it goes with the nature of finance that things will indeed be volatile, but the intrinsic value of the portfolio remains intact, reflected by real-world economics instead of financial economics.

All of the companies in the oil and gas index have been reporting record free cash flows, but most notably all of the players have been quite tight on growth capital in the sector – the free cash flow for the most part has gone into debt reduction, dividends and share buybacks. Now that most of these companies have reached their leverage targets, they are now continuing to deploy more cash into share buybacks, or (in the case of TOU) special dividends.

The financial mathematics of companies giving off sustained free cash flows (key word being ‘sustained’, noting that fossil fuel extraction is a cyclical industry) is interesting to analyze. I will use Suncor as an example.

Suncor guided in Q1 that their income tax payments will go up from the lower $2 billion range to $4 to $4.3 billion (note that income tax is a function of operating income minus interest expenses and after the removal of royalties, which is another huge layer of money given to the government!). Suncor does not have a material tax shield so they will be fully paying cash corporate income taxes. The Canada and Alberta corporate tax rate combined is 23%, and they have other operations in other provinces and overseas, so we will assume 23.5% as a base rate, which puts Suncor at $17.7 billion in pre-tax income ($13.5 billion after-tax).

Those with an accounting mindset will ask whether net income translates directly into free cash, and Suncor’s capital expenditures are roughly in line with depreciation. My own on-a-paper napkin free cash modelling also corresponds roughly to this $13.5 billion amount in the current commodity price environment.

Suncor has 1.413 billion shares outstanding as of May 6, 2022, so the upcoming year of income is $9.55/share. Suncor trades at $44/share as I write this, and has an indicated quarterly dividend of 47 cents per share ($1.88 annually). Although management has hinted this will go up over time, for now let us assume it is a static variable.

Deciding between debt reduction, dividends and share buybacks usually are a dilemma, but when the math is this skewed it is not.

Suncor’s debt currently costs them about 5.25%, or 4% after-tax. A share buyback not only alleviates the company from paying out the 4.27% dividend, but is also purchasing a 21.7% return on the equity.

This is a no-brainer decision from an optimization standpoint – every penny after regular capital expenditures, should go into a share buyback. The dividend should be brought to zero and shares should be bought back with that amount instead, until such a point where the return on equity goes below a particular threshold (my own personal threshold if I was calling the shots at management would be 12% or anything below $80/share in the current price environment!).

However, there are other variables to consider.

One is that the commodity price environment might not (and indeed is very unlikely to) last forever. There is a pretty good case to made that this particular price environment will last longer than most (instead of spending on capital expenditures like drunk sailors, companies across the grid are shockingly being very disciplined about limiting the amount of growth in production), and also the margin of error of the price level itself is quite high – West Texas Intermediate is at US$100 and even if it goes down to US$75, my models still have Suncor making around $8 billion in free cash. My $80 threshold price for share buybacks would drop to $47/share in this scenario – very close to the current market price.

So the argument to reduce debt is not out of financial optimization, but rather reducing the brittleness of the financial structure of the company. Hence the decision to allocate the residual 75% of free cash minus capital expenditures and dividends to debt reduction, and the other quarter to share buybacks. Although it is not financially optimal if you assume the current environment exists, it is a safe decision. They will do this until they go to under a $12 billion net debt position, which will happen at the end of Q3/beginning of Q4. (Note that Suncor introduced a new conservative fudge factor by adding in lease liabilities into this definition which inflates the net debt number).

After they reach the $12 billion net debt figure, then 50% gets allocated to debt and 50% to the share buyback. At the current commodity environment and share price, they will be able to complete nearly the 10% full buyback with this regime. After they get down to $9 billion in net debt, then the debt reduction goes to 25% and share buyback will go to 75%. I just hope that management has the prudence to taper the buyback and increase the dividend if their share price gets too high.

The other variable is the dividend. While the tax inefficiency of dividends are well documented elsewhere, it does provide a “bird in the hand” component to the stock, and also gives the buyback itself some metric to be measured against. While other people consider a dividend to be very important, I am agnostic about a particular dividend level, except in context of alternatives.

Obviously if a company has capital investment opportunities, you do not want to see a dividend. You instead want to see them deploying this capital in productive ventures. However, in the fossil fuel industry, there is a very good argument to be made to just keep things as-is and just go on cruise control – this is exactly what is happening for all of these companies. They are paying down debt and allocating cash to dividend and share buybacks, especially when all of them are giving out 20%+ returns. There is no reason not to.

The ultimate irony here is that in such an environment where cash flows are being sustained, it works incredibly in the favour of investors that the market value of these companies remains as low as possible, to facilitate the execution of cheap share buybacks.

This leads me to my next point, which is that it does not take a CFA to realize that on paper, many of these oil and gas companies are perfect candidates for leveraged buyouts. Only the perceived toxicity of fossil fuels and ESG has prevented this to date, and I am wondering which institution will be making the first step in outright trying to convert a leveraged loan (even in the elevated interest rate environment, they can get cheap debt) to buy out a 25% cash flowing entity. It is inevitable at the current depressed market prices.

The first warning shot on this matter (which is cleverly disguised as a strategic performance improvement scheme) comes from Elliott Investment Management’s Restore Suncor slide deck. They can’t outright say what they’re thinking – let’s LBO the whole $60 billion (market value) firm!

Needless to say, an investor in this space makes most of their money “going to the movies”, as Warren Buffett said about one of his earlier investment mistakes (selling a company too early). I think this will be the case for most of the Canadian oil and gas complex.