Ominous Signs in the World Oil Market

Dear Reader,

Since many of our readers enjoyed the dividends article last week and there were additional questions on the topic, I'll revisit the issue. A few emails asked: "Aren't dividends the very essence of an investment?" Theoretically, yes; but in practice, no. In theory, any investment is only worth as much as the potential dividends that can be paid out to investors – the key word being "potential." As most of us know, many companies' management teams aren't fans of dividends these days. Thus, most companies will likely never pay out anything close to their worth in dividends.

Isn't the whole point of an investment to invest money and then receive a stream of income payments in return? That's one way to look at it; however, this point of view doesn't depend on a company's dividend policy. Today, I'll teach you about a little trick known in finance known as "homemade dividends." Whether or not a company pays dividends, this is still a useful tool.

Suppose that an investor owns all 10 shares of a company holding only $10. Hence, the shares are worth $1 each. The CEO promises to always pay out a 10% dividend yield. Next year, the company earns another $10. Now the shares are worth $2 each or $20 total. As promised, the company pays out a 10% dividend, or $2.

What's left for the investor after the dividend? He now has $2 cash and $18 in stock (each worth $1.80 since the 10 shares have an underlying value of $18). If this dividend matches his cash-flow needs, then this is great. However, what if the company doesn't pay dividends? How can the investor get to the exact same outcome?

Let's start with the same story again. The investor owns the same shares and sees the price rise the following year – except in this case, the company does not pay out a dividend. At the end of the year, the investor has 10 shares worth $2 each for a total of $20 in stock and $0 in cash. How can he get from here to owning $18 in stock and having $2 in cash? Easily – he just sells one share.

After selling a single share, the investor will have nine shares remaining worth $18 and $2 cash in the bank. This is what financial professionals like to call a "homemade dividend." So, as you can see, it doesn't matter if a company pays dividends or not; one can adjust the cash flows out of one's investments at one's own pace.

However, there are both benefits and downsides to homemade dividends. First of all, there's the issue of capital gains versus the dividend tax rate. For identical payouts, the homemade dividends are only equal to regular dividends when the stock has been held for over a year. Otherwise, the short-term capital gains tax will be higher than the dividend tax rate. Second, there are transaction costs to selling shares, but with cheap discount brokerages available today, this shouldn't be a huge deterrent to homemade dividends in most cases.

There are some advantages, as well. My example of the 10% dividend yield is a bit unrealistic. What's more likely to happen is that dividends will lag the capital gains of a company. If the stock doubles tomorrow, more often than not the dividend will not immediately adjust. As a result, homemade dividends allow the investor to take out as much money from the company as he or she wants. One doesn't have to wait for the company to adjust dividends higher.

We recommend this in our paid-subscription services. For example, our readers may be familiar with the "Casey Free Ride." Essentially, we sometimes take our initial investment off the table following a large price spike. For example, if one invested $10,000 in a stock, and now it's gone up to $17,000, we'll sell $10,000, and let the rest ride. Though we call this the Casey Free Ride, it's technically a very large homemade dividend. And guess when we do this most often… with speculative mining stocks that don't pay dividends.

The point to take away is that there's nothing companies must do in regards to dividends. It's all in each investor's hands to decide how much money to invest and how much to take out.

Next, the Casey Research energy team will discuss a couple of noteworthy events from around the world in the oil business; then I'll return with more general links of interest.


Oil News Roundup

By the Casey Research Energy Team

Qatar Hedges 2012 Oil

A debt-mired global economy needs less oil than one with its books in order, and it seems at least one Middle-Eastern oil producer is concerned that falling demand will depress oil prices enough to warrant spending a fair chunk of change on insurance.

OPEC cartel member nation Qatar seems to have hedged about a quarter of its 2012 oil production, buying put options – contracts that give the holder the right, but not the obligation, to sell at a predetermined price and date – covering about 200,000 barrels of oil per day (bbl/d). We say "seems" because Qatar's government did not announce its move; rather, bankers and brokers noticed signs of a major hedging effort starting in August with a notable surge in option buying and tracked the activity back to Qatar and Mexico.

Over the last two decades Qatar has rarely hedged its oil. Mexico, on the other hand, regularly hedges its oil production; its oil options represent the world's single largest hedge in any commodities market by value. It is also one of only a few major hedging programs carried out by a nation rather than by a company. Mexico hedged the bulk of its net exports for the year, assuring a price of US$75 per barrel for its 800,000 bbl/d. In the past, Mexican officials described the hedge as insurance "against a really bad outcome" for the global economy, not as a bet on the direction of oil prices.

WTI Price Curve Reverses Abruptly into Backwardation

The price of West Texas Intermediate (WTI) crude oil – the North American benchmark – has been pretty stable over the last few months, staying between US$75-$90 per barrel since the start of August. In fact, a barrel of WTI crude cost almost the same amount – $91 – in January, before the Libyan revolution pushed prices up.

The relative stability of the spot price, which always grabs center stage, belies an explosive transition taking place in the wings. Last week, for the first time since the start of the global financial crisis in September 2008, the WTI spot price was higher than the price of its forward contracts.

A price curve that slopes downward in that way is called "backwardation"; it signals a tight balance between supply and demand at present. The opposite situation, where the supply-demand balance is expected to tighten and prices to rise with time, is known as "contango." After three years of contango, WTI has suddenly and dramatically shifted into backwardation.

The shift came as US oil inventories dropped below the five-year average. Physical oil traders have been warning for months that global oil supplies were running too low. Last year at this time, US crude stocks sat 70 million barrels above the five-year average; by two weeks ago the surplus was gone, and stocks are now 10% lower. European inventories started to drop six months ago, pushing Brent oil prices into backwardation in March when Libyan oil supplies dried up. Then Asian stocks started to fall, pushing Dubai crude also into backwardation. Finally, the US has realized that it, too, is short on immediate supplies of oil.

The realization that US crude stocks are limited sent December WTI crude – the contract for immediate delivery – to US$91.27 a barrel on October 24, above all the forward contracts up to December 2019. The move into backwardation pushed trade volumes at Nymex (the New York-based exchange home of WTI) to their highest levels in almost six months as hedge funds that had bet on contango exited their positions en masse.

The drama of the shift into backwardation is more apparent looking back in time. In January, the one-to-twelve month WTI price spread showed a contango of US$3.28 per barrel (meaning WTI crude for delivery in 12 months' time cost that much more per barrel than oil for delivery in one month). When the WTI forwards market changed direction last week, the 12-month spread closed at a backwardation of US$0.75. That's quite a swing.

What do these forward prices mean for oil today? Well, there are three scenarios. The global economy could slow, reducing oil demand and easing pressure on supplies. Oil production could increase, with increased volumes from Libya and the resolution of supply glitches in Angola, Nigeria, and the North Sea. Both of those scenarios would reduce current prices. If neither demand nor supply eases, however, oil prices will likely agree with the market and track higher, at least for the moment.

Speaking of Angola...

With Libya stealing the spotlight, Angola's oil production woes have received scant attention. But supply disruptions in the west African country have undoubtedly helped keep Brent oil prices aloft this year. Thankfully, many of those glitches are close to being resolved, and new fields are set to come online.

Angola joined the OPEC cartel in 2007. In 2010 the country pumped an average of 1.85 million barrels of oil a day (bbl/d), but this year its average has fallen to just 1.65 million bbl/d. Though the country only supplies 2% of global output, Angola's oil is very low in sulfur, making it a sought-after commodity.

Angola deserves credit for boosting production notably in the last decade – in 2001 the country produced only 750,000 bbl/d. However, that momentum stalled starting early last year due to a lull in new projects coming online and production issues in several fields. With less Angolan oil available, China and India both bought more crude from Nigeria, another low-sulfur producer. Nigerian oil usually goes to Europe, so increased demand helped lift Brent prices.

Now it looks like oil production in Angola is getting back on track. Output jumped to a 16-month peak in September. Two majors – ExxonMobil (NYSE.XOM) and BP (NYSE.BP) – have almost resolved issues at their Angolan operations. And several new fields are about to come online. In fact, Angolan production is expected to increase by 400,000 bbl/d over the next year. OPEC may limit the amount available for export, but even so Angola could become a downward force for Brent prices.

[Energy markets are notoriously volatile, but even so, like many sectors these days, the volatility has increased. Without a clear plan in mind, an energy investor can get whipsawed. Don't let that happen to you: a subscription to Casey Energy Opportunities will provide you with expert analysis and specific stock recommendations, including entry and exit prices. Start your risk-free, three-month trial subscription right now.]


Additional Links and Reads

Hong Kong Home Prices May Fall as Much as 45%, Barclays Forecasts (Bloomberg)

According to Barclays Capital, the Hong Kong real-estate market could either take a hard fall of 35% to 45% or a soft landing of 25% to 30%. I'm always skeptical when anyone mentions a "soft landing." These gentle landings are often discussed but rarely seen.

Most Americans Believe Crime in US Is Worsening (Gallup)

A few days ago I highlighted changing attitudes toward gun laws. This poll might explain why:

(Click on image to enlarge)

As I noted previously, fear is spreading beyond just the stock market and the economy. It has spread even to perceptions of crime – even though actual crime statistics are down.

Democrats in Congress Attempt to Eat on $4.50 a Day to Protest Potential Budget Cuts (Huffington Post)

This seems like an interesting protest: nine congressional Democrats are attempting to live on only $4.50 a day each. However, their spending doesn't seem to reflect the actual budget of someone living under these circumstances. Look at Rep. Speier's purchasing decisions – with her small sum, she purchased a bag of coffee, popcorn, a can of chicken noodle soup, and a can of sweet peas. Is that really how a hungry person would spend that money?

First of all, someone who must live on $4.50 per day will almost certainly not waste money on popcorn or coffee. Second, a can of soup will not fill one person's belly, let alone a family – so that wouldn't be purchased either. During college, I had some extreme budgets. Here's one of my easy recipes: Buy a jambalaya mix box, a sausage, and a bag of rice. With these ingredients, one can make an enormous batch of jambalaya for $5-6. It would often last me three days. The same thing can be done with red beans and rice, for an even cheaper alternative. If you're really trying to feed yourself on a miniscule budget, cheap carbs are the key. Sure, it became monotonous after a while, but I certainly wasn't starving.

These congresspeople are not actually trying to live like the poor; this is just an unrealistic publicity stunt. If one is spending one's food money on coffee and popcorn, then you know this experiment is BS. I bet that they're secretly eating their usual lobbyist-purchased lunches. This would be an interesting protest were it actually followed.

That's it for today. Thank you for reading and subscribing to Casey Daily Dispatch.

Vedran Vuk
Casey Daily Dispatch Editor

Nov 01, 2011