Friday, November 28, 2014

Breaking Even in a Low Oil Price Environment

With the price of oil hitting levels not seen for more than four years, it's becoming an increasingly important issue for investors who are long on oil company shares, particularly given that some of the resource plays currently in vogue require prices that are far higher than conventional plays to provide a positive return on investment.  As you will see in this posting, this is particularly true for Canada's oil sands operators and companies operating in the American shale oil region.  In this posting, I will look at three different analyses that, in combination, give us some sense of the headwinds facing the oil industry.

Back in mid-2014, Reuters and Natixis published a brief article on the break-even price of producing an additional barrel of oil by geographic region, including both ethanol and biodiesel.  Here is a summary of their analysis:

The marginal cost of producing an additional barrel of oil from the Canadian oil sands is between $89 and $96 per barrel compared to $70 to $77 per barrel for U.S.-based shale oil.

Here is another analysis by the Carbon Tracker Initiative showing the break-even price for the top twenty largest oil projects in the world that require oil prices of more than $95 per barrel:

Note that the six projects that require the highest break-even oil price are all Canadian oil sands projects, both mining and in-situ.  At this point in time, one has to wonder if these high-cost options will be shelved until the price of oil retraces its decline.

From the same report by Carbon Tracker, we find these interesting graphics which show the proportions of high cost potential production for seven major oil companies:

In the worst case situation, Conoco Phillips has a portfolio containing potential projects that require an oil price of at least $75 per barrel and 36 percent require a price of at least $95 per barrel.  In the case of Shell which has the largest potential production portfolio, 45 percent of their potential projects require a market price of $75 per barrel and 30 percent require at least $95 per barrel.

Let's now look at a graph from a monthly commodity report from Scotiabank back in February 2014 which shows the full cycle break-even costs (including a 9 percent after tax return on investment) for selected production regions in North America:

The graph shows us that the weighted average of all breakeven costs for all projects is between $67 and $68 per barrel.  Among the fifty projects examined, Saskatchewan's Bakken resource play has the lowest break-even costs at $44.30 per barrel.  On the other hand, you'll note that the costs for new oil sands mining and upgrading projects is $100 per barrel, well above the break-even costs for existing oil sands production which comes in at between $60 and $65 per barrel.  SAGD (steam-assisted gravity drainage) projects are quite competitive with a break-even cost of $63.50 per barrel.  This accounts for 1.08 million barrels per day of Canada's oil production or 46 percent of Alberta's oil sands output.  It is interesting to see that the break-even costs of the U.S. Baked and Permian Basin shale oil production is quite high by comparison to the oil sands, coming in at $65 to $73 per barrel and $73 to $89 per barrel respectively.

Fortunately, many oil companies use a system of options which insure their production against price volatility.  Unfortunately, all of these come at a cost and as natural gas producers found out, they only shield production for a finite period of time.  As well, in the past, some companies have found themselves on the losing end of the bet when prices unexpectedly changed, leaving them having to declare very significant mark-to-market losses on their positions.

In closing, here is an interesting graph from Natixis showing U.S. oil production, consumption and imports since 2002:

Given the very steep production declines on shale oil producers, unless oil companies are willing to continue to stay on the production treadmill by drilling oil shale resource plays at the current lower price level that we're experiencing, we could quickly find that the purple production line falls back to its pre-2011 level, putting upward pressure on the price of oil once again....unless, of course, there is another recession!

Wednesday, November 26, 2014

Walmart, Tax Fairness and How to Exploit Tax Loopholes

Now that we're getting into the major shopping weeks of the retail year, I thought that this posting was particularly pertinent, given that it's about the world's largest retailer.

Walmart is the largest corporation in the United States with domestic net sales of $279 billion  during fiscal 2014 and corporate-wide net profits of $15.918 billion. Worldwide revenues in 2014 were $476.294 billion with a gross profit margin of 24.3 percent.  In the United States, the company has 1.2 million "associates" or employees as the rest of the world knows them.  This makes Walmart the biggest single private employer in the United States.  According to Forbes, it also happens to have the wealthiest family in America as its owners with Christy Walton having $41.1 billion in assets putting her in sixth place in the U.S. pantheon of the most wealthy, Jim Walton, the youngest son of Walmart founder Sam Walton having $40 billion in assets, putting him in seventh place, Christy's sister-in-law and Sam Walton's daughter, Alice Walton, having $38.5 billion in assets, putting her in eighth place and S. Robson Walton, Sam Walton's oldest son, and Walmart's current Chairman of the Board having a mere $38 billion in assets in 2014, putting him in ninth place.  Not only is Christy Walton one of the richest people in the United States, she is the wealthiest woman in the world.  While all of this information may seem like an unnecessary aside, Walmart, like many of its corporate peers, prides itself on its ability to pay higher and higher levels of dividends to its shareholders.  Walmart proudly announced that it had increased its dividend for the 41st consecutive year to $1.92 per share.  Here is a look at how many shares Walmart's key Walton insiders control from the company's 2014 Proxy Statement:

As you can imagine, by controlling millions of Walmart shares, every time Walmart raises its dividend, the Walton family gets substantially richer.

With that as background, let's look at a report by Americans for Tax Fairness that gives us an idea of how much Walmart pays in taxes and what accounting maneuvers it makes to avoid paying more than it already pays.

As we know, the headline corporate tax rate in the United States is 35 percent.  While they like to complain, most companies pay nothing that even approaches this rate.  Walmart is no exception.  Over the period from 2008 to 2012, Walmart's effective tax rate was 29.1 percent, with loopholes allowing the company to reduce its tax bill by $5.1 billion over the five year period.  Walmart accomplished this by using "accelerated depreciation" which allows companies to write-off any capital investments that they make faster than those capital goods wear out.  In straight-line depreciation, an asset depreciates at the same rate throughout its useful life.  When companies use accelerated depreciation, as time passes, the effect reverses and there is less depreciation available to shelter income.  Accelerated depreciation is a means of deferring taxes into the future but as long as a company continues to make new capital investments, the tax deferral mechanism becomes more or less indefinite.

As a company that operates outside of the United States, Walmart is also able to avoid paying taxes on its ample offshore profits.  In 2008, Walmart's offshore entities earned net profits of $10.5 billion.  This rose to $21.4 billion in 2013 as shown on this graph which also shows how Walmart's capital expenditures on its international operations have not risen since 2008:

Walmart will pay $0 in taxes on these offshore profits as long as they are not returned to the United States.  Under a territorial tax system, all U.S. taxation of Walmart's overseas profits would be eliminated and Walmart would pay taxes solely in the country in which they are earned.  Countries with lower corporate tax rates than the United States will then become particularly appealing targets for operational expansions as shown on this chart which shows the top ten nations receiving additional profits under a territorial system and their effective tax rates on United States affiliates:

This means that Walmart would be creating jobs outside of the United States rather than at home, in fact, this commentary shows that a territorial tax system would created 800,000 jobs in low-tax nations.  

As I am prone to do, let's see how busy Walmart has been in Washington.  Here is a screen capture showing how much Walmart has contributed to political candidates in the 2014 cycle:

Walmart's 2014 cycle contributions of $2,403,466 puts the company in 88th place overall among 16,411 donors.

Here is a chart showing the actual size of the overall contributions made to Democrats and Republicans:

It is quite clear that Walmart/the Walton family have a strong preference for donations to the Republicans over the Democrats.  It's also interesting to see how the level of their donations rose markedly during the 1990s and how the level has pretty much flatlined since the 2004 Presidential cycle.

Here is a graph showing how much Walmart has spent on the all important game of lobbying in Washington since 1998:

So far in 2014, Walmart has spent $5.22 million on lobbying.  In its peak year of 2011, Walmart spent  $7.84 million on lobbying.  As you can see on this chart, thus far in 2014, among its retail sector peers, Walmart has spent the second-most on lobbying after CVS Health:

In 2014, Walmart has 74 lobbyists with 81.1 percent being revolvers, that is, they have previous connections/employment in Washington.  

Here is a chart showing the issues that have been of most concern to Walmart in 2014:

Not surprisingly, Walmart is most concerned about taxes.

Now, let's travel to an imaginary world for a moment and pretend that America actually has a functional Congress.  If Congress were to sit down and agree to lower the headline corporate tax rate by 10 percentage points to 25 percent, based on the $87 billion in profits that Walmart earned over the five years from 2008 to 2012, they would have paid $3.6 billion less in taxes or $7 billion less over a ten year period.

Perhaps instead of its former "Always Low Prices" motto, Walmart's could recycle and revise its new motto to read "Always Low Taxes".

Tuesday, November 25, 2014

Recessions, the Output Gap and Central Banks

A recent paper by the Federal Reserve looks at the impact of the global financial crisis on the economic recovery in many of the key economies of the world and whether the impact of major crises on economic output is temporary or permanent.   This issue is particularly pertinent, given that the recovery since the Great Recession has been far weaker than what would normally be expected, particularly given the massive doses of monetary policy that the world's key central bankers have injected into their respective economies.

Here is a graphic showing the projected GDP trend (in dashed black) using the growth rate from the fourth quarter of 2007  and the actual GDP in red since the Great Recession for the United States, United Kingdom, Euro-area and Canada:

You'll notice that in each case, post-Great Recession GDP has fallen well short of where it would have been had the economy continued to grow at pre-Great Recession rates (the gap between the dashed black line and the red line).  This could be termed an "output gap".

Here are the actual GDP/output gaps for the early months of 2014:

Note that the largest gap is in the Eurozone where 15.9 percent of potential GDP has been shaved off, followed by the United Kingdom at 14.07 percent, the United States at 9.93 percent and Canada at a rather measly 4.92 percent.

The study goes on to look at all 149 recessions since 1970 for 23 advanced economies to see how growth rates compare after recessions.  Since the authors wish to measure the impact of both modest and severe recessions on economic growth, they exclude the Great Recession  which leaves 117 recessions   The authors calculate pre-recession trend growth as the four-year average growth rate for each country, two years prior to each peak and examine GDP as a percentage of this trend for each recession prior to the Great Recession.  By excluding the two years prior to a cyclic peak, the authors are able to exclude periods of potential "bubble-like" growth that may boost trend growth rates.

Here are their results:

The black line shows the level of real GDP as a percentage of its pre-recession trend around all 117 recessions, the blue line shows the level of real GDP as a percentage of its pre-recession trend for severe recessions and the blue line shows the level of real GDP as a percentage of its pre-recession trend for mild recessions.  On average, GDP remains well below the previous trend for both mild and severe recessions although the loss of output is greater for severe recessions.  You'll notice that the negative impact of even mild recessions on economic growth rates for even mild recessions appears to persist.  

Widely followed economic models have generally assumed that recession-induced output gaps will close over time because post-recession economies experience a period of above trend growth (i.e. there is a surge in economic activity, both output and demand for that output, that makes up for the lost activity during the recession that pushes the economy back to its long-term trend growth rates).   This suggests that recessions of all types, including those that are relatively mild, may have a permanent dampening effect on demand.  The research also shows us that the severity of the Great Recession on the global economy has resulted in a strong and permanently negative impact on demand that has depressed economic growth rates.  It would appear that, despite the unprecedented intercession of central banks and their monetary experiments, the global economy is highly unlikely to return to its pre-Great Recession growth rates anytime soon.  This is particularly concerning for Europe where economic growth rates look extremely anemic nearly six years after the end of the latest recession.

So much for trillions of dollars worth of quantitative easing and twisting!