Category: Columns

Why did oil prices go negative?

Why did oil prices turn negative? How is that even possible? Typically, instead of paying someone to take a product away from you, you would just stop making that product and wait for another day so you can make a profit. Well, it is very difficult to just stop oil production and wait. It’s very costly to shut-in production and then restart.

What led to this issue? Supply is greater than demand right now. Given the impacts of COVID-19 means the largest consumers of oil have halted (jets and cars). At the same time, we’ve been building supply in Cushing, OK which is America’s key storage and delivery point.

Negative prices may seem attractive when you’re getting paid to take product, but aren’t so great when you realize if you were to take delivery (i.e. receive physical oil) you’d have to pay high prices to store it, which could eliminate all your profits.

Why didn’t the energy ETF sell-off more? If you look at Exxon or Shell or any of the majors on April 20th, their stocks were down maybe 3-4%. In fact, if you looked at Brent futures, the benchmark for Europe, it was selling for $25 / barrel. WTI contract for June delivery was $20 / barrel. Huh?

It all has to do with the futures market. Matt Levine also has a great post on this.  In essence, if you want exposure to oil, but didn’t want to actually take barrels of oil, you could buy a futures contract that gives you paper exposure to the commodity until it expires at which point you can either roll the contract (maintain paper exposure) or take physical delivery. If you go to the CME website, you’ll see you can buy oil in 1,000 barrel increments and it is settled “physically” – not financially – so you’d actually have to find a place to store it if you didn’t roll the contract.

When the June oil futures contract price is higher than May, that means the market is in contango. The June cost being higher than May partially reflects “the cost of carry” or storage costs for you to pay someone to hold the oil for you until the contract is settled. In this case, oil went into super contango because the cost of carry went to extreme levels.

This is also why energy companies didn’t sell off more. The “real” price of oil wasn’t actually negative. It was a panic to not settle physically. In fact, if energy companies hedge, they were likely the ones selling futures contracts before this point…

So this caused oil to turn negative?  Yes. As traders looked at their May contracts, they realized they couldn’t take physical delivery without paying huge prices. Also, panic probably settled in.

Was this predictable? Yes, actually. Here is a link to an article published on Bloomberg about 1 month before oil actually turned negative essentially predicting it could happen.

Could it happen again? Yes. And it might given investors decided to buy $USO, the oil ETF, to gain exposure. $1.5BN flooded into the ETF.  The problem is that investors bought this fund, which had to create shares and buying underlying, front-end futures contracts. So what did they buy? They forced it to buy June expiry contracts. So now they have exposure to the June contract in a vehicle that cannot take physical delivery and has no choice but to roll contracts. That may very well lead to this issue happening again in a month.

Oil prices outside of futures contracts remain very low. Could we see the majors like Exxon cutting more dividends?

Another incredible black swan event for 2020!

Otis Stock Spin-out from United Technologies – Quick Thoughts $OTIS

It’s not every day that you hear “recurring business model”, “razor / razor blade”, “route density will drive margins higher” story associated with an industrial company, but here we are. Otis stock has officially spun out of United Technologies so here’s my initial read. In other words, a starting point to see if there should be more work done. I like to take quick looks at topical names (and spin-outs can get interesting) so more of these will likely follow.


Things I like:

  • Service Drives Profitability:
    • New equipment sales were 43% of sales, but just 20% of operating profit. That means service revenue, while 57% of sales, makes up 80% of operating profit
    • This is positive, as it means revenue is much more recurring. Represents a “razor / razorblade” model too in that once the new equipment is installed, the customer needs to come back to Otis for service
    • The model is pretty simple: Otis sells new equipment and operates under warranty for a couple years. After that, Otis sells long-term service agreements that typically last ~4 years.
    • According to the company, an elevator will generate 2.5x its original purchase price in aftermarket service
    • In fact, service is contractual. And I like that the company reports “Remaining Performance Obligations” because it gives a sense of what sales will be in the next 2 years.

  • Generates a lot of unlevered FCF:
    • I was somewhat surprised at the low capital intensity of the business. I would say that this level of capex spend based on my experience is top quartile and that checks a box for Otis stock
    • Further, working capital is really low relative to total assets & sales
    • This means the company likely can use a lot of cash for dividends (looking at 40% payout ratio) and buybacks plus possible M&A of other service providers as the company says the space is fragmented.

  • Consistent business model – life threatening to “skimp” on the service:
    • I like how this business really hasn’t changed in 100 years. It tells me that the next 10 years will probably look similar to the last. That’s something you can’t say about every business so perhaps this deserves a “consistency premium”
    • If I was a firm deciding which elevator to choose, I’m not sure I’d take the lowest offer. I think a firm with a solid track record actually matters here. Elevators not only get people to work
    • Failure here might be unlikely, but the cost is so huge it makes no sense to change. For me, I sense that being true on both new sales and maintenance.
    • In fact, the company says it has a 93% retention rate following end of the warranty period – not bad!

Things I don’t like

  • Operating Margins have been declining
    • At first glance, I thought this might be due to new equipment sales becoming a larger portion of the mix. However, that’s not the case. It has been relatively consistent.

    • It seems to be China sales are the issue. The company has called out this “mix” effect, but also Otis doesn’t not have leading share there. In this business, density matters. So it will take time for the company to build density and improve margins.
    • Quote from prior call on Otis on the importance of route density:

“So today, if you look at us versus our peer competitors, we have a 200- to 300 point — basis point premium margin. We believe with our scale and density that will continue through the future. Add that to, again, this drop-through of productivity enhancements. But scale and density matters in this industry. You go to any city, whether it’s this building, anywhere else, if you’ve already got mechanics, if they’re already out on a route and you can add new customers, you get, obviously, a little additional incremental cost, but you get to add to the portfolio significantly.”

  • Mitigant: Company is targeting supply chain savings (3% of gross spend per year) and thinks it can reduce SG&A from 13.6% of sales to ~12.25% over the medium term, but somewhat of a “show-me story”
  • China is the growth story
    • China’s construction growth worries me. The talk of “ghost cities” being built to support GDP makes me concerned that a reckoning is eventually coming. And the problem is that many of these buildings may be unoccupied and therefore you don’t need to service them.
    • China is the largest elevator market – 60% of global volume. It’s also more competitive it seems.
    • Mitigant: China is getting more focused on building maintenance code, which should support global players like Otis. It should allow more sales to the big players as well as larger service contracts. Real estate developers in China are also consolidating, so it likely means they will want to work with one supplier.

Otis Stock Valuation:

I would say the valuation here is reasonable. Not super compelling in the COVID world, but at least it should be a long-term compounder.

Thysennkrupp’s elevator business was acquired by private equity for $18.7BN, or roughly 17x forward EBITDA. That would point to Otis stock being very cheap on that basis… Given it’s stability and strong cash flow, I can see why P/E would buy out a player. Otis stock is actually a mid-cap, but not too big for someone in Omaha…

Will Exxon Need to Cut its Dividend? $XOM

Saudi Arabia and Russia are in a price war — increasing the supply of crude oil at a time when we are seeing an unprecedented collapse in demand due to the coronavirus (COVID-19). Exxon has gotten crushed this year, down 45% YTD with a 9% dividend yield. They’ve consistently paid, and grown, the dividend over the past 37 years. Exxon’s dividend offers a juicy proposition for a company that is rated investment grade and at a time when the 10 yr treasury yield is <70bps.

But let’s do some quick math to see if the dividend is covered, first by looking at 2019 figures. As shown below, Exxon did $1.5BN in FCF.

This is not good. The Exxon dividend cost $14.6BN in 2019.

One thing we could do is look at what bare-bones capex is. In other words, what did the company spend in 2015/2016 when the oil outlook was also bleak? Cutting capex down to those levels would help preserve cash:

So now we have ~$10.5BN of FCF, but that still doesn’t cover the Exxon dividend. The other problem is that cutting capex is not what the company wants / intends to do. As stated in their March 5, 2020 investor day, they will actually be spending more than 2019:

On April 8, Exxon said it would cut this figure by 30%

Even so, cutting capex back doesn’t help. And the bigger problem is that oil was roughly 100%-200% higher in 2019 than it is right now.

What other ways could the Exxon dividend be maintained?

  • They could sell assets, but what price would they get in a time like this?
  • They could issue a bond to help cover it – but do you want an increase its debt load? Is jeopardizing the company for the dividend worth it?

I think its a matter of when, not if. Besides, I personally don’t think the oil industry is dead – there must be good long-term investment opportunities out there for them now that so many players are distressed.

When should I buy stocks? Putting my buy-decision thoughts completely out there $SPY

I did a post yesterday on some data points to consider before buying in this market.  I’ve been nibbling on the way down, but looking at some of the data points, I have to agree with what Gavin Baker has said in a recent post: this is a tremendous demand shock that we have not seen the likes of before. It will be very difficult to navigate it this time because its almost like a 9/11 and a 2008 demand shock rolled into one (but not a financial crisis like 2008 was). So when should I buy stocks?

The market clearly priced some of this in. The chart below shows the Russell 2000 drawdowns in the past. We’ve already surpassed the drawdown of 2001-2002 and did so much more swiftly. If anything, this drawdown is looking like 2008 just from the slope of the line (its steep).

Obviously, hindsight tells us if you chose to buy stocks during these drawdowns, it would have paid off very handsomely.

IWM Chart

IWM data by YCharts

The Fed has acted quickly, congress knows it needs to get its act together, Trump views the stock market as the best polls, proposals are coming together to give every American $1,000 to bridge the gap, and there is plenty of talk of bail outs. Seems like some lessons were learned from 2008… act fast.

But is that enough? Is everything “priced in”? How will the market react to new information of cases vs. stimulus? That’s a billion dollar question. Does this tell me when I should buy stocks?

Personally, I think we have further to go before I can say we all need to “back up the truck“. Yes, I view this as temporary and there will be pent up demand, but as I think through what happens over the coming months, it goes something like this:

  1. Markets have tanked, fear is palpable, there have been runs on grocery stores. Consumers are literally quarantined so the only thing they can think about is the pandemic which drives more fear
  2. Congress and Fed acted quickly, but this also tells people that things are serious. Congress puts together a bill to give $1,000 to every American; agrees to provide some loans to essential industries
  3. Just like GM – I don’t see why Congress would give a subordinated loan to these industries. In other words, it primes (or comes in front of) existing lenders plus equity holders. It’s hard for me to see how equity holders get out scot-free here, as well as bond holders. Haircuts will be taken.
  4. Even with Congress taking action, if I work in the restaurant, bar, travel, event hosting, leisure, or any service industry remotely attached to that, I’m thankful for $1,200, but I am worried about my job. I pull back spending considerably. As a consumer, thanks for the grand, but I still am not spending much.
  5. This ripples through the economy. First pullbacks on major purchases (vacations clearly cut, but also autos and home buying) and that continues through everything else.
  6. All the while, US count of the virus will likely grow considerably. We likely reach 100,000+ cases as more tests come out. This will cause the market to freak out and people will go from thinking this is a four week thing to a 12 week thing… maybe longer. The market always assumes the bad things will last much longer than they do.
  7. Media headlines will run rampant.
  8. You will also see bankruptcies of small and large businesses. BDCs and middle market private equity that invested (& levered up) companies with major customer risk and exposure to small business? See ya later.
  9. Elsewhere, cases will begin to decline. Markets will take a deep breath that the measures are working, even if they continue to climb in the US. The market is forward looking so they will see hopes for the US.

So what does that mean for equity prices? I think we have further to fall, unfortunately. Don’t get me wrong – I fundamentally do not believe you can time these things (“Well gee, you sure did waste a lot of text writing about what you think will happen…”) and I have bought many names throughout this bear market. As I noted in my cruise lines post, which was really clickbait for readers to see that long-term intrinsic values of businesses will be fine,  I think this creates a good opportunity to buy high quality businesses.

At the same time, I look at the market and it is just below / slightly above Dec 2018 lows depending on which market you’re looking at. As a quick barometer or sanity check, that doesn’t seem low enough for truly pricing in a destruction to GDP in Q2 this year and people worrying about systemic issues.

Backing it up to a P/E ratio: If we did $164 in EPS for 2019. There’s probably 0% chance we’re up from that number. We can haircut it though and multiple to see where things could shake out this year.  You can argue that because these are depressed earnings and we all likely expect a rebound, that the market should trade at a premium multiple. However, I rarely see that play out in real life. Panic causes people to over shoot. And again, this is a cheapness indicator, not an intrinsic value indicator because one year of bad earnings does little to impact your DCF.

This essentially tells me that my “back up the truck” moment for S&P500 is somewhere around 2,000 and below and I’ll still be a buyer at around 2,300 because I believe the storm clouds will eventually pass and this shows if we go back to 18x $164 in earnings, that is very solid upside.

Ok – I put my thoughts out there. I open myself to being wrong in the future and this post won’t be deleted. Where do you think we shake out? Why?

Is it Time to Buy Stocks? Here are Data Points Worth Considering. $SPY

The market is clearly in panic. Americans and other global citizens in quarantine will clearly not help most businesses (and therefore it doesn’t help stocks). Is it time to buy stocks now?

One piece of data I came across this weekend was Open Table’s data on restaurant reservations, found here.  As shown below, the US saw a ~42% decline in reservations Y/Y and globally they are down 40%.

Update: this data has only gotten more ugly

Not to mention, we have many public school closures, work travel has been postponed, cruises are putting up ships, and restaurants and bars are limited to take-out meals only. Heck, I can’t even go to the gym anymore. This will clearly crimp many businesses and could pressure liquidity.

This feels like SARS and 9/11 rolled into one. After 9/11, business confidence was hammered and many consumers were fearful and did not want to travel or go out to eat as much. United’s CEO said that this experience has been worse than 9/11 –

After 9/11, revenue was down 40% for two months and then began a gradual recovery… Our gross bookings in the Pacific are down about 70%, so there are still some bookings occurring even in the Pacific region. In Europe, our gross bookings are now down about 50%. Domestically, we’re currently seeing net bookings down about 70% and gross bookings down about 25%. While those numbers are encouraging compared to international, we’re planning for the public concern about the virus to get worse before it gets better.”

After 9/11, we had a tremendous shock to the system and it took some time to recover. Peak to trough, the S&P declined ~30% but within time, we recovered relatively quickly. Recall at this time, we entered a recession and also had a lot of air coming out of the tech bubble as well.

So on one hand, we have an extreme scenario. Short-term funding for a wide array of industries will need to be provided and I personally think we will need to see the US government step in meaningfully.

On the other hand, let’s look at the positives to see if it can help us answer if it is time to buy stocks:

  • Short-term pain, long-term gain. It appears the US is now taking the virus more seriously. While there will be short-term pain from a quasi-quarantine, this will help damped the rapid spread of the virus. This will also prevent a overrun of our hospitals and healthcare system
  • Authorities acting relatively quickly. The fed has now cut rates 2x and initiated bond buying (QE5). Although this won’t cure the virus, it could help calm financial markets which will then allow for liquidity to flow through to businesses who need it now. While not established yet, I bet we will see a cut to banks’ reserve requirements to also help the system
  • Not a financial crisis. While there are financial aspects to this (i.e. liquidity, companies drawing on revolvers) this is not like the 2008 mortgage crisis. Although banks are now cutting GDP estimates for Q2 and Q3 2020, many expect that demand will rebound meaningfully.
  • The US is behind the curve, and that is a good thing. Although the outbreak is hitting US shores later than Europe and China, it also means we can look at their data to when cases tend to peak and level out. The US now is essentially in quarantine and that will help fight the spread. (Note, I thoroughly enjoyed the charts posted in this WaPo article for how social distancing actually does work). I think the market will move up even if cases in the US are rising once we see Italy, South Korea and China under control.
  • The biggest companies in the world are flush with cash. Add up the cash held by Apple, Microsoft, Google, Berkshire Hathaway, and Facebook. These businesses fortunately will not be facing liquidity needs, represent large proportions of the S&P, and have longer time horizons than most investors today.

With many stocks I look at down 50-60%, this could be an opportunity of a lifetime given they are pricing in a long-term pronounced downturn. As discussed previously, a one-year impact to earnings that everyone largely expects will be temporary has little impact on the intrinsic value of businesses.

In sum, do I think stocks can continue to go down? Yes. They have historically over shot in both directions. But we can’t time it. I personally am looking at a collection of businesses that will continue to compound earnings at extremely attractive rates.

In this case, I think the situation will be written about extensively. There will be things we don’t even know about yet that books will be published on. 

But as you think about the past and uncertainty, realize that those times are actually the best in terms of investing. Buying when everything looks amazing and nothing can go wrong typically turn out to be poor outcomes (e.g. peak of tech bubble, the calm before the 2008 storm). Everyone knows in hindsight to buy when others are fearful. I’d also add the richest people in the US are typically perma-optimists, not perma-bears.

Is it time to buy stocks? Up to you, but you should have a plan for when you will.