October 2014 Market Commentary

Markets have been upset over the last few weeks, especially oil. Equities have sold off while the Treasury market has been strong. The yield on the 10 year note fell into the low 2.30% during the equity market selloff. Several factors have contributed to this market move. With global turmoil scaring investors, they have become more risk averse. Large demonstrations in Hong Kong, the Ukraine unrest, the ISIS conflict and overall European stagnation have all contributed. The yield on the German 10 year Bund dropped below 1% while the Japanese government bond is yielding close to 50 basis points. Even the 2.37% yield on the U.S. 10 year bond looks good compared to these other government bonds if you are risk averse. Here in the United States, housing data is showing conflicting signals for the markets. Home prices have declined while new home sales increased. The July S&P/Case-Shiller Index dropped an additional 0.5% after June was revised down 0.3%. When markets have shown a long period of growth, investors start looking for a coming crisis. As stated earlier, geopolitical events around the world give skittish investors plenty of candidates. Fear usually wins in the short term, but fundamentals usually prevail in the long term.

There are several reasons the markets should continue to show gains. The September jobs report showed good gains, an additional 248,000 jobs with an upward revision to the August numbers. Wage increases and hours worked were flat. Is this the Goldilocks scenario? It depends. To the FED, it means no inflation; and to the markets and the economy it means moderate growth. The economy expanded at an upwardly revised 4.6% in the second quarter which is a good sign. Since the dismal first quarter, the economy seems to be improving. The increase in second quarter was due to stronger exports than originally thought as well as more business spending. This is a good omen. When businesses increase spending on plant and equipment, they must see improvements in the economy. Businesses increased spending on plant, equipment and office buildings at a 12.6% rate, larger than the initial estimate of 9.4%. Additionally, our exports grew more than our imports during the quarter. One area of exports that have expanded rapidly is the sales of refined petroleum products. I have mentioned before that our refiners have been exporting about 3.6 million barrels per day rate. This is gasoline, diesel and jet fuel. Last month we exported over 4 million barrels per day. Gulf coast refiners are running wide open. With the lower oil prices, their margins are very wide in overseas markets. Additionally consumers have been held back by slow wage increases. However, with falling oil prices the average consumer in the US will save approximately $140.00 in after tax spending on gasoline over this year. As usual, economic events are a two edged sword. What has caused oil prices to fall and can they stay at these levels long?

Oil prices have traded in a range of the low $90’s to around $106.00 per barrel for several years. West Texas Intermediate (WTI) broke below $90 per barrel and Brent broke below $97 per barrel. There are several factors contributing to this decline. Oil is priced around the world in US Dollars. As our currency has increased in value compared to all other currencies, the number of dollars to buy a barrel of oil decreases, thereby decreasing the price for oil. The value of the dollar has reason 10% this year so far while oil prices have dropped 13% this year. I do not believe the dollar can remain this strong for a long period. Other countries will resolve some of their problems and currencies will drift back to more normal relationships. Another contributor to falling oil prices is this is the time of the year when refiners have their switch over from required summer blends to winter blends. Refiners used over 500,000 barrels of crude per day less last week as several refineries were down for “turn a rounds”. By late October these changes will be over and our refineries will be back to an increased need for crude. Even if oil prices increase, gasoline prices should not increase as fast because in winter months refiners can blend NGL’s in with gasoline lowering the cost. Thirdly even though our production has increased, the amount of oil in storage is not growing. Our demand for products derived from petroleum is increasing here and around the world.

As I have discussed before with the surge in hydrocarbon production, there has been a very large increase in the production of Natural Gas Liquids (NGL’s). Ethane prices have fallen dramatically over the last few years giving chemical producers a large cost advantage over their overseas competitors. This is the primary reason for the dramatic increase in plant construction along the Gulf Coast. The American Chemistry Counsel reported that between 2011 and now there have been 196 chemical plant expansions or upgrades. The usage of NGL’s is the fastest growing segment in the oil & gas sector. Not only does this give our chemical producers a huge cost advantage, but export volumes of these products have reached 700,000 barrels per day according to the Energy Information Administration (EIA). They reported that they expect NGL production to increase from 2.6 million barrels per day in 2013 to 3.1 million barrels per day in 2015. This increase in production should provide ample supply to our manufacturers as well as our ability to continue exports.
We continue to see increased output from producers in the Bakken and Eagle Ford shale and the Permian basin. As these E&P companies learn more about the geological structures they are drilling in, they have modified their methods by adding an increased amount of sand per foot of lateral in the fracturing process. This is increasing the initial flow rate and lessening the decline rate of production. This is increasing their profit per well. This is good news for the E&P companies we follow. For these reasons we view any pullback in stock prices of these companies as a buying opportunity. Several names we recommend in this area are Continental Resources (CLR), EOG Resources (EOG), Oasis Petroleum (OAS), Whiting Petroleum (WLL) and a new add, SM Energy Company(SM). For an investment on the Marcellus shale, Gastar Exploration (GST) and Range Resources (RRC) are where we are putting our money. As new chemical plants start coming on line, there will be an increased need for NGL’s which will further increase the profitability of these companies.

The mid stream sector is adding capacity as well. Several mid stream companies we follow are building capacity to take advantage of this expansion in production and demand in the NGL space. One of these is Enterprise Products Partners (EPD). Their management realized the need for infrastructure in the area and they recently announced the building of their ninth liquids fractionator at their Mont Belvieu facility. This is good timing as they just finished the first phase of the AEGIS pipeline which will bring ethane from the Marcellus and Utica shale’s down to the gulf coast. They also see the increased potential for exporting refined products, gas condensates and liquids as they just announced they are buying Oil Tanking Partners (OILT) to enhance their capacity in this area. They are also working with Pioneer Natural Resources in condensate exports now. Pioneer recently announced they expect to double the volume of condensate export next year. Another company we follow in the mid stream area is Kinder Morgan (KMI). They recently announced they are buying up all the units in their MLP’s, primarily Kinder Morgan Partners (KMP) to become a C Corp. They are also expanding at a rapid rate and they have exposure to the Canadian heavy oil. They have a current pipeline which carries the product to Vancouver. They are in the process of additional permitting to double the capacity of this pipeline. This should give the Canadian producers another export mechanism other than the Keystone pipeline. These are the two big players in the mid stream arena which is a very capital intensive sector and they have the balance sheet strength to enable them to take advantage of the market.

In the chemical sector we still see increased production due to lower input cost. Westlake Chemicals (WLK) and LyondellBasell (LYB) are still our favorites in this sector. As I have mentioned in the past, their expansions are coming on line now thru mid 2017. This will lower their cost even more and enable them to take better advantage of the abundance of NGL production.

Large cap industrials have exhibited weakness in recent months due to the strengthened dollar and a slowing of demand from overseas. We are not adding to our positions until the markets resolve themselves. With lower energy cost, when demand returns, they should maintain good profits. Emerson Electric (EMR), Honeywell International (HON) and United Technology (UTX) have recently pulled back with the general market decline. If their earnings remain strong, which we anticipate they will, this should give us a very good entry point in the near future.

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