July 2014 Market Commentary
Over the last few years, our economy has suffered thru a bad quarter and then returned to moderate growth in the following quarter. The first quarter of 2014 has been revised from a negative 0.1% to a negative 2.6%. Some of this weakness is due to the extremely cold weather. As the economy slowed, yields on U.S. Treasury ten year notes moved below 2.45%. They have since rebounded to around 2.55%. The turmoil in the Ukraine has eased somewhat, at least in investors eyes. However oil is still over $105/barrel for WTI as the unrest in Iraq keeps going. Employment keeps moving ahead at about 200,000 hires per month. Even thought this is not robust, adding 2,400,000 new jobs annually to the payrolls should help the expansion. As a result, the household debt-service ratio as a percentage of after tax income fell to 10%. This is the lowest level since the Federal Reserve began tracking this data. For the current quarter it seems we are moving at a GDP rate of 2.5% plus or minus. So far, Congress has not threatened to have an impasse on the debt ceiling or shut down the government. The overall optimism is aided by other positive numbers. The Institute of Supply Management’s June PMI reading held steady at 55.4. Anything above 50 indicates expansion. Inventories held steady at 53. If the economy keeps growing, manufacturers will need to add to inventories to keep pace. Other indicators also point to expansion. New car sales rose in June to a yearly average of 16.98 million units. This is the highest level since 2006. The Conference Board reported that The Leading Economic Index rose 0.5%. This is the fourth month in a row for the increase. These are forward looking indicators which should point to further expansion. As we finish the second quarter, rail volumes are up much stronger than previous estimates. Along the same line, an index’ that tracks trucking volumes reached the highest level since 2007. In May, the International Energy Agency revised its forecast for oil demand upward by 1.32 million barrels per day to over 94 million barrels per day by the end of the year.
In previous Market Comments I have discussed the tremendous benefits to domestic manufacturing as a result of lower natural gas and natural gas liquids (NGL) prices. In mid June at the Wall Street Journal’s CFO Network Conference, CFO’s sounded very up beat. They felt the economy is improving, employment is increasing and several geopolitical events have not occurred. Manufacturing is growing faster than the economy in general. We are now starting to see shortages in skilled trade positions. There are several hundred billion dollars of investment in facilities to take natural gas liquids and separate, ship, store, and use for feed stock as well as loading facilities for the export of NGLs. Due to an abundance of shale gas, we will soon see another market to take advantage of this. The flood of people around the world moving into urban areas will cause consumers to move from farmers markets to preserved foods. This will cause a lot of our cheap natural gas and NGL’s to be shipped to these areas in the form of resin pellets which they can convert to plastic products to keep farm production safe. This will increase the demand for chemicals, plastics, vinyl’s and other products to be exported. LyondellBasell, a plastics and chemical producer has received a key permit for multi-plant expansion to increase their ethylene production. The $1.3 billion project will increase capacity by 1.85 billion pounds per year raising their capacity by about 10%. Another completed expansion project enabled Westlake Chemical Corp. to buy a German manufacturer of polyvinylchloride (PVC). This adds to the capacity they purchased last year. This purchase allows them to expand their chlorvinyl business and adds important specialty PVC technology to their portfolio. For these reasons we continue to add to our positions in Westlake Chemicals (WLK) and LyondellBasell (LYB). Both of them have seen increased share prices of more than 50% over the last year. Westlake announced in early May the ninth consecutive positive quarterly earnings surprise.
With rising sales prices for natural gas and NGL’s, we are seeing increased profits for the players in the Bakken and Eagle Ford shale. West Texas Intermediate (WTI) has broken out of the channel that it has traded in for over twenty months. Usually the second quarter is when we see annual lows for oil prices because winter is over and the driving season has not started. However, WTI closed over $106.00/ barrel last week which confirmed the break out above the upper limit of the range. The demand for refined products is increasing, causing refiners to buy more crude. This is very good news for the E&P Companies we follow. Not only are oil prices holding above $100/barrel, but NGL prices are rising as well. Lastly, the amount of natural gas in storage at the end of winter was very low. Several analysts predict that we will not be able to replace all of last winter’s withdrawals, leaving us below the needed capacity for this winter. We are now leaving the shoulder season, where large amounts of natural gas go into storage and are entering hotter weather which will cause utilities to increase gas usage to produce more electricity for air conditioning. For these reasons we view any pullback in stock prices of the E&P companies as a buying opportunity. Several names we recommend in this area are Continental Resources (CLR), EOG Resources (EOG), Oasis Petroleum (OAS) and Whiting Petroleum (WLL). For a play on the Marcellus shale, Gastar Exploration (GST) and Range Resources (RRC) are where we are putting our money. Range Resources just announced major production increases in a very BTU rich gas area with a large percent of production in NGL’s. Also, Gastar is seeing good production in their Utica leases.
The mid stream sector is adding capacity as well. Most of the new shale finds are in areas that did not have a lot of infrastructure. Pipelines, gas liquids separation facilities, fractionators, storage capacity and export terminals are being added at a very rapid rate. To add to this need for expansion, the Department of Commerce ruled on June 25th that Enterprise Products Partners LP (EPD) and Pioneer Natural Resources will be allowed to export slightly modified Gas Condensates. The Condensate has been modified to remove very volatile lighter hydrocarbons and therefore qualifies as “not crude.” Several months ago, I mentioned that some mid stream companies are adding “splitters’. Splitters can take this modified gas condensate and turn it into naphtha, jet fuel diesel and gasoil, a refinery feedstock. EPD also announced plans to build a 1200 mile pipeline from the Bakken to Cushing Oklahoma. This should enable more of the Bakken crude to be transported by pipeline which will lower transportation cost, thus increasing margins on oil produced in the Bakken. It will also free up some rail capacity to ship grain which is behind due to a lack of rail capacity. This should enable EPD to maintain its growth going forward.
Large cap industrials are still maintaining good growth. With lower energy cost and increased demand from other economies, they should maintain solid growth. Emerson Electric (EMR), Honeywell International (HON) and United Technology (UTX) are at or near 52 week highs. United Technology has several long cycle businesses that allow them to maintain good growth in share price and dividends over long periods of time. We also hold positions in Rockwell Automation (ROK). They have enjoyed nice increases in earnings over the last year and are forcasting further increases going forward.
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. With interest rates at historic lows, even as dividend taxes go up, the after-tax returns are still higher than most investment grade debt. 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