Our economy is showing signs of steady growth. Last week the Bureau of Economic Analysis released the first preliminary growth in GDP for the third quarter. The number came in at 3.5%, a little better than anticipated. The growth was primarily attributable to personal consumption, exports, non-residential fixed investment and a very large increase in government spending, largely on the military. As usual there are counter trends present in the growth number. Consumer spending was up, but only at a 1.8% clip. In addition, the increase in military spending is not sustainable. The report emphasizes the fact that economic growth is lagging other postwar recoveries. Looking at the economy as a glass half full, there are indications we could show moderate acceleration going forward. Inflation is very low. This coupled with the underutilization in the labor force could allow the Federal Reserve to postpone rate increases past next summer. Also, other indicators are flashing positive. With oil prices low, the average consumer in the U.S. will increase their savings by about $180 this year. This is after tax dollars which can help sustain consumer spending. In addition, existing home sales rose 2.4%, Leading Economic Indicators expanded, housing starts increased, and consumer confidence rose. On Monday, the Institute for Supply Management released its index which increased to a reading of 59 in October from 56.6 in September. This is the highest level in ten years. In addition, the new order index rose to 65.8 which signaled increased demand and production going forward. I believe that this GDP number will be revised down slightly since exports have shown less than originally thought. However, I still believe the final reading with show that the economy expanded in the 2.5% to 2.75 % range for the third quarter.
The third quarter showed a large increase in market volatility. Stock prices moved rapidly and with large price swings. Historically, September and October have shown higher volatility than the November to April time period. We should see more normal volatility based on improving fundamentals as we go toward the end of the year. Also, largely ignored in all the political noise, was the fact that more than 60% of the S&P companies that have reported so far have beaten the analyst’s estimates. As fundamentals have begun to be important again, companies should exhibit growth in their share prices. Another factor contributing to volatility has been the collapse in oil prices. Oil prices have broken through most of the technical support levels on the way to the mid $70’s price range. This has put more money in the pockets of consumers but has driven stock prices down on most E&P companies, even to a larger degree than the drop in oil prices. Most companies that are producers have hedges in place for a large percentage of their production. For the next few quarters the price drop should not affect earnings dramatically. However if prices should remain this low for an extended period of time it will effect their profits and will eventual slow drilling. It is our belief that oil prices should not stay at these levels for an extended period of time. Foreign governments that rely on oil production to balance their budgets cannot tolerate these lower prices for more than about six months of time. As I mentioned last month some of the price decline can be attributed to the rise in the value of the U.S. dollar. Since commodities are priced in dollars, as the dollar rises, it takes fewer of them to buy a widget. The price of gold has fallen as well as oil. Platinum, palladium, copper, and nickel have all had their prices fall as well. As other economies improve, their currencies should appreciate against the dollar allowing prices on all commodities to increase. Last but not least, our refineries have been in their semi-annual shut down time in order to perform routine maintenance and to switch from summer blend to the winter blend. At this time they also modify their process to produce more diesel fuel (heating oil) than gasoline. They are just about finished with this changeover. The fall/winter production of refined products will consume more oil then the summer process which should help to stabilize prices. Just last week, refiners increased their consumption of oil by over 400,000 Bbls. per days.
As I have mentioned many times in the past, with the surge in hydrocarbon production there has been a very large increase in the production of Natural Gas Liquids (NGL’s). Ethane prices have fallen dramatically over the last few years giving chemical producers a large cost advantage over their foreign competitors. This is the primary reason for the dramatic increase in plant construction projects along the Gulf Coast. These facilities are now beginning to come on line allowing our chemical companies to increase sales and margins. These completions will be steadily occurring from now thru the end of 2017. Ethane crackers, condensate toppers and refineries are dramatically increasing production and exports. Westlake Chemicals (WLK) and LyondellBasell (LYB) are still our favorites in this sector. Their expansions are coming on line now thru mid 2017. This will lower their cost even more and enable them to take better advantage of the abundance of NGL production. In Westlake Chemicals third quarter presentation they stated they have been able to raise prices on their products and maintain an increase in sales. The third quarter was the largest revenue quarter in their history and their largest profit quarter as well.
The mid stream sector is adding capacity as well. Several mid stream companies we follow are building capacity to take advantage of this expansion in production and demand in the NGL space. One of these is Enterprise Products Partners (EPD). Volumes thru their fee-based pipelines, processing plants, NGL fractionators, and condensate processors are running at all time highs. EPD is currently operating on all cylinders and has plans of spending billions on new capacity. This expansion of capacity and their very low cost of capital should enable EPD to continue increasing their annual distributions by approximately 6% each year for the next several years. They just announced their 41st consecutive quarterly increase in distributions.
We continue to see increased output from producers in the Bakken and Eagle Ford shale and the Permian Basin. As these E&P companies learn more about the geological structures they are drilling in, they have modified their methods by adding an increased amount of sand per foot of lateral in the fracturing process. This is increasing the initial flow rate and lessening the decline rate of production. This is increasing their profit per well. This is good news for the E&P companies we follow. For these reasons we view any pullback in stock prices of these companies as a buying opportunity. Several names we recommend in this area are Continental Resources (CLR), EOG Resources (EOG), Oasis Petroleum (OAS), Whiting Petroleum (WLL) and a new add, SM Energy Company(SM). For an investment in the Marcellus shale, Gastar Exploration (GST) and Range Resources (RRC) are where we are putting our money. As new chemical plants start coming on line, there will be an increased need for NGL’s which will further increase the profitability of these companies.
Large cap industrials are starting to show their strength again after the late quarter swoon. Manufacturing companies, especially industrial, have exhibited good profit gains in their third quarter reporting. We are not adding to our positions until the markets resolve themselves. With lower energy cost, when demand returns, they should maintain good profits. Emerson Electric (EMR), Honeywell International (HON) and United Technology (UTX) have recently pulled back from their highs. If their earnings remain strong, which we anticipate they will, this should give us a very good entry point in the near future.
We are emphasizing investments in companies with good cash flow, good cash distributions and companies that operate in areas where they have a competitive advantage due to much lower energy costs and raw material input costs. We prefer companies with price earnings ratios that are at levels that are attractive compared to the low interest rates on investment grade bonds. BSG&L is a long term investor and we believe that if you are patient, build cash and buy good companies on pull backs, your portfolio will have good growth over the long term.
Ben Dickey CFP/MBA/CHFC
BSG&L Financial Services LLC