Assessing the strength and weakness of the U.S. economy is like trying to explore a naval aircraft carrier. Big doesn't even begin to describe the U.S. economy. However, by looking at company specific data and macroeconomic indicators perhaps we can get a better idea on how to navigate the stock market.
In order to complete this analysis, I'm going to assess the earnings of Microsoft (MSFT), Exxon Mobil (XOM), UnitedHealth Group (UNH), Wal-Mart (WMT), Ford (F), and Wells Fargo (WFC). This isn't an exact proxy of the United States economy, but these companies are certainly big enough to get us some much needed insight on how this jigsaw puzzle looks.
I do warn though that there are many moving parts, and trying to draw the lines between everything has been a painstaking process. The data and insights offered by the CEOs and CFOs aren't conclusive by themselves. Certain pockets of the United States economy should continue to grow, but there are certain pockets that are likely to be hit with significant weakness.
However, given what I know about the economy, I feel confident in the overall trajectory of growth and investment within the United States.
For now, it seems that the Federal Reserve is transitioning responsibilities from the current Fed Chief Ben Bernanke to Janet Yellen. There are a lot of mixed feelings about her, and some are even willing to point out that she's likely to continue the accommodative monetary policy set in place. Despite the media's lack of fawning over her, I guess we're going to have to get used to seeing her on the front cover of the Wall Street Journal from now on.
Honestly, the first time I saw Janet on the front cover of the Wall Street Journal, it brought back memories of an old principal from elementary school. Actually, let me change my mind, it brings back old memories of Angela Merkel covering the front page of media as the contagion spread throughout all of Europe. So other than the fact that she's a woman, and she's probably slightly smarter than Ben Bernanke, I see no significant change in the way the Federal Reserve will conduct its monetary policy. Of course, Alan Greenspan boosted her creditability, recently on CNBC. So, not all is lost over in the land of banking.
Of course, the past is not necessarily always the best indicator of the future. But, let's move onto some basic economic indicators. It's also important to remember that the Federal Reserve target date for raising the discount rate is looking to be 2015. Market participants may have already partially priced in the Federal Reserve's guidance into the value of bonds. To add to this, holding onto longer-dated treasuries is considered to be a melting pot according to William Gross at Pimco:
But bond investors with a survival instinct (being one and the same as our cooking frog) should reflect on that old teeter-totter metaphor and realize that prices near the boiling point automatically imply yields near subzero. Granted, 5-year Treasury rates near 1.70% are not zero and 10s and 30s are even better, but much of the Treasury yield curve now rests in negative territory when compared with expected future inflation, and that should send our bond investor into a hoppin' funk. Prices are already nearing the boiling point and his coupons are subzero, CPI adjusted. Total return…and our frog…are cooked, or if not they are certainly trapped in a future low return kettle of water.
So going forward it's not only a no-brainer to the major bond fund managers that it's time to transition out of longer maturity bonds. It's also a duh case scenario to start hedging positions in the bond market. Usually this involves derivative contracts that help to put a floor underneath price depreciation on the underlying coupon, or selling short treasury futures (TBT). But, anyone in the land of bond market euphoria would understand that the implied volatility in bond securities is extremely low in comparison to other asset classes making it substantially more practical to buy non-exchange traded derivatives to hedge risk on longer-term bond notes. Hedging is important, and if you don't have access to those types of strategies, then having the right timing with regards to asset rotation is probably more important.
Again, anyone who works in the financial advisory believes that the bond market is a tricky landscape to be in. The outflows from bond funds have begun while the flow into the stock market is starting to cause investors to panic. Some are calling it the QE bubble, or market euphoria. Whatever works for you! The structural change in the stock market (SPY) is something most of us are not accustomed to. This is why discounted cash flow models are constantly being adjusted and analysts are raising price targets on every publicly traded company.
However, we really want to zero-in on the concept of risk-on mentality, which can be summarized with this chart below.
Source: Goldman Sachs
The stock market offers the most compelling risk to reward as I believe that bonds will be sold once quantitative easing comes to an end. This is primarily because, investors are already responding to rising interest rates by investing into higher risk investments. We're seeing investors chase bonds that are higher on the risk spectrum, causing a significant reduction in price depreciation on lower quality debt giving me further reassurance that the cool-off period for risk hasn't actually begun.
Source: Goldman Sachs
I believe that higher price-to-earnings ratios on stocks are here to stay. Eventually, the Federal Reserve will end quantitative easing. But, just because the Federal Reserve is no longer going to offer quantitative easing does not mean that liquidity is being bankrupted from the economy. It's likely to be a moderation phase, just as fractional reserve lending is starting to take off. When the amount of "real" lending in the economy increases, the CPI inflation rate should reach 2%, which is the point where the Federal Reserve starts to raise the target interest rate.
Some think that when the Federal Reserve stops adding liquidity to the system the stock market will crash. However, data on fund flows largely indicate that this simply isn't likely to be the case. What's more likely to happen is a crash in the coupon value of bonds, which will force frogs to jump out of the bond kettle and into the cool and risky waters of the stock market. Either that, or investors will look for alternative assets that are less interest rate sensitive that will generate higher rates of return. In this case, corporate bonds with a lower rating may be one of many alternatives used to hedge interest rate sensitivity.
In summary, I believe that owning exchange traded bond funds like the iShares TIPS Bond (TIP) to be suicidal. This is because, at maturity an actual bond note will return the investor the principal value of the note, but with an exchange traded ETF bond fund, you have to sell the note at market even if you held onto it for ten years. Ten years down the road I'm doubtful of the value on exchange traded bond funds.
This is the pillar of the economy that many want to jump right over because it's complicated and boring to analyze. So what gives me the credibility to offer an open discussion on the topic? I earned editor's choice on Seeking Alpha for a JPMorgan Chase article. Plus, numerous readers said the overview was some of the most comprehensive analysis ever written on a bank. Therefore, I believe that I have enough credibility when offering analysis on big banks.
A lot has happened recently. Riskier activities like trading are being frowned upon by regulators. Universal banks are becoming difficult to manage as JPMorgan Chase (JPM) was hit with a massive fine for market manipulation. Again, things happen, but under the watch of Jamie Dimon, things went haywire. Market participants were relatively unaffected by the cost of a $13 billion settlement. JPMorgan Chase reported earnings recently. The company came out with a year-over-year decline in earnings from $1.51 per share to $1.42 per share. So the impact to shareholders weren't as material as the media is trying to portray. Going into Q1 2014, analysts have revised forecasts down and expect growth to moderate for a period of time as restructuring charges are likely to hit the bank as they exit out of businesses that aren't very friendly to regulation.
Wells Fargo, on the other hand, is doing extremely well in this environment. Well, it's not a high flying social network like Facebook. But, what Wells Fargo tends to offer is stable growth in commercial and consumer banking. Wells Fargo's recent acquisition of Wachovia Bank helped to branch it from west to east coast. Anyone in the western half of the United States is extremely familiar with the layout of a Wells Fargo bank, so I think it's a decent enough of a proxy for assessing the strength of consumer and commercial lending.
However, one downside to analyzing a massive bank like Wells Fargo is that regulation is keeping the bank from lending as much as it could potentially lend. In the recent quarter, analysts were questioning the impact that the CCAR would have. And for all of you who don't know what CCAR is, it stands for comprehensive capital and review, which is an annual exercise conducted by the Federal Reserve in order to ensure the sufficiency in capital held by banking institutions. I'll have a more comprehensive article on the impact of comprehensive capital and review, but in the meantime we need to focus on the impact that CCAR has had on Wells Fargo.
John Stumpf the CEO of Wells Fargo during the most recent earnings conference call states:
Here is how we think about that. If you think about the CCAR process, we now have - every year we do this, we learn more. We have more experience. Rules that were proposed are becoming more known, not everything that's known today but this CCAR process will know a lot more about final roads that we knew in the past, that doesn't mean everything is known. Secondly, we have made great progress. Tim mentioned and I mentioned in our comments that if you look at just one ratio but we don't look at only one, the Tier 1 common using Basel III rules as we understand them, we're over the 7% plus the 1% SIFI buffer gets us 8%, [indiscernible] 1% to 9%, we're already 9.50% - north of 9.50%. In our company, the way you run it here is really about shareholder and you saw the activity we had last year in returning capital to our stockholders. We purposely made a comment, both Tim and I did, about returning more to our shareholders and we're looking forward to this upcoming CCAR process. It's surely an iterative process.
So in plain English, what John is basically saying is that Wells Fargo is working out the CCAR process and is confident in the way it has managed its capital. More specifically, the bank has sufficiently met its capital ratios. John is hoping to generate a greater return for shareholders by returning cash through share buybacks along with increasing lending activity. This can be further supported by the quarterly drop in Basel Tier 1 capital, which fell by 7 basis points. This largely indicates that lending should resume at higher rates as Wells Fargo will no longer accumulate an ever greater amount of capital on its balance sheet in order to meet CCAR. More specifically, Wells Fargo grew deposits by 8% year-over-year in the most recent quarter. Lending trailed the deposit growth with lending up by around 3.6% year-over-year.
Wells Fargo management was trying to communicate that it can increase lending activity while lowering costs at the same time. If lending activity continues to increase, then my theory on fractional reserve lending, and increased activity in the mortgage space will definitely hold true. Going forward, inflation should start to improve assuming this trend in lending growth continues.
Source: Goldman Sachs
The amount of collateralized mortgage backed security issuances in billions has gone down significantly since the 2007 high of $229 billion. I am willing to assume that collateralized mortgages will grow significantly in 2014-2015 as capital needs for banks stabilize, and you can rest assured that inflation should inch up enough to cause investors to panic in the bond pits. After all, if inflation were to jump modestly, fears over an early end to quantitative easing by the newly appointed Janet Yellen could cause panic.
However, the loss of coupon value should be adequately hedged by institutional investors. The bigger concern is the little guy. The prevailing theory is that rising inflation will spook stock investors. Instead, I think it will spook both bond and stock investors.
Eventually bond investors will sell bonds and start chasing higher risk investments in order to offset inflationary risk. Sounds downright weird, but for now, the data largely indicates that longer-dated treasury investors are going further up the risk spectrum.
Retail and Durable Goods
I'm going to dedicate this section to both durable goods and retail. Typically in a cyclical recovery, goods that are more expensive like cars tend to experience a substantial uptick in demand as labor enters into the labor force. This can be substantiated with better household formation and the falling unemployment figures below.
Currently US disposable income continues to trend higher as consumption for higher end purchases like cars have picked up over the year. The unemployment rate has continued to decline throughout 2013, and it's currently at 7.2%. Household formations peaked in 2011, but this trend may eventually improve assuming lending activity picks up in 2014.
The theory of income elasticity of demand is a measure that calculates the change in spending with respect to the change in income. The automotive industry has an income elasticity of demand that ranges from 2 to 4. What this basically indicates is that as income increases the amount spent on a car increases at either 2 to 4 times the rate. To translate this into English, when the economy recovers and people become employed, and the average disposable income goes up, the demand for cyclical goods that are more income elastic tend to go up significantly when compared to goods that are less income elastic.
We can apply the theory of elasticity using information from the Ford October conference call. John Murphy, which is one of the analysts at Bank of America, asked a pretty interesting question to Alan Mullaly:
And then lastly, Alan, U.S. sales have been incredibly strong. Obviously there's some noise around some timing and potential weakness in the September numbers. But given where the economy is in general, auto sales are running way ahead of where you would expect relative to everything else that's going on in the economy.
I think you really hit the main elements that we're looking at, really kind of starting with the fundamentals of the recovery, especially the housing and the pent up demand. Of course as we start to satisfy that pent up demand over the next couple of years, it will come down to more of a normal growth rate based on demographics and discretionary income, and we think that it's going to be in the 16 million to 17 million range.
I think the peaks that we've seen in the past that were fueled by a lot of factors as you know, we don't expect to see. And I think that nice, steady rate that reflects those fundamentals would be welcome by all. And I think that's the way we're looking at that right now.
To translate Alan into laymen terms, he believes that Ford's momentum should eventually stabilize but stabilize at a rate that's significantly higher to what it was coming right out of the economic slump. He believes that part of the demand in cars was due to pent-up demand. Difficulty accessing credit, plus other factors may have hindered auto sales in the past. But going forward even if Ford was to depend on discretionary income, and household formation, things are looking bright as Ford's earnings performance is extremely sensitive to increases in income and employment.
In other words, we're starting to see changes in consumer demand with respect to changes in income. Since income is going up, demand for inferior products and services will go down. If that's the case, people will be spending more time at high-end fashion retailers and will be shying away from every-day-low-pricing. However, because durable goods purchases have gone up by so much in the past year, I'm starting to think that retail sales could be somewhat sluggish as consumers will have to budget a larger portion of their income towards car payments. Plus, once housing demand starts to pick up, the average consumer will have even less discretionary purchasing power.
Matt Fassler at a Goldman Sachs Global Retail Conference asks the President of Wal-Mart USA a good question about the overall trajectory of the economy:
Now, as the largest company in the country and certainly the largest retailer, you have your finger on the pulse of the U.S. consumer. And the question that we are asking all of the presenters at this conference is what your expectation is for the environment in the second half of the year relative to where it was in the second quarter of the year?
Bill Simon (President of Wal-Mart USA) responds:
I think we have said that we expect sales to be better in the back half than they were in the first half, so we are planning on that and we are focused on driving that, through initiatives. I think that there is a lot of yanks still in the economy today. We all know what they are, the 2% I think is the affordable (care racket) implemented. I think individual customers; consumers are still trying to understand what that means to them and how they will go forward with that.
This pretty much sounds like gibberish from Bill Simon. But basically, they're thinking that second half earnings will be somewhat better than the first half for Wal-Mart. Unfortunately, it's not that Wal-Mart's retail model no longer works, it just doesn't prosper in an economy that has rising discretionary purchasing power. Wal-Mart grew year-over-year quarterly sales at a much higher pace during the recession than it did post-recession.
Nothing fundamentally changed about Wal-Mart's retail business model. Sure, we can be really selective, and point out how Amazon could be wooing away some customers. But realistically, underpinning macroeconomic forces such as rising disposable income is causing demand for inferior goods to drop. Also, I don't want to call Wal-Mart's products an inferior good, but Wal-Mart deli doesn't really scream quality.
On the other hand, demand for organic food is up. Analysts on a consensus basis anticipate Whole Foods Market to generate an 18.71% compound annual growth rate over the next five years. This high growth rate is supported by Whole Foods Market's historical annual growth rate of 55.39% over the past five years. Again, to reiterate the point, Wal-Mart is not losing customers because it lacks broad enough appeal. It's just that when the economy recovers, consumers migrate to higher-end products, and this is mainly driven by the theory of income elasticity.
The Bank of America analyst (John Murphy) partially alluded to this by pointing out that Ford seemed to be doing extremely well in comparison to other pockets of the economy. In response to that Alan Mullaly made a small reference to housing. Looking at the numbers, Ford was able to generate 14% year-over-year sales growth in 2013, whereas Wal-Mart generated 2%-3% year-over-year sales growth. This indicates that if you're jumping on the economic prosperity bandwagon, it's time to own names like Nordstrom rather than Kohl's. Own Target rather than Family Dollar. Buy Ford instead of non-cyclical stocks like Philip Morrison. Of course, this is if total return is much more important than trying to manage risk.
Technology a formidable force in our economy
Microsoft posted some fairly solid earnings in the most recent quarter (Microsoft beat consensus earnings by 15% this past quarter). While Microsoft isn't a complete bellwether, for the whole entire technology industry, I felt that reviewing its guidance for some of its operating segments to be a useful exercise in practical forward thinking. Also, some of you investors can gain a greater appreciation for the conglomerate nature of Microsoft just by looking at how each individual segment could be its own Fortune 500 company.
Amy Hood, the CFO of Microsoft reiterates that the PC market should be able to recover:
Now, let me share some quick thoughts on the PC market which turned out better than we had expected. We are seeing signs of stabilization in the business segment with two consecutive quarters of growth and a relatively stable outlook for the next couple of quarters. While the consumer segment is more volatile with increasing competition for share of wallet and also performed better than expected, particularly in developed markets.
Ken Wong an analyst from Citigroup asked a good question:
Hi, guys. This is Ken Wong. I guess, we wanted to focus a bit on Windows, and the OEM business was down just 7% this quarter versus down 15% last quarter and what seemed like you guys had a lot of pressures on ASPs and what not. What drove sort of the quick turnaround from quarter-to-quarter? Maybe if you could just dig in a little bit there.
Amy Hood (CFO) replies:
Let me try to break it up a little bit, Ken, to make sure I understand and get a chance to talk about the overall performance. Business was better than we expected, so actually ASPs were probably higher than many people had modeled and what we had expected, due to mix Growing 6% in the Pro segment was both, better than we expected and probably better than many people had considered.
In summary, Microsoft was able to mix in a higher number of Microsoft Pro licenses for the Windows segment. A higher mix implies that higher margin products grew at a high enough of a rate to offset the falling demand for lower margin products. Also, because Microsoft was able to generate higher average selling prices, the company was able to perform better than expected. This is why Microsoft is starting to offer better guidance for its Windows segment. However, we're not out of the woods yet, and this guidance is primarily a run rate projection using variable costing methods. However, if anyone knows the overall trajectory of computer demand, it would probably be the CFO of Microsoft.
Demand for computers is recovering on a quarter-over-quarter basis. Computers are a durable good, implying that consumers are buying bigger ticket items. Sure, we can argue about how the Windows ecosystem should be doing a better job in comparison to Apple. Plus, we can also point out the displacement in demand for tower systems because of tablet and smartphones being a greater priority with the average user. But despite all this negativity, it seems that consumers are starting to check off the lowest priority items on their shopping cart checklist, a Windows 8 computer.
Microsoft's guidance gave investors some hope, and helped to alleviate the fears of a computer apocalypse. Hence the sudden price surge. Last quarter guidance was pretty terrible, so you can only imagine how surprised analysts were by the recent quarterly earnings report. Devices and consumer sales (consumer Windows licenses) are expected to decline by 7% year-over-year in the next quarter. Following that hardware sales (Xbox One, and Surface) are expected to grow by 37% year-over-year in the next quarter. Gross margins are expected to decline by 54% year-over-year (this is for the Xbox One and Surface only) as a product push of the Microsoft Surface will result in rising costs and falling margins. D&C other segment revenue is expected to grow by 17% in the next quarter (Bing, Xbox Live, Skype, and 365 Office Consumer). The Commercial business of Microsoft (Office 365 Business, Commercial Cloud, Commercial Operating System Licenses, and CRM) is expected to grow revenue by 10% year-over-year in the next quarter.
I think the real trend we should keep an eye on is the Office 365 subscription model. Microsoft believes that getting consumers into cloud based software will help to reduce the difficulties in cross platform functionality while at the same time improve the total amount of revenue generated from each consumer.
Services and software that improve productivity are being heavily invested into (business to business). Cloud driven solutions, productivity enhancing software, along with customer relationship management seem to be growing at a steady clip. Plus, advertisers are leveraging Microsoft's Bing search engine, for better click through rates, indicating that digital advertising growth is here to stay. Server growth is likely to be sustained given the favorable guidance. Sure, we would like server license growth that is higher than mid-single digits. But there's no indication that demand will worsen over the short term. So if anything, investors should start to see some stabilization in server demand. Corporate investment on technological solutions is growing at a very rapid rate.
Turning our attention away from the technology sector, I want to focus on healthcare and insurance. The economy can be extremely broad in scope, and there's a lot that has happened in the realm of healthcare that investors simply cannot ignore.
Recently, the Democratic Party took a ton of heat for making a dysfunctional website that didn't work. The website, Healthcare.gov was an ambitious attempt to help the individual find healthcare solutions that would match their needs. The individual would have to go through a process of inputting information to see if they qualify for lower-end government subsidized products like Medicaid or Medicare. If you're not too broke to be given state subsidized health insurance or too old to receive the federal government's Medicare for retirees, you have to buy health insurance. Individual health insurance has to be purchased from the healthcare marketplace. The healthcare marketplace is supposed to reduce information inefficiencies, and increase the amount of transparency to buyers of health insurance. This is because insurance products are generally thought to be inelastic, making price comparison difficult as the price may vary significantly from one company to the next.
The effectiveness of the marketplace was questioned as only six people enrolled on the first day healthcare.gov went online. But to be fair, there were website difficulties. This pretty much highlighted how ineffective the government can be at running its own organization. This gave a ton of ammunition to the Republican Party as every major news network put on loud speaker the defunct healthcare.gov website.
The grand compromise of the Affordable Care Act is that it gives health insurers a broader pool of people to insure. This has resulted in more revenue on the top line. The downside to the Affordable Care Act for health insurers is that the healthcare marketplace reduces profit margins. Because of this, investors should be careful when considering the risks of owning a health insurer.
Earlier in the year, I did research on UnitedHealth Group, which was part of my journey to do research on every Dow component name. At the time, I believed that the impact of Affordable Care was going to be a sharp increase in revenue with a negative impact on margins. I expected profit margins of health insurance companies to remain similar to one another as health insurers make their best attempt at maximizing profit in a price competitive market. This prediction of mine remained true.
Source: UnitedHealth Group
On a year-over-year basis, the UnitedHealth Group was able to grow revenues by around 10%. However, what surprised analysts this quarter was a further gain in the net margin from the second quarter to the third quarter. This helped to boost expectations for better earnings from operations for fiscal year 2014.
Going forward investors should expect modest improvement in margins, with further revenue growth. When the penalties for not having health insurance rise, the incentive to purchase health insurance will increase, which will boost health insurance revenues for companies like UnitedHealth Group.
David A. Styblo, (Jefferies LLC, Research Division) had the most direct question on the private health care exchange in the most recent earnings call conference:
It's Dave Styblo in for Windley. I had just a question on the private exchange, and if you could talk a little bit more about your strategy there, how you guys are approaching it and what sort of success you're having this year, as well as the enrollment cycle that's going forward so far?
Gail Koziaria Boudreaux (Executive Vice President and Chief Executive Officer of UnitedHealthCare) responds:
Good morning. It's Gail Boudreaux. First of all, in terms of the overall exchange market, we're very positive about it. We see it as a significant opportunity both for UnitedHealthcare and for Optum. And I think one of the things to remember, the private exchange market isn't brand new. While it's certainly seeing some acceleration going into 2014, we have had offerings, strong product offerings and feel very well positioned in a number of those markets.
Thinking about the private exchange market, I think you have to think about 2 subsectors of it. One is the retiree exchange, and that retiree exchange has had a very consistent movement over the last few years of employers moving into either group Medicare or into private exchange offerings. Again, our product offerings there have continued to grow and are very strong.
We also offer, through Optum, an opportunity to do a multiemployer exchange, which has seen increased enrollment and we expect to see solid enrollment going forward. The active space is really getting a lot of recent press. You heard, in Steve's comments, our offering. We participate pretty broadly, actually, and again, feel that we have a very strong product offering in the private active exchange, and we expect to continue to see growth.
From our perspective, there are a number of different types. Certainly, the movement from a self-funded offering to a fully insured offering is a positive for us. But overall, we're pretty optimistic and positive, and we see them as an expanding distribution channel going forward.
In summary, the CEO of UnitedHealth Group believes that the market is growing quite rapidly. Plus, they believe that their alternative exchange platform through Optum for employers will continue to see rising enrollment. It seems that the company feels confident in its ability to thrive in an environment of added regulatory involvement.
Currently the UnitedHealth Group is 34.33% above its 52-week low, which just comes to show how optimistic investors are starting to become as a result of The Affordable Care Act. Investors had low expectations for health insurers this year and were rewarded for it with upbeat commentary and guidance from healthcare executives.
Energy in the United States
Everyone likes to see falling gas prices (USO). We smile every time the price of gasoline reaches below $3 per gallon. I mean, with gas at $3 per gallon, things like road trips go from being a possibility to a hardcore reality.
Demand for crude oil imports is falling as domestic production has been on an upward trajectory. Technologies like horizontal drilling and fracking have helped US oil drillers gain access to oil wells that were previously inaccessible. More specifically, oil wells can be exhausted more effectively as drilling sideways into an oil reservoir tends to produce higher oil production yields.
Currently crude oil makes up 71% of gasoline cost. Rising crude oil production results in falling prices. To offset these issues, Exxon Mobil has been exporting more crude oil in the most recent quarter, and increased its production level in order to offset declines in pricing.
Exxon Mobil suffered in the beginning of the year as investors had to contend with falling crude oil prices. In fiscal year 2013, the company didn't have the benefits of a restructuring gain carried over from 2012, which made the year-over-year comparisons leery at best. However, when the year-over-year restructuring gains were excluded the company generated a 2% decline in earnings per share. The company did poorly in an environment of falling oil prices.
Faisal Khan a Citigroup Analyst asked a very good question during the company's most recent earnings conference call:
Okay, thank you. Could you - I appreciate the KPI along the unconventional resources in the U.S. and production. But could you give me a little bit more color on if I look at the total liquids production in the U.S. of roughly 423,000 barrels a day. How much of that is really coming from shale oil and shale liquids it sounds like your Permian production is mostly geared towards conventional than CO2 flooding's so is that primarily at that level where it's producing anything from shale oil or tight oil.
David Rosenthal (VP of Exxon Mobil) replies:
But certainly as we go forward the conventional continue to decline and even though I mentioned some of the steps we are taking to stem that we do see decline in Alaska and et cetera. But the real key for the U.S. is we are just really getting started on the unconventional side. And as I've mentioned before we spent a lot of time in the last couple of years evaluating what we've had, doing a lot of testing, a lot of technology work, a lot of research work and that's why I pointed out now you are really starting to see wells coming on, not for evaluation and delineation but to sell. So we can start ringing the cash register from these investments and you are starting to see that uptick.
David's response largely confirms my suspicion that Exxon Mobil is starting to capitalize on advances in drilling technologies, which is helping Exxon Mobil drill wells fast enough to turn a profit. This can be indicated in how Exxon Mobil was able to generate a pretty significant boost in revenue and profitability from its upstream division from the figure below. The unconventional fuels are starting to take center stage, but there are certain wells in certain parts of the United States that are becoming exhausted, which may be offsetting a bit of the production gains from unconventional fuel sources.
Source: Exxon Mobil
The company's performance in the upstream was strong. But its downstream business struggled in the most recent quarter. It seems that the downstream business is much more sensitive to the pricing of crude oil than the upstream business. The reason for this is that the refining business is being hit with falling demand.
When you're a midstream operation, you're a volume business. When the volume dries up, the fixed costs of the business have to be paid, but without the revenue to support it. Think of it like the stock market, if NASDAQ trading volumes dropped by 10%, but all costs remained the same, the business would suffer a terrible quarter. Likewise, all the major integrated oil companies were hit by falling volumes. This assumption can be further supported by this article.
The falling price of gasoline at the pump is also being driven by falling demand. The theory of supply and demand takes hold. Look at this quick illustration below.
Between 2010 and 2013 there has been a significant up-tick in the average MPG of fleet vehicles. However, because of recently proposed regulation, the average MPG is expected to be 54.5 by 2025.
At least according to NPR:
Under fuel-economy rules announced by the White House this summer, cars will have to get an average of 54.5 miles per gallon by 2025 - nearly double the current average. Reaching that goal will take not only feats of engineering but also changing how Americans think about their cars and how they drive them.
Since, the fuel economy for vehicles is expected to rise significantly; it is unlikely that Exxon Mobil's, Chevron's, or Shell's downstream businesses will be able to recover over the next ten years. This is because falling volumes cannot be overcome with better cost management especially in a capital intensive business like refining. Because of this, depreciating assets will be sitting on the book, labor costs will continue to plague Exxon Mobil, but the costs won't be passed onto the customer because of the market dynamics of a free market economy. This is why; I'm going to be avoiding any investment into oil companies.
Falling demand and increasing supply will push down the price of gasoline. Falling oil prices has less of a negative impact on an oil company's upstream operation. The biggest concern is the midstream and downstream business of refining and marketing. The refining/marketing margins will continue to be compromised as falling demand is a precursor to falling prices, and falling prices indicate falling volumes.
So in summary, the damage is done. Rising supply, falling demand, the equation isn't good. The developed markets will be a sore spot for the oil industry for years to come. On the upside, falling fuel prices will have a positive impact on discretionary and durable goods purchases.
To summarize, bond investors have called the bond market a melting pot on the longer duration notes. This is driven by the fact that investors will only accept a negative real return for so long, before the bonds have to float upwards in value. Also, because investors are trying to capitalize on more compelling opportunities they're moving up the risk spectrum, thus leading to frothier multiples in the stock market. The guidance of ending quantitative easing is a strong indicator for how markets will actually react when the punch bowl is taken away. For those who forgot, the bond and stock market fell immediately. But eventually bond coupon values continued their long-term decline, whereas stocks continued their long-term uptrend.
Consumer sentiment took a modest hit due to political uncertainty. On the other hand, the amount of discretionary income increased, and unemployment has declined in recent months. This resulted in greater demand for housing, and we're even seeing savings pile up on a bank balance sheet, hence Wells Fargo was able to report 8% year-over-year deposit growth. The growth in deposits is indicative of households saving up for purchasing bigger ticket items like cars or homes. This clearly corresponded with the strong results that Ford has been able to publish.
Demand for lending, however, has been constrained due to comprehensive capital and review, which require banks to hold onto a large amount of deposits when lending money. Going forward, I think this trend in accumulating capital on a bank's balance sheet will end, and Wells Fargo will lend more aggressively in order to generate earnings and revenue growth.
Having been 3-years since the CAFÉ (corporate average fuel economy) has improved, partially due to regulation, the impact on crude oil prices is starting to be felt. The developed markets will be a plague to the oil companies as they're both a source of supply, and at the same time falling demand, the ultimate duo of falling prices.
Corporate investment into productivity enhancing technologies has been aggressive. Services like Microsoft Office 365 continue to experience organic demand from businesses. The demand for PCs has been able to stabilize, and some believe that the desktop and laptop platform will actually survive.
Finally, the healthcare reform act caused a lot of confusion. This even led to a defunct website that caused the media to go haywire over the Democratic Party. Health insurance companies feel confident that they can thrive in this environment. More specifically margins weren't damaged too significantly, and the added revenue from the growth in health insurance policies was well above the street's low expectations going into 2013. Going into 2014, it's likely that health insurers will be able to grow earnings.
The United States is well on its path to recovery. Corporate investment and durable goods purchases are up. Falling energy prices will encourage spending. Demand for low-end retail is dropping, but higher-end retailers seem to be thriving. Bond yields are likely to rise as investors move up the risk spectrum. Markets are becoming more normal, and because of this fact, I remain optimistic on the United States economy.