Good Riddance, 2008
Most investors are no doubt happy to have seen the end of 2008. Last year was the worst for the major market averages since 1937.
Energy-related names were no exception to that rule. The Philadelphia Oil Services Index fell nearly 60 percent and the S&P 500 Energy Index was off 35 percent, while the S&P 500 was down 37.
I’ll offer a detailed rundown of returns for the three The Energy Strategist model portfolios in the January 21 issue. My preliminary calculations show that the portfolios mainly beat their benchmarks, but were certainly hit hard in the final months of the year and ended lower.
But the long-term outlook for the energy sector remains bright. Short-term slowdown aside, strong economic growth in developing markets will continue to power strong demand growth in coming years.
Meanwhile, the supply of key energy commodities, particularly crude oil, is limited longer-term by rapid declines in production from mature fields and the technical complexity of developing new fields such as those in deepwater. I maintain my forecast that oil will top USD100 a barrel once again in 2010.
Even better, there are signs the broader market and major energy indexes are approaching a key low, setting up for a major rally that will kickoff no later than mid-2009. We’re already seeing a marked improvement in performance in the past few weeks, particularly for our three key themes for the New Year: high income potential; natural gas over oil; and integrated Super Oils.
Understanding the way forward for energy stocks requires an appreciation for the historic nature of the current economic downturn. See The Broader Market.
The focus has been almost entirely on the demand side of the energy equation. We’re beginning to see signs of change in consumer behavior, and the supply question will soon loom large once again. See Oil and Gas.
Coal has held up better than oil during the recent commodity swoon. Its role as the major input for electricity generation around the world provides even further demand support. See Coal.
The refining business has been under pressure during the last 12 months. It’s a widely misunderstood industry, with few pundits following what really matters–the crack spread. See The Refiners.
A couple recent income-focused additions to the TES Portfolio are rallying as the issuing company enjoys some operational successes. We’re taking a fresh look a Biofuels Field Bet play, and a recovery in gathering and processing margins has upside implications for master limited partnerships. See Stock Updates.
The S&P 500, energy commodity markets and related stocks have all been hit by the same basic fundamental problem: the worst US recession in more than 20 years and a global economic slowdown. It’s impossible to evaluate energy stocks in a vacuum; the path of the S&P 500 in coming weeks will have an important bearing on the performance of oil and energy stocks.
The broader market averages have already seen a significant rally off their late November lows; the S&P 500 tacked on a 20 percent gain through the end of 2008. The big question: Is this just an impressive bear market rally, or have we seen the end of the 2007-08 misery?
Historical patterns shed some light on the answer.
Source: Bloomberg, National Bureau of Economic Research, The Energy Strategist
The table above summarizes the market reaction to every economic cycle in the US going back to the Great Depression. As you can see, the average US recession lasts 13 months; the current contraction has already equaled that average. And if we exclude the Great Depression from the average, this one looks particularly long in the tooth.
The average stock market reaction to a recession (including the Depression) is about 36 percent, a figure we’ve already well exceeded.
But the most important information to note here is in the final column, the lead time. This is an approximation of how many months before the official end of the recession the S&P 500 bottomed in each cycle. I excluded two cycles from the average calculation, 2001 and 1945.
In 2001, the market bottomed after the official end of the recession. But the 2001 recession was unusually mild; many would argue there wasn’t a recession at all. Moreover, the main reason for the market’s decline had to do with the tech bust that began a year earlier rather than the recession itself.
As for 1945, there really wasn’t much of a market decline associated with that contraction. It’s fair to say the market’s reaction over this time period had a lot more to do with the end of World War II than a mild, eight-month contraction for the US economy. Excluding these two outliers, the market typically bottoms out about five months before the end of the recession.
We also have a convenient post-bubble analogy in Japan. Japan’s stock market topped out in 1990 and hasn’t logged a new high since. The 1990s have come to be known by many economists as “The Lost Decade” because it was essentially two major recessions accompanied by two weak recoveries. Notably, Japan tried a total of 10 stimulus packages totaling more than JPY100 trillion during the ’90s (about USD1 trillion at current exchange rates).
At any rate, Japan’s TOPIX bottomed out about 14 months prior to the first recession and four months prior to the second. This is congruent to the US experience.
This is the worst recession in the US since at least the ’70s, if not the post-Depression era. I expect the contraction to last longer than normal and engender a much larger decline in the averages. But even the most pessimistic economists are looking for a recovery to begin no later than the first quarter of 2010. If history is any guide, the market should see a rally kickoff sometime around the third quarter of this year at the latest.
This forecast is based on historical norms and plenty of educated assumptions; I have no crystal ball. However, as I explained in the Dec. 24 TES, it does make logical sense. After all, governments the world over have been piling on the stimulus.
I have deeply held reservations about the wisdom of all this government intervention, and I’m concerned about the longer-term hangover for the US dollar. Nonetheless, I suspect the US economy and markets will get a boost.
The same can be said for China. Although it’s clearly experiencing a slowdown, the government’s more than USD2 trillion in foreign reserves should be enough to allow it to fund any stimulus package it might wish. I wouldn’t be at all surprised to see China add to the USD586 billion of spending it’s already announced for the next two years.
Back in the late October and early November issues I spilled considerable ink examining some shorter-term indicators of the broader market’s health. Most of these indicators suggest we saw a key low for the S&P 500 in late November.
For example, the S&P Volatility Index (VIX) continues to decline from record levels.
Source: Bloomberg
As I explained in the Oct. 1, 2008, TES the VIX is a good measure of fear priced into the S&P options market. Suffice to say that when the VIX is elevated, S&P options traders expect large moves to occur in the underlying index. A high reading on the VIX indicates significant market uncertainty.
The VIX is a contrary indicator; high readings tend to correspond with lows in the major market averages. Investors are bearish and fearful near important market lows. The VIX saw two prominent spikes in the final months of 2008 and has now declined to under 40. This rapid spike and equally rapid decline is a classic indicator of a market low and is similar to the behavior in the VIX around the 2002-03 lows for the S&P 500.
Meanwhile, global credit markets appear to be showing tentative signs of improvement.
Source: Bloomberg
This chart shows the average yield on an index of 10-year corporate bonds rated BBB, the lowest investment-grade rating. BBB-rated bonds continue to yield more than 5 percent above Treasuries of similar maturity; this is close to record levels.
However, the spread remains elevated mainly because the yield on 10-year US Treasury has dropped rapidly; extreme risk aversion has prompted traders to run for the safety of government bonds despite historically low yields. As you can see from the chart, the yield on these BBB bonds is falling back to levels unseen since late September and early October.
And the interbank lending and commercial paper markets are also benefiting from direct government intervention. The so-called TED Spread now sits at 133 basis points, down from around 500 in October. This takes us back to last summer’s levels.
I’m also seeing signs of moderation in hedge fund redemptions and carry trade unwinding that plagued the market for much of last year. Basically, many institutional investors have been using the Japanese yen as a funding currency in recent years; they borrow money in yen to take advantage of that nation’s ultra-low interest rates. These investors would then use the borrowed yen to purchase securities denominated in dollars or euros.
The surest sign around that these leveraged trades are being unwound is a decline in the value of the dollar and euro against the yen. That indicates traders are selling their euro- and dollar-denominated stocks and bonds. They’re using the proceeds to buy yen and repay their yen-denominated loans.
Source: Bloomberg
Source: Bloomberg
Both currency rates have been altered such that a rising line indicates yen strength. A rising line is, for reasons outlined above, a sign that leveraged carry trades are being unwound.
The sharp advance of the yen from late summer through November corresponds to a massive wave of institutional deleveraging. But since that time, the yen has, at the very least, seen a significant moderation in the pace of its advance against both currencies. This suggests the deleveraging process has stalled for now.
We’re also seeing a recovery in the market despite continued weakness in economic data. Although a month’s action hardly makes a trend, it’s always encouraging to see a market rally on bad news. That’s an indication news may already be priced in. I’ll be watching this Friday’s jobs report and corporate earnings releases starting at the end of January for signs a trend could emerge.
I suspect the rally that kicked off in late November can continue, as credit markets continue to normalize and stocks simply bounce back from extraordinarily depressed prices at the end of 2008. And with more than USD8 trillion sitting in money market and deposit accounts in the US, there’s plenty of firepower for a major rally in coming weeks.
Based on historical precedent, it wouldn’t be unusual to see the S&P 500 rally back to above 1,100. After all, that would simply take the index back to late-September levels.
That said, I’d be extremely surprised not to see at least a stab to the downside, if not a retest of the November 2008 lows, before summer. A more durable rally will likely kick off in the third or fourth quarter, as traders begin to price in a recovery and the effects of recent stimulus efforts begin to prop up growth.
In short, I suspect that the 2008-09 bottom for the S&P 500 will look much like the 1974-75, 1981-82 and 2002-03 lows. It’s unlikely to be V-shaped; rather, there will be one or more retests of the low before the next big rally kicks off.
Check out the charts of the 1974-75 and 2002-03 lows for a closer look at how a typical bottom forms in the broader averages.
Source: Bloomberg
Source: Bloomberg
Energy stocks are likely to be big outperformers in the early stages of any broader market rally. As expectations of an economic recovery take hold, the supply/demand balance in global commodity markets will quickly tighten. I continue to look at the 1997-98 and 2001-02 bear markets in energy stocks for a clue as to how the group will behave amid the current market environment. Check out both cycles below.
Source: Bloomberg
Source: Bloomberg
The charts show the Philadelphia Oil Services Index (OSX) during the relevant periods. The major declines so evident on both look similar to the more than 70 percent decline in the OSX from July 2008 through early December 2008.
In both 1997 and 2002, the initial rally in the OSX off the lows was as much as 100 percent. A similar move this time around could take the index back toward 200 from its current 135.
But just as with the S&P 500, the OSX takes time to find a true bottom–the 2002 and 1998 rallies proceeded in fits and starts after that initial bounce before finally taking off in earnest.
Bottom line: We saw a key low for the broader market and energy shares late in 2008. But don’t get complacent. This rally is unlikely to move in a straight line higher. The only exception would be if you believe I’m way too pessimistic about a recovery for the US economy. A move straight up from here would suggest the recession ends mid-2009, a full half-year before I suspect.
I continue to recommend focusing on three key themes: high income potential; gas over oil; and integrated Super Oils. If I’m correct about the volatile bottom we’re putting in place, the stocks I discussed in the Dec. 24 TES are well positioned to outperform.
To that list of key themes I’ll add one more point. There will be opportunities to make money over shorter time frames, playing the volatile rallies and selloffs of the next few months. I’ll be looking for opportunities to play shorter-term moves from time to time in the aggressive Gushers Portfolio.
I’ll also be more proactive in taking partial profits or hedging risk using options strategies detailed in my special report, The ABCs of Options to Hedge Risk, if the rally in energy shares continues to accelerate over the next few weeks.
My outlook for crude oil and natural gas prices is largely unchanged from what I described last issue. A few recent developments in both markets are worthy of note.
I’ve suggested that oil would likely find a low somewhere in the USD30 to USD40 per barrel range. It appears we did find the low USD30s in December; crude is now bumping up against the psychologically key USD50 level.
The focus of the oil market throughout the back half of 2008 was demand and the impact of the global slowdown. I’m now starting to see a subtle shift toward closer scrutiny of the supply side of the equation.
Investors are just beginning to pay attention to the potential for supply destruction in non-OPEC countries caused by declining investment in exploration and development; a long list of projects have now been delayed as they simply aren’t economic at sub-USD70 oil.
Moreover, OPEC’s supply cuts are finally beginning to take hold. Based on a late-December release, it appears the United Arab Emirates (UAE) is reducing output in line with agreed OPEC quota reductions. There are also growing rumors that Iran and Kuwait have informed certain customers to expect lower crude oil shipments, a sign these countries are also complying. I expect better-than-normal compliance with recent reductions because producing countries are truly scared by current depressed oil prices.
On top of continued evidence of supply reductions, we’re seeing tentative signs of a moderation in US crude oil demand.
Source: Energy Information Administration
This chart is based on weekly data released by the Energy Information Administration (EIA) that compares average total refined product demand over the past four weeks with the same four-week period one year ago.
The data can be volatile, but the picture is clear: The pace of decline in US demand has been steadily shrinking since mid-October. US crude oil demand figures were actually reasonably strong a year ago, so this data point does suggest some real change in patterns of consumer behavior.
US retail gasoline prices have plummeted at the fastest pace in history, falling from above USD4 a gallon in mid-summer to about USD1.74 as of the most recent data. If the pattern continues, it’s a sign this decline in price is encouraging crude oil consumption on the margin. It’s too early to tell if this data has any significance, but it’s a point to keep watching.
Supply factors, growing geopolitical tensions in the Middle East, and some tentative signs of a creep-back in demand have put a floor under prices around the USD30 area, but I’m not convinced we’re off to the races for a V-shaped recovery in crude. More likely oil prices will carve out a volatile trading range over the next few months and begin to rally more aggressively alongside the S&P 500 later in the year.
I’d be inclined to take on some short exposure to oil if we see a spike toward the USD60 a barrel level over the next couple of months. We’re not out of the woods just yet; oil inventories remain healthy in the US, and weak demand will remain a headwind for at least the next three to six months.
There are two exchange traded funds (ETF) that allow investors to short oil easily, MacroShares Oil Down (NYSE: DOY) and PowerShares DB Crude Oil Double Short (NYSE: DTO). By purchasing the former, investors are essentially short oil on a roughly one-for-one basis; the latter, you’d be double-short crude. It’s not yet time to buy either ETF, but I may look to recommend a trade on a further push higher for oil.
The number one factor to watch in the US remains the rig count, a measure of the number of rigs actively drilling for oil and gas in the US. Last week, the rig count fell by 98, another record amount. We’re now down 427 rigs since the rig count topped out last summer.
Source: Bloomberg, Baker Hughes
The last time the US rig count dropped so abruptly was back in 200–in response to another big selloff in gas prices. However, the rig count is actually falling a bit faster than was the case back then and is now down more than 20 percent after just 16 weeks.
It’s clear that some of these rigs are coming out of the shale plays. Many have feared that strong production growth from US shale plays would offset declines in production from conventional fields. This, as I noted in the last issue, appears unlikely.
And keep in mind that the average first-year decline rate–the rate at which gas production declines in a well first year–is close to double what it was in 2002 thanks to greater reliance on high-decline-rate shale wells. That means the drop-off in the rig count will show up in the form of falling production far more quickly than was the case seven years ago.
Natural gas is also benefiting from an ongoing dispute between Russia and the Ukraine that’s pushed the Russians to cut back on the flow of gas through a pipeline that passes through the Ukraine. The problem is these pipes also serve several EU member states. The first to encounter drastic problems is Bulgaria; the nation has no more than a few hours of natural gas supplies left.
But other countries, including Hungary, Germany, Austria, the Czech Republic and the Baltic states, will also see supplies drop off sharply as a result of the cut. This should help to support EU gas prices and keep the flow of liquefied natural gas (LNG) moving into the EU rather than the US this winter.
My positive outlook for natural gas remains unchanged, and I suspect any drop-off in demand will be more than balanced by the fall in supply resulting from lower drilling activity and continued weak imports of LNG.
Coal prices have held up far better over the past year than oil prices. Nonetheless, the key global commodity has endured a nasty selloff since mid-2008. The overall picture for this industry is mixed near term; investors should remain highly selective.
First up, as far as the domestic US market goes I’m watching coal inventories at electric power utilities closely.
Source: Energy Information Administration
This chart shows the inventories of coal held at US electric power utilities for each of the past five years. The data for 2008 shows that US coal inventories are higher than for any other year on the chart. All things equal, you might expect this “coal glut” to result in further downward pressure on coal prices.
But there are a few factors at play here. One is that the utilities are keen to avoid revisiting the extreme coal shortages that prevailed in the fall of 2005 and left some coal plants with less than 10 days of supply.
Since that time utilities have generally boosted the amount of coal they hold in inventory as an additional buffer. After all, based on this chart, 2007 coal inventories also looked extremely glutted, but coal prices still averaged far more in 2008 than in 2007.
Let’s examine the same data in another way.
Source: Energy Information Administration
This chart shows US coal inventories in terms of months’ worth of consumption. It’s simply total coal inventories divided by total monthly consumption; I’ve also included EIA forecasts for 2009. Over the past few years, demand for coal in power plants has risen steadily. When we adjust for demand, the US inventory picture looks far more favorable.
And coal is truly a great recession fuel. It makes up about half the US electricity grid, most of it used as a baseload power source–coal plants provide always-on, 24/7 power. Thus even when electricity demand contracts or growth slows, the effect on coal demand is minimal.
It’s also worth noting that the US coal markets face the same case of supply destruction as the natural gas and crude oil markets. In fact, we’re already seeing it play out.
Source: Energy Information Administration
This chart shows US coal production by month up through November 2008, the latest figures available. It’s clear that US coal production spiked earlier in 2008, no doubt due to the record-high coal prices available over the summer months.
But many mines, particularly in Appalachia, that were profitable at last summer’s prices are no longer making money. On top of that, many coal firms are heavily leveraged and depend on borrowed money to fund new mine construction. But those funds are drying up. The result: several producers have announced scaled-back production plans or have simply shuttered higher-cost mines.
Of more concern longer term is the potential decline in global demand.
One of the big drivers of upside in coal prices from the fall of 2007 through mid-summer 2008 was export demand. (See TES, September 17, 2007, What to Do in the Energy Sector Now.) Key consuming countries such as China and India were experiencing strong growth in electricity demand due to high rates of economic growth; at the same time, producing countries such as Australia and South Africa experienced bottlenecks in production and port infrastructure. That combination led to a price boom.
Even the US, traditionally not a major coal exporter, has become embroiled in this trend–exports to Europe soared in 2008 as EU consumers sought newer, more secure suppliers. The US has the world’s largest coal reserves and some of the highest quality; miners were able to secure long-term contracts at high prices.
But check out the chart below.
Source: Bloomberg
This chart shows the year-over-year change in Chinese electricity production. China’s electricity demand growth has been shrinking sharply since late summer 2008 and went negative; the latest reading is around a 9 percent drop year-over-year. This is a clear change in trend and a negative for coal consumption, as China gets close to 80 percent of its power from coal.
Although definitely not an encouraging sign, it’s unclear this marks a new trend. As I noted earlier, China is spending the equivalent of 16 percent of its GDP on a stimulus package. This comes on top of moves designed to make it easier for businesses and consumers to borrow money and to encourage property market transactions.
There have been a few prior instances, visible on the chart, where electricity demand has slumped in China only to reaccelerate again after a few months. And don’t forget, the winter heating season is still around the corner (the latest data on generation are for November). A cold winter could also reverse the shift on coal consumption sharply by early next year.
These factors have conspired to drive down coal prices traded all over the world. Here are charts for two key benchmark coal grades traded globally.
Source: Bloomberg
Source: Bloomberg
The first chart shows the spot price of Big Sandy Barge coal, a US-traded benchmark. The second is the spot price of coal in Australia at the port of Newcastle. Note that the two charts aren’t directly comparable; Big Sandy is priced in US dollars per short ton, while Newcastle coal is priced in US dollars per metric ton (approximately 1.1 short tons).
Both spot indicators are well off their respective summer 2008 highs. However, both are trading well above levels of a year or two years ago–this is why I say coal prices are holding up better than the prices of other basic commodities.
The most important point is that the path of coal spot prices isn’t directly related to the profits and earnings streams for the mining firms, especially the big US miners. (See TES, October 22, 2008, Playing the Coming Energy Rally.)
The reason is that most coal is supplied under long-term contracts at fixed prices; these multiyear deals are rolled over as they expire. Contracted prices only gradually adjust to conditions in the spot market over a multiyear timeframe.
My point is that most of the big US coal miners have substantially all, or at least a vast majority, of their planned 2009 production contracted. Many of the new contracts these firms signed last year that replace expiring agreements were signed as coal prices rallied earlier in the year.
For example, my favorite name in the space, Peabody Energy (NYSE: BTU), actually had very few unpriced tons for 2009 as of its third quarter conference call in October. For some of its coal grades, it negotiated 2009 prices as much as 70 percent higher than contracts it agreed to a year earlier. That means Peabody will still see prices rise for 2009 regardless of what happens to the coal spot benchmarks.
Peabody has an enviable reserve base in two regions: Australia and the Powder River Basin (PRB) of the US. The former is valuable because Australia will remain a key exporter of coal to Asia. Short-term economic conditions aside, the long-term case for growing electricity demand in countries like China and India is robust. That means there’s demand for seaborne coal shipments.
And the PRB is an attractive resource because its America’s fastest-growing major coal-producing basin. The cost of producing coal in the region is lower than for Appalachia. Coal in the Eastern US typically comes from underground mines whereas PRB coal is mined from prolific surface reserves. The cost differential will only widen in coming years as new safety and environmental regulations imposed on underground coal mining render small, high-cost mines unprofitable to operate even at much higher prices.
I’ve recommended Peabody on a few occasions, booking nice gains in the stock in prior moves. Most recently we were stopped out for a loss during the fall 2008 carnage. Although I’m not yet recommending Peabody again, it’s atop my list of potential additions and will be tracked in How They Rate as a buy.
Just as with oil and natural gas, there are reasons for concern about near-term coal demand. Longer term, coal prices will rise with electricity demand. But these concerns are of little import to coal miners such as Peabody, as they’ve already contracted much of their 2009 production at favorable prices.
The refining industry is among the most poorly understood of all in the energy industry. You’ll often hear pundits recommend refining companies as a play on rising energy prices; in reality, these companies are more often hurt by rising oil prices than they are helped.
Independent refining firms don’t produce oil or natural gas. Rather, these companies buy crude and process it to make usable products such as gasoline, diesel and jet fuel. Crude oil is, therefore, a cost for refiners, and rising oil prices spell rising costs.
Refiners instead make money on the spread between the price of crude oil and the value of refined products–this spread is known as the crack spread. In other words, if the price of gasoline rises faster than the price of oil, the crack spread expands, and so do profit margins for the refiners. And if oil prices fall faster than gasoline, refiners’ margins expand, as their costs are falling faster than their revenues.
The most common calculation of the crack spread is the 3-2-1 crack spread; basically, the profit margin refiners can expect from processing three barrels of crude oil into two barrels of gasoline and one barrel of heating oil (diesel). The current 3-2-1 crack spread is USD7.56, up sharply from its lows this fall of USD3. The spread is close to the highest it’s been since early September 2008.
Source: Bloomberg
These are hardly impressive numbers; this spread can expand to more than USD20 a barrel in a strong market and remain at lofty levels for weeks. But the stocks in most refining firms are already pricing in a depressed environment, and I’m looking for an expansion in crack spreads between now and next spring. Such a move would power strong gains for refining firms.
As to the first point, my favorite pure-play refiner is Valero Energy (NYSE: VLO). I like this company because it owns some of the most technologically capable refineries in the US and has extraordinarily good geographical coverage.
(If you’re unfamiliar with the reasons why all that matters, check out my detailed explanation of the refining industry in the March 21, 2007 TES, Looking Refined. While the advice in that issue is clearly out of date, the explanation of the industry is perfectly relevant.)
To summarize, refining margins can differ greatly between US regions due to local supply and demand conditions. Having broad coverage allows Valero more scope to take advantage of superior margins in one region of the country. And more importantly, high-tech refining operations mean Valero can buy cheaper grades of crude, lowering its feedstock costs and boosting margins.
Valero trades at 4.7 times current earnings estimates for 2009, 0.6 times book value and 2.8 times cash flow, close to its lowest valuations in over a decade. Valero also has a relatively clean balance sheet, with close to USD2.8 billion in cash and about USD6.5 billion in debt; for a firm with a market capitalization of more than USD11 billion, Valero shouldn’t see any cash flow issues.
There are two main reasons the stock has been hit. First, refining margins were weak in the first half of 2008 because crude oil prices rose faster than gasoline prices–refiners’ costs rose faster than the value of the products they sell. Then, oil prices dropped after mid-year, but gasoline prices plummeted faster than crude. Second, since mid-2008 demand has also been a big problem–lower demand for gasoline means falling sales for the refiners. But weak demand for gasoline already appears to be baked into Valero’s valuation.
Meanwhile, crack spreads are expanding, a move I expect is part of an annual seasonal move higher in spreads. Crack spreads tend to rise in the first five months of the year because refiners are gearing up for the summer driving season.
Source: Bloomberg
This chart shows the action in crack spreads between January 6 and May 1 of each year going back to 2003. Not one year actually saw crack spreads fall over this time period. The average run-up was about USD5.70.
Since the 2009 summer driving season is expected to be weak, this seasonal spread effect will be smaller than normal; however, if history is any guide it will happen to some degree.
Due to the rapid run-up in crude oil in early 2008, refiners didn’t see their normal seasonal run between year-end 2007 and May 1, 2008. But excluding 2008, Valero has rallied between these dates in six of the past seven years. The average gain: about 30 percent.
Given this historical precedent, Valero Energy (NYSE: VLO) looks like a good trade on a seasonal run-up. I should stress this is not an investment opinion; rather, it’s a shorter-term opportunity for more aggressive investors.
That said, I think an even better bet on an expansion in refining margins this year is integrated oil company Marathon Oil (NYSE: MRO).
Most integrated oil companies are primarily exploration and production (E&P) firms with a smaller refining business. Marathon is different, as close to half its 2007 profits came from refining and marketing operations.
As I noted above, the refining business has been weak over the past year, first due to soaring oil prices, then to slumping demand for gasoline. This is precisely why Marathon stock has underperformed the other integrated oil companies over the past 12 months; Marathon is off nearly 50 percent, compared to an 11 percent decline for ExxonMobil (NYSE: XOM), 35 percent for Hess (NYSE: HES) and 15 percent for Chevron (NYSE: CVX).
Traders’ concerns about profitability in the refining and marketing division overshadowed a solid performance from E&P. In the third quarter of 2008, total production grew 7 percent over the same 2007 quarter, excluding the impact of hurricanes in the Gulf of Mexico.
And production growth should average 12 to 15 percent over the next three years thanks to additional expansion projects in Marathon’s main operating regions. For example, Marathon has an interest in a deepwater oil project known as Droshky in the Gulf of Mexico. Marathon expects first production by early 2011 and to see peak production of about 52,000 barrels a day (bbl/d) soon thereafter. Onshore in the US, Marathon is a player in the Bakken shale of North Dakota and Montana, a promising unconventional resource. Total production from the Bakken should reach 20,000 bbl/d by 2012.
And don’t forget natural gas. Marathon has 9,000 acres in the Piceance Basin of Colorado, one of the largest fields in the Rockies. The company believes it can achieve total production of 140 million cubic feet per day by 2012. In addition, Marathon has significant acreage positions in the Marcellus Shale of Appalachia, Haynesville Shale in Louisiana and the Woodford Shale of Oklahoma, all extraordinarily promising unconventional plays.
In Libya, Marathon has existing production of about 360,000 bbl/d but has plans for several additional projects that could push total production above 600,000 bbl/d by 2016. And in Equatorial Guinea, Marathon has a 60 percent stake in a 3.7 million metric tons per year LNG liquefaction facility.
Meanwhile, while the refining business hasn’t been terribly profitable over the past 12 months, it’s hard to find fault with Marathon’s position in the business. The company has over 1 million bbl/d of throughput capacity, making it one of the largest refiners in the US. And like Valero, Marathon’s refineries are capable of handling cheaper heavy and sour grades of crude. Marathon also owns a large number of terminals that can be used to blend refined products and ethanol.
My rationale for recommending Marathon is two-fold. First, if I’m right and we see a seasonal improvement in refining margins near term, investors should focus away from Marathon’s refining operations and pay more attention to its impressive E&P division. Marathon stock should play a bit of catch-up with its peer group.
Second, Marathon is considering a deal to break itself into two parts, an E&P division and a refining operation. The company had indicated it would make a final decision on such a divestiture by the end of 2008; in mid-December, Marathon postponed that into 2009 due to market conditions. However, over the next two months Marathon has scheduled a number of high-profile events, including its first quarter earnings release, an analyst meeting and a mid-quarter update. Each of these could easily mark an opportunity to pitch the merits of such a split to shareholders and analysts.
Because Marathon has suffered from its heavy refining exposure, such a split would highlight the value in its E&P division and would be a major positive for the stock. This additional catalyst is why I prefer a trade in Marathon to Valero at this time.
The Energy Strategist is primarily focused on intermediate- to long-term investments, but most investors can benefit from the occasional short-term trade. In volatile markets like the current one, these trades can be particularly profitable. But please note there’s a difference between a trade and an investment.
The natural tendency of many investors is to “marry” a trade and hold on far too long, or to sit for endless months watching a stock do nothing. The key to trading is to identify a specific catalyst or catalysts, take a position and then sell out once the catalysts pass–whether you have a winner or a loser.
It’s particularly important to place stop-losses on trades as you don’t want to sustain any big damage; when we’re wrong and the market tells us so, we’re out.
In this case the catalysts will play out over the next three to four months. I’m looking for a gradual improvement in refining margins and more clarity on Marathon’s plans to split into two pieces. My upside target on this stock is above USD40, about a 35 to 40 percent move higher.
Buy Marathon Oil under USD32 and set a stop loss at USD23.75 for now; I’ll track it the aggressive Gushers Portfolio.
Chesapeake Energy Preferred D (NYSE: CHK D) and Chesapeake Energy 6.375 Percent Bond of 06/15/15–I recommended Chesapeake bonds and the convertible preferreds in the November 19, 2008, issue (High Income with Upside).
One of the main criticisms hanging over Chesapeake is that its debt burden is too high and it doesn’t have enough cash to meet its spending plans. As I explained in the above-referenced issue, I believe that both fears are massively overblown.
The latest evidence of this is that Chesapeake has successfully sold its fourth volumetric production payment (VPP) deal to a private firm for a total of USD412 million. The deal covers about 98 billion cubic feet of proved reserves and 60 million cubic feet per day of total production.
The total price works out to USD4.20 per thousand cubic feet, a generous price especially when you consider the VPP only covers the intervals–particular underground formations and layers–currently producing natural gas. Chesapeake has retained the rights to drill and produce from deeper intervals under the same acreage.
This deal has further allayed concerns over Chesapeake’s funding, and explains in part why the bond and the preferred have begun to rally sharply.
Source: Bloomberg
Source: Bloomberg
Both the bond and preferred have rallied above their original buy-under prices, but I still see more upside as Chesapeake continues to prove its critics incorrect and credit markets begin to stabilize.
Buy Chesapeake Energy Preferred D under USD73 and Chesapeake Energy 6.375 Percent Bond of 06/15/15 under USD89.
Mosaic (NYSE: MOS)–Mosaic is a fertilizer producer I recommend inside the biofuels field bet of the aggressive Gushers Portfolio. For those unfamiliar with these plays, my field bets are mini-portfolios designed to play higher-risk, higher-potential themes.
To make a long story short, our biofuels plays, and especially the fertilizer names, generated some huge returns for us in 2006, 2007 and early 2008. Fortunately, we recommended taking significant profits on many of these positions long before the big selloff this year. I’m once again becoming interested in this group and plan to cover it in depth in an upcoming issue.
Mosaic actually reported a weak quarter yesterday, and its conference call was hardly upbeat. The prices of agricultural products have fallen alongside metals, oil, and just about any other commodity you can imagine. This has meant falling demand for fertilizers, pesticides and other key inputs into the agriculture industry.
But despite the weak report, Mosaic rallied on heavy volume and is now trading near a two-month high. This suggests the stock has already priced in some dire news and has room for significant upside on the slightest whiff of positive developments.
There are some fundamental signs that turn to the upside could be imminent. First and foremost, soybeans, corn, and other agricultural commodities have rallied nicely off their late-November lows. Soybeans, for example, touched a low under USD8 per bushel late last year but have rallied back over USD10 more recently. As agricultural prices find a low, the economics for farmers should improve, and they’ll buy more fertilizer.
For Brazilian farmers, a stronger dollar is a positive. That’s because Brazilian farmers’ income is priced in dollars; most crops are traded in dollars, so when the dollar rallies against the real, Brazilian farmers’ incomes rise. Brazil is a huge market for companies like Mosaic.
Finally, as fertilizer prices have declined, larger producers have cut back their capacity. Smaller producers, or those with higher-cost fertilizer mines, have, in many cases, been forced to shutter their operations completely. In other words, we’re seeing the same sort of supply destruction in fertilizer as in other commodity markets.
Mosaic’s positive reaction to a weak report coupled with some early signs of a turn to come suggest it’s time to start buying the stock again. I’m raising Mosaic, a play in the biofuels field bet, back to a buy.
Gathering and Processing Margins–Many subscribers will have noticed the dramatic rally in some master limited partnerships (MLPs) such as Hiland GP (NSDQ: HPGP), Eagle Rock Energy Partners (NSDQ: EROC) and Williams LP (NYSE: WPZ) in recent days.
The reason has to do with a recovery in gathering and processing (G&P) margins.
Here’s a chart showing the margins available to processors on the Gulf Coast.
Source: Bloomberg
Margins remain depressed by any historical measure but have begun to improve. Given strength in crude oil and natural gas liquids prices in recent weeks, I suspect we could see these margins increase further; this should power further upside for companies with exposure to G&P.
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