December 2014 Market Commentary

Oil prices collapsed in the last week or so.  WTI prices fell from over $100 per barrel in early summer to the $66 to $67 per barrel today.  History indicates that this large of a price reduction rebounds sharply and does so in a relatively short period of time.  I am a firm believer that it will be like that again.  There are several reasons why I feel that will occur.  Although we are currently producing a little more than we are consuming on a worldwide level, each year the level of oil production needs to be supplemented with new discoveries.  Next year the world needs to find approximately 4.5 million bbl per day just to stay even.  And any improvement in the world economy with increase the daily consumption so these are good reasons why new exploration cannot slow down, which it will if prices remain low for any period of time.  I believe most of the OPEC members require much higher prices in order to support their economies.  Their committed expenditures are based on the higher prices for oil and they do not want to face having to reduce their levels of social spending for their population. So, if oil is in the low $60 per barrel range at the January OPEC meeting, I believe they will attempt to implement a lower level of production going forward in order to raise prices.  Russia is also in dire straits at this price level.  The Russian economy has slipped into a recession and needs foreign reserves to move the economy forward.


There is an axiom in the Engineering world, “for ever action, there is an opposite and equal reaction”.  Even thought some marginal producers will be hurt, the large reduction in the price of refined products is a huge positive to consumers.  As I have written before, wages in the US are not keeping pace with inflation.  The price reduction at the pump will add several hundred million dollars to the US economy in the next year and some estimates predict billions of dollars being added into the world economy.  There are other positive factors related to the world economy.  Central Banks around the world are adding stimulus into their economies.  China surprised the markets by reducing its benchmark lending rate for the first time in over two years. Mario Draghi spoke of future increases in liquidly injections by the European Central Bank, and Japan stated they would increase the purchase of their government securities, or Quantitative Easing.  These economies are not doing well but this should help them.  However the best news is that the US economy is growing at a faster rate than thought.  Third quarter GDP growth originally announced at a 3.5% increase was up revised up to 3.9% by the Commerce Department.  Consumer outlays were larger than thought, being helped by lower fuel prices. Consumer spending which accounts for 70% of the US economy increased at a 2.2% rate in the quarter. There was also an increase in business outlays.  This is important for the economy to keep expanding as it should produce more jobs and help efficiencies to keep improving. Employers have added over 200,000 jobs per month for nine months and the November jobs report posted at a large increase of over 320,000 new jobs.  As I have been touting for some time, manufacturing in the US is benefiting greatly from lower energy cost.  For the US economy to keep expanding, the manufacturing sector is very vital.  Sales of US made goods account for about 30% of GDP.  Last month the Supply Managements index for manufacturing stood at 58.6, up from 56.6 in September.  Yesterday the Energy Information Agency (EIA) released the previous week’s oil storage report.  Our refineries are running at over 93% of capacity, which is very good for 40 year old refineries.  Even at this pace, the report showed that our storage levels of gasoline, diesel, and heating oil fell and are in the lower half of the five year average range.  I believe these reasons are why the drop in oil prices will be a V shaped recovery, not a long slow grind.


The oil price collapse has caused some traders to throw out the baby with the bath water.  As I have mentioned many times in the past, with the surge in domestic hydrocarbon production there has been a very large increase in the production of Natural Gas Liquids (NGL’s). One sector of the economy that benefits from lower prices is the Chemical Industry.  Westlake Chemicals (WLK) and LyondellBasell (LYB) are still our favorites in this sector.  Their expansions are coming on line now thru mid 2017.  This added capacity 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. However this year Westlake’s share price is down from the mid $90 range to $64 and change today.  We feel both of these companies are much oversold.  We do not feel that the price of oil is going to remain low enough for long enough to have any sort of negative impact on their earnings so we will be adding to these positions as cash becomes available.


The mid stream sector was hit as well.  These companies derive most of their income from fee based revenue through their pipelines and NGL processing.  They are largely shielded from the price of the hydrocarbon.  Several mid stream companies we follow are building capacity to take advantage of the domestic 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. Kinder Morgan (KMI) has completed it’s acquisition of all their MLP units and now is operating as a C Corporation.  They are also adding capacity to take advantage of this surge. Again, although the market does not currently agree with us, we think that this lower price of oil is not going to last long enough to materially impact the earnings ability of their facilities.  We feel that this sector is underpriced and has a very good chance of producing large increases in profits from now thru 2017.  This is another sector we will be adding to our positions.


We continue to see increased output from producers in the Bakken and Eagle Ford shale and the Permian Basin.  This sector has ben hit the hardest.  Their income was assumed to fall with the reduction in oil prices and their stock prices have fallen off substantially over the last couple of weeks.  Once again, we disagree with the market valuation on these companies because many of the better managed companies have large percentages of their production hedged both for 2015 and even into 2016 and very high levels and will not suffer the income reduction proportionately to the reduction in oil price.  They have also continued to reduce their production cost and can be profitable at prices lower than we now see. For these reasons we view the current situation as a buying opportunity.  Several names we recommend in this area are Continental Resources (CLR), EOG Resources (EOG), and Linn Energy (LINE).  For an investment in the Marcellus shale, Gastar Exploration (GST) and Range Resources (RRC) are where we are putting our money.


Large cap industrials are starting to show their strength again after the late third quarter swoon. Manufacturing companies, especially industrial, have exhibited good profit gains in their third quarter reporting. As we see evidence of improvement in the world economy, we will start to add to our positions.  Emerson Electric (EMR), Honeywell International (HON) and United Technology (UTX) are the stocks we are following and are hoping to add new money soon.


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.



BSG&L Financial Services LLC