June 2014 Market Commentary
Last month, I mentioned that the American economy over the last few years has moved in “fits and starts”. The first quarter of 2014 came in at a dismal 0.1% growth rate. This has now been revised lower to a 1% decline in Gross Domestic Product. Some of this weakness is due to the extremely cold weather. With the GDP drop, yields on the ten year U.S. Treasury note fell to 2.43%. As usual, foreign events contributed to the decline. Tensions between Russia and the Ukraine as well as the Chinese devaluing their currency has influenced foreign investor to seek “safe” investments, primarily U.S. Treasury’s. In addition, domestic corporations are flush with cash and are not entering the credit markets at their usual pace. Lower interest rates should help the general economy going forward. As rates move lower, mortgage rates should also decline. This should help the housing market which is a large part of overall GDP. Employment has been grudgingly moving upward. 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 the other numbers; The Institute of Supply Management increased May’s PMI to 55.4%, an increase of 0.5% over April. The PMI, hiring, and consumer spending are increasing after the frozen first quarter. Other indicators also point to expansion. Although we are only two thirds thru the second quarter, rail volumes are up much stronger than previous estimates. There are estimates that rail traffic could be raised by about 5%. Recently, the International Energy Agency revised its May forecast for oil demand by 1.32 million barrels per day to over 94 million barrels per day by the end of the year. This week, General Motors announced a 13% year over year increase in sales. Chrysler Group announced a 17% increase in May year over year sales. This should add to jobs, increase manufacturing, gasoline sales and rail traffic going forward.
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. Also, as the Chinese economy improves, wages are rising. China and other emerging market countries have seen double digit increases in wages. It now appears the labor advantage China has over the U.S. has shrunk to about 4%. When you adjust the cost advantage by shipping costs as well as our productivity advantage and the extra inventory needed, in some industries it is cheaper to manufacture here. As I have been stating in previous months, the surge in oil and natural gas production has pushed down our domestic energy cost. In recent years, most European countries, especially Germany, have paid over twice as much for electricity and four times as much for natural gas. This is one of the reasons you are seeing huge investment in certain domestic industries. 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 natural gas liquids (NGL). 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 quarterly earnings surprise.
Refiners are also adding capacity. Phillip’s Petroleum (PSX) is adding refining capacity as well as increasing capacity in their chemical division. They recently announced a 12% increase in their first quarter profit, prompted by a 70% increase in profit for their midstream business. Liquid transportation fuels account for 90% to 95% of the crude oil produced. As a result, we are adding to our position in PSX, partly due to the chemical influence but also due to the tremendous increase in light sweet crude production from the Bakken and Eagle Ford shale formations which is increasing their refining profits. We have also iniated a position in Valero (VLO). They are seeing increases in production, income and profit. Their exports of refined product is increasing also.
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 been testing the upper limit of a trading range that had been in place for over 20 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 $104.00/ barrel last week which is a break 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 analyst predict that we will not be able to replace all of last winters withdrawals, leaving us below the needed capacity for this winter. 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. Our favorites in the sector are Kinder Morgan Partners (KMP), Enterprise Products (EPD), and Breitburn Energy Partners (BBET). Enterprise Products Partners will build the world’s largest refrigerating facility for the export of ethane. In addition, this export facility will tie in with their completed expansion of their Mt. Belvieu facility which contains over 650 million barrels per day of fractionation capacity. This facility receives NGL’s from all major basins in the U.S. by pipeline. This expansion should enable Enterprise Products to continue to increase their distributions as well as see increases in share price for years to come.
In the pure industrial space, our holdings in 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