Wrestling The Russians & The Slippery Oil Market
After a recent OPEC meeting, neither the Russians nor Saudis could agree on oil production quotas. As such, the two energy nations decided to flood the market with oil. Although this created immense volatility, it is not entirely good or bad.
The bad aspect is that it puts immense pressure on oil commodities. Prices for crude fell 24% in one day. Even stalwart energy companies like Exxon were down double digits.
Make no mistake; this is not a feud between Russia and Saudi Arabia. Rather, it is an attempt to drive energy prices down such that U.S. shale producers cannot stay in business. This is a dangerous proposition for energy producers around the world.
Many investors are using this as an opportunity to chase after what appears to be unbelievable dividend yields. A word to the wise–if it looks too good to be true, it usually is.
Prior to the current decline in oil, Exxon paid $3.43 in dividends per share despite the fact that they only earned $3.36 per share. As such, they were going into debt just to support their dividend. This is a foolish business decision. Not only does increasing debt make Exxon riskier, but it means they probably are not reinvesting into their production and equipment.
Exxon’s current dividend yield is more than 8%. However, it is a mirage. Exxon’s earnings will fall putting even greater pressure on the energy company to either cut their dividend or go further into debt to fund their dividend.
Occidental Petroleum has already announced they are slashing their dividend by 86% and reducing their capital expenditures. Surely, they will not be the last.
Russia’s leader, Vladimir Putin, is smart and cunning. He knows that oil is a commodity which primarily trades on the basis of supply and demand. Quick swings in supply create volatility. Putin is seizing upon this to create as much chaos as possible.
Putin also knows that most companies in the energy sector are highly leveraged (have borrowed lots of money). Furthermore, the majority of companies operating in the energy sector are characterized as “junk” or high-yield debt. They are at the lowest rungs of the credit ladder. This puts individual companies at risk for financial troubles when oil drops. It is quite possible that many of these heavily leveraged companies may go into a restructuring or go out of business entirely.
Of the $15 billion in high-yield deals in 2020 so far, roughly two-thirds came from energy companies. Additionally, there is more than $55 billion of energy related debt maturing in the next three years.
Putin senses a moment of weakness and is attempting to exploit this to the best of his abilities. The combination of these factors makes it incredibly difficult to invest in the energy sector.
On the positive side, the drop in oil lowers the cost of gasoline, electricity, paint, plastic, carpet, and at least 70 other major products. Being as 70% of Gross Domestic Product comes from consumer spending, lower oil costs is like giving an immediate tax credit to every American family.
Putin is not the only one hoping for volatility. The other villain you are battling is our own financial markets. Very little of the stock market volatility is driven by individual trading. Instead, it is driven by Wall Street based computers. This causes significant volume in stock trading and erratic movements.
We know these computers are hyper-focused on short-term trading with little consideration for the long game.
It is worth understanding that even in a world that appears to offer low-commission or no-commission trading, there are still many trading costs. Each time a trade is placed, there are bid-ask spreads. This means that any time a security is traded, the buy order is placed at one price while simultaneously the sell order is at a slightly lower price. In a normal orderly market, the spread is quite small.
In a volatile market, the spread widens and Wall Street rejoices. Wall Street loves the trading on the way down and the way up. No matter which way the market is going, the more volatility the better for Wall Street.
Knowing this, if you allow your emotions to get the best of you, Wall Street will take advantage every time. Be a long-term investor who trades as little as possible. The easiest way to win Wall Streets game is not to play at all.
Dave Sather is a Certified Financial Planner™ and owner of Sather Financial Group. His column, Money Matters, publishes every other week.