Weekly rollup | Oct 24-30 2022
Stocks Mentioned: Core Scientific (CORZ), Copper miner Freeport (FCX), Snowflake (SNOW), FedEx (FDX), Phillips 66 (PSX), Cloudflare (NET), Core Scientific (CORZ), Coinbase (COIN), Marathon Digital Holdings (MARA), Meta Platforms (META), Snowflake Inc (SNOW), Silvergate Capital (SI), Ark Innovation ETF (ARKK)
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October 25 2022
Texas Natural Gas Drops Toward Zero as Output Swamps Pipelines
About a fifth of companies in the S&P 500 have reported third-quarter results as of Friday last week and 72% of those posted earnings beat Wall Street expectations, according to FactSet.
October 26 2022
Buy Bitcoin at $20,600
Band squeeze breakout confirmed, which means there is a high probability of a move to the upside. Especially significant that this is happening when stock futures are weak.
October 27 2022
Shale firms discount 'U.S. put' as inadequate to lift oil output
Column: Oil investors on defensive as recession forces intensify
Who's going to be right? My money is on the hedge fund managers selling oil futures. OPEC produces 30 million barrels of oil per day (mb/d) while Russia produces 10 mb/d. The announced production cut of 2 mb/d is 5% of OPEC+ production. Ask yourself this: with the oil price well above their breakeven price, why are they hurting themselves by decreasing their profits? The answer? Lack of demand. Except in the minds of economists, the demand curve for oil is not inelastic, i.e. demand does not remain the same even as prices go up. It drops. In a recession, demand falls off a cliff. The production cut is an attempt by OPEC to mask the demand problem. It is a sign of their desperation.
If a lumber mill curtails production due to lack of demand from the housing sector, would you say there is a shortage of lumber due to the lack of production? Energy bulls can answer this question correctly when it comes to lumber, yet suffer from cognitive dissonance if you substitute lumber with oil.
Once oil prices start falling, compliance with the agreed upon production cuts will drop to zero. Using numbers just to make the case, let's say an oil field produces 1 mb/d. The fixed cost is $40 million/day, while the operating (marginal) cost per barrel is $20. This implies a breakeven price of $60/barrel. At $88 oil, the well makes a profit of $28/bpd, for a profit margin of 31.8%. What happens if you cut production by 5%? Fixed cost rises to $42.1/bpd while marginal cost remains at $20/bpd. Breakeven rises to $62.1, implying a profit of $25.9/bpd for a profit margin of 29.4%.
That doesn't appear to be a big difference, but the drop in production lowers the per day profit from $28 million to $24.6 million, or 12.1% lower. At 10% lower oil prices, with a 5% production cut, the daily profit drops to $17 million. The higher the breakeven price, and the higher the fixed cost, the worse the economics of the oil field if the operator cuts production.
Think Saudi will willingly give up market share and settle for lower profits once the other OPEC members exceed their daily quota? No way. They have seen this scenario in 2014 and are not going to sit around twiddling their thumbs while other oil producers bank massive gains and take market share. A small drop in oil prices is all that will be needed to trigger balls to the wall over-production from every oil field operator. We are headed for a repeat of the 2014 experience.
The cure for high prices will be high prices. Avoid oil stocks.
Core Scientific (CORZ), the largest public listed bitcoin miner, has filed with the SEC saying they might file for bankruptcy as they are out of funds. Stock is down 75% pre-market. And yet, bitcoin is at $20.7k. This is an amazing sign of strength, especially considering the news of Celsius and 3 Arrows Capital going bankrupt led to a capitulation event in June. Coupled with the band squeeze breakout, bitcoin looks like an amazing buy here.
October 28 2022
Time to get bullish tech stocks and bearish commodity producers?
US mega cap tech stocks are getting blasted. Ostensibly, it's due to poor Q3 results and over-valuation. It's also due to tech falling out of favor after it's ytd performance, forcing institutions to offload their holdings before they publish their monthly holding statement. You don't want to be the fund manager long Amazon at month end when it's down 20%.
Chinese tech stocks are done. Their stock market bubble burst in 2014 and it has been downhill ever since. More so now that Xi Jinping has been re-instated for a third term and has taken control of the tech sector. Xi is openly hostile to education and gaming companies, and wants control of Chinese digital infrastructure. The problems are only going to get worse now that the US has sanctioned Chinese semiconductor companies. Besides, US listed Chinese tech stocks confer no actual ownership rights over the actual Chinese subsidiary, making them risky at the best of times. And China is known for frauds and fooling dumb US investors (see Sino Forest, Luckin Coffee).
When I say bullish tech stocks, I don't mean catching falling knives. As a general idea, I like tech stocks in this environment. Here's my reasoning.
Commodity producers are capex heavy, and that capex gets financed with debt. Copper miner Freeport (FCX) has a debt-to-equity ratio of 0.44x. Cloud service provider Snowflake (SNOW), which has a comparable market cap to FCX, has a debt-to-equity ratio of 0.044x. Why is this important? Think about it like this. Every well-run business produces an operating profit. If the business is financed solely with equity, the return on assets (RoA) is equal to the return on equity (RoE). When a company adds debt, it adds an extra line item - interest expense - to its P&L. As long as the profits from the assets bought with debt financing exceeds the interest expense, RoE>RoA, and shareholders benefit from the deal.
Capital is cheap in boom times and expensive in a recession. Credit expands when economic conditions are rosy, and contracts when conditions worsen. What happens when interest rates rise? First of all, rising interest rates coincide with periods when companies experience a revenue shortfall. If the company has a well-thought out capital structure (mix of debt and equity), the added interest expense can be managed in tough times. But, this will lower RoE and close the gap between RoE and RoA. The share of operating profit going to debt holders goes up, the share going to equity holders goes down. The more the debt, the more the hit to the company's valuation metrics. Added to this, the risk of debt default, equity financing or bankruptcy further hurt the share price.
Debt-free companies don't suffer these problems. Even if revenue takes a hit, a well-run profitable business has no bankruptcy risk. It's not going to see a sudden collapse in RoE due to rising rates. In a tax-free world, if you own the whole business, the D/E ratio does not matter (see Modigliani-Miller theorem). If equity goes to zero, you still control the company because you own the debt. For an equity investor, the D/E ratio matters a great deal in an environment of rising rates.
Also, the problem with commodity producers is not just the debt. It's the fact that they tend to overshoot on the supply side, bringing on new mines and oil fields that have a lifetime of 30+ years. When commodity prices turn down along with the business cycle, they can't just shut down production to avoid a glut. That's why commodity prices always go through booms and busts, and share prices tend to follow the same pattern. We've seen the boom. I believe we're now on the cusp of a bust.
Chinese real estate has collapsed, taking with it demand for cement, steel, etc. US housing starts have collapsed as mortgage rates cross 7%. Oil demand has collapsed, which is why OPEC+ is forced to curb production by 2 mb/d in order to stave off a glut. For all the hoopla about EU demand for nat gas, Spain has actually warned that they may turn down incoming LNG cargoes as supply exceeds capacity. Demand for physical goods has collapsed, which is why retailers are faced with an inventory glut and FedEx (FDX) had to issue a profit warning. The post-lockdown surge in demand for stuff is turning into a collapse in living standards and curtailment of consumption, all thanks to the Fed's efforts to destroy global wealth in the name of fighting inflation. The commodity world changed after China joined the WTO in 2001. With the Chinese consumption bubble now firmly in the rear-view mirror, there's a lot of excess supply capacity that needs to be worked off. This is not a trading view, but an opinion of a long-term trend change.
When your net worth goes down by 25% in a year, you don't just linearly cut all expenses by 25%. New car? It can wait. Kitchen remodelling? Maybe next year. Flat screen TV on Black Friday sale? Nope. Costco, not Whole Foods. iPhone 14? Forget about it. Do I really need Disney+, Netflix, Amazon Prime, Hulu and Apple One?
Wealth destruction does not just mildly destroy demand, it annihilates it. CPI numbers are going to go negative soon. Wait for it.
But why tech stocks? Simple. No debt. No bankruptcy risk. There's risk of technological obsolescence, but that's a different topic and has nothing to do with interest rates. Even in an environment of rising rates, tech companies will have high RoE. They will still grow by acquiring customers, scaling operations, and improving productivity. They are best suited to perform even during a recession. Losing a few customer orders, or having customers defer an expansion plan, is not as painful as having the price of iron ore go down 50% in a couple of months. The stock price correction takes care of valuation excesses from the prior boom, and you're left with a value stock that exhibits a high growth rate and low price-to-earnings growth (PEG) ratio.
My goal is to find those gems amongst the tech rubble, and just buy-and-hold for the long haul.
Phillips 66 (PSX) is cutting staff at multiple refineries and terminals as it restructures to optimize its cost structure. Some staff are being repurposed, while others are being let go. Phillips is looking to cut $700 million in expenses to remain competitive “in any market environment” and to prepare for the transition away from fossil fuels.
Funny, you'd expect to see this during bear markets, not in a year with peak refining margins.
I made my first foray into buying individual tech stocks. This is a sector I know absolutely nothing about fundamentally, having spent my entire career in finance on the commodities side. So take my actions with a heavy dose of skepticism and don't consider what I say below to be a trade recommendation. I like to dabble before I plunge, and I'm buying a few stocks at random just to get a "feel". Here's what I have so far:
Cloudflare (NET) - every serious website absolutely depends on them for protection against attacks
Core Scientific (CORZ) - bankrupt bitcoin miner. I suspect a takeover, preferably by MARA. Reason being it's quicker to takeover before the company winds its way through bankruptcy court, and their hash power will make a big difference to whoever owns it
Coinbase (COIN) - largest public listed bitcoin exchange
Marathon Digital Holdings (MARA) - largest public-listed bitcoin miner that's not bankrupt (yet)
Meta Platforms (META) - stock is a disaster but Facebook, Instagram and WhatsApp may all have a future
Snowflake Inc (SNOW) - something, something, something cloud infrastructure and cross-cloud compatibility
Snowflake (SNOW) has only 6,808 customers and has visibility for growing revenue from the current $1.2 billion to $2.7 billion. Of their customer base, only 246 customers account for over $1 million in product revenue. I like the moonshot potential, even though I don't understand the business or the tech.
Buy Silvergate Capital (SI)
Thesis unchanged. This is my second attempt at this trade.
Keep this in mind when you listen to analysts bashing tech stocks on TV
October 30 2022
What a difference a couple of weeks makes!
It's time to buy the garbage and prepare for a weaker dollar sending equities higher. I'm going to go out on a limb and do so ahead of the FOMC decision, given my outlook that the lows are highly likely to be in the past.
What to buy? Individual garbage stocks still carry bankruptcy risk. An ETF that holds a lot of them is a better idea.
Buy the Ark Innovation ETF (ARKK).