A Patch of Problems

By David Stockman  |  September 18, 2018

Strange, strange are the dynamics of oil and the ways of oilmen.

– Thomas Pynchon, Gravity’s Rainbow (1973)

“Unhinged” is the only word to describe the Acela Corridor today.

A major consumer brand built an entire ad campaign around the social media habits of the President of the United States of America.

Millions of people burned merchandise they’d already paid for to protest it.

The stock price of the company took a short-term hit. But it got back to new highs within several trading sessions…

And that’s the punch line, brought to you by Bubble Finance.

Since 2010, Nike’s (NYSE: NKE) market cap has grown by $100 billion, or 18.5% per year.

During the same period, its free cash flow has grown by the grand sum of 4.2% a year.

Eight years ago, the stock traded at 12 times free cash flow. That’s the kind of multiple you’d expect to pay for growth like Nike’s shown.

But “valuation expansion” means Nike’s trading at 33 times free cash flow.

Forget the Kaepernick Kaper. It’s still not clear why Nike was a $131 billion company in the first place.

But if Wall Street is unhinged so, too, is Imperial Washington.

This morning, we have news that Democrats may succeed in derailing what was once an inevitable confirmation of Judge Brett Kavanaugh’s nomination for a seat on the Supreme Court.

That’s on top of news that Paul Manafort is cooperating with Prosecutor Mueller…

And that’s on top of the Woodward book…

And that’s on top of the Donald’s Trade War…

And that’s on top of the Federal Reserve’s “normalization”…

Still, Wall Street believes none of what’s happening – including the Tweeter-in-Chief fulminating his way onto the Dick Nixon Memorial Helicopter – threatens the market or the economy.

Let’s take a look at more potential unintended consequences – in addition to the investing class’s torpor – of monetary central planning.

Valuations are extended. And this weak and old recovery is nearing its sell-by date. All it takes is a catalyst.

We’ve noted several in recent weeks. The U.S. energy sector – where the shale “boom” is happening – is another.

Indeed, The New York Times and solid-as-they-come reporter Bethany MacLean hit it a couple weeks ago: The Next Financial Crisis Lurks Underground.

It’s a cogent explanation of why the end is near: The industry produces a lot of oil and gas but never cash.

McLean notes:

The 60 biggest exploration and production firms are not generating enough cash from their operations to cover their operating and capital expenses. In aggregate, from mid-2012 to mid-2017, they had negative free cash flow of $9 billion per quarter.

Alas, “These companies have survived because, despite the skeptics, plenty of people on Wall Street are willing to keep feeding them capital and taking their fees.”

From 2012 through 2017, these 60 E&Ps burned $212 billion in the shale patch. Half of that came from liquidation of balance sheet capacity through borrowing and asset sales. The other half was through new equity issues.

Yes, the “shale revolution” put the U.S. on a path toward “energy independence.”

All it took was the massive falsification of asset prices on Wall Street.

That’s what made it possible for energy companies to raise endless amounts of capital to finance money-losing operations.

As interest rates “normalize” and rise, the flow of cheap debt to the energy patch is going to dry up. That’ll put the brakes on E&P activity.

The real problem is all the E&P debt that’s coming due, soon.

Rising yields will push the “carry cost” of that debt higher and higher. That will require more and more cash. And the rollover requirements for existing debt will soar at the same time.

This is not a virtuous cycle.

In fact, it’s pretty unhinged.

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David Stockman

David Stockman is the ultimate Washington insider turned iconoclast. He began his career in Washington as a young man and quickly rose through the ranks of the Republican Party to become the Director of the Office of Management and Budget under President Ronald Reagan. After leaving the White House, Stockman had a 20-year career on Wall Street.MORE FROM AUTHOR