The Correction Continues
Last week I sent out two flash alerts discussing the continued selling pressure we’re seeing in the oil and natural gas markets. First, the bad news: The selloff in crude oil, natural gas and energy-related stocks continues, and I wouldn’t be surprised to see further selling over the next few weeks to take oil back to around $110 per barrel. Clearly, the TES Portfolio holdings aren’t immune to the damage, and we’ve taken our fair share of hits over the past month.
The good news: This isn’t the end of the world or the end of the energy bull market. Don’t be tempted to buy into the hype, and don’t panic. We’ve seen several corrections in the energy patch over the past few years, some even more severe than the past month’s move.
I see plenty of opportunities in the current environment, and I believe we’re just a few weeks away from a buying opportunity, particularly in names leveraged to natural gas. In this week’s issue, we’ll take a look at some of my favorite stocks and sectors in light of recent news and earnings events.
Several factors have affected the price drops in the energy sector of late, including seemingly non-related activities such as the shorting of financials. I’ve been highlighting these trends in both flash alerts and the most recent issue of The Energy Letter, TES’ sister publication, and see the potential for oil and natural gas to outperform commodities in the coming months. See Perception Is Reality.
Despite the pullback in energy, some sectors still look set for growth. Here’s a rundown on those sectors and my top picks for each. See How to Play It.
I continue to watch Schlumberger as an indicator on trends in the services sector. The company discussed a number of important topics during its second quarter conference call last month, all of which should bode well for the company going forward. See Strength in Services.
Two stocks in the TES portfolios touched my recommended stop levels. One is worth re-entering at this point; one isn’t. See Portfolio Update.
I’m recommending or reiterating my recommendation in the following stocks:
Source: StockCharts.com
As you can see, viewed in the context of a four-year period, the recent pullback doesn’t look all that unusual. Oil prices have simply returned to levels last seen in early May, just three months ago. In fact, the move looks like a correction of a market that simply got extended toward the end of the second quarter. A quick perusal of this chart shows similar corrections in 2006-07 and on a few occasions back in 2005.
Also, remember that a year ago oil prices were trading under $75 per barrel and the first analysts to predict $100-per-barrel oil took a good deal of criticism in the press. Oil crossed $100 per barrel for the first time just about six months ago. This is hardly the bursting bubble and crash some have made it out to be.
Each of these pullbacks has ultimately resulted in an outstanding buying opportunity for investors. Although that golden opportunity is likely still a few weeks away, we’ve capitalized handsomely on these opportunities in TES before, and I firmly believe we’ll have just such an opportunity once again.
The ultimate, fundamental driver of this weakness is a faltering US economy that’s likely to get even weaker before it improves. There are valid fears that US consumers are reducing their consumption of gasoline and are cutting back on their driving during the typically busy summer driving season. This is clearly visible in the chart below.
Source: Federal Highway Administration
This chart shows the total vehicle miles traveled in the US, which are based on machines that automatically count traffic at 4,000 locations all over the US, both highways and rural roads.
The data are released with a time lag; the Highway Administration just released data for May last week. But the trend is clear: The yellow line represents travel in 2008, and it’s sharply below the levels we saw in 2006 and 2007. The period of seasonal strength in driving demand–the so-called summer driving season–is less evident on this year’s chart than in prior years.
In fact, the Highway Administration reported that this is the largest year-over-year drop in vehicle miles traveled for the month of May since it began publishing this measure. Moreover, this is the third-largest year-over-year drop ever.
I’ve been on the record suggesting the US economy has been in a recession since the beginning of 2008. (See the Jan. 23, 2008, issue, Strengthening Headwinds, for a more-detailed view of that assessment.) Longtime readers know that one of my favorite measures of economic health is the US leading economic indicator (LEI), which is shown in the chart below.
Source: Bloomberg
The LEI is actually a composite of 10 key economic indicators. The list includes housing starts, consumer expectations, jobless claims and even the performance of the US stock market.
The chart shows the year-over-year percent change in leading economic indicators. As evidenced from this chart, the LEI tends to turn negative just ahead of or coincident with US recessions.
For example, the LEI turned negative on a year-over-year basis in June 1989; a US recession followed in July 1990 and lasted through March 1991. Similarly, the December 2000 dip in the LEI below zero foreshadowed the March-November 2001 recession.
Like every indicator, the LEI is far from infallible. For example, a short dip below zero in 1996 turned out to be a false alarm. However, the indicator is correct more than it’s wrong, and we can’t ignore the slump we’ve seen since late last year.
The LEI is now at -2.1 percent year-over-year, a level unseen since the recessions of 2001 and 1990-91. Although the impact of the US government’s fiscal stimulus checks seems to have moderated the deterioration over the past few months, we could definitely see more downside ahead.
Also remember that two consecutive quarters of negative growth in the gross domestic product is not the official definition of a recession. This is a common fallacy. The official start and end dates for US recessions are decided by the National Bureau of Economic Research (NBER) business cycle dating committee and are based on a much wider number of indicators than simple GDP growth.
Usually, recessions are announced long after they actually start; in some cases, the dating committee only determines that a recession occurred long after it’s over. A look at the broader definition of recessions suggests we’re almost certainly in contraction right now or, at least, soon will be.
These statistics make for scary reading. However, it’s important to remember that the US and, more broadly, the developed world aren’t the drivers of global oil demand growth.
Source: BP
This chart shows contribution to global demand for oil from the US, Organization of Economic Cooperation and Development (OECD) countries and non-OECD countries over the past few years. The OECD countries are a proxy for the developed world, while the non-OECD nations include emerging markets such as China and India. I excluded the US from the OECD data and charted that data separately.
As you can see, the yellow bar representing the growth in demand from the developing world has been far and away the most important source of demand growth over the past decade. In fact, over the past few years, US and other OECD countries have actually had a negative impact on global demand; OECD demand (excluding the US) actually declined by nearly 400,000 barrels per day last year, offset only by a near 1.4 million-barrel-per-day jump from the developed world.
As I noted in the Jan. 23, 2008, issue, the growth in oil demand from emerging markets is a secular shift, not a cyclical upturn. As these economies grow and consumers become wealthier, it’s only natural that energy consumption rises.
Chinese consumption has indeed been rising but remains at around two barrels of oil per person per year, a tiny fraction of the 25 barrels per person annually consumed in the US and the 10 to 15 barrels per year common in developed European nations. Chinese oil demand growth continues to have plenty of room to rise.
Source: Bloomberg
This chart shows monthly Chinese automobile sales going back to the beginning of 2005. Although there are certainly monthly variations, sales remain strong. This will power growth in demand for oil over time.
The trends at work in the global oil market really aren’t particularly surprising from a basic economic viewpoint. The past few years have brought huge growth in global oil demand led by growth in emerging economies. This is likely to continue generally in coming years as these economies continue to develop.
Meanwhile, supply growth has and will remain constrained. Oil production from outside Organization of the Petroleum Exporting Countries (OPEC) has consistently missed analysts’ expectations. Consider just the pattern in non-OPEC production growth estimates for 2008.
Source: International Energy Agency
The International Energy Agency (IEA) begins estimating non-OPEC production growth for the following year in July; the agency began estimating 2008 production growth in July 2007.
Last July, the IEA first published 2008 forecasts for non-OPEC production growth of nearly 1 million barrels a day. That figure has once again steadily dropped, reaching 422,000 as of the most-recent report, published July 10.
Even less encouraging, from a supply standpoint, is that IEA estimates for 2009 non-OPEC supply growth currently stand at just 639,000 barrels a day. It’s quite likely that forecasted supply growth will drop even further in coming months, following the pattern witnessed in each of the past four years.
New supplies from regions such as Brazil and Kazakhstan are due to come online over the next five years, but these supplies will do little more than make up for declining output from mature fields. There’s growing evidence that the IEA and other major agencies that follow the global energy markets are consistently underestimating the decline rates of global oilfields. In other words, production from existing oilfields is falling at a faster-than-expected rate. This is the main reason estimates have proven too optimistic in recent years.
And more than half of the projected increase in non-OPEC production for 2009 is expected to come from a jump in biofuels output. Biofuels such as ethanol and biodiesel are derived almost exclusively from crops such as corn, soybeans and rapeseed. Already the dramatic increase in biofuels production of the past five years is straining the global agriculture market and prompting large jumps in prices of basic foodstuffs. There are real questions as to the sustainability of growth in biofuels output.
The same basic pattern of disappointing non-OPEC production has occurred like clockwork in recent years. To fill the gap, OPEC has boosted output. But that increase has all but eliminated the world’s spare oil capacity. (Spare capacity is surplus oil production capacity that can be brought online within a month and reliably produce oil for at least 90 days.)
According to the Energy Information Administration (EIA), current global spare capacity is likely closer to 1.2 million barrels per day. That means the global oil market is running at close to 99 percent of capacity, leaving little cushion to offset supply-and-demand shocks.
This global oil market imbalance is having the predictable outcome. If demand is rising and supply can’t rise to meet demand, prices must rise. Rising prices have the effect of choking off oil demand enough to bring supply and demand back into balance.
In the oil market, geological conditions make it very hard for supply to adjust upward; therefore, the only factors that can change are price and demand. This is exactly the effect we’re seeing in the US and other OECD countries right now: The rise in oil prices to near $150 per barrel and that quick spike in gasoline to more than $4 per gallon finally pinched the ever-resilient US motorist.
Ultimately, we’re seeing a historic shift in the engine of the global oil market from the US and OECD to the emerging markets. Traders and investors haven’t yet sorted out all these changes, so there’s a natural tendency to cling to the indicators that governed the oil markets five or 10 years ago. That means an overfixation on US oil inventories and demand projections. As the market works through this fundamental shift, the conflicting fundamental crosscurrents are contributing to the volatility we’re seeing in the crude oil markets.
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Whether you look at gold in the 1970s or the Nasdaq Composite in the ’90s, you’ll find plenty of nasty corrections in the context of a general uptrend that were highly profitable for investors. We’re now experiencing such a correction; this move will soon mark yet another extraordinary buying opportunity. In fact, as I detail below, I’m already seeing some selective opportunities.
We can’t completely ignore the inevitable pullback. The only effective strategy is to take steps to hedge your risks and maintain a consistent discipline. In addition, a number of plays in the TES portfolios will actually benefit from softer oil prices or, at least, a moderation in the pace of oil’s advance; in other words, there are plenty of ways to make money even if oil pulls back further over the next few weeks.
As I noted earlier, the primary fundamental factor pushing oil prices lower is fear over US demand trends. But just as important as declining US demand is a number of technical and psychological factors. In fact, while fundamental supply and demand will govern longer-term trends, sentiment, greed and fear are behind short-term volatility in oil.
In the June 4, 2008, issue, Crude Realities, I analyzed speculation in the energy markets and its effect on pricing. My view was that speculation isn’t the root cause of rising energy prices; nonetheless, it can certainly have a short-term impact. And profit-taking by speculators at the beginning of the third quarter has certainly been a factor driving energy commodities and related stocks lower.
You can clearly see this in the chart below, which also appeared in the July 23, 2008, issue, Clean Coal and Energy Efficiency.
Source: Bloomberg
This chart depicts US oil prices in the top pane and the total open interest in the futures market–the total number of contracts open in this market–on the bottom pane. As you can see, open interest has been declining for months, long before crude oil hit a peak in early July. This flies in the face of the idea that speculators have been massively increasingly their exposure to oil and pushing prices higher this year.
But note that open interest has been unwinding at a faster pace since the beginning of the third quarter. This indicates a more-rapid unwinding of traders’ bullish positions in crude oil. I suspect the same thing is happening in the energy stocks as too many traders try to take cash off the table simultaneously.
This really shouldn’t come as a huge surprise. After all, the broader stock market was extremely weak in the first two quarters of 2008; oil- and energy-related stocks were two of the only positions that actually made money. Traders clearly sought to lock in some of these gains at the end of the second quarter and in the early days of this quarter.
Two additional factors exacerbated this trend. First, on several days over the past month, when energy stocks had been hit hard on heavy volume, there had been rumors of distressed hedge funds selling down their portfolios. I never put too much stock in rumors, but the tremendous downside volume witnessed in many commodity-related investments at times is reminiscent of the action around the September 2006 blowup of the energy-focused Amaranth hedge fund.
Although there’s no way to know for certain, it seems logical that some hedge funds might have been caught on the wrong side of the quick selloff in oil prices last month; their unwinding probably contributed to the downside because they were distressed sellers. They simply had to sell at any price to raise cash. We also know for a fact that SemGroup, a midstream energy infrastructure provider, collapsed last month after losing big on speculative oil positions; the company was forced to unwind these trades for huge losses.
Source: Bloomberg
The chart above shows the Philadelphia Banking Index, an index containing major US financials. Although it might seem totally off-topic to discuss banks in an energy newsletter, it isn’t.
In the first two quarters of 2008, the big winning trade (apart from energy) was to bet against, or “short,” financials. But the US Securities and Exchange Commission (SEC) decided to ban or, at least, severely limit that practice last month when it prohibited short sales of certain financials unless the seller had actually borrowed the shares. That move, coupled with the virtual bailout of mortgage giants Fannie Mae and Freddie Mac, prompted what’s known as a short squeeze in financials.
When you initiate a short sale, you’re essentially selling shares in a company you don’t own. (Technically, you’re supposed to borrow the shares.) You make money if the stock in question falls in value. When you close, or “cover,” a short, you must buy back the shares you sold on the open market. If enough short sellers decide to buy back a stock, it sends the price higher.
But the higher the stock goes, the more money the shorts lose. This pain, in turn, prompts more shorts to cover their bets. And that kicks off a vicious cycle: Shorts cover their bets and send the stocks even higher, leading to even more short covering. I believe this short covering is exactly what sent the Banking Index sharply higher in July.
To make a long story short, any trader short the financials in early July got caught in this squeeze and likely felt plenty of pain. This probably prompted some funds to raise cash by selling down their bets in energy stocks. The nearly inverse moves in financials and energy shares suggest this view has some merit.
All told, this tends to support the view of the crude oil market I outlined in last week’s flash alert, “Oil–Neither Here nor There”: Negative headlines about demand destruction, coupled with some of the shorter-term technical factors I just outlined, will likely push oil lower in the short term.
On a shorter-term basis, I’m always suspicious of markets that fail to rally on bullish news; oil has, in fact, been falling despite heightened hurricane activity, a bullish inventory report last week and continued geopolitical strife. This means that traders are using any rallies–such as we saw a week ago in the wake of a bullish US oil inventory report–as an excuse to sell into strength. This is a powerful indication of more near-term downside to come.
At the same time, a collapse is highly unlikely, despite what you may hear from some oil bears. The longer-term fundamental factors I outlined earlier in today’s report will act as a floor for prices.
Further, as I noted in last week’s issue of TEL, Defining Demand Destruction, I’m not sure all the decline in US oil consumption represents permanent demand destruction instead of a temporary retrenchment. After all, retail gasoline prices are falling nationwide; this quick relief might actually encourage drivers to try to take advantage with a late-summer holiday.
My view of the oil market remains that we’re in for a volatile trading range. Oil prices will remain supported around $110 per barrel and capped at around $145 per barrel. Short-lived spikes are possible on both sides of that range.
Before I delve into exactly how I recommend playing this environment, two additional points are worth mentioning: the potential for a decoupling of energy stocks from commodity prices and natural gas.
Source: Bloomberg
The S&P 500 Energy Index hit its high on May 20, 2008, more than one month before crude oil hit its recent top in early July. Moreover, crude oil rallied more than 40 percent in the first half of 2008, and natural gas prices were up 65 percent over the same time period. But the S&P 500 Energy Index was up just 9 percent, and the Philadelphia Oil Services Index was up less than 18 percent.
This illustrates that oil- and gas-related stocks handily underperformed the commodities in the first half of this year. This suggests to me that energy stocks never really fully priced in $147-per-barrel oil and the $13.50-per-million-British-thermal-units natural gas.
Clearly, a rapid decrease in oil and gas prices, such as we’ve witnessed in recent weeks, can sour sentiment on related stocks short term. However, I see the scope for energy stocks to actually handily outperform the underlying commodities over the next few months; some sectors of the energy patch could move higher even if oil drifts down to around $110 per barrel short term. The reason is simple: The group never priced in $150 oil and is, therefore, overreacting to the commodity price drop over the past few weeks.
My second point is that I see far less of a fundamental rationale for natural gas and coal prices to be falling right now. Both commodities appear to be falling in sympathy with oil. Natural gas has a reputation as “the widow-maker” because of its extreme price volatility; the commodity rose more than oil in the first six months of this year and has fallen faster over the past few weeks.
The only fundamental rationale I can see for gas prices to decline is that some traders believe that US production growth will swamp demand, thanks to strong production increases from so-called unconventional reserves. (For those unfamiliar with this term, check out the Feb. 20, 2008, issue, Growing Unconventionally.)
This is a valid point. However, to date, it just hasn’t been showing up in the natural gas inventory figures. So far this year, natural gas in storage has actually fallen from glutted levels to below the five-year average.
In addition, natural gas demand is holding up extraordinarily well despite the economic slowdown that’s been crimping oil demand. I believe there are two reasons for this: the weather and the stability of electricity demand. To make a long story short, a cooler-than-normal winter clearly drove demand for natural gas as a heat source last winter. A heat wave in June and again this month are also driving demand for gas as a source of electricity to run air conditioners.
As for electric demand, it’s worth noting that electricity prices at the retail level haven’t risen as much as oil and gasoline prices in recent years. According to the EIA, US residential electricity prices are expected to rise just 5.2 percent this year, a small amount compared to the jump in gasoline prices year-over-year. Therefore, we haven’t seen high natural gas prices choking electricity demand to the same degree as rising oil prices have hit auto travel. Despite the sickening selloff of the past few weeks, I see little reason for natural gas to be trading below $9 per million British thermal units (MMBtu).
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First, the recent episode serves to reiterate the importance of the risk management strategies I recommend in TES. The big run-up of May and June was an excellent time to either take partial profits in your big winners or use options to hedge your downside risk.
I recommended doing just that in the June 12, 2008, flash alert, Unsteady as She Goes, and again in the July 16, 2008, flash alert, Oil’s Rollercoaster. I again urge readers to check out these two flash alerts and my special report on options, The ABCs of Options to Hedge Risk; an understanding of these techniques can save you considerable pain during energy market corrections.
In addition, it’s important to maintain your discipline. Do not buy hold-rated stocks in the TES portfolios and avoid buying stocks trading above my buy targets. I revise these targets periodically to ensure that investors don’t jump into recommended stocks at unfavorable prices.
But that leaves the obvious question of what to do right now. Consistent with my view that oil prices have more downside to come, I continue to favor stocks in the transportation sector.
The railroads top my list, and Wildcatters Portfolio holding Norfolk Southern is my favorite play on that sector. I explained my outlook for the railroad sector and Norfolk Southern at great depth in the July 2, 2008, issue, Take a Ride. Last weekend’s Barron’s also included a feature article that made almost exactly the same points about the group.
My primary rationale for recommending the rails is not that oil prices are falling, although this could be a tailwind. To summarize, the railroads are seeing declining shipments of consumer goods and commodities such as lumber that are leveraged to housing and construction demand. But weakness in those commodities has been more than offset by growth in shipments of coal, agricultural products and ethanol.
In addition, the railroads are the most fuel-efficient form of transport around. Even if oil prices were to pull back to $80, fuel costs remain relatively elevated. There’s a long-term shift underway in favor of modes of transport that can save on fuel costs.
And the railroads have pricing power. They’ve been able to demand higher rates for hauling goods, thanks to strong demand; rising prices have helped supercharge earnings growth.
Norfolk Southern is up about 25 percent since my recommendation a little more than a month ago. Nevertheless, I see the stock heading higher from here. Norfolk’s second quarter earnings, released in late July, topped analysts’ expectations by 13 cents per share. What was particularly impressive about this result was that Norfolk Southern was able to push its prices higher, actually offsetting a slight decline in total volumes of goods transported.
Norfolk, like most rails, uses fuel surcharges to help offset rising diesel fuel costs. This allows the rail to offset most of the rise in fuel costs but not all of the costs. Fuel charges are typically calculated using average prices on a trailing basis; if energy prices rise rapidly, the fuel charges lag those increases slightly. At any rate, this effect means that Norfolk Southern would benefit from a more-stable pricing environment for diesel fuel.
I’m also impressed by Norfolk’s ability to control costs and boost its efficiency; the railroad has been among the most consistently well-managed in the sector. Buy Norfolk Southern up to 77; I’m raising my recommended stop order to 54.50 to lower overall risk.
For a shorter-term play in transports, I favor airlines. I recommended Delta Air Lines and US Airways in the July 29 flash alert and added Delta to my aggressive Gushers Portfolio.
Railroads don’t need oil prices to perform well; however, airlines are heavily influenced by the path of crude. This makes the group an outstanding, short-term hedge against my further expected slide in crude.
To give you an idea of how important fuel prices are to the airlines, consider that Delta’s fuel costs soared by nearly $1 billion in the second quarter of this year compared to the year-earlier quarter. That’s a huge number when you consider that the entire market value of Delta Air Lines is just $2.64 billion.
Delta’s total fuel costs in the second quarter were $1.7 billion. Let’s assume that Delta’s fuel prices fall by just 15 percent this quarter. That works out to a $255 million fuel savings. Based on its outstanding float of about 300 million shares, that’s an 85-cents-per-share impact on the bottom line per quarter. Current estimates are that Delta will lose 21 cents per share in the third quarter; it’s easy to see how fuel prices can make the difference between a decent profit and a sickening loss for the airlines.
I don’t believe that fuel prices have to crater for this trade to work out. Although high fuel prices are a problem for the airlines, what’s an even bigger problem is the speed of the change. With fuel prices rising so rapidly, it’s all but impossible for Delta and the other airlines to manage their pricing, capacity and labor force to shore up profitability. If fuel prices just stabilize or stop rising, this task will become far easier.
And contrary to popular belief, the airlines are taking steps to ameliorate their condition. As I highlighted in the flash alert last week, the major carriers are cutting capacity; they’re literally ending certain unprofitable routes and retiring older, fuel-inefficient airplanes. Major capacity reductions are planned for this fall, providing yet another huge tailwind for the group.
Delta is the more-conservative pick and is among the most financially stable US air carriers. US Airways is the more-aggressive, more-leveraged play on moderating oil prices. Both stocks should be considered risky, and those buying these stocks should be prepared for some volatile moves in both directions. I don’t expect to hold the airlines for more than a few months; these aren’t long-term investments.
Delta is up 11 percent since that recommendation last week, while US Airways is up 38 percent over the same time period. Delta Air Lines remains a buy in the Gushers Portfolio up to its new target of 9.25. Investors should consider using a smaller-than-average position size to control risk on this play.
The tanker firms also continue to look like good plays in the current market. I highlighted this sector at some length in the June 18, 2008, issue, Trading Tankers. My two favorite tanker stocks are Proven Reserves holding General Maritime and Gushers Portfolio holding Nordic American Tanker.
Spot tanker rates are highly volatile and based on short-term supply-and-demand conditions. Check out the chart below.
Source: Bloomberg
The Baltic Dirty Index is a broad measure of tanker rates over various routes and for various tanker sizes. As the chart shows, tanker rates have dropped lately quite abruptly. That said, the current level of the Baltic Dirty Index is 1,751, the highest for this day in any of the past five years. The summer is a seasonally slow period for tanker rates; however, this year rates didn’t moderate much over the summer months. I explained some of the reasons for this in the June 18 issue.
As a result of the higher-than-normal rates, Nordic American has stated it’s likely to pay a dividend of more that $1.50 per share for the second quarter. Although Nordic’s dividends are variable and based on tanker rates, a quarterly dividend of $1.50 would be equivalent to a 16 percent yield.
There are some worries that a slowdown in US oil demand will mean less demand for oil imports. But the decline in US oil imports would be offset to some extent by rising imports from the developing world. And given weak non-OPEC demand growth, more of the world’s oil will have to come from the Middle East; 90 percent of oil from the key Persian Gulf region is moved by tanker, so higher OPEC output typically spells higher demand for tankers.
Finally, tanker companies are reducing the speed of their ships to conserve fuel; this effectively reduces capacity. Despite the near-term crosscurrents, I’m sticking with Nordic American and General Maritime.
Finally, for a more-diversified play, consider Gushers Portfolio recommendation iShares Dow Transport Average.
The iShares were first recommended in the May 5, 2008, flash alert, Buying Transports. This exchange traded fund (ETF) owns a portfolio of stocks in the transport industry, including a one-third weighting in the railroad index and a smaller weighting on airlines. Buy the iShares Dow Transport Average under 97.
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But this couldn’t be more untrue. Just since the beginning of June, the S&P 500 Energy Index is down more than 17 percent. Although most oil- and natural gas-levered names have seen some sort of pullback, not all have fallen at the same rate. Consider, for example, that Wildcatters Portfolio holding Schlumberger is down less than 10 percent since the end of June despite the selloff in crude.
Meanwhile, most small cap E&P firms are off more than 30 percent over the same time period. Some E&Ps that are heavily leveraged to gas, such as Petrohawk Energy (NYSE: HK), are down even more than that; Petrohawk is off nearly 40 percent since the end of June.
I don’t mention Petrohawk to say it’s a bad company or a poor long-term holding. In fact, I’m looking at Petrohawk and several other smaller, fast-growing E&P firms as potential portfolio additions; as I noted earlier, I see limited downside and a great deal of upside for natural gas prices at current levels.
My point is that E&P companies are in the business of actually producing oil and/or natural gas. These companies are, therefore, inherently more leveraged to pullbacks in commodity prices. Because natural gas prices have pulled back more sharply than oil since early July, E&P firms with heavy exposure to gas have been hit harder than those with balanced exposure to natural gas and oil.
In contrast, services companies such as Schlumberger don’t produce oil and gas. These companies don’t sell commodities and, therefore, have no direct leverage to commodity prices. Instead, these companies provide key services to oil and gas producers (the E&Ps) to help them produce their fields.
Therefore, oil services companies aren’t leveraged to prices but to drilling activity; the more aggressively producers are drilling, the more demand there is for services. For a more-detailed rundown of the services firms, check out the May 7, 2008, issue, Follow the Leader.
Obviously, there’s a relationship between commodity prices and drilling activity: When oil and gas prices rise, producers have an incentive to drill more aggressively to take advantage of those higher prices. This tends to be beneficial for the services firms.
But this is an overly simplistic view. As I’ve noted before, big international oil producers such as ExxonMobil and Chevron Corp don’t change their drilling plans with every tick in the oil futures market. These companies typically seek to exploit large reserves in international markets or in regions such as the deepwater Gulf of Mexico. These projects are planned out years in advance and are economical at oil prices lower than half the current quote. I suspect oil prices would need to slump back to around $50 per barrel for a prolonged period before international oil and gas projects would be canceled.
North American land-based operations are more volatile. They tend to be smaller, shorter-term drilling projects that can be canceled or scaled back with little notice. This makes services firms with heavy exposure to North America more commodity sensitive than their international rivals.
Longtime readers know that one of my favorite indicators of health in the services industry and the energy business in general is Schlumberger. It operates in just about every imaginable segment of the services business and every energy-producing region of the world; therefore, management has an unparalleled view of key trends underway in the industry. The company’s most recent report confirms broad-based strength in Schlumberger’s business and the services industry in general.
More important, I suspect we’ll actually see growth accelerate going into 2009. This will be a major catalyst for the stock. If you aren’t yet in Schlumberger, take advantage of the recent knee-jerk pullback in the stock to buy; Schlumberger is one of my top picks for newer subscribers who don’t already have positions in TES recommendations.
For a more-detailed rundown of the types of services Schlumberger performs, check out the May 7 issue. Here’s a quick rundown of the key points I gleaned from Schlumberger’s earnings release and conference call last month:
A New Offshore Exploration Cycle–Late last year, Schlumberger expressed some concern that demand for services related to offshore E&P activity would slow in 2008. The reason wasn’t a decline in demand but simply a shortage of offshore drilling rigs; there’s a big shortage of offshore rigs globally, making it tough for producers to produce all the fields they’d like to produce. This is known as the “platform problem.” (I explained it at length in the May 7 issue.)
As it turned out, a strong upswing in demand for land-based drilling projects offset that slowdown. But it now appears that both land and offshore markets are set to accelerate in tandem because a large number of new offshore drilling rigs are scheduled to be delivered over the next year and a half. An easing of the offshore rig shortage will allow producers to accelerate their offshore drilling activity.
Schlumberger estimates that 35 new rigs will be delivered in the fourth quarter of 2008. A total of 180 rigs are due for delivery over the next few years.
Russian Acceleration–When CEO Andrew Gould was asked about promising markets for 2009, he mentioned that he was looking for an acceleration in drilling activity and services demand in the lucrative Russian market because Russia is lowering the taxes it charges oil producers.
These taxes take away a large chunk of the benefit of rising oil prices from local producers. Because local producers don’t get the full benefit of rising prices, they’re not incentivized properly to undertake more drilling projects; oil production from Russia has actually been dropping recently for the first time in many years.
The Russian government knows this and is cutting taxes on producers to encourage more E&P activity. When an analyst asked if the proposed cuts would be enough to support more activity, Gould responded with a simple, unequivocal “yes.” Because Russia is a huge market for Schlumberger, this reacceleration in activity is an undeniable positive.
Competition not a Huge Issue–One concern about the big international services firms has been that they’d compete aggressively for big contracts, which would put pressure on the prices they could charge for key services.
But this doesn’t appear to be the case. Schlumberger noted that many big offshore projects in the deepwater cost $1.2 million per day in basic rig and operating costs. Therefore, operators are just as concerned about a services company’s ability to execute a project quickly and efficiently as they are about how much it costs to utilize the services firm.
To give you an idea of the importance of speed and efficiency, consider that operators are no longer fishing on offshore projects. Fishing in the oil business has nothing to do with a rod and reel; rather the term refers to retrieving equipment or waste material that gets stuck or breaks off in a well. Examples might include well testing equipment, bits of pipe or drill bits.
In year’s past, operators would try to fish these items out of the well to save costs. But now many operators are simply leaving the equipment in the hole and drilling around it. This causes the equipment to be permanently lost but also speeds up the drilling process. And at $1.2 million per day, time is definitely money.
Schlumberger’s history or executing complex services projects quickly and efficiently gives it a leg up on would-be, smaller competitors with a less-proven track record. Schlumberger isn’t seeing huge competitive pricing pressures.
International Gas Exploration–Schlumberger also highlighted the fact that oil drilling isn’t the only activity accelerating worldwide but natural gas drilling as well. Remember natural gas prices in the US and foreign markets are rarely equal; currently international gas prices remain higher than those in the US.
As I’ve mentioned on a number of occasions, I see continued growth in natural gas demand globally in part because of its status as the most-environmentally friendly fossil fuel. For more on that, check out the April 23, 2008, issue, Electric Charge.
During Schlumberger’s conference call, Gould noted:
This quote suggests that natural gas drilling activity is much stronger abroad than Schlumberger expected. This also bodes well for activity levels and Schlumberger’s business
Unwilling to Call North America in 2009–Schlumberger’s CEO refused to speculate as to activity levels in the US and Canada next year. As I noted earlier, these markets are the world’s most commodity-price sensitive.
Schlumberger was clearly surprised by the big run-up in drilling activity in the first half of 2008 for North America. This was due primarily to the big rally in natural gas since the end of 2007. Gould seemed unwilling to bet either way on whether the red-hot pace of activity would continue into 2009. The company did suggest it would continue through this year and it’s seeing pricing power even in previously weak markets such as pressure pumping. (See the Feb 20. issue for an explanation.)
All told, these points add up to strong, continued growth internationally for Schlumberger. Because the firm is among the least exposed of any services provider to North America, volatility in that business isn’t a particular concern.
There’s also fast-growing service provider Weatherford International. I suspect this company has been hit harder than Schlumberger mainly because of its relatively large North American exposure and fear that lower gas prices will hit this market.
However, Weatherford’s main growth driver in recent years has been international, not North America. Each quarter its exposure to the domestic market falls a bit more; these fears are overblown.
Moreover, I still believe that natural gas prices have limited downside from current levels; I don’t see a huge North American slowdown next year. Weatherford International remains a buy under 43.60.
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We got stopped out of XTO Energy at 45 Monday, Aug. 4, for about a 12.5 percent gain from my original recommendation. However, I recommended hedging this position in the June 12 flash alert using the November 65 put options (XTO WM).
If you took that recommendation, you’re still holding XTO and sitting on a 64 percent profit. This hedge would have all but eliminated the pain of the recent selloff. This illustrates in vivid detail the value of this strategy.
I don’t include options when calculating TES returns because I’m aware that not all subscribers are willing to do options hedge trades. However, I also recommended booking partial gains on a third of to half your position on two occasions, in the June 12 and July 16 flash alerts.
If you booked just a one-third profit on the latter date, you’re still sitting on a sizeable 25 percent gain despite the fastest selloff in this stock since 1999. I can’t stress enough just how important this sort of risk management is in a volatile market.
XTO Energy is one of my favorite E&P firms because of its exposure to unconventional reserves and its history of strong cost management. Nonetheless, as I explained above, natural gas-focused E&Ps are the weakest energy sector right now because of the sharp selloff in gas prices. If you were stopped out, I recommend standing aside XTO Energy for now; I’ll recommend jumping back in at the first sign of stability.
If you’re still holding the stock and puts, follow the advice in the July 25 flash alert.
Hercules Offshore is a shallow-water contract driller focused on the Gulf of Mexico. The company’s recent earnings report suggested an uptick in activity levels and rising day-rates for its rigs; day-rates are simply the fees charged for leasing drilling rigs from Hercules.
The stock has also been hit because of falling gas prices. However, this is an extreme overreaction to gas around $9 per MMBtu. I suspect natural gas would have to drop below $8.50 per MMBtu for several weeks to really destroy the recent signs of an upturn.
We were stopped out of the stock earlier this week, roughly flat with my entry point. Although I’m surprised by the rapidity of the selling, I see the current price as an attractive buying opportunity. I’m adding Hercules Offshore back to the aggressive Gushers Portfolio.
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The good news: This isn’t the end of the world or the end of the energy bull market. Don’t be tempted to buy into the hype, and don’t panic. We’ve seen several corrections in the energy patch over the past few years, some even more severe than the past month’s move.
I see plenty of opportunities in the current environment, and I believe we’re just a few weeks away from a buying opportunity, particularly in names leveraged to natural gas. In this week’s issue, we’ll take a look at some of my favorite stocks and sectors in light of recent news and earnings events.
In This Issue
I recently highlighted the pullback in the energy prices. This isn’t a reason to panic; such corrections have occurred several times over the past couple years, and energy prices have still risen. But the US is no longer the driving force it once was for oil prices. Emerging market demand growth will continue to be a major factor going forward. See Looking for Context.Several factors have affected the price drops in the energy sector of late, including seemingly non-related activities such as the shorting of financials. I’ve been highlighting these trends in both flash alerts and the most recent issue of The Energy Letter, TES’ sister publication, and see the potential for oil and natural gas to outperform commodities in the coming months. See Perception Is Reality.
Despite the pullback in energy, some sectors still look set for growth. Here’s a rundown on those sectors and my top picks for each. See How to Play It.
I continue to watch Schlumberger as an indicator on trends in the services sector. The company discussed a number of important topics during its second quarter conference call last month, all of which should bode well for the company going forward. See Strength in Services.
Two stocks in the TES portfolios touched my recommended stop levels. One is worth re-entering at this point; one isn’t. See Portfolio Update.
I’m recommending or reiterating my recommendation in the following stocks:
- Delta Air Lines (NYSE: DAL)
- General Maritime (NYSE: GMR)
- Hercules Offshore (NSDQ: HERO)
- iShares Dow Transport Average (NYSE: IYT)
- Nordic American Tanker (NYSE: NAT)
- Norfolk Southern (NYSE: NSC)
- Schlumberger (NYSE: SLB)
- Weatherford International (NYSE: WFT)
- XTO Energy (NYSE: XTO)
Looking for Context
It’s important to put the recent move into context. Although the selloff has been quick, sharp and scary, look at the longer-term chart of West Texas Intermediate Oil prices below.Source: StockCharts.com
As you can see, viewed in the context of a four-year period, the recent pullback doesn’t look all that unusual. Oil prices have simply returned to levels last seen in early May, just three months ago. In fact, the move looks like a correction of a market that simply got extended toward the end of the second quarter. A quick perusal of this chart shows similar corrections in 2006-07 and on a few occasions back in 2005.
Also, remember that a year ago oil prices were trading under $75 per barrel and the first analysts to predict $100-per-barrel oil took a good deal of criticism in the press. Oil crossed $100 per barrel for the first time just about six months ago. This is hardly the bursting bubble and crash some have made it out to be.
Each of these pullbacks has ultimately resulted in an outstanding buying opportunity for investors. Although that golden opportunity is likely still a few weeks away, we’ve capitalized handsomely on these opportunities in TES before, and I firmly believe we’ll have just such an opportunity once again.
The ultimate, fundamental driver of this weakness is a faltering US economy that’s likely to get even weaker before it improves. There are valid fears that US consumers are reducing their consumption of gasoline and are cutting back on their driving during the typically busy summer driving season. This is clearly visible in the chart below.
Source: Federal Highway Administration
This chart shows the total vehicle miles traveled in the US, which are based on machines that automatically count traffic at 4,000 locations all over the US, both highways and rural roads.
The data are released with a time lag; the Highway Administration just released data for May last week. But the trend is clear: The yellow line represents travel in 2008, and it’s sharply below the levels we saw in 2006 and 2007. The period of seasonal strength in driving demand–the so-called summer driving season–is less evident on this year’s chart than in prior years.
In fact, the Highway Administration reported that this is the largest year-over-year drop in vehicle miles traveled for the month of May since it began publishing this measure. Moreover, this is the third-largest year-over-year drop ever.
I’ve been on the record suggesting the US economy has been in a recession since the beginning of 2008. (See the Jan. 23, 2008, issue, Strengthening Headwinds, for a more-detailed view of that assessment.) Longtime readers know that one of my favorite measures of economic health is the US leading economic indicator (LEI), which is shown in the chart below.
Source: Bloomberg
The LEI is actually a composite of 10 key economic indicators. The list includes housing starts, consumer expectations, jobless claims and even the performance of the US stock market.
The chart shows the year-over-year percent change in leading economic indicators. As evidenced from this chart, the LEI tends to turn negative just ahead of or coincident with US recessions.
For example, the LEI turned negative on a year-over-year basis in June 1989; a US recession followed in July 1990 and lasted through March 1991. Similarly, the December 2000 dip in the LEI below zero foreshadowed the March-November 2001 recession.
Like every indicator, the LEI is far from infallible. For example, a short dip below zero in 1996 turned out to be a false alarm. However, the indicator is correct more than it’s wrong, and we can’t ignore the slump we’ve seen since late last year.
The LEI is now at -2.1 percent year-over-year, a level unseen since the recessions of 2001 and 1990-91. Although the impact of the US government’s fiscal stimulus checks seems to have moderated the deterioration over the past few months, we could definitely see more downside ahead.
Also remember that two consecutive quarters of negative growth in the gross domestic product is not the official definition of a recession. This is a common fallacy. The official start and end dates for US recessions are decided by the National Bureau of Economic Research (NBER) business cycle dating committee and are based on a much wider number of indicators than simple GDP growth.
Usually, recessions are announced long after they actually start; in some cases, the dating committee only determines that a recession occurred long after it’s over. A look at the broader definition of recessions suggests we’re almost certainly in contraction right now or, at least, soon will be.
These statistics make for scary reading. However, it’s important to remember that the US and, more broadly, the developed world aren’t the drivers of global oil demand growth.
Source: BP
This chart shows contribution to global demand for oil from the US, Organization of Economic Cooperation and Development (OECD) countries and non-OECD countries over the past few years. The OECD countries are a proxy for the developed world, while the non-OECD nations include emerging markets such as China and India. I excluded the US from the OECD data and charted that data separately.
As you can see, the yellow bar representing the growth in demand from the developing world has been far and away the most important source of demand growth over the past decade. In fact, over the past few years, US and other OECD countries have actually had a negative impact on global demand; OECD demand (excluding the US) actually declined by nearly 400,000 barrels per day last year, offset only by a near 1.4 million-barrel-per-day jump from the developed world.
As I noted in the Jan. 23, 2008, issue, the growth in oil demand from emerging markets is a secular shift, not a cyclical upturn. As these economies grow and consumers become wealthier, it’s only natural that energy consumption rises.
Chinese consumption has indeed been rising but remains at around two barrels of oil per person per year, a tiny fraction of the 25 barrels per person annually consumed in the US and the 10 to 15 barrels per year common in developed European nations. Chinese oil demand growth continues to have plenty of room to rise.
Source: Bloomberg
This chart shows monthly Chinese automobile sales going back to the beginning of 2005. Although there are certainly monthly variations, sales remain strong. This will power growth in demand for oil over time.
The trends at work in the global oil market really aren’t particularly surprising from a basic economic viewpoint. The past few years have brought huge growth in global oil demand led by growth in emerging economies. This is likely to continue generally in coming years as these economies continue to develop.
Meanwhile, supply growth has and will remain constrained. Oil production from outside Organization of the Petroleum Exporting Countries (OPEC) has consistently missed analysts’ expectations. Consider just the pattern in non-OPEC production growth estimates for 2008.
Source: International Energy Agency
The International Energy Agency (IEA) begins estimating non-OPEC production growth for the following year in July; the agency began estimating 2008 production growth in July 2007.
Last July, the IEA first published 2008 forecasts for non-OPEC production growth of nearly 1 million barrels a day. That figure has once again steadily dropped, reaching 422,000 as of the most-recent report, published July 10.
Even less encouraging, from a supply standpoint, is that IEA estimates for 2009 non-OPEC supply growth currently stand at just 639,000 barrels a day. It’s quite likely that forecasted supply growth will drop even further in coming months, following the pattern witnessed in each of the past four years.
New supplies from regions such as Brazil and Kazakhstan are due to come online over the next five years, but these supplies will do little more than make up for declining output from mature fields. There’s growing evidence that the IEA and other major agencies that follow the global energy markets are consistently underestimating the decline rates of global oilfields. In other words, production from existing oilfields is falling at a faster-than-expected rate. This is the main reason estimates have proven too optimistic in recent years.
And more than half of the projected increase in non-OPEC production for 2009 is expected to come from a jump in biofuels output. Biofuels such as ethanol and biodiesel are derived almost exclusively from crops such as corn, soybeans and rapeseed. Already the dramatic increase in biofuels production of the past five years is straining the global agriculture market and prompting large jumps in prices of basic foodstuffs. There are real questions as to the sustainability of growth in biofuels output.
The same basic pattern of disappointing non-OPEC production has occurred like clockwork in recent years. To fill the gap, OPEC has boosted output. But that increase has all but eliminated the world’s spare oil capacity. (Spare capacity is surplus oil production capacity that can be brought online within a month and reliably produce oil for at least 90 days.)
According to the Energy Information Administration (EIA), current global spare capacity is likely closer to 1.2 million barrels per day. That means the global oil market is running at close to 99 percent of capacity, leaving little cushion to offset supply-and-demand shocks.
This global oil market imbalance is having the predictable outcome. If demand is rising and supply can’t rise to meet demand, prices must rise. Rising prices have the effect of choking off oil demand enough to bring supply and demand back into balance.
In the oil market, geological conditions make it very hard for supply to adjust upward; therefore, the only factors that can change are price and demand. This is exactly the effect we’re seeing in the US and other OECD countries right now: The rise in oil prices to near $150 per barrel and that quick spike in gasoline to more than $4 per gallon finally pinched the ever-resilient US motorist.
Ultimately, we’re seeing a historic shift in the engine of the global oil market from the US and OECD to the emerging markets. Traders and investors haven’t yet sorted out all these changes, so there’s a natural tendency to cling to the indicators that governed the oil markets five or 10 years ago. That means an overfixation on US oil inventories and demand projections. As the market works through this fundamental shift, the conflicting fundamental crosscurrents are contributing to the volatility we’re seeing in the crude oil markets.
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Perception Is Reality
Although the basic, long-term story for oil remains bullish, that doesn’t mean the trend will proceed in a direct line higher. No great bull market in history has unfolded in this manner, including the energy market of the past few years.Whether you look at gold in the 1970s or the Nasdaq Composite in the ’90s, you’ll find plenty of nasty corrections in the context of a general uptrend that were highly profitable for investors. We’re now experiencing such a correction; this move will soon mark yet another extraordinary buying opportunity. In fact, as I detail below, I’m already seeing some selective opportunities.
We can’t completely ignore the inevitable pullback. The only effective strategy is to take steps to hedge your risks and maintain a consistent discipline. In addition, a number of plays in the TES portfolios will actually benefit from softer oil prices or, at least, a moderation in the pace of oil’s advance; in other words, there are plenty of ways to make money even if oil pulls back further over the next few weeks.
As I noted earlier, the primary fundamental factor pushing oil prices lower is fear over US demand trends. But just as important as declining US demand is a number of technical and psychological factors. In fact, while fundamental supply and demand will govern longer-term trends, sentiment, greed and fear are behind short-term volatility in oil.
In the June 4, 2008, issue, Crude Realities, I analyzed speculation in the energy markets and its effect on pricing. My view was that speculation isn’t the root cause of rising energy prices; nonetheless, it can certainly have a short-term impact. And profit-taking by speculators at the beginning of the third quarter has certainly been a factor driving energy commodities and related stocks lower.
You can clearly see this in the chart below, which also appeared in the July 23, 2008, issue, Clean Coal and Energy Efficiency.
Source: Bloomberg
This chart depicts US oil prices in the top pane and the total open interest in the futures market–the total number of contracts open in this market–on the bottom pane. As you can see, open interest has been declining for months, long before crude oil hit a peak in early July. This flies in the face of the idea that speculators have been massively increasingly their exposure to oil and pushing prices higher this year.
But note that open interest has been unwinding at a faster pace since the beginning of the third quarter. This indicates a more-rapid unwinding of traders’ bullish positions in crude oil. I suspect the same thing is happening in the energy stocks as too many traders try to take cash off the table simultaneously.
This really shouldn’t come as a huge surprise. After all, the broader stock market was extremely weak in the first two quarters of 2008; oil- and energy-related stocks were two of the only positions that actually made money. Traders clearly sought to lock in some of these gains at the end of the second quarter and in the early days of this quarter.
Two additional factors exacerbated this trend. First, on several days over the past month, when energy stocks had been hit hard on heavy volume, there had been rumors of distressed hedge funds selling down their portfolios. I never put too much stock in rumors, but the tremendous downside volume witnessed in many commodity-related investments at times is reminiscent of the action around the September 2006 blowup of the energy-focused Amaranth hedge fund.
Although there’s no way to know for certain, it seems logical that some hedge funds might have been caught on the wrong side of the quick selloff in oil prices last month; their unwinding probably contributed to the downside because they were distressed sellers. They simply had to sell at any price to raise cash. We also know for a fact that SemGroup, a midstream energy infrastructure provider, collapsed last month after losing big on speculative oil positions; the company was forced to unwind these trades for huge losses.
Source: Bloomberg
The chart above shows the Philadelphia Banking Index, an index containing major US financials. Although it might seem totally off-topic to discuss banks in an energy newsletter, it isn’t.
In the first two quarters of 2008, the big winning trade (apart from energy) was to bet against, or “short,” financials. But the US Securities and Exchange Commission (SEC) decided to ban or, at least, severely limit that practice last month when it prohibited short sales of certain financials unless the seller had actually borrowed the shares. That move, coupled with the virtual bailout of mortgage giants Fannie Mae and Freddie Mac, prompted what’s known as a short squeeze in financials.
When you initiate a short sale, you’re essentially selling shares in a company you don’t own. (Technically, you’re supposed to borrow the shares.) You make money if the stock in question falls in value. When you close, or “cover,” a short, you must buy back the shares you sold on the open market. If enough short sellers decide to buy back a stock, it sends the price higher.
But the higher the stock goes, the more money the shorts lose. This pain, in turn, prompts more shorts to cover their bets. And that kicks off a vicious cycle: Shorts cover their bets and send the stocks even higher, leading to even more short covering. I believe this short covering is exactly what sent the Banking Index sharply higher in July.
To make a long story short, any trader short the financials in early July got caught in this squeeze and likely felt plenty of pain. This probably prompted some funds to raise cash by selling down their bets in energy stocks. The nearly inverse moves in financials and energy shares suggest this view has some merit.
All told, this tends to support the view of the crude oil market I outlined in last week’s flash alert, “Oil–Neither Here nor There”: Negative headlines about demand destruction, coupled with some of the shorter-term technical factors I just outlined, will likely push oil lower in the short term.
On a shorter-term basis, I’m always suspicious of markets that fail to rally on bullish news; oil has, in fact, been falling despite heightened hurricane activity, a bullish inventory report last week and continued geopolitical strife. This means that traders are using any rallies–such as we saw a week ago in the wake of a bullish US oil inventory report–as an excuse to sell into strength. This is a powerful indication of more near-term downside to come.
At the same time, a collapse is highly unlikely, despite what you may hear from some oil bears. The longer-term fundamental factors I outlined earlier in today’s report will act as a floor for prices.
Further, as I noted in last week’s issue of TEL, Defining Demand Destruction, I’m not sure all the decline in US oil consumption represents permanent demand destruction instead of a temporary retrenchment. After all, retail gasoline prices are falling nationwide; this quick relief might actually encourage drivers to try to take advantage with a late-summer holiday.
My view of the oil market remains that we’re in for a volatile trading range. Oil prices will remain supported around $110 per barrel and capped at around $145 per barrel. Short-lived spikes are possible on both sides of that range.
Before I delve into exactly how I recommend playing this environment, two additional points are worth mentioning: the potential for a decoupling of energy stocks from commodity prices and natural gas.
Source: Bloomberg
The S&P 500 Energy Index hit its high on May 20, 2008, more than one month before crude oil hit its recent top in early July. Moreover, crude oil rallied more than 40 percent in the first half of 2008, and natural gas prices were up 65 percent over the same time period. But the S&P 500 Energy Index was up just 9 percent, and the Philadelphia Oil Services Index was up less than 18 percent.
This illustrates that oil- and gas-related stocks handily underperformed the commodities in the first half of this year. This suggests to me that energy stocks never really fully priced in $147-per-barrel oil and the $13.50-per-million-British-thermal-units natural gas.
Clearly, a rapid decrease in oil and gas prices, such as we’ve witnessed in recent weeks, can sour sentiment on related stocks short term. However, I see the scope for energy stocks to actually handily outperform the underlying commodities over the next few months; some sectors of the energy patch could move higher even if oil drifts down to around $110 per barrel short term. The reason is simple: The group never priced in $150 oil and is, therefore, overreacting to the commodity price drop over the past few weeks.
My second point is that I see far less of a fundamental rationale for natural gas and coal prices to be falling right now. Both commodities appear to be falling in sympathy with oil. Natural gas has a reputation as “the widow-maker” because of its extreme price volatility; the commodity rose more than oil in the first six months of this year and has fallen faster over the past few weeks.
The only fundamental rationale I can see for gas prices to decline is that some traders believe that US production growth will swamp demand, thanks to strong production increases from so-called unconventional reserves. (For those unfamiliar with this term, check out the Feb. 20, 2008, issue, Growing Unconventionally.)
This is a valid point. However, to date, it just hasn’t been showing up in the natural gas inventory figures. So far this year, natural gas in storage has actually fallen from glutted levels to below the five-year average.
In addition, natural gas demand is holding up extraordinarily well despite the economic slowdown that’s been crimping oil demand. I believe there are two reasons for this: the weather and the stability of electricity demand. To make a long story short, a cooler-than-normal winter clearly drove demand for natural gas as a heat source last winter. A heat wave in June and again this month are also driving demand for gas as a source of electricity to run air conditioners.
As for electric demand, it’s worth noting that electricity prices at the retail level haven’t risen as much as oil and gasoline prices in recent years. According to the EIA, US residential electricity prices are expected to rise just 5.2 percent this year, a small amount compared to the jump in gasoline prices year-over-year. Therefore, we haven’t seen high natural gas prices choking electricity demand to the same degree as rising oil prices have hit auto travel. Despite the sickening selloff of the past few weeks, I see little reason for natural gas to be trading below $9 per million British thermal units (MMBtu).
Back to In This Issue
How to Play It
I recommend approaching the current environment in exactly the same way we’ve approached prior rallies and corrections in energy stocks over the past few years.First, the recent episode serves to reiterate the importance of the risk management strategies I recommend in TES. The big run-up of May and June was an excellent time to either take partial profits in your big winners or use options to hedge your downside risk.
I recommended doing just that in the June 12, 2008, flash alert, Unsteady as She Goes, and again in the July 16, 2008, flash alert, Oil’s Rollercoaster. I again urge readers to check out these two flash alerts and my special report on options, The ABCs of Options to Hedge Risk; an understanding of these techniques can save you considerable pain during energy market corrections.
In addition, it’s important to maintain your discipline. Do not buy hold-rated stocks in the TES portfolios and avoid buying stocks trading above my buy targets. I revise these targets periodically to ensure that investors don’t jump into recommended stocks at unfavorable prices.
But that leaves the obvious question of what to do right now. Consistent with my view that oil prices have more downside to come, I continue to favor stocks in the transportation sector.
The railroads top my list, and Wildcatters Portfolio holding Norfolk Southern is my favorite play on that sector. I explained my outlook for the railroad sector and Norfolk Southern at great depth in the July 2, 2008, issue, Take a Ride. Last weekend’s Barron’s also included a feature article that made almost exactly the same points about the group.
My primary rationale for recommending the rails is not that oil prices are falling, although this could be a tailwind. To summarize, the railroads are seeing declining shipments of consumer goods and commodities such as lumber that are leveraged to housing and construction demand. But weakness in those commodities has been more than offset by growth in shipments of coal, agricultural products and ethanol.
In addition, the railroads are the most fuel-efficient form of transport around. Even if oil prices were to pull back to $80, fuel costs remain relatively elevated. There’s a long-term shift underway in favor of modes of transport that can save on fuel costs.
And the railroads have pricing power. They’ve been able to demand higher rates for hauling goods, thanks to strong demand; rising prices have helped supercharge earnings growth.
Norfolk Southern is up about 25 percent since my recommendation a little more than a month ago. Nevertheless, I see the stock heading higher from here. Norfolk’s second quarter earnings, released in late July, topped analysts’ expectations by 13 cents per share. What was particularly impressive about this result was that Norfolk Southern was able to push its prices higher, actually offsetting a slight decline in total volumes of goods transported.
Norfolk, like most rails, uses fuel surcharges to help offset rising diesel fuel costs. This allows the rail to offset most of the rise in fuel costs but not all of the costs. Fuel charges are typically calculated using average prices on a trailing basis; if energy prices rise rapidly, the fuel charges lag those increases slightly. At any rate, this effect means that Norfolk Southern would benefit from a more-stable pricing environment for diesel fuel.
I’m also impressed by Norfolk’s ability to control costs and boost its efficiency; the railroad has been among the most consistently well-managed in the sector. Buy Norfolk Southern up to 77; I’m raising my recommended stop order to 54.50 to lower overall risk.
For a shorter-term play in transports, I favor airlines. I recommended Delta Air Lines and US Airways in the July 29 flash alert and added Delta to my aggressive Gushers Portfolio.
Railroads don’t need oil prices to perform well; however, airlines are heavily influenced by the path of crude. This makes the group an outstanding, short-term hedge against my further expected slide in crude.
To give you an idea of how important fuel prices are to the airlines, consider that Delta’s fuel costs soared by nearly $1 billion in the second quarter of this year compared to the year-earlier quarter. That’s a huge number when you consider that the entire market value of Delta Air Lines is just $2.64 billion.
Delta’s total fuel costs in the second quarter were $1.7 billion. Let’s assume that Delta’s fuel prices fall by just 15 percent this quarter. That works out to a $255 million fuel savings. Based on its outstanding float of about 300 million shares, that’s an 85-cents-per-share impact on the bottom line per quarter. Current estimates are that Delta will lose 21 cents per share in the third quarter; it’s easy to see how fuel prices can make the difference between a decent profit and a sickening loss for the airlines.
I don’t believe that fuel prices have to crater for this trade to work out. Although high fuel prices are a problem for the airlines, what’s an even bigger problem is the speed of the change. With fuel prices rising so rapidly, it’s all but impossible for Delta and the other airlines to manage their pricing, capacity and labor force to shore up profitability. If fuel prices just stabilize or stop rising, this task will become far easier.
And contrary to popular belief, the airlines are taking steps to ameliorate their condition. As I highlighted in the flash alert last week, the major carriers are cutting capacity; they’re literally ending certain unprofitable routes and retiring older, fuel-inefficient airplanes. Major capacity reductions are planned for this fall, providing yet another huge tailwind for the group.
Delta is the more-conservative pick and is among the most financially stable US air carriers. US Airways is the more-aggressive, more-leveraged play on moderating oil prices. Both stocks should be considered risky, and those buying these stocks should be prepared for some volatile moves in both directions. I don’t expect to hold the airlines for more than a few months; these aren’t long-term investments.
Delta is up 11 percent since that recommendation last week, while US Airways is up 38 percent over the same time period. Delta Air Lines remains a buy in the Gushers Portfolio up to its new target of 9.25. Investors should consider using a smaller-than-average position size to control risk on this play.
The tanker firms also continue to look like good plays in the current market. I highlighted this sector at some length in the June 18, 2008, issue, Trading Tankers. My two favorite tanker stocks are Proven Reserves holding General Maritime and Gushers Portfolio holding Nordic American Tanker.
Spot tanker rates are highly volatile and based on short-term supply-and-demand conditions. Check out the chart below.
Source: Bloomberg
The Baltic Dirty Index is a broad measure of tanker rates over various routes and for various tanker sizes. As the chart shows, tanker rates have dropped lately quite abruptly. That said, the current level of the Baltic Dirty Index is 1,751, the highest for this day in any of the past five years. The summer is a seasonally slow period for tanker rates; however, this year rates didn’t moderate much over the summer months. I explained some of the reasons for this in the June 18 issue.
As a result of the higher-than-normal rates, Nordic American has stated it’s likely to pay a dividend of more that $1.50 per share for the second quarter. Although Nordic’s dividends are variable and based on tanker rates, a quarterly dividend of $1.50 would be equivalent to a 16 percent yield.
There are some worries that a slowdown in US oil demand will mean less demand for oil imports. But the decline in US oil imports would be offset to some extent by rising imports from the developing world. And given weak non-OPEC demand growth, more of the world’s oil will have to come from the Middle East; 90 percent of oil from the key Persian Gulf region is moved by tanker, so higher OPEC output typically spells higher demand for tankers.
Finally, tanker companies are reducing the speed of their ships to conserve fuel; this effectively reduces capacity. Despite the near-term crosscurrents, I’m sticking with Nordic American and General Maritime.
Finally, for a more-diversified play, consider Gushers Portfolio recommendation iShares Dow Transport Average.
The iShares were first recommended in the May 5, 2008, flash alert, Buying Transports. This exchange traded fund (ETF) owns a portfolio of stocks in the transport industry, including a one-third weighting in the railroad index and a smaller weighting on airlines. Buy the iShares Dow Transport Average under 97.
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Strength in Services
One of the ongoing themes in TES is that not all segments of the energy patch trade in the same direction at the same time. All too often investors look at energy stocks as a homogenous group and make little distinction between oil services stocks, exploration and production (E&P) firms and even companies leveraged to natural gas and coal.But this couldn’t be more untrue. Just since the beginning of June, the S&P 500 Energy Index is down more than 17 percent. Although most oil- and natural gas-levered names have seen some sort of pullback, not all have fallen at the same rate. Consider, for example, that Wildcatters Portfolio holding Schlumberger is down less than 10 percent since the end of June despite the selloff in crude.
Meanwhile, most small cap E&P firms are off more than 30 percent over the same time period. Some E&Ps that are heavily leveraged to gas, such as Petrohawk Energy (NYSE: HK), are down even more than that; Petrohawk is off nearly 40 percent since the end of June.
I don’t mention Petrohawk to say it’s a bad company or a poor long-term holding. In fact, I’m looking at Petrohawk and several other smaller, fast-growing E&P firms as potential portfolio additions; as I noted earlier, I see limited downside and a great deal of upside for natural gas prices at current levels.
My point is that E&P companies are in the business of actually producing oil and/or natural gas. These companies are, therefore, inherently more leveraged to pullbacks in commodity prices. Because natural gas prices have pulled back more sharply than oil since early July, E&P firms with heavy exposure to gas have been hit harder than those with balanced exposure to natural gas and oil.
In contrast, services companies such as Schlumberger don’t produce oil and gas. These companies don’t sell commodities and, therefore, have no direct leverage to commodity prices. Instead, these companies provide key services to oil and gas producers (the E&Ps) to help them produce their fields.
Therefore, oil services companies aren’t leveraged to prices but to drilling activity; the more aggressively producers are drilling, the more demand there is for services. For a more-detailed rundown of the services firms, check out the May 7, 2008, issue, Follow the Leader.
Obviously, there’s a relationship between commodity prices and drilling activity: When oil and gas prices rise, producers have an incentive to drill more aggressively to take advantage of those higher prices. This tends to be beneficial for the services firms.
But this is an overly simplistic view. As I’ve noted before, big international oil producers such as ExxonMobil and Chevron Corp don’t change their drilling plans with every tick in the oil futures market. These companies typically seek to exploit large reserves in international markets or in regions such as the deepwater Gulf of Mexico. These projects are planned out years in advance and are economical at oil prices lower than half the current quote. I suspect oil prices would need to slump back to around $50 per barrel for a prolonged period before international oil and gas projects would be canceled.
North American land-based operations are more volatile. They tend to be smaller, shorter-term drilling projects that can be canceled or scaled back with little notice. This makes services firms with heavy exposure to North America more commodity sensitive than their international rivals.
Longtime readers know that one of my favorite indicators of health in the services industry and the energy business in general is Schlumberger. It operates in just about every imaginable segment of the services business and every energy-producing region of the world; therefore, management has an unparalleled view of key trends underway in the industry. The company’s most recent report confirms broad-based strength in Schlumberger’s business and the services industry in general.
More important, I suspect we’ll actually see growth accelerate going into 2009. This will be a major catalyst for the stock. If you aren’t yet in Schlumberger, take advantage of the recent knee-jerk pullback in the stock to buy; Schlumberger is one of my top picks for newer subscribers who don’t already have positions in TES recommendations.
For a more-detailed rundown of the types of services Schlumberger performs, check out the May 7 issue. Here’s a quick rundown of the key points I gleaned from Schlumberger’s earnings release and conference call last month:
A New Offshore Exploration Cycle–Late last year, Schlumberger expressed some concern that demand for services related to offshore E&P activity would slow in 2008. The reason wasn’t a decline in demand but simply a shortage of offshore drilling rigs; there’s a big shortage of offshore rigs globally, making it tough for producers to produce all the fields they’d like to produce. This is known as the “platform problem.” (I explained it at length in the May 7 issue.)
As it turned out, a strong upswing in demand for land-based drilling projects offset that slowdown. But it now appears that both land and offshore markets are set to accelerate in tandem because a large number of new offshore drilling rigs are scheduled to be delivered over the next year and a half. An easing of the offshore rig shortage will allow producers to accelerate their offshore drilling activity.
Schlumberger estimates that 35 new rigs will be delivered in the fourth quarter of 2008. A total of 180 rigs are due for delivery over the next few years.
Russian Acceleration–When CEO Andrew Gould was asked about promising markets for 2009, he mentioned that he was looking for an acceleration in drilling activity and services demand in the lucrative Russian market because Russia is lowering the taxes it charges oil producers.
These taxes take away a large chunk of the benefit of rising oil prices from local producers. Because local producers don’t get the full benefit of rising prices, they’re not incentivized properly to undertake more drilling projects; oil production from Russia has actually been dropping recently for the first time in many years.
The Russian government knows this and is cutting taxes on producers to encourage more E&P activity. When an analyst asked if the proposed cuts would be enough to support more activity, Gould responded with a simple, unequivocal “yes.” Because Russia is a huge market for Schlumberger, this reacceleration in activity is an undeniable positive.
Competition not a Huge Issue–One concern about the big international services firms has been that they’d compete aggressively for big contracts, which would put pressure on the prices they could charge for key services.
But this doesn’t appear to be the case. Schlumberger noted that many big offshore projects in the deepwater cost $1.2 million per day in basic rig and operating costs. Therefore, operators are just as concerned about a services company’s ability to execute a project quickly and efficiently as they are about how much it costs to utilize the services firm.
To give you an idea of the importance of speed and efficiency, consider that operators are no longer fishing on offshore projects. Fishing in the oil business has nothing to do with a rod and reel; rather the term refers to retrieving equipment or waste material that gets stuck or breaks off in a well. Examples might include well testing equipment, bits of pipe or drill bits.
In year’s past, operators would try to fish these items out of the well to save costs. But now many operators are simply leaving the equipment in the hole and drilling around it. This causes the equipment to be permanently lost but also speeds up the drilling process. And at $1.2 million per day, time is definitely money.
Schlumberger’s history or executing complex services projects quickly and efficiently gives it a leg up on would-be, smaller competitors with a less-proven track record. Schlumberger isn’t seeing huge competitive pricing pressures.
International Gas Exploration–Schlumberger also highlighted the fact that oil drilling isn’t the only activity accelerating worldwide but natural gas drilling as well. Remember natural gas prices in the US and foreign markets are rarely equal; currently international gas prices remain higher than those in the US.
As I’ve mentioned on a number of occasions, I see continued growth in natural gas demand globally in part because of its status as the most-environmentally friendly fossil fuel. For more on that, check out the April 23, 2008, issue, Electric Charge.
During Schlumberger’s conference call, Gould noted:
….there is a lot of gas exploration in the Middle East for example…What we are seeing more and more and I suspect is that, as you point out, the shortage of worldwide gas means that people are starting to look at unconventional sources of natural gas overseas, which is something we thought would come much later.
Source: Schlumberger Second Quarter Conference Call, July 18, 2008
This quote suggests that natural gas drilling activity is much stronger abroad than Schlumberger expected. This also bodes well for activity levels and Schlumberger’s business
Unwilling to Call North America in 2009–Schlumberger’s CEO refused to speculate as to activity levels in the US and Canada next year. As I noted earlier, these markets are the world’s most commodity-price sensitive.
Schlumberger was clearly surprised by the big run-up in drilling activity in the first half of 2008 for North America. This was due primarily to the big rally in natural gas since the end of 2007. Gould seemed unwilling to bet either way on whether the red-hot pace of activity would continue into 2009. The company did suggest it would continue through this year and it’s seeing pricing power even in previously weak markets such as pressure pumping. (See the Feb 20. issue for an explanation.)
All told, these points add up to strong, continued growth internationally for Schlumberger. Because the firm is among the least exposed of any services provider to North America, volatility in that business isn’t a particular concern.
There’s also fast-growing service provider Weatherford International. I suspect this company has been hit harder than Schlumberger mainly because of its relatively large North American exposure and fear that lower gas prices will hit this market.
However, Weatherford’s main growth driver in recent years has been international, not North America. Each quarter its exposure to the domestic market falls a bit more; these fears are overblown.
Moreover, I still believe that natural gas prices have limited downside from current levels; I don’t see a huge North American slowdown next year. Weatherford International remains a buy under 43.60.
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Portfolio Update
Two stocks in the TES portfolios touched my recommended stop levels. For those unfamiliar with stops, these are automatic orders you leave with your broker to sell you out of a stock at a preset price. I use stops both to protect our downside risk and to lock in gains over time.We got stopped out of XTO Energy at 45 Monday, Aug. 4, for about a 12.5 percent gain from my original recommendation. However, I recommended hedging this position in the June 12 flash alert using the November 65 put options (XTO WM).
If you took that recommendation, you’re still holding XTO and sitting on a 64 percent profit. This hedge would have all but eliminated the pain of the recent selloff. This illustrates in vivid detail the value of this strategy.
I don’t include options when calculating TES returns because I’m aware that not all subscribers are willing to do options hedge trades. However, I also recommended booking partial gains on a third of to half your position on two occasions, in the June 12 and July 16 flash alerts.
If you booked just a one-third profit on the latter date, you’re still sitting on a sizeable 25 percent gain despite the fastest selloff in this stock since 1999. I can’t stress enough just how important this sort of risk management is in a volatile market.
XTO Energy is one of my favorite E&P firms because of its exposure to unconventional reserves and its history of strong cost management. Nonetheless, as I explained above, natural gas-focused E&Ps are the weakest energy sector right now because of the sharp selloff in gas prices. If you were stopped out, I recommend standing aside XTO Energy for now; I’ll recommend jumping back in at the first sign of stability.
If you’re still holding the stock and puts, follow the advice in the July 25 flash alert.
Hercules Offshore is a shallow-water contract driller focused on the Gulf of Mexico. The company’s recent earnings report suggested an uptick in activity levels and rising day-rates for its rigs; day-rates are simply the fees charged for leasing drilling rigs from Hercules.
The stock has also been hit because of falling gas prices. However, this is an extreme overreaction to gas around $9 per MMBtu. I suspect natural gas would have to drop below $8.50 per MMBtu for several weeks to really destroy the recent signs of an upturn.
We were stopped out of the stock earlier this week, roughly flat with my entry point. Although I’m surprised by the rapidity of the selling, I see the current price as an attractive buying opportunity. I’m adding Hercules Offshore back to the aggressive Gushers Portfolio.
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Speaking Engagements
We invite you to tune in as KCI’s LIVE webcast events air from the 30th annual Money Show San Francisco. The editors will be presenting their latest insights and recommendations surrounding this year’s central theme “Tech and Biotech Investing.”Registration is FREE and can be completed at MoneyShow.com using the priority code 011425, so please check out the events and tune in Aug. 7-10, 2008.
The Best Stocks Money Can Buy
Friday, Aug. 8
6 – 6:45 pm PDT
North America’s Energy: Coal, Natural Gas, and Unconventional Oil
Sunday, Aug. 10
8 – 8:45 am PDT
I also have a special invitation for readers to join me and my colleagues Roger Conrad, Gregg Early and Neil George aboard an exciting 11-day investment cruise Dec. 1-12 through the Caribbean and Panama Canal.
This will be a unique opportunity to step away from your daily routines, relax in one of the most beautiful parts of the world and share analysts’ knowledge and passion for the markets. During the sail, you’ll not only explore the cerulean splendor of the Caribbean, but you’ll also delve deep into current markets in search of the most profitable opportunities for your portfolios. You’ll also have the rare chance to sail through one of the world’s engineering marvels, the Panama Canal.
It’s always a special treat to meet and talk with subscribers in person, and we couldn’t have picked a better setting than aboard the six-star Crystal Serenity. This is sure to be an especially memorable experience. We hope you’ll join us.
For more information, please click here or call 877-238-1270.
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