The Bear in the Mirror
Feb 19, 2018 Trading Blog
I spent the entire four day weekend trying to shake this huge bearish bias, but so far, absolutely no luck. I want to be bullish, mostly because everyone else is, but it just isn’t happening for me right now. It’s really lonely being the only bear. After an entire weekend of reading and studying, I just can’t get rid of the FED angle on this market that I posted last weekend: “If the FED gets looser we buy, don’t fight the FED”. But what if the FED is getting tighter? Does the logic then flip to “If the FED gets tighter we sell, don’t fight the FED”? There is also the eventual rise in the strength of the dollar that inevitably comes with rising interest rates, which doesn’t help oil at all. I’m still thinking the SPY bottoms out around the 245 level in the next couple months.
As for energy, my bearish bias is even stronger than the overall market. I spent hours reading the latest earnings reports and the thing that absolutely jumps out at me is the increase in dividends and the increase in buybacks. This is a huge red flag. You have to ask yourself WHY are they doing this and what this says about their expectations for the price of oil. And these weren’t just tiny increases in dividends, some of them were huge percentage increases, and almost back to the pre-crash levels. We only started recovering from the last XOP correction less than 6 months ago (and remember the XOP is still really close to those lows), so do these companies really have the money to do this? Also, many of these companies are just loaded with debt, and interest rates are on the way up, which means debt is going to cost MUCH more. Why not pay off debt and cut the interest expense? Do they really want to go to the debt market to load up on more expensive debt to pay a dividend that was never necessary to increase in the first place? Why? Are they that desperate to attract buyers for the stock? This says to me that they don’t think the fundamentals of the company or commodity are going to get better anytime soon, so they are trying anything else they can to save the share price.
So now the energy companies have higher debt expense, higher dividend expense and higher buyback expense, and the scary part is that most of them aren’t even cash flow positive BEFORE adding all these expenses. So where is all this money to pay for all these things going to come from (other that from ever more expensive debt discussed above)? They have cut expenses to bare bones just to survive over the last couple years, so cutting more expenses isn’t the answer. In fact, this is actually going in the opposite direction as I’ve read many E&P’s complaining about service cost inflation, which is another expense that is increasing. The only thing they could cut in such an amount to make up that much money is CAPEX itself. After adding all these other expenses, they can’t possibly even consider increasing CAPEX budgets could they? At this point, I think they have certainly taken increasing CAPEX off the table. The only way that they could even go down the path of burdening themselves with all these extra costs, while at the same time hoping to increase earnings, is if they projected oil price to spike up hard. Does a skyrocketing oil price seem realistic right now? Would a skyrocketing oil price be more likely if they actually cut CAPEX and cut production before it climbs any higher? Probably. Maybe they have finally figured out that increased drilling is NOT in their best long term interest. Maybe they have finally found the outer boundary and constraints (either temporary or permanent) of what production is possible with shale? It can’t keep expanding forever can it? But the real question is, do they have the discipline to restrain CAPEX if oil price establishes itself higher?
A sustained oil price in the 70+ range would be perfect, but honestly, I really don’t see this happening at all, especially if the economy slows and demand weakens or if supply continues to inflate. An oil spike like that would probably do more harm and would shock the overall economy more than it would help the E&P’s. All we need is $4 gas right now to provide the FED more ammunition to hike rates, which takes the entire stock market down, including the E&P’s. But, what if rising oil price isn’t what they are expecting, but rather they expect oil price to settle back into the mid 50’s? Do their current actions make more sense now? Absolutely, YES. Is the fact that E&P’s are stabilizing or cutting CAPEX a clear signal that they see oil prices lower rather than higher? If they can’t make more money drilling for oil, are the buybacks the only way they can increase their earnings? Same earnings with less shares looks great to stock bulls. Is it easier to create guaranteed better earnings with a buyback rather than taking that money and drilling another well at $50 oil? Absolutely. It looks even better if you pile on a nice dividend to go along with a buyback supported share price.
So taking into consideration that many of these companies are voluntarily taking on all these extra expenses, what does this tell us about the future price of oil? I think it says that they are hoping for the best, but planning for the worst. If E&P’s truly thought that sustainable $70+ oil was in the cards, most of them would be drilling more, not less. They would be looking to cut their voluntary expense and apply that money to CAPEX, not increase expenses with dividends and buybacks while keeping CAPEX level or decreasing it. If they saw $70+ oil, earnings would probably increase faster by using their money to drill more rather than using that money going down the buyback route. This is especially true for the smaller E&P’s who don’t pay dividends or have buybacks, but they aren’t increasing their CAPEX either (and they are the ones who should be if oil was headed up). But at the $50 oil level, these actions by both big and small E&P’s make perfect sense. Earnings are pretty bad at $50, so why drill more when you can take that same money and guaranteed pump up the earnings with a buyback? And remember, these aren’t small buybacks, these things are around 1-2 Billion, which is comparable to the entire CAPEX budget of some of these companies. These dividends aren’t small either, most of them are back in the 1-3% range, which amounts to hundreds of millions, if not billions per year extra expense.
It is my opinion that all of this is being done in anticipation of $50 oil, which is why I’m bearish right now on the E&P’s. I’m also bearish because I think something has changed in the overall market with the FED. The E&P’s are doing damage control right now. What else can they do? With $55 oil they aren’t making any money and know they are going to get punished, just look at what happened with XOM and CVX last quarter. At $55 oil, most earnings are mediocre at best and nobody wants to buy these stocks. Why buy these when you can jump over to tech or banks? These buybacks and dividends are a Hail Mary to attract buyers to the stocks because these companies (and their earnings) have absolutely nothing else to offer. If these stocks were such a great deal based on expected earnings, or if oil was truly expected to run higher, would the XOP be sitting at lows while the SPY shows such strength? Probably not.
The real danger and disaster scenario that these companies are gambling against now is that they take on all these extra costs AND oil price tanks back under $50. What then? Their gamble would prove very costly as earnings would absolutely crash and the companies would likely have to take on even more debt to pay off the dividends. Increasing the dividend and having oil crash soon after would prove to be one of the worst management decisions ever. Could you imagine the exodus from these stocks if they had to cut these just raised dividends? Funds might not ever return to the sector again after getting burned so badly. But maybe the companies just don’t care. Maybe they realize the end is coming anyway. Maybe you do what you have to do to survive until you get lucky with a sustained oil price recovery.
Maybe I’m just seeing this whole thing incorrectly, or just biased and looking for causes to support my position. These fundamental reasons don’t even begin to get into my thought on the technical side of the market, which is possibly even more bearish. Maybe I’ll look back in a couple of months and realize I have missed something big or that oil price has spiked. Sometimes the market just ends up making you look stupid, wouldn’t be the first time for me. But to trade in this market, you need to have an opinion about the macro picture, whether it be correct or not. If you don’t have an opinion, you simply have no starting reference point from which to trade. You don’t have to be right to make money and you can always adjust your thinking to get on the right side of the market, but you have to start somewhere. This is just where I have chosen to start, it doesn’t mean that I am right.
I am bearish right now, as there are just so many things that could go wrong, but I am not attached to that position, because the energy sector can change on a dime. The only things that would cause me to change my opinion is if oil starts to establish itself in the $70 range or if the SPY breaks to new all time highs. In the $70 oil situation, the E&P’s have hit the jackpot with stable to lower CAPEX, less shares and higher oil prices (earnings). The dividends and buybacks are then easily absorbed and simply turn into an expensive insurance policy that wasn’t really needed. If the SPY runs to a new all time high situation, I’m still bearish E&P’s, but the overall market will drag everything up with it, which makes shorting anything (including E&P’s) very difficult.
I’m probably going to be on the sidelines for the next couple of weeks to see what the SPY is going to do on the approach back toward the 280 range. I think it fails and sets up the next leg down toward 245, as the clear reversal signal will be put in and definitely draw more panic than the most recent correction. If that happens, there are going to be some incredible deals as we likely see the XOP under 30. I will still be doing some daytrading, but the real money is going to be made picking these energy stocks up on the next correction for longer term swing trades, and that requires the patience to wait for the right environment to swing trade.
Sorry guys, this article went on way longer than I planned. Have a great week!