March 2014 Market Commentary
Over the last few years we have witnessed the U.S. economy move in “fits and starts”. The last half of 2013, especially the fourth quarter, is still being revised downward. December and January payroll additions have averaged about 100,000 new jobs per month. February payroll additions came in better, 174,000. However, some of this was the seasonal adjustments. Still these numbers are far below what is needed to reduce unemployment. This low hiring rate over the last three months is convincing me to reduce my estimate for the first quarter Gross Domestic Product (GDP) by 25 basis points. It is too early to determine whether the weather caused the slow hiring, or the economy is slowing again. I still believe that we will have a 2.5% growth in GDP for 2014 if several trends continue. The increase in my growth estimate for the back half of 2014 is based on increasing consumer spending as well as an increase in corporate capital spending. Consumer spending did slow from December thru February due to the weather. However, capital spending is holding up and there continues to be an increasing consumption of refined products.
Another strong indicator of economic growth is the Institute for Supply Management’s Purchasing Managers Index (PMI) rose to 53.2 in February. Although this index peaked at 57.3 last November, a reading of 53.2 is a very good number and the employment portion of the index was up for 14 of the 18 sectors. Manufacturers also have not been impaired by the turmoil in emerging markets. The survey reported an expansion of exports for the fifteenth consecutive month. The ISM also reported their index for new orders rose to 54.5 in February. The reported backlogs also increased which is an indication of future growth. This last week at an HIS CERAWEEK meeting in Houston, the consensus was that a revival in manufacturing has been occurring in the U.S. as a result of the energy boom, primarily natural gas. I have mentioned in several previous reports that manufacturing from heavy industry to chemicals and refining are benefiting from the abundance of energy as well as its very low cost.
The world seems to lurch from one geopolitical event to another. Russia and the Ukraine are flashing swords over the Crimea. Over 75% of the imported oil and gas from Russia into Europe passes thru the Ukraine. This puts the European economy in panic mode. On Thursday the European Central Bank (ECB) announced they would leave interest rates unchanged. This may mean they feel their economies do not need any additional stimuli. In addition, the emerging markets are improving although they are not back to the levels they experienced before the last recession. Also, Fed watchers believe Janet Yellen for sure will not increase the taper and quite possibly could slow it down if job creation does not pick up.
In previous Market Comments I have discussed the more than $100 Billion dollars in pipeline expansion underway as well as upwards of $110 Billion in chemical plant expansions domestically. As midstream companies continue to see rising prices for Liquefied Petroleum Gas (LPG) and an increase in contracts for Liquefied Natural Gas (LNG) for export, they will continue their expansion plans. The mid-stream sector should be the place to be this year. For this reason we are adding to our positions in Enterprise Products Partners (EPD) and Kinder Morgan Partners (KMP). Additionally, refiners have started having positive quarterly results. Refiners have not built a new refinery since the mid 1970’s both because of environmental restrictions and lowered profitability. However, with a flood of light sweet crude from the Eagle Ford shale in south Texas, refiners are now beginning to increase their ability to use light sweet crude which is more readily available than it was before. Refiners are adding new, small processors in existing plants which allows them to bypass stringent EPA regulations. All these improvements together will add about 400,000 barrels per day of refining capacity in the U.S. Although we cannot export oil, we can export refined product. With our lower input cost for oil and gas, our refiners have a definite advantage over foreign competitors. Additionally, refiners are adding the capability to process the ultra light Eagle Ford crude into near gas which can then be exported to Central and South America where they can be further refined. With the availability of such large quantities of this light sweet crude, players not traditionally in the refining business, such as Kinder Morgan are now getting into it. 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. We believe their fourth quarter profits will reflect a dramatic increase over the year before. As these companies better understand the reservoirs they are drilling in, they are able to decrease their drilling cost and timeframe, which increases production faster and improves their margins. Several names we recommend in this area are Continental Resources (CLR), EOG Resources (EOG), Oasis Petroleum (OAS) and Whiting Petroleum (WLL).
In addition to the oil and gas industry, the chemical industry is also expanding both capacity and their profits. One of our current holdings, Westlake Chemicals (WLK), has seen increases in margins and increases in shipments of specialty chemicals. Their olefins and vinyl production has increased 26% year over year. Other companies that we recommend, LyondellBasell (LYB) and Huntsman Chemicals (HUN), are also seeing similar type increases. We are adding to these positions as cash becomes available. Over the last 12 months, both Westlake Chemicals and LyondellBasell have increased their share price in excess of 40%. Year to date they are both up over 10%. 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 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 that generate good, after-tax returns. Their price earnings ratios 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. There is a growing shift from very low yield bonds into equity. 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