Tag Archives: energy

Peak Oil And Runaway China: A Dangerous Combination Of Memes

By Ron Rimkus, CFA Back in 2005, investors heard an endless chorus in the financial media around two memes: the end of oil, and the growth of China. Oil production was supposedly hitting its upper limits. In 2005, the US Department of Energy published a study on the peaking of world oil production (.PDF) that stated: Because oil prices have been relatively high for the past decade, oil companies have conducted extensive exploration over that period, but their results have been disappointing [….] This is but one of a number of trends that suggest the world is fast approaching the inevitable peaking of conventional world oil production [….] The world has never faced a problem like this [….] Previous energy transitions (wood to coal and coal to oil) were gradual and evolutionary; oil peaking will be abrupt and revolutionary. The peak oil narrative was reaching a fever pitch around the same time as China’s “runaway growth” meme. A BBC report on ” 2004: China’s Coming Out Party ” highlighted how China’s increasing appetite for oil was affecting global prices. Other articles made eye-popping comparisons of China’s cities before and after the country’s economic changes (decades apart). For instance, Shenzhen transformed from a sleepy fishing village in 1980 to a bustling urban empire by 2006 . Shenzhen had grown at an annual pace of 28% per year during this 26-year period. Yes, you read that right. The pair of memes led some investors to embrace the notion that oil supply was peaking just at the moment that oil demand was accelerating- a recipe for higher and higher oil prices. Then, we all marveled as the price of oil rose from $30 per barrel in 2003 to well over $100 by 2008 . In subsequent years, both memes were proven wrong. There was no “abrupt and revolutionary” oil peaking, and China’s energy demands would not keep growing forever . But higher oil prices created an umbrella of opportunity for capital formation, and much of that capital flowed into US shale oil projects. Between 2009 and 2015, total US oil production nearly doubled from 5,000 barrels per day to just under 10,000 barrels per day , thanks largely to shale oil. The shale revolution, which took place because high prices stimulated investment and innovation, blew apart the notion that the world had reached peak oil. By the end of 2014, it became apparent that oil output would satisfactorily meet demand growth. Blindly following popular investment memes is a recipe for disaster, and investors who convinced themselves that oil prices would remain above $100 per barrel were blindsided by the return of oil priced under $40 per barrel – even though it was a function of price signals directing capital investment as a normal part of the business cycle. One person who correctly identified the business cycle as it played out was Amy Myers Jaffe , executive director for energy and sustainability at the University of California, Davis. “When I would talk about this boom and bust cycle in 2005 and 2007,” Jaffe said in a 2013 issue of The Planning Report , “people would heckle me off the stage because it looked like the price of oil was going to be high forever.” But time has a way of vindicating truth, and now her perspective looks quite prescient. Jaffe will be sharing her views on current events in global energy markets at the 69th CFA Institute Annual conference in Montréal. All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

The Most Crowded Hedge Fund Bets At Year-End 2015

Most analyses of hedge fund crowding focus on their residual (idiosyncratic, stock-specific) bets. This is misguided, since over 85% of the monthly return variance for the majority of hedge fund long equity portfolios is due to factor (systematic) exposures, rather than individual stocks. Indeed, it is the exceptional factor crowding and the record market risk that have driven much of the industry’s recent misery (just as they have driven much of the earlier upswings). In Q4 2015, a single factor accounted for half of U.S. hedge funds’ relative long equity risk. We survey all sources of hedge fund crowding at year-end 2015 and identify the market regimes that would generate the highest relative outperformance and underperformance for the crowded factor portfolio. These are the regimes that would most benefit or hurt hedge fund investors and followers. Identifying Hedge Fund Crowding This piece follows the approach of our earlier articles on crowding : We processed regulatory filings of over 1,000 hedge funds and created a position-weighted portfolio ( HF Aggregate ) consisting of all the tractable hedge fund long U.S. equity portfolios. We then analyzed HF Aggregate’s risk relative to U.S. Market using the AlphaBetaWorks Statistical Equity Risk Model – a proven system for performance forecasting . The top contributors to HF Aggregate’s relative risk are the most crowded hedge fund bets. Hedge Fund Aggregate’s Risk The Q4 2015 HF Aggregate had 3.7% estimated future tracking error relative to U.S. Market; over two thirds of this was due to factor ( systematic ) exposures : Components of the Relative Risk for U.S. Hedge Fund Aggregate in Q4 2015 Click to enlarge Source: abwinsights.com Source Volatility (ann. %) Share of Variance (%) Factor 3.10 69.07 Residual 2.08 30.93 Total 3.73 100.00 Simplistic analysis of hedge fund crowding that lacks a capable risk model will miss these systematic exposures. Among its flows, this comparison of holdings will overlook funds with no position overlap but high future correlation due to similar factor exposures. Hence, this simplistic analysis of hedge fund crowding fosters dangerous complacency. Hedge Fund Factor (Systematic) Crowding Factor exposures drove nearly 70% of the relative risk of HF Aggregate at year-end 2015. Below are the principal factor exposures (in red) relative to U.S. Market’s exposures (in gray): Significant Absolute and Residual Factor Exposures of U.S. Hedge Fund Aggregate in Q4 2015 Click to enlarge Source: abwinsights.com Of these bets, Market (Beta) alone accounts for two thirds of the relative and half of the total factor risk, as illustrated below: Factors Contributing Most to Relative Factor Variance of U.S. Hedge Fund Aggregate in Q4 2015 Click to enlarge Source: abwinsights.com Factor Relative Exposure Factor Volatility Share of Relative Factor Variance Share of Relative Total Variance Market 18.27 12.46 68.12 47.05 Oil Price 2.28 29.43 13.08 9.04 Bond Index -7.53 3.33 4.97 3.43 Utilities -3.10 11.28 4.77 3.30 Consumer -8.30 3.75 3.54 2.44 Energy -3.21 11.77 -2.96 -2.04 Health 4.79 7.22 2.54 1.75 Communications -1.67 11.98 1.91 1.32 Finance -6.89 5.08 1.68 1.16 Size -1.96 8.09 1.34 0.92 (Relative exposures and relative variance contribution. All values are in %. Volatility is annualized.) Thus, the most important source of hedge fund crowding is not a stock or a group of stocks, but systematic exposure to the U.S. Market Factor . When nearly half of the industry’s risk comes from a single Factor, fixation on the individual crowded stocks is particularly dangerous. The U.S. Market crowding alone explains much of the recent industry misery. In this era of systematic crowding, risk management with a robust and predictive factor model is particularly vital for managers’ and allocators’ survival. Hedge Fund Factor Crowding Stress Tests Hedge Fund Crowding Maximum Outperformance Given Hedge Fund Aggregate’s bullish macroeconomic positioning (Long Market, Short Bonds/Long Interest Rates), it would experience its highest outperformance in an environment similar to the March-2009 rally. In this scenario, HF Aggregate’s factor portfolio would outperform by 20%: Historical Scenario that Would Generate the Highest Relative Performance for the Q4 2015 U.S. Hedge Fund Aggregate Click to enlarge Source: abwinsights.com The top contributors to this outperformance would be the following exposures: Factor Return Portfolio Exposure Benchmark Exposure Relative Exposure Portfolio Return Benchmark Return Relative Return Market 66.04 120.07 101.80 18.27 83.00 67.50 15.50 Oil Price 87.13 1.53 -0.75 2.28 1.05 -0.51 1.56 Bond Index -6.29 -4.92 2.61 -7.53 0.31 -0.17 0.48 Energy -12.54 1.61 4.82 -3.21 -0.20 -0.61 0.41 Communications -17.62 0.52 2.19 -1.67 -0.10 -0.41 0.31 Hedge Fund Crowding Maximum Underperformance Given Hedge Fund Aggregate’s bullish macroeconomic positioning, combined with a long Technology and short Finance exposures, it would experience its highest underperformance in an environment similar to the 2000-2001 .com Crash. In this scenario, HF Aggregate’s factor portfolio would underperform by 8%: Historical Scenario that Would Generate the Lowest Relative Performance for the Q4 2015 U.S. Hedge Fund Aggregate Click to enlarge Source: abwinsights.com The top contributors to this underperformance would be the following exposures: Factor Return Portfolio Exposure Benchmark Exposure Relative Exposure Portfolio Return Benchmark Return Relative Return Finance 47.97 12.48 19.36 -6.89 5.27 8.26 -2.99 Market -14.21 120.07 101.80 18.27 -17.22 -14.48 -2.74 Technology -36.73 23.75 20.14 3.62 -9.83 -8.38 -1.45 Utilities 52.32 0.22 3.31 -3.10 0.10 1.51 -1.42 Consumer 12.36 14.87 23.17 -8.30 1.82 2.85 -1.02 Hedge Fund Residual (Idiosyncratic) Crowding A third of the year-end 2015 hedge fund crowding is due to residual ( idiosyncratic, stock-specific) risk. Valeant Pharmaceuticals International and Netflix are responsible for nearly half of it: Stocks Contributing Most to Relative Residual Variance of U.S. Hedge Fund Aggregate in Q4 2015 Click to enlarge Source: abwinsights.com Though there may be sound individual reasons for these investments, they are vulnerable to brutal liquidation. Given the recent damage to hedge funds from herding, these crowded residual bets remain vulnerable: Symbol Name Relative Exposure Residual Volatility Share of Relative Residual Variance Share of Relative Total Variance (NYSE: VRX ) Valeant Pharmaceuticals International, Inc. 2.67 43.72 31.56 9.76 (NASDAQ: NFLX ) Netflix, Inc. 1.57 54.62 17.15 5.30 (NASDAQ: JD ) JD.com, Inc. Sponsored ADR Class A 1.60 31.91 6.05 1.87 (NYSEMKT: LNG ) Cheniere Energy, Inc. 1.38 33.35 4.88 1.51 (NASDAQ: CHTR ) Charter Communications, Inc. Class A 1.79 20.31 3.08 0.95 (NYSE: TWC ) Time Warner Cable Inc. 1.85 16.14 2.06 0.64 (NYSE: AGN ) Allergan plc 1.83 14.62 1.66 0.51 (NYSE: FLT ) FleetCor Technologies, Inc. 1.18 19.61 1.23 0.38 (NASDAQ: PCLN ) Priceline Group Inc 1.12 20.10 1.18 0.36 (NASDAQ: MSFT ) Microsoft Corporation 1.54 14.13 1.10 0.34 (Relative exposures and relative variance contribution. All values are in %. Volatility is annualized.) Though stock-specific bets remain important, allocators and fund followers should pay particular attention to their factor exposures in the current environment of extreme systematic hedge fund crowding. Many may be effectively invested in leveraged passive index fund portfolio, with the added insult of high fees. AlphaBetaWorks Analytics address all of these needs with the coverage of market-wide and sector-specific herding, plus aggregate factor exposures of funds and portfolios of funds. Summary The main source of Q4 2015 hedge fund crowding, responsible for nearly half of the relative long equity risk, was record U.S. Market exposure. The main sources of Q4 2015 residual crowding were VRX and NFLX. Given the high factor (systematic) crowding among hedge funds’ long equity portfolios, current analysis of crowding risks must focus on the factor exposures, rather than individual positions. The information herein is not represented or warranted to be accurate, correct, complete or timely. Past performance is no guarantee of future results. Copyright © 2012-2016, AlphaBetaWorks, a division of Alpha Beta Analytics, LLC. All rights reserved. Content may not be republished without express written consent. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Why Now May Be The Moment To Get In On Value

The market’s almost immediate plunge to start 2016 cast a pall over what might have been shiny prospects for a new year, just two weeks from the Fed’s “balanced” assessment of U.S. economic conditions and the first rate hike in nearly nine years. Often forgotten in the doom and gloom is that volatility means down… and up. What intrigues me as a 30+-year value investor is that value stocks have been among the most volatile. And that seemingly has sent investors packing. At the end of 2015, there was $2.7 trillion in growth mutual funds, almost double the $1.5 trillion invested in value mutual funds. This underallocation to value stocks could mean missed opportunity. Let’s look at a hypothetical $10,000 investment in growth, core and value segments over the last decade. We can see where an investor might have missed out in this case. Click to enlarge Opportunity in the making We believe the recent overallocation to and performance strength in momentum and growth sets the stage for investor rebalancing. While the long-term path to value outperformance is not a straight line, and may be marked by alternating spates of value and growth leadership, we fully expect that investors are going to want and need to re-allocate back to value in their portfolios. As shown below, some of the periods of greatest value underperformance are followed by some of the most significant periods of outperformance. While the timing is impossible to predict, it’s not too great a leap to suggest we may be setting up for a rotation in favor of value stocks. Click to enlarge Actively seeking value Beginning in August of last year, the market began to price in weakening global economic conditions. The bearishness tightened its grip in the fourth quarter and early 2016, and as a result, we saw defensive stocks bid up to very full prices as value stocks got cheaper. It seems clear to me that the heightened volatility over this period has created attractive valuations in certain areas of the market. Indeed, by producing dislocations in the market, volatility effectively separates the potential stock winners of the future from underperformers. As the chart below shows, the valuation spreads within sectors are wider than their long-term historic average in many areas of the market. The greater the controversy in the investment case, the greater the dispersion in valuation. That means some stocks are priced low and others high. We are seeing that most acutely in the energy sector. Click to enlarge But buyer beware: Determining which of those low-priced names are true bargains and which are priced low for good reason requires deep understanding of each industry and company. While we approach the market stock by stock, certain areas seem riper for the picking now: Banks. We see banks as less volatile than they have been in the not-too-distant past, characterized by stronger balance sheets and less volatile results. Yet, they are trading at lower valuations. Energy. The key questions here are: 1) when will oil prices bottom and 2) how high will oil prices go in a recovery? We lean to the optimistic side on both. We think oil prices could bottom in the second quarter and head up in the second half of 2016. And while the consensus sees oil recovering to $50-$60 a barrel, our year-end estimate is above $75. But selectivity is important. An investor grab for high-quality, low-risk stocks without regard for valuation or risk/reward has created some attractive long-term opportunities elsewhere in the sector, but a number of stocks in this sector will continue to underperform. Technology. By our analysis, large-cap tech stocks with high return on invested capital are trading at cheap valuations relative to both their history and the broader market, while also generating solid cash. The significant cash balances allow flexibility, and the recent price declines of fast-growing companies may create attractive merger and acquisition opportunities. Healthcare. Despite current market fears, we’ve found a number of interesting stocks that are attractively priced relative to history and compared to the broader market. Healthcare also exhibits better growth and is cheaper than other defensive sectors, such as consumer staples and utilities. The sector benefits from favorable demographic tailwinds (namely, the aging of the population) and continued innovation. Of course, this only scratches the surface. My colleagues and I are excited about the opportunity ahead. Our objective is to work from the bottom up (starting with the individual stocks) to find compelling investment opportunities that are mispriced by the market over a two- to three-year time horizon. We believe the current environment is wildly conducive to that. While we acknowledge China’s overcapacity and economic weakness, we believe the market was overzealous in pricing in the probability of a U.S. recession. In fact, February and early March have shown a reversal in pessimism… and in markets. This has created some attractive investment opportunities. In our assessment, the period of underperformance has produced some bargains and sets the stage for a rebalancing in favor of value. This post originally appeared on the BlackRock Blog.