Today, the price per barrel of West Texas Intermediate reached a low of -$40.32. That’s right: the price was negative.
West Texas intermediate (WTI), also known as Texas light sweet, is a grade of crude oil used as a benchmark in oil pricing.
Everyone has the same question: How is this possible?
The reality is that there is simply too much oil being produced right now and not enough demand. Production is being curtailed globally, but that takes time. It’s not like a light switch that can simply be turned on and off.
The chart below shows supply and demand for the world oil market going back to 2000. As you can see, most of the time there tends to be minor variance between supply and demand.
In contrast, today the gap between supply and demand is extremely wide. This means there is a massive surplus of oil being produced right now.
That oil needs to be stored somewhere, and as storage capacity is maxed out fewer people are willing to take delivery.
With May 2020 WTI futures contracts expiring on April 21, oil producers are desperate to offload about 100 million barrels. With limited storage and plummeting demand, producers are now forced to pay others to take the oil off their hands. Nobody wants to take delivery and the oil has to go somewhere.
You read that right. Oil producers right now must pay others to take delivery of their oil. Of course, anyone taking delivery must have somewhere to put it and means to transport it. That all costs money.
Vanguard Energy ETF (VGE), Exxon (XOM), ConocoPhillips (COP), Chevron (CVX) and Canadian Natural Resources (CNQ) are getting hurt badly today. However, the United States Oil Fund (USO) is down even more, more closely reflecting the maturing May contract.
Is this epic collapse an epic opportunity?
Beware if you’re considering buying an ETF that buys oil futures like the United States Oil Fund (USO). These types of ETFs shouldn’t be used to get long-term exposure to oil.
Oil ETFs tend to invest by purchasing futures contracts (i.e. they don’t actually buy barrels of oil). When a futures market is in “contango” (see chart below) futures contracts expiring near-term have a lower price than those expiring farther out into the future. The oil futures market is currently in record contango. Indeed, there is currently (mid-day April 20th) roughly a $50-60 spread between the May and June contract.
Even if prices along the futures curve for Oil remains constant, when the market is in contango an oil ETF that buys futures contracts will experience a negative roll yield as future contracts approach expiry and converge with lower spot prices. This is a great way to lose money over the long term. Oil ETFs that invest in futures contracts are best used for very short term trades.
If you are brave enough to invest in energy right now as a long term play, I would instead choose an ETF that invests in actual producers.
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Theoretical purists will hate this, but I love dividend stocks. I know total returns are what really matter in the end, but I truly appreciate the discipline forced on executives managing a dividend paying company. As an added bonus, there are also psychological benefits to owning dividend paying stocks.
Executives at dividend paying companies don’t want to cut their dividend. Consequently, they work harder to preserve and grow cash flow. They also are more likely to return excess cash to shareholders instead of spending it on pet projects and empire-building. I believe dividends enforce a level of discipline on corporate executives.
Moreover, a tangible, growing cash return provides a psychological buffer to the unpredictable ups-and-downs of the stock market. An investor that believes he will continuously receive his dividends will be less likely to make emotional sell decisions when things get difficult. Things are difficult right now.
During the Covid-19 coronavirus crisis, stock prices have plummeted. As stock prices plummet dividend yields have exploded. (Dividend yield = $ dividend per share / share price) This has attracted the interest of many investors that read this blog.
Just look at the sexy dividends in the table below (as at April 1, 2020). But beware – high dividend yields are sometimes like a siren’s call, attracting yield-chasers to their doom.
While on the surface a high dividend yield can look appealing, there is much more that needs to be considered.
Dividends are not guaranteed. They can be reduced or even eliminated. It has happened many times and will continue to happen in the future.
Broadly-speaking, Goldman Sachs is predicting the aggregate of dividends paid by companies in the S&P 500 will decline in 2020. According to US equity strategists at Goldman Sachs, S&P 500 dividends will decline by 25% in 2020 compared to 2019. Since dividends have already risen so far this year by 9%, that implies between now and the end of the year, dividends will decline by 38%.
The market collapse is barely a month old and we’re already witnessing numerous dividend cuts and suspensions. Here are just a few:
Boeing: Dividend suspension
Marriott International: Dividend suspension
Ford: Dividend suspension
Delta Airlines: Dividend suspension
Freeport-McMoran: Dividend suspension
Darden Restaurants: Dividend suspension
Bloomin’ Brands: Dividend suspension
BJ’s Restaurants: Dividend suspension
Macy’s: Dividend suspension
Nordstrom: Dividend suspension
A&W: Dividend suspension
Occidental Petroleum: Dividend cut
Apache: Dividend cut
Targa Resources: Dividend cut
DCP Midstream LP: Distribution cut
Sabre: Dividend suspension
At the same time, there are other companies that have (more-or-less) publicly stated they will not cut their dividend. CIBC’s CEO, Victor Dodig, on March 31st made the following statement on BNN:
So how are you supposed to know a dividend is secure?
Dividends – like price returns – must be viewed as uncertain. The likelihood of a future dividend exists on a scale of probabilities. Some are less likely to continue, others are more likely. Fortunately, there are ways to help identify dividends that are more likely to be paid in the future.
Management at companies with a long history of paying dividends are more likely to do everything they can to protect the dividend. 1) No CEO wants to be the one to break a multi-decade track record. 2) After decades of protecting the dividend, shareholder cashflow management becomes part of the corporate culture and design. 3) A company that has consistently paid a dividend throughout previous crises is likely in an industry with relatively steady demand and predictable margins (compared to other industries).
Avoid dying industries
You could own shares of the best run company with a management team committed to paying a dividend, but if that company is in a deteriorating industry the dividend still might get cut. Remember record companies, newspapers and magazines?
The challenge is that many companies in industries with a potentially big future (e.g. Tesla) don’t pay dividends. Companies in these industries might be growing fast, but they don’t yet have a stable source of cashflow. Instead, most dividend investors focus on are mature industries that will continue to stand the test of time – telecommunications, consumer non-discretionary, utilities, banks.
You’ll notice I didn’t include the energy industry. While this industry is mature and critical to the economy, it is highly cyclical and subject to the whims of the commodities markets. While there may be a place for energy companies within a dividend portfolio, I would consider these to be at the riskier end of the spectrum.
Find companies with cash to pay their dividends
When choosing dividend stocks, pick companies that can actually pay their dividends. This sounds like common sense, but when the high-yield sirens call many forget this.
Unlike many other items on financial statements, dividends aren’t some kind of accrued line-item. To pay a cash dividend a company must actually have cash. For a dividend to be sustainable, that cash must come from earnings. (Believe it or not, many companies finance their dividend payments by borrowing money.)
While I wouldn’t expect anyone to trace the origins of where a cash dividend came from, a simple measure can provide some guidance. The dividend payout ratio (annual dividend per share / annual earnings per share) indicates the proportion of earnings paid out as dividend. While companies in more stable industries can handle higher payout ratios, generally a payout ratio below 50% of earnings is very comforting to me.
Who is competing for your cash?
Stockholders get paid last. They receive the remnants of cash left over after interest payments on debt. Technically-speaking, debt is higher on the capital structure than equity. This means stockholders don’t get paid their dividends until after bondholders have received their coupons.
For this reason, when investing in a dividend paying stock you need to understand how debt affects a company’s cashflows. Conveniently, the dividend payout ratio somewhat bakes this into the calculation, since earnings per share shows what’s left after debtholders have been paid.
Still, it helps to understand how indebted the company is. This requires a bit of homework, but dividend investors should pay attention to a company’s debt-to-assets and interest coverage ratios. A heavily indebted company – especially one in a cyclical industry – will have a much harder time committing to dividend payments.
Yes, I have a life and day job
I don’t have hours a day to dive into company financials. The most prudent way to proceed is to assume at least some investments will at some point cut or suspend their dividends. (Mitigating unavoidable mistakes is part of the entire premise of DumbWealth.com.) My simple workaround is, within the equity portion of my portfolio, to diversify by spreading a portfolio across 20-30 dividend paying stocks and a range of industries.
This can be done by purchasing individual stocks or by buying an ETF that invests in dividend paying stocks.
Personally, for my long-term buy-and-hold investments I prefer to own the actual stocks. That way I avoid any perpetual fees associated with an ETF. However, this strategy would not make sense if my portfolio was small (say less than $20-30k) or if I had a shorter time horizon.
Please let me know below if you have any questions!
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The Covid-19 economic crisis is gripping the world. After 20 years in the asset management business, it looks like we are fighting through unprecedented territory.
This is war. I created a 17 step, 47 page guide to help DumbWealth subscribers get through this.
I originally planned on printing the guide and selling copies for $20+. Instead I’m giving this away free because I think we all need to help each other during these difficult times.
Dig gold? Gold is hot again and the number of supporters is quietly on the rise. Famously, billionaire investors Ray Dalio and Jeff Gundlach have both recently announced their support for the metal but there are many others coming out of the woodwork. After a multi-year hiatus it seems like the case for gold is strong again.
According to Dalio:
“…the world is leveraged long, holding assets that have low real and nominal expected returns that are also providing historically low returns relative to cash returns (because of the enormous amount of money that has been pumped into the hands of investors by central banks and because of other economic forces that are making companies flush with cash). I think these are unlikely to be good real returning investments and that those that will most likely do best will be those that do well when the value of money is being depreciated and domestic and international conflicts are significant, such as gold. Additionally, for reasons I will explain in the near future, most investors are underweighted in such assets, meaning that if they just wanted to have a better balanced portfolio to reduce risk, they would have more of this sort of asset. For this reason, I believe that it would be both risk-reducing and return-enhancing to consider adding gold to one’s portfolio.”
I have also illustrated the case for holding gold in my article “The 60/40 Portfolio is Dead“. In this article I looked at various portfolios (some including gold, others not) across different investing paradigms.
The past 40 years benefited from the tailwind of declining inflation and interest rates. Clearly, with interest rates near zero today, what worked over the past 40 years won’t work over the next 40 years. So I examined these portfolios going back to 1970 when inflation and interest rates were rising. When examined across both investing paradigms, Gold exposure was shown to stabilize returns and reduce downside.
Canadian investors looking to buy gold first have to decide whether they want to own gold mining stocks or gold bullion. My preference is gold bullion since it is a pure play on the price of gold. In contrast, gold mining stocks are influenced by extraction costs, equity risk premiums and management decisions, in addition to the price of gold. However, gold miners can be used as a leveraged play on gold since they tend to rise and fall faster than the actual metal.
For my portfolio construction purposes, an allocation to gold bullion makes the most sense.
There are a number of ETFs in Canada that buy and hold actual gold bullion stored in vaults. There are also ETFs that gain exposure by purchasing gold futures contracts. I prefer a fund that owns bullion to gold future contracts because I don’t want exposure to the added complexities introduced by the the futures market (e.g. counterparty risk, negative roll yield).
What Gold Bullion ETFs Exist for Canadian Investors?
Below I have identified 4 low cost gold bullion ETFs available on the TSX. Note that some are hedged and some are not. For a Canadian investor, owning an unhedged gold ETF, in my opinion, is the purest way to own the metal: