Thursday, December 11, 2014

Thursday Roundup: Oil and Commodity Crash, Amazon's Capital Leases and Free Cash Flow, Low Volatility Anomaly

Econbrowser bullish on $60 oil:

"The current surplus of oil was brought about primarily by the success of unconventional oil production in North America, most new investments in which are not sustainable at current prices. Without that production, the price of oil could not remain at current levels. It’s just a matter of how long it takes for the high-cost North American producers to cut back in response to current incentives. And when they do, the price has to go back up."
Take breaks:
"The results are even starker when we are talking about very long working hours. Output at 70 hours of work differed little from output at 56 hours. That extra 14 hours was a waste of time."
The oil/energy crash looks like the NASDAQ crash in 2000 or the homebuilder crash in 2007:
"The S&P 500 Energy sector has now fallen 25% from its peak nearly six months ago, while the S&P 500 Oil Exploration and Production group has fallen even more at -45%."
Be careful with commodity mean reversion trades:
"commodities tend to trend better than stocks. Another way to say the same thing is that stocks tend to mean revert more often and more strongly than commodities. If you have traded stocks for a while, you probably have a sense of when a move has gone far enough to be due for reversal, and you’re probably used to seeing longer term positions more or less alternately green and red on the day over any reasonable stretch of time. Be careful, because these (correct) instincts will work against you in commodities, which can trend and trend and trend and end in blowoff moves that go far beyond what anyone expected. Simply put, if you come to commodities from a stock trading background, temper your urge to fade moves."
Why did Continental Resources cover hedges so early?
"While it is unclear what process was undertaken to reach the decision to remove the hedges, the trend downward in oil was actually accelerating when they removed the hedges. Even a rudimentary trend following process would have suggested keeping at least some of those hedges in place. Have to wonder whether his deep industry knowledge got in the way of an objective, process-driven assessment."
Great post on AMZN, Understanding How Amazon's Use Of Capital Leases Overstates Its Cash Flow Metrics:
"[T]there are a significant amount of short-lived operating expenses that Amazon is able to capitalize and amortize under GAAP accounting, much of them under Capital Leases, which significantly increases the stated Operating cash flow of the company. Once again, nothing is out of line with GAAP accounting, but the company implores you to ignore GAAP accounting losses and focus on the Operating cash flow number, which does not represent economic reality.

This is the biggest mistake people make when using Cash Flow-based assessments of companies including EBITDA, which is adding back ordinary operating expenses that are accounted for through the Amortization of assets."
Great essay "Crisis 2.0" about low commodity prices leading to a wave of defaults:
"[A]ny levered player with commodity exposure has a credit impairment and/or a default. The ramifications of this are dramatic. There is a crap-load of paper in this sector - and it all becomes impaired. The current tight spread environment (both high yield and investment grade) is rationalized based on the assumption that default rates will 1) be low and 2) have high recoveries. A prolonged commodity rut will turn that assumption on it heels, and I think the market is just starting to digest that reality. It’s not hard to envision a scenario where cross-default risk balloons - coal, mining, E&P, Frackers, MLPs, etc, etc — it’s basically Crisis 2.0. What killed us last cycle was cross-default risk. We all assumed things weren’t correlated and they were."
Stagflationary Mark's 30 year yield prediction:
"As I walked back to my house I couldn't help but think it was the same one I bought in 1997. I didn't think it looked all that different. Since my property taxes had been going up at an alarming rate, I didn't actually feel better off. And if taxes continued to rise into the distant future, I would eventually be forced to sell my house and downsize."
Falky has a new paper out on the low volatility anomaly:
"The creation of asset pricing theory focused on a Robinson Crusoe world, where investors are indifferent to anything outside their wealth. It is now widely accepted that low volatility equities offer a superior Sharpe ratio, high volatility equities an inferior one, and for this to exist in equilibrium one needs more than just a subset of delusional, constrained, or perversely incented investors, as commonly asserted.

A simple explanation is that benchmark risk is missing in the standard approach, that investors are afraid of underperforming. A more general way to phrase this is to say people are somewhat relatively oriented, and so do not maximize Sharpe ratios alone. This has the interesting implication that fads and bubbles are much easier to explain, in that if everyone decides, say, tech stocks or housing are popular asset classes, rational status-seeking agents will stay somewhat long that asset class because they are afraid of missing out.

This result highlights the importance of systematic overconfidence, which is correlated with volatility. Shiller noted that stock prices seem too volatile relative to future dividends and interest rate changes... It seems probable that to the degree deluded investors affect equilibrium prices these biases are not stable but rather fluctuate over time and sectors."
Another good post by the Crisis 2.0 guy, about passive vs active and feedback loops. Looks like good blog to follow:
"[T]he increase in passive dollars has the potential to dramatically increase trends in both directions – passive funds holding off supply from the market on the way up and decreasing floats, while adding supply and rapidlly increasing floats on the way down. Low volume melt-ups followed by high volume dramatic meltdowns. Floating up and falling down."
Don't forget to join the 2015 prediction contest.


Stagflationary Mark said...

Be careful with commodity mean reversion trades...

As we've both discussed numerous times, think silver!

Although silver rose to $45, I have absolutely no desire to buy it at $17.

I sold physical silver in 2006 for a 50% gain at just over $10. I owned a ton of it. It took less than 2 years to get that gain. What's easy to make, is also easy to lose.

If I didn't like it at $10 in 2006, then why would I want it at $12 (crudely adjusted for inflation) in 2014?

I've been bearish on our long-term economy since 2004 and continue to be. So being bearish can't be the reason. Nothing's changed there. I don't see how silver can protect a person when we know what oil's just been through. I doubt it is the only commodity that can do it. If nothing else, it takes energy to get other commodities out of the ground. Cheaper energy, and well, you know.

Since the peak, SLV has had falling knife syndrome written all over it. Where it stops nobody knows.

And why did I own silver in the first place? Unlike housing, I bought it solely with the intent to sell it to someone else someday. I had no use for it personally and I knew I never would. That's a dangerous reason to own something. It better at least be darned cheap!

CP said...

What's easy to make, is also easy to lose.

Very important concept.