Oil Price Declines: why fundamentals are continuously ignored. UPDATED

Many brokers consider shares of oil and gas companies as attractive investments and recommend these stocks as a good buy. As a justification, they show dividends history in comparison to other sectors. 

It has always confused me because payments of dividends do not indicate whether investing into a particular company’s shares is a good idea. The fundamental basis for such recommendation, in my opinion, shall be financial health the of the company.

Is it just unreasonable optimism?

Numbers do not support optimism

Financial position of the selected oil and gas companies: shall we hope for a brighter future?

Unreasonable optimism is not going to help

It is especially difficult to understand because the global economy recently sustained a significant damage during the 2007-2009 financial crisis with long-lasting negative consequences.

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Deloitte indicates that the state and local governments’ leverage rose during the recession, picking in 2009 at 20% of GDP. Federal Reserve plans to hike interest rates would be a particular challenge for the government since interest payments are funded out of the operating budget—the budget that must be balanced each fiscal year. However, given the long-term nature of outstanding state and local debt, it will take a prolonged period of higher interest rates and seriously impact most states’ and localities’ budgets.

The disparity between federal revenues and spending will raise the annual deficit. As the deficit continues to accrue, the debt level will rise from the current 75.6% of GDP to 86.1% in 2026.


If we look at oil companies’ financial position it shows that it is far from stable.

Lucas Hahn, InvestorPlace Contributor indicates that BP stock initially looks undervalued relative to peers. Among the four oil supermajors, BP trades at a price-to-book ratio of just 1.18, versus 1.22 for Royal Dutch Shell plc (ADR) (NYSE:RDS.A, NYSE:RDS.B), 1.42 for Chevron Corporation (NYSE:CVX) and 2.06 for Exxon Mobil Corporation (NYSE:XOM).

BP’s price-to-sales ratio makes it look even more enticing; BP trades at just 0.58 times sales, against 0.94 for Royal Dutch Shell, 1.81 for Chevron and 1.54 for Exxon-Mobil.


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BP stock’s price-to-forward-earnings ratio also doesn’t stand above peers. BP trades at 12.9 times forward earnings, which may be lower than Exxon-Mobil and Chevron, which trade at a multiple of 17 and 18, respectively. However, Royal Dutch Shell trades at an even lower multiple; 11 times forward earnings.

But the price-to-earnings ratio doesn’t tell us everything about oil stocks; this is a very cyclical industry, and earnings can fluctuate a great deal. Instead, we should look at cash flow.

I must say that difference of opinion is normal. However, I did not expect that Fidelity, one of the leading online brokers would agree with our views.

In its “Q2 2017 sector scorecard: mixed results” Fidelity highlights that the technology, financials, and industrials sectors each had two positive indicators in Q1, and tech had the best return of any sector. Healthcare rallied after a disappointing 2016, and both consumer sectors displayed strong fundamentals. Energy slipped in Q1, pressured by falling oil prices and higher-than-hoped-for production levels.


Note: Past performance is no guarantee of future results. Sectors as defined by the Global Industry Classification Standard (GICS®); see additional information in the appendix. Factors are based on historical analysis and are not a qualitative assessment by any individual investment professional. Green portions suggest outperformance; red portions suggest underperformance; unshaded portions indicate no clear pattern vs. the broader market as represented by the S&P 500. Quarterly and year-to-date returns reflect the performance of S&P 500 Sector Indices. It is not possible to invest directly in an index. All indices are unmanaged. Percentages may not sum to 100% due to rounding. Source: FactSet, Fidelity Investments, as of March 31, 2017.

This chart show a continuous negative trend in the Energy sector with uncertainty ahead. It is also clear that no other sector is expected to perform at similar negative level.

Fidelity also specifies that Healthcare had strong fundamentals in Q1, benefiting from healthy earnings per share growth and free cash flow. Consumer discretionary and consumer staples also scored well, notably in return on equity. Energy fundamentals slipped in Q1 as oil prices trended downward and supply remained robust.


Forward earnings yield reflects analysts’ published earnings-per-share estimates for the next 12 months, divided by market price per share; it is the inverse of the price-to-earnings (P/E) ratio. Free-cash-flow yield reflects free cash flow divided by market price per share; it is the inverse of the price-to-free-cash-flow ratio. During periods of extreme earnings volatility, metrics like earnings yield may not be indicative of market consensus of valuations. Financials and Real Estate not represented in the Free-Cash-Flow Yield chart; see Glossary and Methodology slide for the explanation. Source: FactSet, Fidelity Investments, as of March 31, 2017.

The strong defensive rally during much of 2016 continued to fade from memory by Q1 2017. Cyclical sectors, such as financials, technology, and industrials, posted the strongest performance relative to the broad market. Less economically sensitive sectors were generally not as competitive with the S&P 500 during the past six months.

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Profit recoveries have often coincided with improved credit and a steeper yield curve, meaning long-term rates are increasing relative to short-term rates. Improved credit typically causes the valuations of financials stocks to expand, while a steeper yield curve tends to coincide with an acceleration in profits for the financials sector.*

Fidelity points out that the financials sector is unique in two ways: When it has beaten the S&P 500 over a six-month period*, it’s beaten it again over the next six months almost 70% of the time. No other sector has shown this same tendency. And when financials outperform the S&P 500, the sector typically beats the returns of other cyclical sectors as well.

I guess that the language Fidelity used answers the question I asked a few days ago: when investment funds will start to pull off?.  It is clear that investors would try to redirect their funds into financial sector.

The oil price started to decline again. It is another indication that OPEC is no longer in a position to influence crude oil prices. CNBC reports that the U.S. economy is moving oil pricesU.S. crude futures have posted losses for two weeks in a row and are poised to sink again, according to a historical correlation between oil prices and GDP data.

There is no doubt that the expressed view of CNBC regarding the influence of the U.S. economy on oil price. However, whether it is the major factor, in my opinion, is yet to be confirmed. Because we still have lack of clarity on the role of investment funds in relation to the oil price movement.

I am not claiming that there is any link, but it is difficult not to notice that coincidentally, the oil price started to decline a few days after Fidelity published its report.

What is clear is that there are SEVEN MAIN TYPES OF FUNDS:

(i) Money market funds (to invest in short-term fixed income securities such as government bonds, treasury bills, bankers’ acceptances, commercial paper and certificates of deposit);

(ii) Fixed income funds (to buy investments that pay a fixed rate of return like government bonds, investment-grade corporate bonds and high-yield corporate bonds. They aim to have money coming into the fund on a regular basis, mostly through interest that the fund earns);

(iii) Equity funds (to invest in stocks and aim to grow faster than money market or fixed income funds, so there is usually a higher risk that you could lose money. Investors can choose from different types of equity funds including those that specialize in growth stocks (which don’t usually pay dividends), income funds (which hold stocks that pay large dividends), value stocks, large-cap stocks, mid-cap stocks, small-cap stocks, or combinations of these);

(iv) Balanced funds (investing into a mix of equities and fixed income securities. They try to balance the aim of achieving higher returns against the risk of losing money. Most of these funds follow a formula to split money among the different types of investments. They tend to have more risk than fixed income funds, but less risk than pure equity funds. Aggressive funds hold more equities and fewer bonds, while conservative funds hold fewer equities relative to bonds);

(v) Index funds (These funds aim to track the performance of a specific index such as the S&P/TSX Composite Index. The value of the mutual fund will go up or down as the index goes up or down. Index funds typically have lower costs than actively managed mutual funds because the portfolio manager doesn’t have to do as much research or make as many investment decisions)

Active vs passive management

Active management means that the portfolio manager buys and sells investments, attempting to outperform the return of the overall market or another identified benchmark. Passive management involves buying a portfolio of securities designed to track the performance of a benchmark index. The fund’s holdings are only adjusted if there is an adjustment in the components of the index.

(vi) Specialty funds (focus on specialized mandates such as real estate, commodities or socially responsible investing. For example, a socially responsible fund may invest in companies that support environmental stewardship, human rights and diversity, and may avoid companies involved in alcohol, tobacco, gambling, weapons and the military)

(vii) Fund-of-funds (These funds invest in other funds. Similar to balanced funds, they try to make asset allocation and diversification easier for the investor. The MER for fund-of-funds tend to be higher than stand-alone mutual funds)

Although it is clear that Speciality Funds can influence the oil price movement, I do not know what is their share in the overall traded volumes. It is possible that banks participate in oil trading for the purpose of selling it later (besides hedging). Or it could be an arrangement which nobody knew until recently. The following outstanding story raise the question: is there anything else we should know?


Bloomberg in its Article, titled “Uncovering the Secret History of Wall Street’s Largest Oil Trade”, published on April 4th, 2017, highlights that everybody knew the world was tipping into a financial ­crisis at the time, but because of its excellent banking and political connections in the U.S., Mexico may well have had special insight into just how bad things would get. What’s more, as one of the world’s top oil exporters, the country generally has better information than, say, hedge funds, about where the market is heading. In 2008, that information led those in the room to believe global supply was well in excess of global demand.

Sure enough, as the banks executed the deal over a five-month period, oil prices tipped into free fall amid the worst financial catastrophe since the Great Depression. In 2009 oil prices would average less than $55, well below the average price of the options of $70.

The key to success behind this huge sovereign oil hedge was moving “quickly, very quickly,” says Gerardo Rodriguez. Undersecretary of finance and public credit at the time, he was one of those in the room; he’s now a managing director at BlackRock Inc.“At the start of the summer we saw that the financial crisis was spreading fast,” he says. “Despite that, oil prices were still high. They were even climbing. We told ourselves, ‘We need insurance, and we need to take advantage of $150 oil prices.’ ”

In December 2009 the four investment banks involved in the deal wired the proceeds of the wager back to Mexico. Official records tracking the money that landed in Account No. 420127 at state-owned Nacional Financiera bank show the tidy sum ­Mexico made: $5,084,873,500.


Oil hedges aren’t uncommon. Airlines and U.S. shale producers rely on them to lock in revenue. But no deal comes close to matching Mexico’s annual “Hacienda hedge.” “Mexico is the biggest annual oil deal,” says Goran Trapp, founder of boutique advisory firm Energex Partners and former global head of oil trading at Morgan Stanley. Over the last 10 years, the notional value of the hedge has added up to $163 billion. “It’s the deal that all banks wait for each year,” says Richard Fullarton, founder of commodity fund Matilda Capital Management and a former senior trader at Royal Dutch Shell and Glencore. “It’s so large that it can make or break their year.”

Despite its size, impact, and huge fees, the deal is one that few people, even in the energy industry or on Wall Street, know much about. Painstakingly, the world’s 12th-largest oil producer and its bankers have cloaked the program in secrecy to prevent others—namely trading houses and hedge funds—from front-running Mexico’s orders. “Minimizing its visibility is extremely important,” wrote Javier Duclaud and Gerardo García, two senior officials at Mexico’s central bank, in a 2012 report for the International Monetary Fund.

This is the untold story of how Mexico, as early as 1990, constructed what quickly became the world’s largest and best-­concealed oil trade. Bloomberg Markets unraveled the secret history of the Hacienda hedge through dozens of interviews with current and former government officials, traders, brokers, bankers, and consultants, as well as a review of thousands of pages of previously unreported documents, some obtained through ­freedom-of-information requests in the U.S. and Mexico. Although some people agreed to speak on the record about the deal, others did so only on condition of anonymity because they were discussing a confidential government program.


Mexico’s oil hedge has real economic significance. Until fairly recently, the country relied on oil for about a third of its income, leaving it dangerously exposed to boom-and-bust price cycles. 

What’s more, it’s a fiscally responsible exercise that ­reduces the country’s borrowing costs, says Fabián Valencia, a senior IMF economist in Washington who follows Mexico. “The hedge means Mexico pays about 30 basis points less on its sovereign debt,” he says. Hedging is like buying insurance, says Guillermo Ortiz, who was governor of the country’s central bank from 1998 to 2009: “You buy it hoping you won’t need it.”

For its part, Mexico has shown a Wall Street-style wizardry in trading oil. It usually makes money on its hedges—sometimes a lot of money, as in 2008-09. From 2001 to 2017, the country made a profit of $2.4 billion; its hedges raked in $14.1 billion in gains and paid out $11.7 billion in fees to banks and brokers. (The banks have an additional incentive: They can make money by creating trades of their own that are linked to but separate from the hedge itself.)

So far, Mexico has managed to dodge some obvious risks. “If you get it wrong,” says George Richardson, a senior official at the World Bank, “it’s a serious political problem.” The fat fees going to the banks may also end up looking wasteful and may even dissuade other oil-producing countries.

The government of Carlos Salinas de Gortari also sensed the boom wouldn’t last, not with the U.S. economy cooling and President George H.W. Bush preparing for war. According to Aldo Flores Quiroga, the country’s current deputy oil minister, the “thinking on the use of financial instruments of this kind has its origins in the 1980s, when Mexico was seeking to stabilize its fiscal stance.” In particular, the government had failed to anticipate the 1985-86 oil crisis, when Saudi Arabia flooded the market and prices tumbled. By 1990 the prospect that Washington could tap the brakes on oil prices by dipping into U.S. strategic petroleum reserves loomed large.

To make sure Mexico wasn’t again exposed to forces beyond its control, the Salinas government decided to bet on prices falling and enlisted Goldman Sachs. Stephen Semlitz, a rising star and head of energy trading at J. Aron & Co., the bank’s legendary in-house commodities unit, and Robert Rubin, Goldman’s co-chairman, who later became U.S. treasury secretary, proved instrumental in helping Mexico lock in a price of $17 a barrel for the first few months of 1991. The deal worked: Maya crude, Mexico’s benchmark, plunged as low as $9.75 a barrel that year. Despite the modest success of the Gulf War hedge, Mexico didn’t do it again for years, as oil prices remained relatively stable.

Until 2009, the Mexican government didn’t disclose any information about the Hacienda hedge. Since then, its practice is to disclose as little as possible. And the banks? They never publicly acknowledge their participation in deals like this. Still, for all the Mexican government’s efforts to keep its megahedge hidden, a detailed history of how the deal works can be gleaned from the thick, bound volumes of the legislature’s ­annual audit, the Auditoría Superior de la Federación. Among other ­insights, the thousands of pages reveal that Mexico’s current practice is to buy so-called Asian-style put options. That allows the country to hedge an ­average price rather than the price at the expiration of the contract, as is the case with “American-style” options.

While the Mexican government hedges every year, it doesn’t enter the market at the same time. According to the audits, it has started buying options as early as May and as late as August. In the early years, Mexico locked in the price of West Texas Intermediate, but that caused trouble because of WTI’s ever-changing price relationship with Maya, Mexico’s main crude export grade. Today, to avoid price variations from benchmark to benchmark, the hedge involves a combination of Maya—usually 80 percent to 90 percent of the total—and Brent, the world standard.


The audits confirm Mexico’s reputation in the oil market for shrewd trading and its keen desire to keep the deal quiet. No year epitomizes those characteristics as much as 2007, the year before the big deal that made $5.1 billion for Mexico. The men from Hacienda started early in 2007, hedging 5 million barrels during the week of June 18. With prices failing to decline, Mexico slowly built up its position, selling 185 million barrels in the next three weeks. In late July, with prices rising fast, it went all in, doing 100 million barrels in a single week. The wave of selling sent prices tumbling 10 percent. Mexico ­immediately vanished from the market, staying quiet for three weeks. The men from Hacienda didn’t return until the end of August, as prices rose again, quickly selling an additional 85 million barrels in 10 days. In total that year, Mexico sold 435 million barrels in 68 deals. Goldman Sachs handled the bulk of those orders—250 million barrels in total.


The audits also disclose something oil traders have long suspected: Mexico doesn’t trade just in the summer; it’s been in the market during the winter at least once. In the summer of 2013, Mexico, as usual, bought put options, securing a price of $81 a barrel. But contrary to its usual practice, the country reentered the market in January and February 2014, restructuring the deal at $85 a barrel.

Mexican officials have argued that the hedge, which runs annually from Dec. 1 to Nov. 30, doesn’t affect prices. However, bankers who are or have been involved in the deal, as well as oil traders who monitor it closely, say Mexico’s hedging, in fact, roils the market. That certainly happens when Mexico’s bankers sell futures to protect themselves, putting downward pressure on oil prices. If only because of its magnitude, the hedge is a fount of rumor, chatter, and volatility—particularly when Mexico is hedging and the market is falling, as in 2008 and again in 2014.


The political opposition to President Sixto Durán Ballén, according to an IMF review of the deal, blasted “the high losses to the country,” and Ecuadorean lawmakers appointed a special committee to investigate allegations of corruption against ­several officials involved in the hedge. (The panel concluded there was no wrongdoing.) Ecuador’s mistake may well have been to see the hedge as a bet rather than an insurance policy.

Mexico’s hedge has never triggered a ­political backlash of any real consequence. But that doesn’t mean the joyride can last forever. Oil is no longer the make-or-break revenue generator it once was. Last year it accounted for only 17 percent of total government revenue. And oil production is declining even as domestic demand is climbing—reducing net exports and hence the size of the deal.

In the hedge’s halcyon days, Mexico sold forward more than 450 million barrels of oil; this year it’s done only 250 million. Despite the budgetary stability the annual big bet has brought to this country of 122 million people, the sun may be setting, however slowly, on the hedge and the men from Hacienda who pull it off.

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A few months ago I started to think that the issue of global oversupply might not be the only reason for the sustained crude oil price. But after reading Bloomberg’s article, I do not need any evidence because when there is little transparency it means that something isn’t right.

I am confident that as long as markets function as a casino, we are likely to continue to make the same mistake.

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