The Federal Reserve held their September meeting and left interest rates unchanged. The strength of the dollar and turmoil in the U S and international markets gave the Federal Reserve pause. If they had raised, the dollar would have increased and depressed emerging market currencies. Also, inflation is running below the Fed’s goal of 2% on an annual basis. The spread between the 10 year treasury and the 10 year inflation projected note fell to the lowest amount since 2009. In addition, the August trade deficit widened due to the strength of the dollar and a drop in overseas orders. We imported more goods and exported less. The dollar, stronger than it has been in over 10 years, is undermining the demand for goods manufactured in the US. The two sectors hit the hardest are manufacturing and mining, which includes oil and gas exploration activity. Almost no jobs have been added in manufacturing and, in total, oil and gas companies have announced the lay off of over 120,000 workers. As a result, manufacturers purchased less durable good such as machinery, trucks, plant and other equipment. The August manufacturing manager’s index was lower in August than July, producing the lowest level since May of 2013. After the robust 3.9% growth in GDP for the second quarter, it appears the 3rd quarter is going to come in around 1% to 1.5%.
In direct opposition to these numbers, the American consumer is doing well. In September, same store sales increased 0.8% from a year ago. Additionally, new home mortgages applications are still strong. The American consumer is also feeling confident enough to have increased their debt levels by $16 Billion. It also appears the European Union is improving after the ECB’s Quantitative Easing.
As I have mentioned before, the strong dollar is part of the reason for the collapse of oil prices. Oil prices have been very volatile as of late. The price fell into the high thirties per barrel, bounced back to almost fifty dollars per barrel and is now hovering in the mid forties per barrel. This is slowly stabilizing as our production falls and the world is still slowly increasing the demand for oil. China has increased its demand for oil more than 1.4% year over year and we have increased our demand by 1.6% year over year. More than $200 Billion in oil and gas projects have been put on hold worldwide. There are several reasons that oil companies will increase their profitability in the near future. Net exports of oil to Mexico are now running at over 48,000 barrels per day. Also, domestic E&P companies are lowering their drilling cost as they learn more about the geology in the field and as service companies lower their prices. Lastly, Saudi Arabia is taking market share away from Russia in Europe so much so that Russia cried uncle and has approached the Saudi’s about slowing their production. Most state run oil companies need prices in the $90/barrel to over $120/barrel to supply their governments the cash flow needed for their social policies. In a game of chicken OPEC, Russia, and the US shale producers are seeing who can hold out the longest. Some of our producers are profitable at these prices in a few of their fields, but there is not enough oil that can be profitability produced at these prices to produce the 95.7 MM barrels per day the world consumes. If your investment horizon is in the one to two year time frame buy good companies with strong balance sheets on pull backs. Here we like Conoco Phillips (COP), EOG (EOG), Range Resources (RRC), Concho Resources (CXO), and Contential Resources (CLR).
The mid-stream market of the oil & gas sector has been sold off without good reason. MLP’s have been hard hit. The Alerian MLP index has lost 25% so far this year, while oil prices for domestically produced product is down 11%. These companies are toll roads where the price of the commodity does not impact their earnings to the level of E&P companies are affected. These companies have also brought on line new capacity for transporting, separating, storing and exporting the various produced products. They are building new pipelines to export to Mexico as well as bringing on line several Liquefied Natural Gas export terminals starting in the first quarter of 2016. For these reasons we have added to our positions in Enterprise Products Partners (EPD), and Kinder Morgan Inc. (KMI). Their dividend coverage is very comfortable and they are able to pay for capital projects with cash flow.
In the down stream sector of refiners, they are showing good profit as they have a fair spread between Brent and WTI prices which allows them to export over 4,000,000 barrels a day of refined product with very good margins. They also have the advantage of being able to refine heavy sour crude in place of the more expensive light sweet crude. For these reasons we like Phillips 66 (PSX), Northern Tier Energy LP (NTI) and Alon USA Partners LP (ALDW). The last two are variable rate MLP’s, but have yields in the 17% range.
In the chemical industry, natural gas is both a fuel and a raw material. The boom in shale gas and an abundant supply of natural gas liquids has enabled the chemical industry to have a strong competitive advantage over other producers around the world. The American Chemistry Counsel (ACC) believes this will enable our domestic producers to export product with very good margins. There are over $149 billion of capital expansion in 249 projects that are under way. Most of the rest of the world’s chemical plants use naphtha to make there ethylene, where due to our abundance of Ethane which is a natural gas liquid, our input costs using ethane are much less. The U.S. chemical industry reported a 4% gain in chemical production year over year for 2014. The ACC is projecting a year over year gain of 3.2% in 2015 and 3.0% in 2016. There is a lot of chemical usage in the automotive and construction industries. Westlake Chemicals (WLK) and LyondellBasell (LYB) are showing good profit gains on a year over year basis. Their capital expansion projects are beginning to come on line, allowing them to further reduce their unit costs. LyondellBasell added 800 million pounds of ethylene capacity last year and just recently completed a major ethylene expansion at is Channelview plant and is continuing expansion work at their other plants. This helped them to report a 13% gain in their second quarter profit compared to prior year. Westlake Chemical recently increased its dividend and has maintained 44 consecutive quarters of paying a dividend. They also reported a 40% higher profit in the second quarter on a year over year basis. .
In previous Market Comment’s I have mentioned companies that derive income from overseas have been hurt by the strong dollar. However, companies that are domestically orientated have done well. For this reason we are adding to our positions in several companies that are showing good growth in the consumer sector. The names we like are Kroger (KR), Walt Disney (DIS), Home Depot (HD) and Tractor Supply Company (TSCO). These are companies that will benefit as the consumer starts to reaccelerate their spending after having paid down their debt balances. Other companies we like are Wells Fargo (WFC) in the financial sector and Eli Lilly (LLY) and Bristol-Meyers Squibb (BMY) in the pharmaceutical sector.
We are not adding new money to our industrials positions at this time, but we are not selling out of them either. These companies are holding up fairly well in spite of the strong dollar. We will continue to watch the dollar and to listen to their next quarterly reports. Honeywell (HON), United Technologies (UTX), Emerson Electric (EMR) and Rockwell Automation (ROK) are the ones we like.
We are monitoring the strength of the dollar, employment gains and the ability of Iran to begin exporting more oil. As the world’s economy grows, we believe the imbalance in oil will reverse and prices will return to more normal levels. Stay invested 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