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Will Monetary Policy Bring Further Down Oil Prices?

Summary The price of USO remained around $20 over the past month. The FOMC could start raising rates soon. Will it bring down oil prices? The potential rise in OPEC’s production could keep pressuring down shares of USO. The recovery in the oil market has cooled down as the price of WTI oil is around $60 – it hasn’t moved from this level the past month – and the United States Oil ETF (NYSEARCA: USO ) remained around $20. Besides the changes in supply and demand, which are the main factors shifting the fundamental conditions of the oil market, monetary policy also plays a role in the movement of oil prices. Let’s take a closer look at this issue and its potential impact on the oil market and the price of USO. Are interest rates going up? So far, the answer isn’t clear cut. Interest rates have gone up in recent weeks, but they are actually lower than where they were a year ago. For now, the market is still uncertain whether the Federal Reserve will raise rates this year and the pace of the subsequent rate hikes. And even if it does raise rates, how high can they go? Despite the high uncertainty, the current expectations are for the FOMC to start raising rates this year – in one scenario, the FOMC could start in September and bring the cash rate to 0.5% by the end of the year. But will higher interest rates push down oil prices? If interest rates were to start climbing up again, they may have some repercussions on oil prices. The effect of higher interest rates has been studied and here is one source that summarizes the intuitions and the factors that come into play in bringing oil prices down when rates go up. But, as you can see below, for oil prices to reach low levels – say falling below $40 – interest rates will have to climb back up to the high levels they were back in the 90s, when 10-year treasury rates were around 5%-7%. And the current oil market isn’t the same as it was back in the 90s or early 2000s. In any case, since rates are expected to remain very low this year and next, the main impact could come from the change in market expectations about where rates are heading once the FOMC starts to raise rates. (click to enlarge) Source of chart taken from FRED The chart also suggests, at face value, that there isn’t a strong relation between interest rates and oil prices. So, the basic intuition for the relevance of monetary policy in the context of oil prices is only one among many factors moving oil prices. The changes in supply and demand will likely be leading the way in impacting oil. When it comes to supply, OPEC is still adamant at keeping its quota of 30 million barrels per day, which has exceeded this level in the past few months. Even though Iran’s deal with the U.S. isn’t in place, the country is already preparing to ramp up production in the next couple of years – this could make it harder for OPEC to keep its 30 million barrels per day without someone else among the OPEC members reducing their market share. Thus, we should expect OPEC to de facto produce more than 30 million barrels per day. For the short term, however, oil prices could start to come down as the market adjusts its expectations regarding a possible rate hike by the FOMC and more importantly the change in policy that could lead to even higher rates down the line (albeit it could take a while before rates reach high levels, perhaps even years). The FOMC could shed some light on the timing of the rate hike or at least show if a rate hike is on the table in the coming months. For the USO investors, the price could take another beating as the market adjusts its expectations and rates start to climb back again. Thus, USO could also suffer from the changes in market expectations about the direction of interest rates. Even though the changes in demand and supply will trump up any changes in monetary policy, the potential rise in oil production by OPEC along with the stable oil output in the U.S. could start pressuring back down oil prices, at least for the short run. (For more please see: ” USO Investors – Beware of The Contango! “) Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

The Little Worm That Is Destroying Capitalism

By Jason Voss, CFA In response to the Great Recession, central banks continue to engage in massive monetary stimulus to artificially depress the costs of capital. Many commentators have expressed concerns (and I concur) about the inflationary forces they believe must naturally be building up because of this stimulus. Yet, very few commentators have discussed the consequential little worm that is destroying capitalism, and the mindset thus birthed. Costs of Capital Generations of business schools have taught – and business leaders have implemented – capital budgeting philosophies based on expected rates of returns and weighted average cost of capital (WACC). First, cash flows over a time horizon are estimated for a proposed project. On the positive cash-flow side, these may include additional revenues created or future expenses saved. Either way, there is some benefit to a business of the proposed project. Netted against these benefits are the negative cash flows – the expenses – that are expected to be incurred to implement the project. Next, the net flows over time are discounted by the WACC, and the assumed risks of successfully implementing the project are built into this discount rate. If the net present value (NPV) of this calculation is positive, then businesses are supposed to proceed with the project. Still, others prefer to compare their expectations for internal rate of return (IRR) to the WACC. Either way, the process is the same. The Little Worm But this entire framework has a problem – the little worm that is destroying capitalism, albeit slowly. Namely, in calculating cost of debt and cost of equity for businesses, market-based rates are used, and with the misnamed “risk-free rate” serving as the root of all other costs of capital. What happens though when central banks’ loose monetary policy creates too much capital and artificially holds down root costs of capital? Companies adjust their required rates of return down, too. In fact, one could argue that this is a principal reason for why central banks are holding root costs of capital so low: to spur business investment. Yet when WACC is held artificially low, many projects are accepted that previously would never have been considered viable under normal circumstances. Put another way, the problem is using relative values – not absolute values – in calculating costs of capital. Examples of such projects providing marginal benefits are: improving financial reporting systems through better information technology, minor tweaks to supply chain logistics, cutting back on marketing or increasing low-cost advertising (like social media), “rationalization” of head count, holding average wages as low as possible, squeezing suppliers a little bit, not repatriating earnings to stave off taxation, refinancing rather than retiring debts, and the share buyback that is insensitive to a company’s current stock price. I could go on. It is not that these marginal WACC projects are unworthy and shouldn’t be done, it is that the lifeblood of capitalism is creative destruction. It is fiery and intense. Capitalism is supposed to be more like a volcano than a hot plate keeping the coffee warm! Evidence that the worm is eating away at capitalism is that revenues continue to grow much more slowly than do earnings per share (EPS) . Furthermore, revenues continue to miss consensus estimates even though EPS continue to beat estimates. Also, EPS continue to grow so quickly due mostly to a shrinking denominator (i.e., big share buybacks). Ask yourself: When was the last time you heard genuine risk-taking behavior on the part of your portfolio of businesses? I think you will agree that only a handful of companies are engaged in proper game-changing capitalistic risk taking. Normalized Cost of Capital In the developed nations, I estimate a normalized long-term project after-tax WACC of around 6.5%, versus an estimated late 2014 WACC of only 3.0%. Even if you disagree with my estimates, I believe if you calculate your own, you will find that current costs of capital are about less than half of a normalized figure. That means you should expect at least 100% more projects being approved than under normal cost of capital scenarios. Yet this high figure may actually understate the number of excess projects being funded. This is because as cost of capital asymptotically approaches zero (i.e., ” to negative nominal yields and beyond!” ), the actual number of projects thought of as viable may follow a power law distribution instead of behaving linearly. In other words, businesses are currently in the process of destroying what was, once upon a time, a precious resource to be conserved: capital. A Remedy? If you agree with me, I propose, as a simple remedy, that costs of capital for a business begin to be evaluated on an absolute, normalized basis, rather than on a relative basis. And, I would add, treating externalities as free/not considering economic, social, and governance (ESG) is not going to cut it either. As a shareholder – or prospective shareholder – you do not need to wait for a company to engage in this behavior. Instead, you can begin to use normalized costs of capital in your own estimates of fair value. This may shrink your universe of investible assets, so be wary of diversification being worse. Fear the Worm My big fear is that even once costs of capital begin to rise/normalize, a generation of gutless business leaders is being hatched in the current gutless business culture. In short, artificially low costs of capital are eroding the capitalist’s risk-taking, return-generating mindset. Yikes! In conclusion, which company would you rather invest in: the one using normalized costs of capital in capital budgeting, or the company just using traditional methods? Thought so! Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

Reality Shares’ DIVS ETF: A Really Complex Dividend Tracker

Summary DIVY is Reality Shares’ primary ETF offering. DIVY is an interesting ETF that is based on dividend growth. DIVY, however, isn’t about income. If you love dividends, wouldn’t an exchange traded fund, or ETF, that ties itself to the growth of dividends be an ideal investment? The answer depends on what you want from your investments. This isn’t about income To get this out of the way up front, the Reality Shares DIVS ETF (NYSEARCA: DIVY ) isn’t looking to produce income for investors. So, if you like dividends for the income they provide, this ETF is not for you. However, if you like the fact that broader market dividends have a history of increasing over time and buy dividend stocks because you expect them to increase in value (capital appreciation) as their dividends increase, then, well, you might be interested… maybe. A little confused? You should be. DIVY is a very complicated ETF. For example, according to the sponsor, DIVY uses, “An investment strategy seeking to deliver the dividend growth of Large Cap Securities independent of stock price.” So, looking at this from a big-picture perspective, DIVY’s value is intended to increase by the amount that dividends grow. It is all about capital appreciation. But DIVY’s value won’t change based on the stock price movements of dividend paying stocks. Or at least that’s the goal, anyway. Why would you want that? Because dividends have historically grown in most years (though not every year). For example , the S&P 500 Index has seen dividends grow in 40 of the last 43 years. We all know painfully well that stocks have a habit of going up and down in often violent fashion. So dividend growth, while slow and steady, is really not well correlated with stock price movements. That offers diversification and, potentially, safety in broad stock market downdrafts. OK, that’s interesting. But remember, this is about capital appreciation, not dividends. So if you want income, you won’t find it here. An “option” to watch The thing is, DIVY can’t just buy dividend growth. It has to use an options strategy to mimic dividend growth: The Fund may purchase a series of listed index option contracts that, when combined together, are designed to eliminate the effect of changes in the trading prices of the Large Cap Securities and the effect of interest rate changes on the prices of the option contracts. As a result, the value of the Fund’s option portfolio is designed to change based primarily on changes in the expected dividend values reflected in the option prices. These option combinations are designed to reflect expected dividend values and eliminate the Fund’s exposure to changes in the trading prices of the Large Cap Securities. There’s a lot of math involved in figuring out how to turn that mouthful into actual investments. And, to be sure, it’s an impressive feat that DIVY even exists. But all that math leads to an expense ratio of around 0.85%, so in ETF land this is a pricy product. And then there’s the not-so-small fact that this is a relatively new product that hasn’t lived through a market downturn. The idea sounds really great, but that doesn’t mean it will stand the tests of a bear market. After all, DIVY is an ETF that trades based on supply and demand. True, it should trade fairly close to its net asset value, or NAV, because of the ETF structure, but it might not, too. Why do I say that? Because ETFs trade close to their net asset values because of the arbitrage available to large traders who take make payment in kind redemptions. For an S&P 500 Index that means getting all the stocks in the index. So, if an S&P 500 Index ETF is trading below its NAV a large investor will simply redeem via payment in kind and sell the securities it receives at a profit. But DIVY is a complex collection of options contracts. If it trades below its NAV, who’s going to want to own all those options contracts? In reality, it’s more likely that redemptions will be paid in cash , but DIVY has fees in place to discourage frequent creation and redemption activities. And what if everyone rushes to redeem at once? This process hasn’t been stress tested by a bear market and the fund’s complexity could mean it implodes at exactly the time when you are expecting it to hold steady. Wait for the next downturn At the end of the day, DIVY is an interesting concept that hasn’t proven itself. I’d suggest waiting and watching, for now. The idea sounds great, but then so did the idea of portfolio insurance, bonds backed by mortgages, and any number of other investment ideas that blew up in the face of adversity (tulip bulbs anyone?). If DIVY does what it’s supposed to, it could be a good addition to a diversified portfolio. If it doesn’t, you’ll be glad you waited before jumping aboard a complicated new product. Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.