Category: Economics

Crude oil is down the biggest percentage I have seen in my investing history – West Texas Intermediate (WTI) currently down 20% (from a close at US$41 to US$33 presently). Brent is about US$37. There is no way to describe this other than a crash.

Canadian oil has been trading at a heavy differential, with Western Canadian select closing last Friday at US$28/barrel.

Needless to say, this is going down on Monday, probably to around US$22/barrel if we keep things at a 20% discount to WTI.

There is no Canadian oil company that can survive at this price level. Even though there are some companies where this is under the marginal cost of extraction (e.g. looking at CNQ’s last year, they had a CAD$12.41 marginal cost of extraction for their North American production, not including royalties) you still have costs associated with drilling and financing to pay off, and a US$22/barrel model completely destroys this.

Some obvious implications are that capital spending is going to decrease to the bare minimum, even more so than what has previously been announced. High cost production is going to be shut down, and we will be seeing another wave of insolvencies in the energy sector. Not pretty at all.

In these high-volatility situations, there is always money to be made by correct timing and correct decision-making, and right now the winners are those that don’t have a single barrel of crude oil in their portfolio. There will be spillover, however, plenty of it.

For example, geopolitically, countries that are heavily reliant on crude imports can’t continue to function for very long. Iran, for instance. Rock-bottom crude oil prices will have ripple effects that are not immediately obvious on a first order level of thought.

As the whole world at this point knows, the US Federal Reserve reduced short term interest rates to a target rate of 1-1.25%, down 0.5% in response to economic concerns about the Coronavirus.

I’m not sure how changing a very low short term interest rate into something that is even lower will help matters.

The yield curve today looks like this:

1-month: 1.11%
3-month: 0.95%
1-year: 0.73%
5-year: 0.77%
10-year: 1.02%
30-year: 1.64%

Needless to say, these are low. Not European-style negative rate low (Germany’s bonds are trading at a -0.81% for 5-year and -0.63% for 10-year), but things clearly are at the point where if you’ve got reasonable credit, you can borrow money for nearly free.

QE4 is also alive and well, with $400 billion more in purchased securities on the federal reserve’s balance sheet from August 2019, most likely ending up in the stock market.

I’m guessing the Bank of Canada will probably announce a rate cut tomorrow to follow lock-step with the USA. The only question is whether they’ll drop a quarter point or a half point.

The analogy has been used many times before that lowering rates from current levels is like giving the metaphorical drug junkie another hit of heroin to keep high just a little bit longer – I can’t imagine on anybody’s financial spreadsheets how the incremental reduction in a 0.5% rate decrease from 1.5% to 1.0% will alter a capital investment decision, say to spend $10 billion dollars on a pipeline over the next 3 years, when there are so many other dominant variables that will take priority.

I also project there will continue to be a massive amount of government spending and deficits that will be incurred – when the cost to borrow is effectively free, why not?

This would explain why Gold is going crazy, but in theory, any assets that have the capacity to generate (inflation-adjusted) cash should also do relatively well.

Take a look at the S&P 500 over the past two months:

It is not entirely coincidental this aligns fairly well with the monetary loosening of the next phase of quantitative easing by the US Federal Reserve, which started in September:

Most of this excess capital tends to find its way pumping demand into the asset market. Right now, that demand gets centered around the large capitalization, large liquidity companies, but eventually that demand flows to parts of the economy that still offer morsels of yield.

The currency depreciation war is active and alive (below is a chart of the US Dollar to Chinese RMB exchange rate, showing a 3% devaluation over the past couple days which is historically quite volatile for the currency):

We’re entering into a strange topsy-turvy financial world where things are going to stop making much sense at all. We already have that in Europe, where a lot of sovereign bonds are trading at negative yields (which is the definition of financial insanity).

Interest rate futures for the US federal reserve already show that the fed funds rate will slip down to about 1% – the December 2020 fed funds futures are a full percentage point below the present values. The Bank of Canada will likely be forced to match to some degree – I would look for the Bank of Canada to drop their rates correspondingly.

In terms of investment themes, always keep in mind TINA – There Is No Alternative – as safe bond yields get pushed into the low single digit yields, in order to make any returns at all, the risk frontier continues to get pushed further and further into the equity realm. Dips in equity valuations will eventually be bought as pensions and institutions need to seek returns that they are not going to be receiving from bond portfolios. Specifically, domestic industries (i.e. no China exposure) with cash flow pricing power will remain king.

The allure of leverage (why not when you can borrow so cheap?) will also be tempting.

Unfortunately, a lot of these companies (e.g. most utilities) already trade rich, but there’s a decent chance that the escape for safety will continue to push asset prices even higher.

Also, with medium-term interest rates declining, those 5-year rate reset preferred shares will also likely take a hit. There may be some interesting opportunities coming up in this space as shares get sold off.

I talk much more about finance than accounting on this website, although I am a professional accountant. A good analogy is math and physics – people in both fields tend to understand the other, more so than the difference between chemistry and biology.

Effective this year, companies will have to adopt IFRS 16, which governs accounting for leases.

Other than enriching accounting consultants that will have to dig into the structures of leases of various firms, this will have a material impact of the reported assets and liabilities on a company’s balance sheet. New students of accounting will also have one more layer of complexity to memorize at exam time, while textbook manufacturers will undoubtedly be happy.

Specifically, the distinction between an operating lease vs. a capital/finance lease is removed and instead all leases will have an asset and liability component. The asset of the lease (the item which you are buying the rights to use) will be depreciated over time, coupled with an interest expense component for the financing cost of the lease, with a depreciation charge to reduce the asset value.

From an investment perspective this changes the character of “EBITDA”, where companies that heavily use operating leases would previously have expensed such costs (typically in operating expenses), while after IFRS 16 is implemented, they will suddenly find their EBITDAs increase because the lease cost will have strictly an interest and depreciation component. They are still expenses, but the characterization of the expense is now changed. This will be an accounting windfall for companies that traditionally are valued on EBITDA metrics.

So if you find it annoying how companies use EBITDA as a proxy of profitability (which it could be given the right assumptions – but most companies abuse the EBITDA number to inflate the perception of their profitability), after IFRS 16, good luck! Just remember, you can only live on after-tax cash flows and not EBITDA!

The other strange implication of the rule is that once a lease is initiated, it will initially be more expensive at the beginning of the lease, and less expensive later in the lease as the embedded interest expense of the lease declines. So let’s say you lease a million dollar jet for 10 years, your expense profile, depending on your cost of capital component, on year 1 would be $125,000 while on year 10 would be $75,000 even if you fork out $100,000/year to use it. Investors have to add one more layer of effort to separate what is happening on the income statement with what is happening on the cash side of things. (Even this example is not quite correct – the lease asset may be $1 million, but the liability is going to be bigger since nobody will want to lease a $1 million jet for a $1 million stream of cash).

You have to love these accounting standards that make life even more complicated for the layman in the name of increasing accuracy. Currently, an investor could look at the notes on the financial statements to understand what a company’s future lease commitments were. One-shoe-fits-all accounting sounds great in principle but it has the consequence of making financial statements more difficult to read and understand between companies even though the goal is to make them directly comparable.