FINANCIAL REVIEW

Earnings Season Kickoff

Sinclair Noe — January 12, 2015

Podcast: Play in new window | Download (Duration: 13:16 — 6.1MB)

DOW – 96 = 17,640
SPX – 16 = 2028
NAS – 39 = 4664
10 YR YLD – .06 = 1.91%
OIL – 2.58 = 45.78
GOLD + 10.00 = 1234.40
SILV + .09 = 16.71

The drop in the price of oil has been amazing; the daily moves are big: 3%, or 4% or more on any given day (5% today). Eventually prices will bottom out but we get no indication of where that bottom is. Today, Goldman Sachs made sharp cuts to its oil price projections. The bank’s energy analysts revised down their three-month forecast for WTI crude to $41 a barrel from a previous estimate of $70. They see WTI at $39 a barrel in six months and $65 a barrel in a year, versus previous price forecasts of $75 and $80, respectively. They see Brent at $42 in three months, $43 in six months and $70 in 12 months versus previous estimates of $80, $86 and $90, respectively.

When oil is trading at $45 and falling, it really isn’t shocking to say it could drop to $41. Goldman Sachs is playing catchup, and today’s revisions clearly show that their earlier estimates were grossly inaccurate.

In an interview with Maria Bartiromo of Fox Business News published in USA Today, Saudi Prince Alwaleed bin Talal said: “If supply stays where it is, and demand remains weak, you better believe [the price of oil] is gonna go down more. But if some supply is taken off the market, and there’s some growth in demand, prices may go up. But I’m sure we’re never going to see $100 anymore.”

Alwaleed said the Saudi government and other oil producers were caught off guard by the steep drop in oil prices. A lot of people were caught off guard, and right now all the forecasts amount to nothing more than guesses. Your guess is as good as Goldman’s or the guess of a Saudi prince.

The collapse in oil prices is set to crimp one of the few fast growth areas for banks since the financial crisis – lending to the energy industry. Banks have been underwriting bonds, advising on mergers, even financing the building of homes for oil workers. All of this has provided a boon to banks that have been struggling to find more companies and consumers wanting to borrow. When times are good, the capital-intensive oil business is a banker’s dream. From new wells dug in North Dakota and Texas to the oil patch of Alberta, oil producers have turned to Wall Street and local banks to help them sell billions of dollars in bonds, raise equity and arrange lines of credit. As oil prices drop, some energy companies will be unable to service their huge debts, and defaults are likely.

We know that the energy sector is a big part of the investment banking revenues of several big banks; nearly 12% of investment banking revenue for Citibank, 20.2% for RBC Capital Markets, 34.6% for Scotiabank, 14.9% for Wells Fargo Securities. These revenue sources are likely to dry up. A precipitous drop in oil prices can quickly turn loans that once seemed safe and conservatively underwritten into risky assets. The collateral underpinning many energy loans, for example, is oil that was valued at $80 a barrel at the time the loans were made. As oil has dropped well below that price in recent months, the value of the banks’ collateral has sunk. Many oil companies have bought hedges on oil prices, which are providing lenders with additional cushion. But when those hedges expire, and if oil prices remain low, the banks may need to reserve money against the loans.

It’s not a crash right now but it is a slowdown and we’ll find out more as the banks report quarterly earnings later this week. You can bet that analysts and investors will be asking about the pain of that slowdown and demanding forward guidance. Investors in the junk bond market, of which energy companies account for an estimated 18%, are not so optimistic. Junk bonds issued by energy companies are signaling a significant increase in the number of defaults in the coming months. Yields on energy junk bonds appeared to be predicting that 6% of the bonds would default this year, and even more in 2016.

The sidebar story is that banks always chase hot money, whether it’s the housing market or the energy market. So as credit in the oil patch slows down, the bankers are likely to move their fast money. Where? One possibility is to consumer businesses. The less cash consumers have to spend filling up their gas tanks or heating their homes, the more emboldened they may feel to sign up for a credit card or take out a mortgage. The banks have already put us in their crosshairs.

Make no mistake, low oil prices are good for the US economy. The banks are going to have to weather this mess on their own – no bailouts this time. Meanwhile, the good stuff is not just more money left in your wallet when you fill the tank. Low oil prices have declawed the Russian bear, and this all seems more than just a bit coincidental, coming on the heels of Russia’s invasion of Ukraine. This weekend, Venezuela’s president Nicolas Maduro stood beside Iran’s Hassan Rouhani as they urged OPEC members over the weekend to “neutralize schemes by some powers against OPEC and help stabilize an acceptable oil price in 2015.” Heavily relying on high prices to drive their economies, the current plunge in oil has placed a severe strain on the two countries.

Alcoa kicked off the earnings reporting season after the close of trade today. Yes, we have had a few scattered earnings reports over the past week or so, but Alcoa was always considered the first major company to report. It used to be one of the Dow 30 Industrial stocks and the ticker symbol is AA, so it was just an alphabetical distinction, but the tradition carried over. Alcoa reported a net profit of $159 million (or 11 cents per share) compared with a loss of $2.3 billion a year earlier. Excluding restructuring costs, Alcoa’s net profit was $432 million or 33 cents per share, beating estimates of 27 cents. Revenue grew by 14%. Alcoa shipped a record volume of automotive aluminum sheet in the quarter. Auto companies such as Ford Motor, which started making its lightweight, aluminum-bodied F-150 pickup in November, are using more of the metal to boost fuel efficiency.

The energy sector is expected to whack overall profits. Forecasts for first-quarter profits in the Standard & Poor’s 500 Index have fallen by 6.4 percentage points from three months ago, the biggest decrease since 2009. Reductions spread across nine of 10 industry groups and energy companies saw the biggest cut. Either there is nothing to worry about and crude bottoms out real fast, or we have entered an earnings down cycle for an appreciable portion of the market. American companies are facing the weakest back-to-back quarterly earnings expansions since 2009 as energy wipes out more than half the growth and the benefit to retailers and shippers struggles to play catch up.

Profit is forecast to have grown 2% in the final three months of 2014 and increase 2.8% for the current quarter, down from analysts’ October estimates of 8.1% and 9.2%, respectively. Without energy companies, profit gains would have been 4.7% and 7.8%, the most recent projections show. Of course, you and I have been around long enough to know that part of this is a game played by the companies and the analysts to lowball earnings estimates, and then beat the diminished expectations. Companies are fairly pessimistic, or lowballing more than usual, as 81% of those providing an earnings outlook for the fourth quarter have given one that has fallen below the Wall Street consensus. And we can probably look forward to a new phrase to justify weak results: earnings “ex-energy”; in other words, the company could have had a nice earnings report except for one excuse or another.

On Friday we covered the jobs report; the numbers for December were pretty good, the economy added 252,000 jobs and the unemployment rate fell to 5.6%; it was the 51st consecutive month of job gains. That’s all good. But unfortunately, it’s still nowhere near where it needs to be.

According to recent analysis from the nonpartisan Economic Policy Institute, the U.S. economy is missing about 5.6 million jobs. That’s the number of additional jobs there would be if the economy regained all jobs lost in the recession and the job market kept pace with the natural increase in job seekers. Each year, the population keeps growing, and along with it, the number of people who could be working. To get back to the same labor market we had before the recession, we need to not only make up the jobs we lost, but gain enough jobs to account for this growth.

If the economy continues to expand at a rate of 353,000 jobs per month — that’s the number of jobs added in November 2014, which was the best month for job growth last year — the job market will be fully recovered in August 2016. If the job market improves at the same rate it did last year, adding an average of 246,000 jobs per month, the labor market won’t be fully recovered until August 2017. The EPI analysis did not say how much we would need to make up for the slow growth in wages.

After we wrap things up today at the old radio ranch, I’ll head home to watch the national college football championship game between Ohio State and Oregon. If you watch the game be sure to take note of the end zone. Rather than end zones painted in each school’s colors, as is typical for bowl games and the now-defunct BCS National Championship Game, the end zones in AT&T Stadium will be black, with merely the College Football Playoff logo and each school’s name. Next to the team names, it will feature a gold football logo on a black field. That football logo matches the football on the championship trophy, also gold and black. In fact, that gold on black logo is all over the place. And that is today’s lesson in branding.