Source: Bloomberg, as of June 2022.
You might have gotten the impression from listening to the news that oil drillers have not reacted at all to the rise in the price of oil over the last year. Yet the rig count has roughly tripled, from a low of 180 to its most recent level of 574. True, the increase in the rig count has not been proportionate to the rise in the price of oil the way that it was after the financial crisis of 2008, but keep in mind that this earlier period saw the spread of the new hydraulic fracturing technology (i.e., “fracking”), and that has made wells more productive (in terms of output) than they used to be. In Figure 2 we look at the rig count again, but also at the actual production of oil (in thousands of barrels per day) (Figure 2).
Source: Bloomberg, as of June 2022..
Oil production in the U.S. had peaked at around 10 million barrels per day back in 1970 and, by the early 2000s, had fallen to half of that level. But fracking drove a huge boom in oil output, even under the purportedly “anti-oil” (at least if it came from federal lands) Obama administration. By the beginning of 2020 the U.S. was producing almost 13 million barrels per day, until COVID came along and crushed the demand for energy. But output began to recover by the end of that year and today, the U.S. is producing 25% more oil per day than it was in 2014, with only about a third as many rigs operating. Yes, output could be higher if the oil companies operated more rigs (or added new ones), but that decision is influenced by a mix of factors, from government policy (which turned rhetorically hostile to fossil fuel production again after the Biden administration came in), to doubts about the economic outlook as the Fed raises interest rates to try to curb inflation, to yes, concerns that additional wells will not earn a good return on investment if the price of oil falls in response to increased production (or to an economic slowdown). That last factor is a perfectly legitimate one for companies to consider. To believe, however, that this factor, and this factor alone, is somehow restricting the supply of oil is to ignore both the importance of the other factors involved, as well as the actual data on how much oil is still being produced, which is only about 10% off its all-time high. Investors demanding good returns on investment have not created some huge oil production shortfall.
Now let’s turn to housing. Figure 3 shows the number of housing starts in the U.S. on a monthly basis going back fifty years (Figure 3).
Source: Bloomberg, as of January 2022.
Housing starts collapsed between 2006 and 2009, for well-known reasons – i.e., we were way too lax in lending money to people who really couldn’t afford it so they could buy houses in the years leading up to 2006. The result was that vast numbers of people defaulted on those loans, creating a huge overhang of houses for sale that took several years to work off, not to mention sparking a huge financial crisis as banks found themselves holding all sorts of suddenly much less valuable derivative securities tied to those now-defaulted mortgages. Since 2009, however, housing starts have marched steadily upward, thanks to generally rising incomes and low interest rates, which have made houses affordable to many new buyers. In recent months, housing starts have been at a higher level, apart from the peak years of 2003-2006, than at any time over the last thirty-five years. And as we just discussed, the numbers during that peak period were in essence artificially boosted by what turned out to be disastrously generous lending standards – hardly a benchmark we should hold out as our goal. (Today’s numbers would look lower compared to the past if we adjusted for population growth, admittedly.) So, as we saw with oil, there really isn’t strong evidence that return-conscious investors have been driving some sort of restrictions on housing supply. Why are rents rising in some places? You can blame a host of other factors for localized supply issues: zoning regulations and “not in my backyard” opposition to more housing, among others. But it seems silly to blame it on investors wanting to earn a good return.
Earning a return on invested capital that is higher than the cost of that capital is simply the way a company increases its value. It is no different than the way an individual increases his or her net worth. If you went out and borrowed money at a 5% interest rate and invested it in a project that earned 9%, you would grow your wealth; if the project only earned 3%, you would find your wealth reduced once you paid off the loan. That is not a sustainable outcome for companies any more than for individuals.
To see what happens when an industry fails to earn its cost of capital, consider the U.S. airline industry’s performance over the decades. For years, the industry struggled with the effects of too much capacity for a product – a seat on a flight – whose value depreciated to zero if the flight took off with the seat empty. This combination led to endless fare wars, which were great for consumers but terrible for the profitability of the airlines, many of whom made more than one trip through bankruptcy. Figure 4 shows how the S&P 500 Airline Index performed compared to the overall S&P 500 since the end of 1989 (Figure 4).
Source: Bloomberg, as of December 2021. Past performance is no guarantee of future results. It is not possible to invest directly in an index.
Over the 25 years through 5/31/22, the S&P 500 Airline index produced an annualized total return of just 1.2%, compared to 8.5% for the S&P 500. But even 3-month Treasury Bills*, the ultimate risk-free investment, earned 1.9% per year over that time. Investing in an industry that earned poor returns destroyed wealth for those investors.
Airline consolidation eventually solved the capacity issue, reducing the frequency of unprofitable discounting and enabling airlines to start charging additional fees (for luggage, meals, etc.) without worrying whether other airlines would follow suit. Profitability within the industry did improve over time, and the stocks enjoyed better relative returns (outperforming the S&P 500 for the decade ending in 2018, for example). Consumers, having been spoiled by the years of cheap airfares they previously enjoyed, could (and did!) complain in recent years that the airlines’ ability to earn better returns on capital had come at their expense. The truth is that when they were enjoying those cheap airfares in earlier years, they weren’t bearing the true cost of their flying – airline investors were. And it was not unreasonable for those investors to want the airline industry to change the way it operated, even if it meant higher fares for flyers. No industry can be expected to survive if it is not creating value for the investors in that industry. And that would be the worst outcome of all for consumers. Earning good returns on capital is not an obstacle to satisfying consumer demands; it’s what enables companies to continue to satisfy those demands.
1. Source: CBS News, “U.S. producers reluctant to drill more oil, despite sky-high gas prices,” as of March 25, 2022.
2. Source: Bloomberg, “Why is the cost of rent going up? Ask the federal reserve,” as of June 18, 2022.
3. Source: Huffpost, “How Wall Street’s short-term fixation is destroying the economy,” as of November 6, 2015.
4. Source: Wall Street Journal, “Short termism is harming the economy,” as of June 6, 2018.
The S&P 500 Index is a stock market index tracking the stock performance of 500 large companies listed on exchanges in the United States.
The S&P 500 Airlines Index is a stock market index tracking the stock performance of large companies in the airlines industry in the United States.
Treasury Securities are backed by the full faith and credit of the United States government as to payment of principal and interest if held to maturity. Interest income on these securities is exempt from state and local taxes.
The information contained in this paper is distributed for general informational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. The information contained in this paper is accurate as of the date shown, but is subject to change. Any performance information referenced in this paper represents past performance and is not indicative of future returns. Any projections, targets, or estimates in this presentation are forward looking statements and are based on Epoch’s research, analysis, and assumptions made by Epoch. There can be no assurances that such projections, targets, or estimates will occur and the actual results may be materially different. Other events which were not taken into account in formulating such projections, targets, or estimates may occur and may significantly affect the returns or performance of any accounts and/or funds managed by Epoch. This material is provided as a resource for information only. Neither New York Life Insurance Company, New York Life Investment Management LLC, their affiliates, nor their representatives provide legal, tax, or accounting advice. You are urged to consult your own legal and tax advisors for advice before implementing any plan.
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