Category: Economics

“What’s left of Canadian oil?” – March 29, 2020:

27-Mar-2020: TSX Oil Producers

Name	Root Ticker	MktCap 31-Jan-2020 ($M)	MktCap 27-Mar-2020 ($M)	Loss
Suncor Energy Inc.	SU	61,973	25,172	59.4%
Canadian Natural Resources Limited	CNQ	44,182	15,811	64.2%
Imperial Oil Limited	IMO	23,343	9,816	57.9%
Cenovus Energy Inc.	CVE	14,155	2,887	79.6%
Husky Energy Inc.	HSE	9,230	3,226	65.0%
Tourmaline Oil Corp.	TOU	3,617	2,116	41.5%
Vermilion Energy Inc.	VET	2,985	587	80.3%
ARC Resources Ltd.	ARX	2,486	1,335	46.3%
Crescent Point Energy Corp.	CPG	2,308	481	79.2%
Seven Generations Energy Ltd.	VII	2,222	488	78.0%
MEG Energy Corp.	MEG	2,024	365	82.0%
Whitecap Resources Inc.	WCP	1,974	387	80.4%

On January 31, 2020 there were 12 companies trading at a market cap of above $1 billion in the space (I removed the non-Canadian ones trading on the TSX). At the end of March 2022, there are about 28 of them.

CNQ is now the top dog with nearly a $100 billion market cap.

CVE bought HSE and is now sitting at around $50 billion.

How things have turned.

The even more interesting factoid is that when looking at CNQ’s quarterly earnings report, they have gone painfully out of their way to avoid telling people how much money they will be making.

The entire complex is trading as if the commodity environment is a ‘transient’ event. As a result, we are seeing very low free cash multiples to enterprise value.

This creates two avenues to earning a return.

One is that you sit on your rear end and wait for these firms to buy back their stock and/or give out dividends and you will earn a return the old-fashioned way – by buying and holding.

The other way is through speculation that the fossil fuel price environment is here to stay for a lot longer than most expect – you will then be a happy recipient of a multiple expansion.

Unlike a technology company stock that promises to pay out a decade from now after making copious amounts of expenditures, most (if not all) of the fossil fuel producers are generating cash today.

What is even more interesting is putting your mindset into the perspective of a pension fund manager.

You have a mandate to earn a return of, say, 7% for your clients. I’m ignoring the fact that CPI has skyrocketed this year (which would inevitably push up this number for the cost of living allowances that are typically given out with defined benefit plans, including the CPP).

On a day like today, both the overall equity market AND the long-term bond market have dropped. Normally there is an inverse correlation between the two assets. This correlation appears to be breaking.

If your pension plan is forbidden from investing in fossil fuels for whatever reasons, the pension managers have to achieve their returns in the rest of the market that does not include fossil fuels.

This is an exaggeration, but it is the financial equivalent of trying to earn a 7% net return on the residential condominium market in Toronto (or Vancouver, take your pick).

Formerly you were able to do it with leverage (e.g. take a 4% gross return and turn it into 7% by borrowing a bunch of money at 2%), but today, you can’t do this in a rising rate environment. Rising interest rates increase the cost of carrying debt, and hence why you are seeing liquidations.

Likewise in the equity and bond markets, the leverage trade appears to be unwinding. Central banks have given fair warning rates are increasing. Unlike in 2017 when rates rose again and inflation was very low, today’s environment has inflation figures that have not been seen since the early 80s.

This is a misleading article.

Globe and Mail article: Canadians are sitting on record amounts of cash – but nobody is sure what to do with the money

More than two years into the pandemic, Canadians’ wallets are still stuffed with cash.

There is currently about $113-billion worth of physical money in circulation in Canada, up by nearly 25 per cent from pre-pandemic levels. As a share of the overall economy, that’s more cash floating around than at any time since the early 1960s.

One problem with this article is that the amount of physical cash has continually been increasing since 1990, but during Covid-19, the rate of growth has accelerated, but not to a ridiculous degree:

This number has increased by around $25 billion during the Covid panic (measured from March 2020). A more “ambient” year-to-year change is around $7-8 billion in supply, which means that about $10 billion in cash was created as a result of the Covid panic. A large amount of money, yes, but nothing compared to the overall monetary base.

What the article should be focused on is the creation of credit during Covid-19, and you can view some evidence of this by examining the monetary aggregates as compiled by the Bank of Canada (I suggest looking at the unadjusted M2++). Needless to say, in our formerly zero-interest rate environment, credit creation has skyrocketed!

It is very important to remember that all of the trading that happens on the financial markets do not create or destroy anything – money and the asset is simply transferred, and the only change is the price that the asset is transferred. There are minor slippages (e.g. commissions and SEC fees) but for the most part, on a daily basis, it is a closed loop system.

The options market is completely zero-sum over the long run – every dollar a participant makes has to come out of the pocket of another participant. When option contracts expire, this is when the ultimately reconciliation occurs to zero the sum of transactions.

The stock market differs somewhat in that, as an aggregate, companies accumulate profits at the end of the day, and shareholders are recipients of these profits. It is a positive-sum game. Unlike option markets, however, equities are perpetual instruments (until bankruptcy or takeover/dissolution) and thus over time, the asset values of market participants should increase at the rate of company profitability, plus or minus the speculative forces we see each day when the market opens.

The lubricant that makes this occur is cash, and this is provided in the form of credit extended by financial institutions and ultimately backstopped by the central banks.

When there is more cash out in the system, it increases the demand for productive assets seeking a return. Likewise, when participants feel insecure or not as risk-taking, the demand for cash depresses demand for assets and will result in a drop in asset prices.

A simple numerical example suffices. If your ideal portfolio fraction is 80% equities and 20% cash and you have a total of $100 in your system, you want to own $80 of equities and $20 cash. If your shares rise in value, you sell a little of it to maintain your 20% cash fraction, while if your shares drop, you buy a little bit of stock to get back to 20%. If monetary policy suddenly infuses you with another $100 of cash, suddenly you will want to buy $80 more in equities to balance your portfolio. The residual cash goes towards an increase in asset value – and you see this everywhere with the stock market and real estate. Increasingly, this cash is starting to diffuse in other outlets, such as cryptocurrencies, NFTs, collectables, used vehicles, and so on.

One of my predictions for 2022 is that liquidity in the form of drenching the economy with cash is not going to solve real world economic problems. It will instead worsen them. Indeed, what we are seeing today is exactly a result of this – it is a world where (thankfully not literally, I am using some hyperbole here) everybody becomes a day trader. Every minute spent tapping a buy or sell on Wealthsimple (or perhaps Crypto dot com) was a minute that may have been spent producing good or service in the economy.

Perhaps day trading is too dramatic an example – and perhaps slightly exaggerated – but we also see this in the real estate market – many are jumping into the real estate agent game – how many times can a land title be flipped in a year?

The phenomena of “no supply at any price” is going to occur with higher frequency in 2022 in the real world. Unlike the financial analogy (e.g. the Volkswagen short squeeze of 2008), this is increasingly going to happen in the real world where only extreme amounts of money can bring supply of specific real-world products. A trivial example currently going on is purchasing a vanilla-styled iPad – they’re not available until the end of February.

This issue of “no supply at any price” will especially occur in price inelastic markets. Energy is one obvious example of a product that will be in very high demand and supply provisions are increasingly becoming expensive (whether politically or geologically) to procure. Another example will be specialized services (e.g. nuclear engineering or other ultra-specialized trades).

Just imagine being involved in a business that involves the assembly of many disparate elements involving multiple suppliers. If one or two of your key suppliers develops 2-3 month lead times, how the heck can you plan on your end the labour component for assembly? It means that you must start stockpiling. This will have a ripple effect return on equity for many businesses, but it will also translate into higher prices. This will go on until there is a demand collapse and only then we will see lower prices.

Lots of headlines are being made about Turkey and its currency, the Turkish Lira:

(The chart with the Turkish Lira to US dollar is very similar).

(Wikipedia Article on the matter)

Turkey’s GDP is about half of Canada’s (i.e. not an insignificant economy).

A lot of the cause of the currency depreciation appears to be the leveraged borrowings in foreign currency by domestic companies coupled with the domestic government wanting to keep interest rates lower than the prevailing market rate.

As a result, the purchasing power of the domestic currency has declined significantly. Even the basic math of accounting changes when dealing with a rapidly inflating currency. Just imagine marking up all of that foreign debt on each quarterly financial statement – normally the foreign currency translation adjustment component of equity on the balance sheet is some small fraction of the overall picture, but in this case, comprehensive earnings becomes a very important figure to watch – your business might be making 500 units of profit, but if foreign currency liabilities increase by 5,000 units of domestic currency, you’re toast!

Since Turkish inflationary headlines have reached the mainstream, chances are there is some actionable ideas, but I am not enough of a macroeconomic professional to truly figure out where things are headed.

On the domestic side of things, Turkish stocks have been a better store of value than pure Lira:

The preceding chart is the iShares MSCI Turkey ETF, the only broad-based Turkey ETF I could find. It is denominated in US Dollars.

Despite the Lira depreciating 75% over the past five years to the US Dollar, the ETF has “only” lost about 25% of its value denominated in US Currency.

Obviously, when the companies that constitute the index have heavy amounts of foreign currency debt, the equity will be taking a considerable hit as companies try to service these debts with domestic cash flows. However, with the currency depreciating at the rate it does, it amounts to an effective interest rate on foreign debt that is very high. One possible conclusion is that there will be a foreign debt default with a subsequent recapitalization and/or nationalization of various strategic entities as I very much doubt the Turkish government wants its major companies to be foreign controlled.

The stock market is thus not a very good retreat if you are forced to live with a currency in a very inflationary environment. This has also shown to be true in other jurisdictions – initially the stock market makes huge gains (everybody is looking for a shelter for depreciating currency), but later the economic damages caused by high inflation rates eventually kills returns on the whole spectrum of the capital structure.

Indeed, there is a huge incentive to leverage at low interest rates (these debts would be repaid in much less real value) and purchase different assets, ideally liquid ones.

Holding USD itself (or Euro) would be a liquid store of value. A physical gold investor over the past 5 years not only would have made a 50% return in nominal US dollars, but the gains would be much, much higher in Turkish Lira. Having a mechanism of storing crude oil would also be a liquid store of value. There are plenty of options, some feasible, some not.

Here in Canada, if companies issue debt in non-Canadian dollar currency, it is most likely to be in US Dollars. Since most of our trade is linked to the USA (we are functionally joined at the hip with them) it is unlikely that we will face the same mechanism of currency decline as Turkey. If our export market starts to evaporate (e.g. we shut down our fossil fuel and automobile industries in the name of climate change) we will be in serious trouble.

Just doing some general review and scribbling down some thoughts.

One is that the S&P 500 and TSX are up 25% and 23% year to date:

This is likely induced by monetary policy, with the US and Bank of Canada historically demonstrating a huge amount of QE:

The central banks have signaled that this party is slowing down.

Picture the flow of a notional dollar of capital from monetary policy.

Monetary policy has the Bank of Canada purchase a bond from a primary dealer (one of the big banks). The result is a BoC asset (government debt), and liability (reserves due to the bank). The big bank receives reserves as a credit at the Bank of Canada, which they can use to make loans. Customer X goes to the big bank and sees something that warrants taking out a loan. Big bank lends a couple dollars to Customer X (loan is the bank’s asset, Customer X has cash, at the cost of a yearly cash flow from customer (debit interest expense, credit cash) and to the bank (debit cash, credit interest revenue). QE makes it “possible” for the big bank to execute on this loan as they can do so more cheaply than if QE wasn’t in place, effectively making credit ‘cheaper’ and thus lowering the rate of interest.

In this scenario, the bank is the one suffering the default risk, and this dollar given to Customer X is not given to him by the central bank, so it is not money printing. The loan must be paid back, with interest.

Customer X takes the loan, and invests it in some widget machine with Company Y. Company Y takes the money to pay labour and materials needed to make the widget machine. The labour tends to spend it on various necessities (food, housing, consumer goods, etc), while the materials provider has to spend it on their payroll (labour) and capital equipment from Company Z, A, B, etc.

All of this is illustrating the flow of where the notional dollar of capital is generated and circulated – originating from a financial institution (the point of money creation) and circulating in the economy. Eventually profits from companies Z, A, B, etc., circulate into shareholder hands, and for the very rich that have nothing else better to do with capital (there is only so much food and drink and housing one can buy), gets slammed back into the equity market.

Clearly there is a point where you can just bypass all of this widget creation and just invest loaned capital into the equity markets directly, which seems to be the result of what has happened. The notional dollar does not get created or destroyed, but the path of where it flows is quite relevant. Depending on the speed it flows (monetary velocity) and where it flows, the economic outcomes wildly vary.

For instance, imagine a world where 99.9% of the cash is held in the hands of day-traders only, circulating amongst them within the Nasdaq and NYSE, and these participants have no interest at all in building widget machines. We seem to be increasingly in an environment where a lot of this capital is held in the financial and not real world.

When money bubbles out of the financial world into the real world, this is when we start seeing a chase up the prices for real assets. For instance, going back to our fictional world where day traders own 99.9% of the financial capital, they might discover that they need to eat food. But since the food markets have been so malnourished, all the day traders can do is just keep bidding up the few morsels of food remaining, until prices reach some absurd high – a typical hyper-inflationary scenario. Indeed, if the day-traders have to eat 100 units of food, and only 70 units of food are available, there is no amount of financial capital available that can satisfy the demand.

One can imagine that the high amount of financial capital available would dramatically increase the volatility for real goods and services when the carriers of financial capital recognize an imminent need.