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Followups Personal Finance

Roth versus non-Roth: If you make a lot Roth probably makes sense

This is a followup to a recent post, where I attempted to dispel some myths around 401k investing and discuss when and when not to invest in a 401k.

I received the following question: “One question though – we are now in the 37% bracket but let’s say I don’t expect to need income above the 24% bracket in retirement. Assuming taxes don’t go up (which they very well might), that makes Roth conversion less favorable no? It depends I guess on how much is base contribution vs how much is capital gain when you withdraw?”

It’s a great question, and in this post, I’m going to lay out some scenarios where Roth is preferred and where it is not preferred. Reminder, with a Roth retirement account you pay the income taxes now and do not pay them when you retire. In a non-Roth, you don’t pay income taxes now, but pay them later. In a qualified retirement account (Roth or non-Roth), you avoid capital gains taxes.

So the question is basically wondering if there is a “tax arbitrage” in that you expect your income tax rate to decline in the future, so you might as well wait and pay that lower rate rather than paying the taxes right now (via a Roth).

Punchline is if you are in this high of an income bracket, you will probably have more savings than can go into a 401k. And while you may be in a lower tax bracket in the future, the capital gains benefit offsets this and suggests utilizing a backdoor Roth.

Ok, let’s get to it.

This specific scenario:

If you are in the 37% marginal tax bracket right now and expect to drop to the 24% marginal tax bracket in the future, then that’s a 13 percentage point gap (you are paying the marginal rate on these investments). However, given this high starting income tax bracket, traditional IRA’s are likely closed off to you, so your choices are 401k’s and Roth-IRA’s (via the backdoor discussed in this post). Now, as discussed previously, unless utilizing a brokerage-linked 401k, you may be paying average 401k fees of 0.82% compared to 0.09% if you just invested in a market-tracking ETF. So that’s about a 0.75% headwind every year from choosing to invest in a 401k rather than a Roth IRA. It’d take about 18 years to eat away at the 13 percentage point tax savings. So if you plan on retiring earlier than 18 years from now, then the Roth is likely not for you if you only looked at this this way. If it’s more than that, then you should consider a Roth IRA. But that’s not the only consideration.

However, you should take two other considerations: (1) tax rates may rise over time, especially if government spending rises (there is a government budget constraint that dictates taxes must rise if spending continues to rise without an offset) and I’m benchmarking this to the current paradigm; Exhibit 5 shows US Federal budget deficit over time; (2) If you are retiring in the next 18 years, you may want to max out your 401k, but at this income level, you likely have excess savings beyond what you’re putting into your 401k. And the question is what to do with those – option A is put it any old account and invest and pay capital gains taxes, which would be about 15% when you retire (under the current regime). For your specific inputs, you’d need to earn about 87% by the time you withdrew the funds from the retirement account to justify the capital gains shield. That may seem high, but that’s about a 3.5% annual return with compounding – quite low. So if you believe that, you should consider a Roth.

General scenarios

I’ve put together the below matrices that try to answer the question depending on different current and future income tax brackets posed in the question. For simplicity, these are presented for married filing joint couples. If you want to see them for another category, please post a comment, and I’ll make them. The main conclusion is you have 20 years to retirement, it basically makes sense to use a Roth if you have filled up your 401k in basically every scenario.

Exhibit 1 shows the gap between your current and future tax rates based on your current income and future income.

Exhibit 2 shows the number of years until retirement to justify a Roth versus a 401k if you pay 0.82% annual fees to a 401k and 0.09% in a Roth.

Exhibit 3 is designed for if you have already maxed out your 401k and need to decide between a Roth and a non-capital gains protected account. It shows the return required on the invested amount to justify Roth’s capital gains tax advantage versus a non-capital gains protected account.

Exhibit 4 takes Exhibit’s 3 output and shows the implied annual return required over a 20year window to justify a Roth over a non-capital gains protected account.

Note: For simplicity and to be conservative, I simply took the 0.82% fee from a 401k manager and applied it to the opening balance; reality is as the investment grows, they will take more of it since the 0.82% is on the entire balance, which makes this conservative.

Exhibit 5: US Federal Budget seems to have been growing steadily absent the 1990’s when briefly returned to surplus

Source: https://stats.areppim.com/stats/stats_usxbudget_history.htm
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Blurbs Followups Themes

It is unlikely we run out of oil storage capacity but that is not the point

Summary

I’ve received a few questions offline from people noting they have seen headlines of energy producers reducing their capital expenditures (capex) or cutting them entirely in response to the lower prices, and wondering whether or not that is sufficient to balance the market, and if so, wondering if that means the coast is clear.

Oil markets are complex, and we’d need need pages to properly answer this good question. But we’re not making an oil call here. What we’re saying is A) cuts thus far have been insufficient for a decline in oil production; B) companies losing money and facing ballooning debt with breakeven economics well above current levels will not necessarily proactively cut their production as that would ensure their demise; they will act as options and hope for a turn, which when not achieved, may force them to shutter; we have not seen that; (C) When that happens, the market will rebalance, and that does not mean things are okay; what it means is that supply finally fell in response to a 30% demand decline (supply and demand rebalanced the hard way). We will then start to see the knock-on implications for other companies indirectly linked to oil, and it will likely not be benign. That’s the main point.

Oh, and along the way, we will not likely face a storage shortage because there will be a (painful) response. But that’s a distraction – the main point from the previous post, is that oil drives a significant portion of the US and without an active consumer, there is no offset to this massive pressure.

Observations and details

  1. Capex cuts are misleading: Headlines abound of energy companies slashing capex. This is misleading for a few reasons: (A) Energy companies have cut capex for years while growing production (capex fell 21% from 2010 to 2018 while production doubled). This is possible due to movement to new formations and horizontal drilling. Beyond our scope, see here for more info. (B) Energy companies already had a decline of 13% at the beginning of the year in 2020 capex vs. 2019; we are now at 22%, so it’s a 9 percentage point increase in the cut, not a fresh 22% cut; (C) There is sustaining capex and growth capex; sustaining capex is the capex to sustain the existing production; growth is investment to expand it. Much of the incremental cuts have been to growth projects, not existing production (perhaps I’ll break this out in a separate post); (D) The big boys, who are better positioned, have cut less than the small players; for the average company, 2020 guided capex is 29% lower than 2019; in total, it’s 22%. See Exhibit 1 showing capex declining with production rising, Exhibit 2 for a rundown of cuts by company, and Exhibit 3 showing a scatter of cuts by size of company with cuts skewed in direction of smaller players
  2. Small players are cutting where they can, but with breakeven economics at least $30/barrel no matter what oil play, they are reluctant to cut existing production. Exhibit 4 shows breakeven by play; Exhibit 5 shows continued oil output still flat at prior year levels (we have cuts in growth, not a decline in production).
  3. Small players may fold. Cash flows are negative. Debt is at all-time highs. Capital markets will be reluctant to issue debt (even at a high yield) to fund distressed oil companies. As they hemorrhage, eventually they may run out of options and option value. Exhibit 6 shows the median debt for high yield companies is up 300% since 2008 and for investment grade companies, it’s up 91%. I’m not bothering to show it vs. cash flow as cash flows are largely negative.
  4. We will likely not run out of storage capacity. According to the Energy Information Associate (EIA) the US has about 653mn barrels total storage capacity, with 372mn barrels already occupying those refineries and tank farms, or 57% of the storage capacity. That leaves about 280mn barrels of remaining capacity. Over the past three weeks, inventories have been rising by about 16mn barrels per week. At that rate, with no supply response, we run out of capacity in 17.5 weeks, a math exercise that has sent off alarm bells. However, we produce about 13mbpd (millions of barrels per day), or 84mn barrels a week. You only need to see a 17.5% reduction in output to stop growing the inventory. Even if it’s just a 5% reduction, that extends the window to 24 weeks; a 10% cut would push this to 40.5 weeks. Exhibit 7 illustrates this.
  5. The point is eventually supply-demand dynamics in oil will rebalance. And that does not mean everything is peachy. It means production fell in response to weak demand, and this is when you will the knock-on effects of reduced oil production on other industries. That’s the point of this post and the original post on caution for market positions. Exhibit 8 is a reminder.
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The hard oil reality and its broad ramifications

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I previously wrote about oil and the consumer as the twin engines of the economy in a recent post “Why I dumped all my holdings…”, noting both are sputtering.

Mayday

Both engines are now in full fail mode, with consumer activity shrinking by the most in history, and oil experiencing its worst-ever decline with some parts of the futures curve in negative territory.

Quick note on negative oil: This is exactly what one should see in the oil market, and it is not surprising. There has been an unprecedented negative demand shock, which has led to output exceeding storage capacity. When that happens, an energy producer has three options: (1) Shutdown; (2) Burn the oil off, dump it in the ground or dispose with it, all of which will incur environmental costs; (3) Pay someone to take responsibility for it. Option 1 has not yet largely occurred because Energy and Production (E&P) companies are facing extreme balance sheet risk, and at this point, they are options on oil; if they shut down, they are just very likely bankrupt, whereas if they wait it out, maybe the price will rise and can stave off bankruptcy. Perverse incentives with shutdown economics only triggered by bankruptcy. We saw this in the coal sector a couple of years ago (perhaps the subject of a future post). Option 2 and Option 3 are related; if you have to pay to dispose of the oil, you might consider offering the oil for negative cost.

Technical note: The Monday decline to negative $37/bbl for West Texas Intermediate (WTI) was somewhat technical in nature, driven by contract expiration (beyond the scope of this post, see here for more details) and will not stay in such deep negative territory (the rest of the futures curve already reflects this).

But the point remains, oil is in dire straits, and we have not seen capitulation in the form of bankruptcies from E&P’s. First, we will see growth capex cut, then second we will likely see bankruptcies. This remains a massive headwind to the market.

Why this is a massive headwind to the market

As I wrote in a previous post, “The market is a feckless child…”, the market is ignoring very real problems in the economy and myopically rising on continued stimulus hopes and prospects for the economy to reopen. There is nothing like the shock factor of imminent bankruptcies to wake the market up.

Most importantly, the sharp decline in oil has massive knock-on ramifications for large portions of the US economy. It is not simply the case that oil is correlated with other sectors; it directly drives large portions of the economy as the US is net long oil and when production and spending slow, derivative sectors, such as industrials, will experience negative demand. And in the present climate where the consumer is absent, they are not experiencing the benefit in the form of lower input prices (usually a partial offset and a strong consumer compensated in 2015).

It’s not just Industrials; there are numerous ripple effects to many sectors. Rather than list them, here’s a look at the number of companies citing oil in their earnings calls over time. The dotted box shows the 2014/2015 period when oil fell from $100/bbl to $40/bbl. Notice the number of companies citing oil (for the most part as a headwind). That’s almost half of stocks in the S&P 500 off of which this study is based. Basically every sector showed an increase in this topic on the calls (exception being energy where it was unchanged as they always talk about oil).

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As another confirmation of oils increasingly important role on the economy, correlations have generally fallen in recent years (which is not unusual in a rising market). But not for oil; oil’s correlation to various sectors has risen.

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Things need to get worse before they get better

We likely need to see massive cutbacks in E&P capital expenditures to reduce supply, but that’s likely not enough. Bankruptices probably will occur, and demand needs to return and consumers need to spend, but that seems very far from happening. Remember, one clue to when this will happen is when school’s reopen, and that does not appear imminent. See the exhibit in “The market is a feckless child…” for a look at school closings nationally.

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So if you haven’t yet evaluated if you can withstand a precipitous and long market drop before recovery and noted the unique challenges this market faces, now may be a good time. Here are some thoughts on that.