January 2015 Market Commentary
The US economy ended 2014 gaining momentum. The last revision for the third quarter placed the increase in GDP at a 5% annual rate. The second quarter was up 4.6%. Economists are expecting a fourth quarter increase of between 2 ½ % to 3%. The growth was attributable to increases in consumer spending, business investment and exports. The Federal Reserve recently announced that the output from manufacturing has now exceeded the levels prior to the recession of 2008. Capacity utilization climbed to 80.1%. These levels should continue because fewer Americans filed for unemployment in 2014 than in the past fourteen years. With manufacturing expanding, consumer confidence rising as wages begin to increase faster than inflation, and with low interest rates and gasoline prices down almost 50%, the economy should continue to improve throughout 2015. The price reduction at the pump should add several hundred billion dollars to the US economy in the2015. As a result of the lower gasoline prices auto sales are up and the car companies are seeing a pick up in the larger, less fuel efficient vehicles. Those are also the cars that usually have higher margins.
There is always two sides to economic data. The U.S. economy and stock markets are growing at a healthy pace but the rest of the world is not doing as well. The low oil prices have hurt Russia worse than our energy markets. Japan is in a recession, Europe is either in a recession or close, China has slowed to around 7.3% growth and the rest of the oil producing countries are hurting as well. For these reasons there has been a huge flight to quality in that foreign investors are buying dollars so they can buy U.S. treasuries. This demand increases the value of the dollar which continues the decline in oil prices. The dollar recently hit an eleven year high. The rise in the dollar causes a fall in other currencies. The Euro hit a nine year low on Monday January 5th.
As I have mentioned before, for every action there is an equal and opposite reaction. Lower oil prices have added more cash to the consumer so the over all economy shows gains. However, oil prices are down from $108/ barrel in June to $48.75/barrel (WTI) today. This large drop is causing E&P companies to dramatically decrease their budgeted Capital Expenditures spending for 2015. An old adage in the oil patch is “Low Oil Prices are a cure for Low Oil Prices”. As prices fall, drilling slows, production growth slows and supply and demand come back into balance. This usually occurs in about a year. However, since over 85% of the world’s petroleum increase has come from U.S. shale or Canadian oil sands, the production fall off will be must faster. The downside is if oil prices stay this low for more than six months then the Dallas Federal Reserve Bank predicts that over 250,000 jobs could be lost in Texas, Louisiana, and Oklahoma. Because of the possibility of labor curtailment in the petroleum industry, the very strong dollar and the stagnation of the remainder of the world, I believe this will allow the Federal Reserve to be very patience when it comes to raising interest rates. With year over year inflation in the US at around 1.3% and the dollar so strong, I don’t believe that the Federal Reserve will start raising interest rates this summer and maybe not until after the first of next year.
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. 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 hard 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 high. Last month they 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.
With the collapse in oil prices, almost all of the E&P companies have slashed their capital expansion spending for the coming year by at least 25% to over 50%. They will not ramp back up until oil prices rise and stabilize. There are several reasons why I believe we will begin seeing prices rise by the beginning of summer. The week ending December 17th saw oil futures contracts traded in which 18,531 contracts bet on increasing oil prices and only 6,701 bet they would fall. Also, the first half of the year is the lowest demand for oil. Refiners can add Natural Gas Liquids to their gasoline reducing the amount of oil they need. Also winter weather slows driving as well as some construction which further reduces the amount of fuel required. Another factor that suggests oil prices will raise sooner rather than later is that current production declines each year as fields mature. Falling supply and a slow but rising demand will bring prices back into equilibrium fairly soon. We are not buying E&P companies until we see prices increase. However the companies we follow have greatly reduced their cost per well and can make money in the $60/ barrel range. We will begin buying these stocks as we see improvement. Several names we recommend in this area are Concho Resources Inc. (CXO), EOG Resources (EOG), and Linn Energy (LINE). For an investment in the Marcellus shale, Gastar Exploration (GST) and Range Resources (RRC) are where we will be putting our money.
Large cap industrials were starting to show their strength again after the late third quarter swoon until the first few days of 2015. The equity markets returned to a risk off mode and all positions sold off except utilities and pharmaceutical stocks. Manufacturing companies, especially industrial, have exhibited good profit gains in their third quarter reporting. As we start to 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.
Ben Dickey CFP/MBA/CHFC
BSG&L Financial Services LLC