Illusory wealth and the oil price: the case of Statoil

A quick follow-up on my last Exxon post (here) where I argued that oil company valuations reflect a bullish outlook for the oil price, i.e. they need way higher oil prices to make fundamental sense.

In today’s FT article (here) on Statoil’s USD 2.3 billion asset write downs, we get more information on what seems to be industry practice,

Statoil lowered its long-term oil price outlook for Brent crude to $75 per barrel in 2020, from a previous forecast for $83, and $80 in 2030, compared with $100 before.

This forced the group to reduce the valuation of its oil and gas reserves, prompting the impairment which caused an unexpected fourth-quarter loss.

As of writing the 2020 Brent forward price is about USD 56, i.e. close to the spot price (I have no data on the 2030 price), which means that Statoil is using an expected value that is 40 percent above market prices to justify its asset value. Moreover, the effect of the expected oil prices on (DCF) valuations is not linear: given that Statoil is a relative high cost producer, it might well be that at market forward rates a lot of its reserves are not viable at all (hence only option value is what’s left).

Although you can always argue that forward prices are not an unbiased predictor of expected prices (at least when it comes to purely financial assets), I still find it somewhat aggressive to deviate that much from observed market prices.

How is that possible?

Whereas it is not uncommon to see auditors twist objective criteria in favour of large clients, I do not think this is what happened here. I truly believe the auditors even acted in good faith and felt comfortable with their decision. This is because I observe a kind of bullish oil mentality out there, not only among market participants (here), but among laymen (such as the auditors) as well.

For instance yesterday, there was a report on Austrian TV on a new regulation prohibiting households from using oil heating systems in new buildings because of environmental concerns (It is apparently environmentally friendlier to burn the forests). The problem of course is that at current prices oil heating is quite competitive. The journalist (no doubt, in favour of “sustainable energy”), however, concluded the report with a confident tone, “…who knows how long this will last?”

This made me think about where this confidence, i.e. bullishness comes from.

And I think I have found the answer: peak oil!

Never mind that the apocalyptic predictions have (spectacularly) not materialized for decades, oil is a finite resource and for most people this fact translates into visions of oil shortages and spiking prices.

But the question that matters is not whether oil is finite in a physical sense, but how its potential supply compares to potential demand over an economically relevant time period. Price reflects of what human actors a willing to pay to satisfy subjective current or future needs, whereby future needs are discounted using time preference curves (here). Time preference is the reason why events in, say, 30 or 50 years should have little impact on today’s price action and cannot be used as an argument in explaining the price action of the next 5-10 years.

So, how likely are we to run out of oil in the foreseeable future?

Not very much, according to this chart taken from BP’s global energy outlook (here),


As one can see global proved oil reserves have continuously increased over the last three decades, to the extent that estimated cumulative demand over the next 35 years is more than twice covered by technically recoverable resources. Of course not all these resources are profitable to extract at current oil prices, but their existence certainly puts a cap on how high oil prices can get. Moreover, the entire estimated cumulative demand (base case) is covered by oil reserves in the Middle East and the former Soviet Union which are low-cost conventional oil fields and highly profitable at current prices.

And lest anybody accuses BP of not being bullish enough (that would be weird, wouldn’t it), here is at how they arrived at their base case demand estimate,


Rising demand from China and India seems to be a safe bet, rumours about capital flight and bad loans notwithstanding…


Exxon mobile finally starting to acknowledge capital misallocation

In summer I argued (here) that integrated oil majors look overvalued and require much higher oil prices to justify current valuations. I was especially puzzled by the fact that Exxon had not written down any of its upstream assets, despite a significant drop in the oil price over the preceding 24 months, something that even had attracted the scrutiny of the SEC.

Well, yesterday Exxon missed forecasts by a large margin, due to impairments (USD 2 billion) on some of its gas fields, which makes it the 9th straight quarter of yoy profit declines. Clearly its fortunes correlate heavily with the oil price. This, however, is missed by the wider analyst community, whose average earnings estimate was almost double the actual result.

And it gets worse.

For, if oil prices stay at current levels, Exxon might be forced to de-book almost 20 (!) percent of its reserve assets, as extracting oil from them has become unprofitable. From Bloomberg (here),

About 3.6 billion barrels of reserves in the Canadian oil sands and the equivalent of another 1 billion barrels in other North American fields could fall off the company’s books if low energy prices persisted, Exxon said in October. That would equate to 19 percent of Exxon’s reserves and would be the largest de-booking since the 1999 merger that created the company in its modern form. Woodbury said an undefined portion of those revisions would be offset by new additions.

Yeah, an “undefined portion” will be replaced by new additions. By the way, production volumes were down 3 percent over the year too.

I do not know about you, but to me Exxon looks like a shrinking business.

Management seems to agree. It is management planning to increase capex to USD 22 billion for 2017, an increase of 14 percent compared to the past year, and equal to the entire “cash flow from operations” of 22 billion for 2016, according to page 19 of the most recent SEC filing (here), increasing the probability that shareholder distributions have to be paid out of debt. Jim Chanos’s “liquidating trust” hypothesis certainly doesn’t look far-fetched to me (here).

The market (ETFs) seems to disagree, however, and thinks that Exxon at a TTM PE of over 40 is a bargain. As does the Swiss central bank, for whom EXXON and Chevron are among the Top 15 holdings together worth more than USD 2 billion.


All the investors in oil majors are betting on a significant recovery in the price of oil. With so much illusory wealth  (add the heavily indebted shale plays as well as suppliers) depending on the trajectory of a highly volatile commodity, one can see why markets get nervous when oil goes down.

Clients abandoning Hedge Funds – the case of Hugh Hendry

I am referring to this Zerohedge article (here) on Eclectica’s most recent monthly letter, where he highlights the AuM of his fund – 35 million. That’s down from 800 million at the peak, if memory serves me well.

Hugh Henry is a manager I admire a lot for his unconventional views, although I think that his arguments on China don’t make any sense whatsoever (obviously, given my positioning). Until recently he has had a great track record, uncorrelated to market moves including a significant positive performance in 2008. He is one of the few true Hedge Fund managers out there.

However, I remember some two years ago, when he turned bullish on the premise that it doesn’t make sense to fight the central banks that I felt he is succumbing to client pressure. Viewed retrospectively turning bullish two years ago was not the worst decision and with most markets mostly up, I would have expected him to do well. So I was surprised to see Hendry somehow managed to lose close to 9 percent YTD. I do not know what happened last year, but it can’t have been that good given the development in assets under management. How is that possible? Unfortunately the letter is short on this information.

In the last three and a half years that I have had a 40 percent cash position, I have had numerous discussions on whether it is appropriate to be defensive when central banks are doing everything to prevent asset markets from falling. This has never happened before, the argument goes, hence it is less dangerous to join the party. Adding to the confusion is the fact that people are generally receptive to the bearish arguments which is not the case in your typical bull market. After all, they can see that something doesn’t feel right from their daily experiences in the real economy. But the bearish argument has been there for years and the bull market has marched on and on, which a lot of people take as a proof that this time is different.

However, when you study market history, you can find a lot of similar episodes when managers had to wait for years for their view to pay off.

Most famously, Warren Buffett closed his highly successful partnership at the end of the 60ies and put his money into Treasuries to return only in 1974. And while it is true that Treasuries yielded a few percentage points back then, making it seem like an easy decision, people forget that inflation was exploding in the following years resulting in significantly negative real yields – much more negative than they are now. That’s a very painful five years of sitting and waiting while the NIFTY 50 is rising into the stratosphere. On the other hand, you do not have to be a genius stock picker to do fantastically well if you put money into a diversified stock portfolio after the 1974 crash and just hold it over the long-term. People like to philosophize about value investing and finding moats, but they forget that a lot of Warren Buffet’s performance is not due to stock picking, but because of his ability to endure psychological pain over long periods.

And then there is the great Benjamin Graham, with a quote I referred to a while back (here),

(…) Only 1 in 100 survived the 1929-1932 debacle if one was not bearish in 1925 (…)

That’s more than four years of painful waiting.

Beating the market has never been easy. I am still convinced it is not different this time.

(Disclosure: short CNH and AUD)


When negative rates mean tightening – Deutsche Bank and monetary policy

(The views in this post are a result of armchair theorizing. I have not looked into Deutsche Bank’s (DB) financial reports in detail because I believe financial accounts are unreliable for this type of financial institution anyway. For this reason alone the stock is generally “uninvestable” and, as a consequence, I do not have any positions on. My interest in it is purely due to monetary, i.e. macro aspects).

Deutsche Bank has been in the headlines lately, its stock price crashing and the main political actors trying to calm markets. The main culprit, according to the consensus, is a higher-than-expected fine (14 billion US dollar) for malfeasance during the mortgage boom ten years ago. While it goes without saying that a higher than expected liability should have negative effects on the stock price, I believe it is not the main problem ailing DB.

That’s because DB’s share price had already lost 2/3rd of its value over the previous 12 months, i.e. long before the fine was made public. It seems DB’s problems have only remotely to do with the fine. Clearly, something else is at work here.

That something, I believe, can be summarized with the following chart (via Macronomy),


It shows the EURUSD cross currency swap (CCY) basis over the past ten years. As one can see, the basis has been negative since the beginning of the financial crisis. A negative basis, means that (secured) US dollar funding more is getting more expensive for a bank that needs dollar funding (and has to post EUR collateral), as it receives less than the market rate (Libor) on its EUR collateral – therefore the negative sign (here for a good introduction).

Cross Currency Swaps – the Basis of the Global Financial System

CCY Swaps are at the heart of the Eurodollar System. Whenever someone outside the US takes out an US dollar loan at his local bank, chances are high that the bank’s dollars have been sourced via swapping its local currency deposits into dollars on the Eurodollar market. Unless the bank is based in a Petrodollar country (Russia, Saudi Arabia, Norway etc.), it is unlikely to have sufficient US dollar deposits to engage in simple US dollar fractional reserve lending. Since unsecured lending via bonds is way more expensive, CCY are is the preferred and easiest route for banks to go. It is through this market that US monetary policy is (unintentionally) disseminated across the globe.

Short on deposits, Investment Banks are heavily dependent on the wholesale market for funding. As a result of their global ambitions and due to the fact that 70 percent of global financial transactions occur in US dollars, this means largely US dollar wholesale funding.

DB is the biggest continental investment bank. And this is precisely its biggest problem. They do not disclose how much of their balance sheet is US dollar denominated, but I suspect it is a lot (just flying over the annual report, I note that it is very, very light on specific information). For that reason, if wholesale funding in US dollars is rising, it hurts their business model disproportionately, which is even worse than a one-time fine. (The second is Credit Suisse which according to Jeff Gundlach (here) might be even worse and shows a similar stock price trajectory despite the absence of a similar fine).

So what is causing the US dollar cost of funding to rise?

Some people are blaming a “US dollar shortage”. That’s what happened in 2009 and 2011/12 when asset markets in Europe (and globally) were crashing because market participants had to liquidate assets to generate US dollar liquidity. In 2012, during the height of the Euro crisis, investors were fleeing Europe, or at least parts of it. Then came “whatever it takes” – and markets calmed until mid-2014, with the basis widening ever since.

If there is an US dollar shortage I do not know what is causing it. Contrary to 08/09 and 11/12, asset markets have been booming in this period – at least in Europe and the US. This year even Emerging markets and commodities have re-joined the rally. Yes, there are issues in China, but the CNY has barely moved (sorry to disappoint, but 2 percent is not a devaluation). In short, this doesn’t feel like a US dollar shortage (yet) – but the CCY basis remains unimpressed.

What else could be the reason?

I believe a big factor this time is negative interest rates, first imposed in June 2014 (red line in the Chart) and subsequently lowered to -40bp as of today. As one can see, the CCY market has deteriorated steadily since then, reversing the normalization phase of the previous two years. That’s the empirical evidence, but correlation doesn’t prove causation and the pattern observed could just be coincidence – we need a good theory of cause and effect.

When negative rates mean tightening

I have written about how negative interest rates will kill European banks’ top line going forward using the example of Italian (here) and Spanish banks (here). These are the direct consequences of negative interest rates, and its effect will soon be seen in the aggregate NIM of the European banking sector.

What is (or will be) seen, however, is usually not what matters with market interventions. It is the unseen – or unintended – consequences of actions that have far more impact, as Bastiat showed 150 years ago (here). Thinking about the potential unintended consequences of negative rates and trying to figure out why the basis has been negative despite the absence of market volatility, I came to the conclusion that negative interest rates play a big part in the negative swap spread thereby increasing the funding cost for banks that rely on USD wholesale funding. In other words, from the view of DB, Mr. Draghi’s unconventional monetary policy looks like tightening. No wonder, DB has been the most vocal critic of ECB’s monetary policy. After all, DB couldn’t care less about German savers and retirees!

In order to understand how negative rates in Euroland translate into a negative EURUSD basis, it is instructive to go through an example.

A European bank (A) wants to increase its USD business. This could be loans to energy companies and traders, emerging markets and general capital markets activities (such as buying MBS for resale). The bank only has EUR funding (deposits, bonds etc.) and needs to generate US dollars. Sure, it has enough Euros, but it needs to come up with USD. The cheapest way to get your hands on dollars is to enter a CCY Swap.

In a CCY Swap A will borrow US dollars from another bank (B) and pay something like $ Libor, just as it would with unsecured interbank lending. However this would expose B to unwanted (bank) counterparty risk, severely reducing the appetite of B to fund the (ambitious) expansion plans of A. To mitigate this inconvenience, A agrees to lend B Euros in turn thereby reducing the net Exposure between the two counterparties to 0. The principal amounts will be swapped back (or repaid) at maturity.

But we are not finished!

We still have not determined how much B has to pay to A for the EUR loan that forms the second leg of the swap. If B is willing to pay Euribor – minus some fee for the transaction, after all B wants to make a profit from lending its dollars – the market is said to function normally, i.e. the basis is close to 0. As we can see, the rate B can/wants pay A determines, whether the market is said to function normally or not.

And what determines B’s propensity to pay?

Answer: the things it can to with these Euros, i.e. the opportunity set.

Now, before the crisis in 07/08 this must have been fun. Huge “opportunities” presented themselves to banks with spare Euros. Remember, all those banks in the PIIGS taking advantage of historically low rates, handing out far more loans than they had deposits and thus paying up in the interbank markets (see my post here)? Well things have changed since then: bank lending is not considered riskless anymore, and the PIIGS are struggling to decrease, rather than increase their debt levels. Lending out all those Euros is neither feasible, nor attractive anymore.

Without explicit business opportunities, B will view the EUR amount as “mere” risk mitigator, i.e. pure collateral. With this emphasis is on safety, B will be willing enter transactions with zero credit risk and pay a rate close to what these assets yield. In the Eurozone this basically means either ECB reserves or German government bonds. Since those rates have been negative for more than two years, it means that not only is B unwilling to pay much, but A has to pay B for the Euros it has lent (to B). Effectively A ends up paying more than $ Libor.

That’s called a negative basis!

And it’s definitely caused by negative interest rates!


Mr. Draghi is partly right when he claims, as he did recently in the Bundestag, that Eurozone banks’ problems are not the ECB’s fault. This is true for the legacy problems still ailing bank balance sheets across the Eurozone. But it is definitely not true on a forward-looking basis, due to the havoc caused by ECB’s mad interest policies. By introducing negative interest rate, the ECB has unintentionally tightened monetary policy for those banks that rely on USD funding for a large part of their business model. This is certainly the case for DB, the systemically most important bank in Europe.

There is no free lunch and central bankers are not omnipotent. Buying stability for government finances and asset markets must come at a price. In this case the price paid is political turmoil and heightened instability in the banking system. This is a very, very bad trade.

They really do not know what they are doing.

Follow up on my GMO post

My recent post (here) on energy companies has led to a lot of interesting responses from readers. One reader has forwarded research by JP Morgan showing that most oil companies they track cover their dividends at around a price of USD 50 per barrel and, therefore, my claim that the currently high dividend yield is unsustainable is wrong. (Interestingly, most commenters have focused on the dividend yield, ignoring my arguments about the other two valuation metrics employed by GMO – a sign of the times?).

Maybe a clarification is in order here to avoid misunderstandings. I never said that every oil company has to cut its dividend. My statement was about the (market-weighted) average that is used by GMO to construct the index referred to in the post. I have chosen Royal Dutch because I was of the opinion that given its 200 billion market cap and high dividend, it is to some extent representative and therefore a good example.

No doubt, there will be companies whose dividends are sustainable at the current price level. Obviously, this doesn’t mean it is true for the sector overall.

Lukoil, for instance, with which I am somewhat familiar due to my bond position (here), looks as if its high dividend yield is fine at current levels. But: Lukoil is exceptionally well positioned on the cost side. Not only is Lukoil a traditional low-cost producer (remember this chart), but it has enjoyed falling costs courtesy of a heavily depreciated Ruble exchange rate. I do not see how Royal Dutch, which sports a similar dividend yield as Lukoil, can match this cost advantage in the near future, even if they are likely to get concessions from suppliers. Either Lukoil’s dividend is supersafe, or Royal Dutch’s is not. I believe the latter. Remember: Lukoil’s dividend yield is high because of the famous Russia discount, not necessarily because of a general undervaluation of the sector.

Apart from that, the responses have triggered my interest and I have decided to have a quick look at the matter. As I do not have access to JP Morgen research, I have looked what Goldman has to say on this issue. In a recent research piece they had this chart,


The chart shows the current dividend yield and the oil price at which Goldman deems the dividend sustainable for the most important (in terms of market cap) players without resorting to debt financing and assuming that their capex estimate is sufficient to maintain production volumes (“organically”). Unsurprisingly, the lower the dividend yield, the lower the required oil price to maintain it. Also note that Royal Dutch needs an oil price of 63 USD – a mere 50 percent above current levels – to keep paying its high dividend over the long – term. The same is true for other major oil companies such as BP, Total, etc.

I would say this confirms my analysis.

The companies whose dividends Goldman thinks safe at current oil price levels, have yields of between 2.5 and 4.4 percent. That’s not bad, but if these yields excite you, I would urge you to have a look at “undiscovered” gems Microsoft (dividend yield: 2.75%) and Cisco (3.34%), both of which I own (here).

Ok, Royal Dutch is doomed, what about the others? Surely, they are good value at nice yields plus a “free option” should oil prices rise?

There is no denying that a 50 percent higher oil price would help – but that’s (bullish) forecasting. Let’s work with what we have and play around with Goldman’s analysis. Let’s focus on the term “organically”.

As explained before, organically in this context means that the capex estimate Goldman uses to estimate the sustainable dividend is high enough to keep current production volumes indefinitely by replenishing reserves 1:1. This is necessary if you are valuing the company as a mature dividend payer. In case Goldman’s capex estimate is too low, your option betting on a higher oil price is not “free”, but paid for by reducing the capital stock. Unfortunately, Goldman is a little unspecific on how they estimate their sustainable level, but they seem to be guided management.

So we have to work around the problem to see whether this is a good idea.

Exxon dominates the sector with its 350 billion market cap. Goldman think’s its yield at 3.5 percent sustainable at current prices. It is considered to be one of the better managed majors, free from the type of government meddling you get with European integrated oil companies. Warren Buffet was a major shareholder until recently calling it a “wonderful business”. In short, the best management.

Nevertheless, despite doubling their annual capex during the oil boom, their reserve replacement ratio has been below 100 percent, if one excludes their acquisition of shale gas play XTO in 2009. That’s according to Jim Chanos (here) who called the integrated oil companies value traps and liquidating trusts for this reason. I observe: even with record capex in the past they were not able to replace their reserves organically.

Now, at lower oil prices capex will have to fall. Who knows, maybe less cash at hand will help focus the mind of management, but it is a bet you have to be willing to make. Also new reserves will likely only come from politically unstable regions (such as Exxon’s Kashgan field in Kasachstan) a risk you also have to factor in. I feel that at current oil prices there is not much margin of safety to compensate for these risks. Cisco’s dividend is safer.

Further, over the weekend there has been an interesting development regarding Exxon mobile’s book value. From the FT (here),

(…) Last week, it emerged that Eric Schneiderman, New York attorney-general, was investigating Exxon’s decisions not to take large charges to its profits for writedowns in the values of its assets following the fall in oil prices. That move built on the probe he launched last year into the company’s statements on climate change.

The SEC is now also looking at Exxon’s reporting of its reserves, asset valuations and writedowns, as well as its disclosures on the risks that climate change creates for its business (…) 

Wow, the SEC is questioning Exxon’s asset valuation, i.e. its book value – although the stock price is trading near its all-time high and nobody has lost any money.

And for a good reason: Management at Exxon, you know the guys who have spent billions on capex when oil was at 100 without actually finding much, think that a halving of the oil price has no consequences for their book value. And what’s better: they seem to be the only ones.

I mean, even Royal Dutch has impaired their assets by USD 8 billion, or 4(!) percent of their asset value. The same goes for Chevron, which at least has reduced book values by USD 4.7 billion.

Message: do not trust these managements (and book values).


Clearly, the oil industry still believes that oil prices will recover significantly. As do many investors who either think the dividend yield is sustainable, or the optionality in case of a higher oil price is worth a lot. This view is embedded in the valuations and therefore this is not a contrarian play. The sector (average stock) is not cheap. Moreover, book value, one of value investor’s favourite metrics appears to be unreliable, just as it was in 2007/2008 with the banks. If oil prices do not recover substantially, we are going to find it out.

They really don’t know what they are doing: QE and Spanish banks

I wrote on how negative rates are destroying the Italian banking system (here). Now, there is a new piece by Exane (here, via valueandopportunity) on how negative rates might play out in Spain. Unsurprisingly, the effects are similar.

Just as in Italy, Spanish banks have heavily invested in government bonds in order to benefit from the free central bank put provided by QE and whatever it takes. Just as in Italy, private sector lending has been crowded out (it probably was too high to begin with) and, just as in Italy, the low hanging fruit has been picked, now that Spanish government bonds yield less than the 10 year US treasury.

The report is entertaining to read, but the most interesting information can be found in this table,


It shows what percentage of the respective bank’s profit before tax (PBT) comes from interest payments and capital gains in the sovereign portfolio. The percentage is lowest for Santander (SAN) and BBVA, as they have substantial operations abroad and had not engaged in foolish real estate lending to begin with. Nevertheless, their dependence on income from their sovereign bond portfolio is substantial. For others, the importance of the sovereign book is way higher. For the seven largest Spanish banks, on average, 93 (!!!) percent of pre-tax net income comes from gains and income on their sovereign books.

The report mentions that the average remaining duration of the sovereign book is between 3-4 years, which means that over the next half decade virtually all of the Pre-tax profit in the Spanish banking system will disappear, if interest rates remain where they are.

Macro economists, as employed by central banks, no doubt would answer that this is exactly the purpose: force banks to lend more and help the economy grow out of the high debt (circular reasoning being a requirement for a PhD in this field).

They forget that in order to lend more to the private sector a bank a.) needs equity and b.) needs to find enough suitable costumers.

As for the equity, most of the equity in Spanish banks consists of tax loss carryforwards, i.e. it is not really there and not available to cover losses – and everybody knows that. Everybody who is not a macro economist, that is.

As for the costumers, Spanish banks are losing their best and biggest clients to – you guessed it – the ECB and to the bond market. Ask yourself: why should big Spanish corporates (Initex, Endesa etc.) pay the overhead costs for such unnecessary things as underwriting departments and bank branches, if they can pay near zero in ETF and central bank dominated bond markets?

Answer: they don’t.

Thus Spanish banks are trying to find costumers by tricking Spaniards into credit card debt with opaque zero cost offers. If the only way you hope to grow your loan book profitably, is to screw your costumers, I would say that this is neither the way to grow your economy, nor sustainable.

There is no conspiracy – central banks really do not know what they are doing.

Why commodity companies might not be as cheap as they seem (and GMO is likely wrong)

Excellent piece by GMO on investing in commodity stocks (I do not know why they call them resource equities, probably for marketing reasons).

There are very useful long-term charts comparing investing in equities vs. investing in the commodity directly. They show that equities in commodity producers have delivered a significant positive return even in the absence of a secular commodity bull market. Further, they demonstrate that for financial investors it is really the only alternative, as the long-term returns from investing in futures are horrible, as a result of negative roll returns. The charts are very useful if you want to market a commodity equity fund.

However, the following statement irritated me,


According to the metric they use, a combination of normalized historical earnings, P/B and Dividend Yield, the valuation of the energy/metals sector has the lowest historical relative valuation on record only matched with 1998 the days of 10 dollar oil.

The reason I was irritated, is that recently when I looked at a few oil mayors, I felt that at the current price level their valuation was excessive and their dividend not sustainable. Moreover this was true across the board, whether it is Exxon mobile or OMV (Austrian integrated oil company).

Just look at Royal Dutch Shell, with a dividend yield of over 6 percent, a normalized (5y) PE of 11 and trading at a price book of 1.3. That’s looks cheap according to GMO’s chosen metric and, no doubt, represents a significant discount the S&P 500.

Just how reliable are these metrics in this case?

The dividend yield at over 6 percent, no doubt is sporty, but in 2014 the dividend cover was a meagre 1.3 whereas in 2015 it dropped to an absolutely unsustainable 0.2. In other words: in the recent past Royal Dutch has paid dividends by tapping the generous debt markets. Clearly, there could be one-off effects on net income that have distorted the dividend cover and we should take that into account.

This brings us to normalized earnings. Obviously, if you believe that the normalized PE of 11 is representative, you will not be overly worried by the low dividend cover of the last two years, as it implies a sustainable 9 percent earnings yield.

But how representative is it?

Let’s look at the main P&L categories to get a better feel for the figures.

Year Net Income EBIT EBITDA
2011 30.9 42.7 55.9
2012 26.7 37.7 52.3
2013 16.4 26.9 48.3
2014 14.9 19.9 44.4
2015 1.9 -3.3 23.5
Average (bn USD) 18.2 24.8 44.9

Unsurprisingly, the figures show that the degree of profitability of any integrated energy company heavily depends on the price of energy. Furthermore it can be seen that 2014, when oil prices started to drop from 94 dollar per barrel to 50 dollar at YE, was still a very good year courtesy of a high average oil price for the whole of 2014. So, for four out of five years used to normalize the earnings saw an oil price trading in the 80-100 USD range – pretty much 100 percent above where we are now.

Normalizing earnings in this case only gives you a good picture if you forecast significantly higher oil prices going forward. But this would involve bold forecasting of oil prices and even Jeremy Grantham contends in his piece that this is impossible.

Unless oil prices significantly increase from here, expect the dividend to be cut or debt to increase further.

Now let’s look at P/B the last metric GMO uses. No doubt, Royal Dutch at a P/B of 1.3 looks cheap relative to the market, but this should not be surprising in a market dominated by tech and service companies with their high (and mostly irrelevant) P/B ratios.

The biggest issue I have with this metric, however, stems from the fact that book value is not what it used to be, i.e. a pure and objective measure of how much has been invested in the business so far. Royal Dutch values most of its assets on an expected cash flow and DCF basis, i.e. it is forward-looking and subjective in nature. Currently they are implying a 6 percent discount rate reflecting the record low-interest rate environment. Put differently, the book value is an implicit bet on low rates.

For this reason I prefer another valuation metric. Given that I cannot forecast oil prices the most reasonable assumption is to take the average price for last year, the first full year of 50-60 USD oil and see what they can earn on that basis. As it seems that net income and EBIT figures for 2015 are somewhat distorted by impairments on assets, I will base my analysis on the EBITDA for 2015 which amounted to 23.5 billion dollars. I will be generous and assume that management is able to cut costs (after all not all profitability depend on the price alone) to deal with the new environment as well as squeeze some synergies from their recent acquisition and postulate that the normalized EBITDA at the current price level can be around 30 billion dollars, i.e. an improvement of 30 percent.

At an enterprise value of 350 billion this translates into a very high normalized EV/EBITDA ratio of slightly below 12. Remember, this is for a business which depends on higher commodity prices and substantial capex for sales growth. Furthermore, the nature of the business is such that constant investment is required to replenish reserves. Over the past 10 years, for instance, Royal Dutch has constantly invested between 150-200 percent of depreciation without significantly increasing its oil reserves (although they have increased their liquefied nat gas capacity), a period over which it has constantly been free cash flow negative.

In line with that, management expects capex spending of about 25 billion per annum for the for the forseeable future. All this results in an expected free cash flow to the firm of 5 billion USD, not even 2 percent of the value of the business. The valuation rests on energy prices rebounding substantially.


All three metrics used by GMO rely on a significant rebound in oil prices in order to be valid. I believe the case of Royal Dutch Shell to be representative to a large extent, at least for the large players. Mr. Grantham implicitly is forecasting higher energy/metals prices. Whether this will happen or not is anybody’s guess, but given that nothing has happened in China yet, I would not bet on it.

Is Investment Spending really too low?

There has been much talk over the past decade about the comparatively low level of aggregate capex spending in the US and Europe. Low investment spending, despite ever lower interest rates, are the main reason why such absurdities as negative rates and endless QE are necessary according to the economic mainstream – because, you know, liquidity trap.

I have been writing about this issue in the past (here) and recently had a discussion in the comment section of the quite interesting moneyness blog (here) on this topic. In essence, I argued that there are many factors affecting investment decisions, the interest rate is just one of many and for some sectors and industries clearly not even the most important one. Economies are too complex to be modelled assuming a simple linear relationship between interest rates and investment spending.

And then I came across this chart,


Who says there has been no capex growth?

With the CNY being more or less fixed to the USD over this time period, it certainly is logical to include China into any analysis involving the effect of Fed policies. As you can also see, investment levels really took off in the aftermath of the financial crisis. Contrary to what one reads, it seems that low interest rates and QE have indeed boosted investment spending. Just not in the US and Europe.

Now, the interesting question: why China, and not the US (or Europe)? Why has there been no corresponding boost in investment spending in the developed economies?

Well, as I already mentioned, there is more than one factor at work. And for various reasons low interest rates seem to have “worked better” in China. From environmental regulations to more flexible labour laws etc. there are ample arguments why China has responded the way it has.

But the most important factor, I believe, is due to the top down decision making process employed by the Chinese mandarins that underlies most investment decisions. Actually, the decision function of Chinese communist leadership likely even resembles the abstruse models the Fed uses to set the “correct” interest rate – similar, that is, in its simplicity of cause and effect. Add to this the supremacy of political objectives over the profit motive, leading to the subsidization of loss making industries ad infinitum and you get the dynamics depicted in the chart above.

Naturally, the decisions made in China, however uneconomic, affect the profit expectations of private businesses in the US and Europe as well. Unless you are a capital goods (think Germany) or commodity exporter (Australia), you will be cautious to expand your business organically knowing you are competing against an irrational market participant with deep, deep pockets. Think steel, think solar panels and many other sectors. Moreover, the announcement of the Chinese to enter into any sector higher up the “value chain” must send shivers down the spine of board members in the respective industries. No wonder buybacks and M&A are more attractive.

The Chinese cannot do this forever, of course as costs are increasing even in the absence of tighter Fed policy. But the capacity of the Chinese leadership to stick with irrational economic decisions is a function of low Fed rates and increasingly so. The lower the opportunity cost of financial folly, the longer it endures and the argument can be made that low Fed rates actually crowd out productive investment in the US in Europe. Which is to say the Fed is responsible. Couple that with the devastating effect negative rates have on banks’ business models and you get the picture (here).

No matter how you look at this, the CNY is at the centre of global economic imbalances. The recent market calm and the likely shake out of the large CNY short position recorded at the beginning of the year (here) have led me to double my CNY short position at reasonable cost.

Disclosure: short CNY, short AUD

Brilliant piece on Tesla

…A headline quacked across my screen: Tesla was having customers sign Non-disclosure agreements (NDAs) in exchange for out of warranty repairs.

No other auto company I am aware of asks customers to sign NDAs in exchange for free out-of-warranty repairs. Regardless of what the company says, there is really only one reason to do that – to suppress bad news that might impact the stock price.

Elon Musk promptly wrote a blog post – in which he attacked the motivations of the journalist who broke the story –  and claimed that the NDAs were never intended to stop a customer from filing a complaint with the National Highway Traffic Safety Administration (NHTSA).  And then Tesla changed the language of the NDAs at the request of NHTSA.

Attacking the messenger, denying the allegation, and then admitting to it.  A crazy red flag…

read the whole piece here (via creditbubblestocks)

Chart of the week and the only question that matters

Whereas the real economy is being squeezed to some extent (see my last post on banking in Italy here), asset markets are enjoying record “inflows” (via Zerohedge)…

And do not forget the crazy lending binge, i.e. “social financing” in China which at least partially is dripping into western asset markets via M&A,


part of which would obviously have to be added to above documented central bank buying.

Most observers focus on retail fund in and outflows since that’s what crashed the dotcom bubble. This is like generals preparing for the last war, fund flows are minuscule compared  to central bank buying. Nowadays, the only question that matters is: how long can central bank buying last and how will it end?