Category: Finance

Negative Oil Prices: Analysis and Ramifications

Laying the foundation

Benchmarks of crude oil

  1. WTI (West Texas Intermediate)
  2. Brent Blend Crude 
  3. OPEC+ reference basket

The Indian Oil Contracts trading on MCX is settled according to the New York Mercantile Exchange’s (NYMEX) Crude Oil (CL) front-month contract on the last trading day of the MCX Crude Oil contract.

Negative Prices in Commodity Market

Negative prices exist in the commodity futures market. These are an indicator of the fact that the opportunity cost of the shutdown, delivery of goods, and other administrative expenses are sometimes quite higher. In other words, it can also imply that you pay people to take the commodity off your hand.

Contango

It is a market condition where the future prices of a commodity are considerably higher than the current spot prices.

The Story so far…

The price of oil made a 34-year low since 1986 on 20th April 2020. The drop-in rates can be traced down to the futures oil market. On the surface, the negative price implies that the producers would pay traders to take away the oil. The price collapse was a market anomaly that portrays how commodities are traded.

The expiry of the May Oil Contract was on 21st April. The WTI crude futures price, which entered the negative territory and made historical lows, needs to be physically delivered at Cushing on expiry. Demand has significantly slumped due to lockdowns, and there has been a steady rise in storage and transportation costs. Also, logistic constraints need to be factored in for the physical delivery of oil. It might even lead to companies claiming force majeure clauses and violation of contracts.

 With no demand for oil and the existing reserves at near capacity, no one wanted the physical delivery of oil to accumulate it and pay for the storage costs.

Speculators are an integral part of the commodities markets too. Speculators usually buy and sell contracts with no intention of accepting or offering the delivery. These participatory speculators need to unwind their positions on the contract expiry day to avoid taking the physical delivery of oil. Speculators were unwinding the future contracts to close their positions or rolling over their contracts before the expiry might have led to such a drastic fall in prices.

The delivery-based traders backing out on the contract due to a fall in oil demand can also be attributed to this fall. A combination of both categories of traders in play has brought havoc in the oil future markets.

Many speculators rolling over their contracts to June and future expiry dates pushed down the short-term prices even more. The future prices of oil are higher, thereby leading to contango in the market. The higher rates in the future also indicate the market expectations of resuming economic activity in the coming future as lockdowns are lifted. We can also expect the storage space to be created as existing reserves will be used up. Contango trades by market participants will be the norm in the coming days. These trades essentially translate to traders buying oil at lower prices now and storing them and releasing it in the market in the future when both demand and prices rise.

Global Impact

The WTI crude price fall also has raised concerns about the liquidity crisis looming over the banks in Texas. However, the Federal Reserve has promised to back up the banks to prevent another systemic failure. The fall in prices might even lead to a deflationary scenario as the price of oil dependent products would fall, which would then raise questions on the usage of substitute cleaner sources of energy.

Impact on India

SEBI and MCX are closely monitoring the negative oil prices. SEBI will be leading the way in dealing with negative rates. Taking in mind the system failures which might occur due to such sudden drops in prices and the drop-in prices in NYMEX Oil from which MCX derives its rates, MCX has now over nightly fixed the settlement price of the contract at Re 1 with further finalizations to be announced.

India has been piling up the strategic reserves in Mangalore, Vishakhapatnam, and Padur, near Udupi. The storing capacity has also been increased to take advantage of the lower oil prices. The fall in oil prices would lead to the fall in the oil expense of the nation and can be seen as an unforeseen relief to the government in its fight against the pandemic. The current account deficit may also reduce if the economic recovery is quick, and we are able to build up momentum with an increase in Indian exports.

Sources:

  1. https://www.mcxindia.com/products/energy/crude-oil
  2. https://www.cmegroup.com/trading/energy/crude-oil/light-sweet-crude.html
  3. https://www.thehindu.com/business/explained-why-are-oil-prices-in-negative-terrain/article31394425.ece
  4. https://www.thehindubusinessline.com/markets/commodities/mcx-fixes-crude-oil-price-at-1-for-april-as-us-price-ends-at-37/article31393857.ece

Financial Modelling

The steps involved in creating financial spreadsheets can be summarized as follows:

  1. Enter Historical data of 3-5 years and calculate historical ratios and observed trends for the company.
  2. List down the assumptions for the business in the coming future and its impact.
  3. Forecast the financial statements on the basis of these assumptions
  4. Calculate FCFF and FCFE and perform DCF analysis for the firm.
  5. Check for errors. Conduct sensitivity, scenario and stress testing for the model.
  6. Create charts and graphs to present the model succinctly.

For further Reference:

  1. https://corporatefinanceinstitute.com/resources/knowledge/modeling/free-financial-modeling-guide/
  2. Damodaran SpreadSheets

MBA Finance Summer Internship Preparation

Summer Internship placements play an important part in shaping your MBA journey. A lot of effort is exerted to make the most of this opportunity by MBA candidates. Choosing the domain to pursue your career can be challenging in the early stages as you may not have knowledge about the entire spectrum of the domain, the nuances in it and the work you would have to do.

Preparations required for each and every domain like Consulting, Marketing, Operations, Finance, ProdMan and General Management differ a lot as the roles require different skills to excel in it. However, preparing for consulting can be a safe option as the preparations for consulting, marketing and GenMan have a certain overlap. This helps the candidates to have a backup option if they are not able to get an internship in their desired domain. Finance prep has inherent risk as the preparation required for the role is quite vast and is an entirely disjoint set to other domain preparation.

Time is a major constraint in an MBA students life, Fin prep itself would occupy your major time that you would hardly be left with any time to prepare for other domain. So, choose the Finance domain wisely. Finance roles typically include Investment Banking, Corporate Banking, Risk, Markets, Quants and niche roles in PE-VC segment.
Shortlists for the consulting companies would be out first, followed by finance and a few prod man companies. Shortlisting criteria for the companies differ as per the roles they have to offer.

Who should prepare for Finance roles:

CA, B. Tech Candidates who have prior experience in the Fin domain( FinTech, Trading, Risk) with enough certifications like CFA, CS, IAI or NCFM/NISM certifications to show their genuine interest in the field and B.Com.( Eco/ Stats)

Shortlists and Hotlists:
The shortlists would come to the candidates with the above-mentioned credentials to their names. As an MBA comes with its own twist and turns, getting a shortlist doesn’t have any effect as the Big Banks would have their preferred candidates who would be on their Hotlists. Evaluate your profile thoroughly and see if make the cut or prepare to face disappointment on the D-Day.

If you make the above cut, let’s get to the internship preparation:

Finance has been a wide domain in itself, it can be divided into different parts:

        • Fundamentals
        • Valuation Techniques
        • Financial Instruments
        • Economics
          1. Macroeconomics
          2. Microeconomics
        • Mergers and Acquisitions
        • PE-VC

Let’s get into the details of each segment:

    1. Fundamentals:

      Basic Accounting course in Sem 1 plays an important part here. Understanding the three financial statements of companies can help the individual to ace this part. The typical questions asked from this part would be to highlight the importance of Balance sheet, Income-statement and Cash-flow statement and to show the relationship between them. How changing entries in one or the other sheet affect the other sheets.
      The to be asked question for every candidate would be on Depreciation.
      What is depreciation? –>> Remember it is a non-cash expense. Doesn’t have any impact on the Cash flow statement.
      Questions around this would be asked for sure!!

    2. Valuation Techniques:
      The four most commonly used valuation techniques are:

      a) DCF

      DCF can be calculated using APV and WACC. Study the CAPM model. Understand the Terminal Year Value, FCF to the firm, different formulae to calculate the FCF like from EBIT, EBITDA or CF statement, FCFE, implications of levered v/s unleveraged Beta. The relation between asset beta and equity beta.
      Common questions would be the CAPM model, levering and unleveraging beta and using it for calculating DCF.Also, study the Gordon growth model, basic assumptions of the model and the DDM model.
      Another topic would be P/E and trailing P/E and the difference between these.One, of the questions asked, was can beta value be negative, if yes can you illustrate an example.
      Yes, the beta value can be negative and Gold is a good example of it.

      b) Comparable transactions method

      This is more useful in comparing M&A valuations. The synergies between the firms can be treated as an intangible asset. This provides with a more realistic and current market evaluation of the firm if the M&A would happen as it would be taking into consideration the recent M&A’s which have happened in the field.

      c) Multiples method

      The multiples method is comparing the basic fundamental ratios of the company to the industry as well as the firms of similar market cap in the given industry. The ratio’s to look for are P/E, P/B, interest coverage ratios, solvency ratios and liquidity ratios.
      An important concept that gets tested here is the Enterprise Value of the firm. Be thorough with the concept of EV. The calculation of EV and it’s implications on the market value of the firm. The famous EV/EBITDA ratio would get tested herein.
      The most frequently asked question would be framed on the lines of:
      “There is a firm that you want to evaluate and don’t have any sheets of the company but know the enterprise value as well as the EBITDA of the firm. Industry knowledge is readily available. How would you evaluate the firm?”

      Even if some aspects of the question are not asked, the interviewer would be expecting you to ask these and reach to the final EV/EBITDA ratio of the firm and get a gross estimate of the firm based on these multiples.

      d) Market Valuation

      This would be directly proportional to the cmp of the listed company * the outstanding shares of the company. However, twisted questions around the value of unlisted company might be asked. A typical example would be, Do unlisted companies have their shares??

    3. Financial Instruments

      a) Stocks

      Different types of shareholding patterns in the company. The common equity stocks, preferred stock and the DVR’s. The rights and liabilities associated with it.DVR’s example would be Tata Motors DVR listed on the Indian Exchanges.
      Stock splits, buybacks, dividends and its impact on the stock price.
      Working hours of the markets, trading algorithms that you are aware of.
      VWAP, TWAP, Stop-loss orders, etc
      Some Technical analysis knowledge can come in handy. The candlestick patterns, RSI oscillator, Willian %R, SMA and EMA’s, etc.b) Bonds and Interest Rates

      Understand the basics of the bonds, at par, discount and premium valuation of bonds, fed rates and reserve requirements. The impact of inflation and interest rates on the prices of the bonds should be studied in detail. As a rule of thumb, interest rates have to be greater than inflation and as interest rates rise, the prices of bonds fall. Understand the relation between economic events like unemployment figures, the dollar weakening against yen, stock market drops and healthy earnings report by companies.
      Other topics to look into would be FRA’s, bond duration, modified duration Macaulay duration, convexity and inverted yield curves.

      c) Currency

      Spot and Forward rate, CME(Capital markets equilibrium), Pegged vs Floating rates, currency appreciation vs depreciation and currency revaluation vs devaluation must be studied.
      Interest and inflation rates directly impact currency values. If inflation rises, the currency value will decrease and vice versa. Similarly, if the interest rate rises in the country, the currency will strengthen and vice versa. A must-read in this section is to know about the Asian Currency crisis,1997

      d) Options, Futures and Swaps

      Understand the difference between Forwards and Futures, premium, different factors like stock price, exercise price, volatility, time to expiration, interest rates and dividends and their impact on option prices, Options put v/s call and going long on an option v/s writing an option. The different strategies like bull call/put, bear call/put, long/short straddle, long/short strangle, butterfly, synthetic long and arbitrage opportunities in it.

      If time permits, the Black-Scholes-Merton model of Option pricing should be studied upon by the candidates.

      Know the market circuit rules for stocks and their impact on the option prices. One typical question asked in this section was, If a stock has a lower circuit on it, what will happen to the prices of the futures market?

      Swaps are an interesting topic to be tested in the interviews. The interest rate and currency swaps are generally well known by the candidates. However, know about the Equity swap and custom swaps in the market. Illustration of the same would be S&P 500 swap between two parties. The questions that would follow would be what happens to the cash flows and how is dividend given by the company accounted for in the swap.

      One of the challenging question encountered in this segment would be to design different financial products using futures and options.
      Eg: Design an equity swap on a single stock making use of option strategies.
      The payoff matrix for each option instrument must be thoroughly understood and then the final product should be designed. The payoffs received in either of the cases should be same.

    4. Economics

      Know about the recent happenings in the country and the important events around the world. The Fed rates and RBI meetings are the events to watch for.  Know the current Repo rate, reverse repo rate, SLR, CRR and MCLR rates.
      Know about the financial crisis of the 1930s, 1980s and 2007; the causes and the effects of it. NBFC crisis in India, economic slowdown, Oil prices from OPEC, negative interest rates in Japan and European countries, the Greek crisis, Venezuela crisis and  Turkish currency crisis.

      Financial Crisis

    5. Mergers and Acquisitions/ PE-VC

      Topics to cover include Stock swaps, cash offers, goodwill accounting, Accretive v/s Dilutive mergers. Also, learn about the different types of valuation methods in details if the candidate is preparing for niche PE-VC role.

    6. Miscellaneous

      Guesstimates play an important part as they might be asked as an ice-breaker or to relieve stress in the middle of an interview. The candidate should also prepare one industry in detail. The in and outs like the profit margins, Porter 5 forces, PESTEL analysis, CAGR and size of the industry should be known. The candidate should also prepare one stock to pitch from this industry. The ratio analysis should come in handy. The candidate should have his/her own opinion on the position to take on the stock. Also, generic questions like what is your opinion about the current markets/economy should be prepared by the candidate.

Also, keep in touch with the latest economic happenings:

Follow Mint, Finshots and Finimize for concise daily summaries.

Feel free to reach out to me. Suggestions for improvements are welcomed.

Union Budget of Indian 2019

Date: 5th July 2019

Piyush Goyal, the then acting Finance Minister, had presented the Interim Union Budget of India for the year 2019 on 1st February 2019. The notable highlights of the budget were the government’s introduction of the Pradhan Mantri Kisan Samman Nidhi and Pradhan Mantri Shram Yogi Mandhan. After the landslide victory in the May 2019 polls, the government has decided to present its final budget on 5th July 2019.

Before the Budget presentation in the parliament, the Department of Economic Affairs of the Finance Ministry presents the Economic Survey in Parliament every year a day before the Union Budget. Some of the key highlights from the Economic Survey are as follows:

  • The center predicts seven percent GDP growth in FY20 if there are stable macro-economic conditions.
  • It also has estimated that the growth rate for agriculture, forestry, and fishing sectors in FY20 would be provisionally around 2.9 percent.
  • As compared to the 6.4 percent fiscal deficit in FY18, the fiscal deficit would be at 5.8 percent in FY19.
  • We need an 8% growth in the economy to reach $5 trillion in the coming 5 years.

Nirmala Sitharaman, the Acting Finance Minister in the Modi Government, presented the budget on Friday 5th July 2019. The notable feature in the budget presentation was the aesthetics used for the budget document. Traditionally since colonial times, the briefcase has been used to present the budget, but Nirmala Sitharaman had broken the stereotype by submitting the budget documents draped in a four-fold red cloth called a ‘bahi-khata’ (ledger). CEA Krishnamurthy Subramanian said that the government is following “Indian Tradition” by switching from the briefcase to the red cloth.

The key takeaways from the budget presented today are noted below.

  1. Govt proposes to include solid waste management in every village in the Swachch Bharat program.
  2. Government has proposed to streamline various labor laws into a set of four labor codes.
  3. To liberalize FDI in aviation, media, animation and insurance intermediaries.
  4. Banks which are run by the State to get Rs 70,000 crore capital to boost credit.
  5. Fundamentally strong NBFCs to keep getting funding from banks and mutual funds.
  6. Debt securities issued by NBFCs will be open to FIIs and FPIs for investment.
  7. The government proposes to set up NRF(National Research Foundation) to finance, organize, and to encourage research in the country.
  8. PAN and Aadhaar made interchangeable, allowing those who do not have PAN to file the return.
  9. Individuals whose taxable income falls in the Rs 2 crore to Rs 5 crore, and Rs 5 crore bracket will have their Surcharge raised by around 3% and 7%, respectively.

The budget is sound, but expectations are for bolder reforms provided the mandate received by the government. The markets did not take the budget pleasantly. The Sensex tanked 395 points as Union Budget fails to impress Dalal Street; Nifty also took a deep dive of 135 points but barely managed to hold above 11,800.

References:

https://www.news18.com/news/business/union-budget-2019-major-takeaways-from-nirmala-sitharamans-maiden-budget-speech-2218639.html