Finding a Bottom
However, there are glimmers of light at the end of the proverbial tunnel; some markets appear to be stabilizing. This is broadly consistent with my view of the global economy. The US economy is still shrinking, but the rate of decline has stabilized, and the recession should end by the latter half of 2009 or early 2010. Meanwhile, growth in select emerging markets appears to have reaccelerated.
This bottoming process is finding confirmation in the stock market. Most energy stocks have begun to rally off recent lows despite the fact that gas prices remain stuck under USD4 per million British thermal units (MMBtu) and oil hasn’t been able to break above USD55 a barrel definitively.
A change in the rate of change of economic data suggests we’re at or near a bottom for this cycle. We’re still in recession, but there are “green shoots” to be found. See Second Derivatives.
I don’t buy the extreme arguments on either side of the where-is-natural-gas-headed debate. I do see signs, however, that support my out-of-consensus view. See Natural Gas.
Economic data and indicators are certainly important, but the most important numbers are those companies release on a quarterly basis. See Earnings Season.
Let’s be clear: The US economy is still shrinking, and the recession that began in December 2007 continues. Nevertheless, there’s been an important change for the better in recent weeks as the economy is no longer shrinking at as fast a pace. Economists call this a second derivative effect or, more commonly, a change in the rate of change of economic deterioration.
Several reports released over the past month illustrate that the US economy is now shrinking at a slower pace than was the case just a few months ago. My favorite indicator, the Conference Board’s Leading Economic Index (LEI), was released on April 20. Long-time TES readers know I watch the year-over-year rate of change in the LEI carefully.
Source: Bloomberg
The basic interpretation of this chart is that when the indicator drops below zero, the US economy is in recession. A rally back above zero traditionally presages a recovery. This simple indicator has been effective over the years in flagging economic downturns; LEI forecast a recession in late 2007, when most economists were still looking for the US economy to skirt a recession entirely or see only a shallow retrenchment.
The latest reading on LEI: -3.8 percent year over year as of the end of March. That’s still a negative number, indicating continued contraction in the US economy, but it’s an improvement over late 2008 or January 2009 readings.
Although March LEI fell 0.3 percent more than the -0.2 percent expected, the February data was revised higher from -0.4 to -0.2. The net change for LEI is roughly in line with what most analysts were looking for.
I’m looking for an even bigger improvement when the April number is released late next month. Several of the 10 indicators that make up the LEI have shown significant improvement this month. I’ll offer a detailed rundown of LEI and the most important components in this Saturday’s issue of Pay Me Weekly.
The Federal Reserve’s Beige Book, a periodic economic survey put together by the 12 Federal Reserve districts designed to help aid the Fed in setting monetary policy, also indicates improvement in certain areas of the US economy. Though the overall tenor of the April 15 edition wasn’t at all bullish, five of the 12 districts noted general moderation in the pace of the economic decline.
I highlighted some of my takeaways from the report in last week’s PMW. Particularly interesting is the fact that even the residential real estate market–the epicenter of the current downturn–is showing signs of life in some districts.
The Beige Book also included a handful of data points of particular relevance to energy markets. Here’s what the Federal Reserve Bank of Dallas, seat of the 11th District, had to say about the outlook for petrochemical demand:
Petrochemical producers generally indicated that the free fall of late last year is over and there was growing stability and even a small turnaround in operating rates. Contacts reported that ethylene and a number of other chemical and plastic products have clearly bottomed out after a massive industry destocking last fall. Contacts said that no one is buying inputs without an order in hand, leaving demand still erratic and unpredictable. Operating rates are slowly moving up however, from 70 to 75 percent.
This commentary is interesting for two reasons. First, the petrochemical industry is a key source of demand for both oil and natural gas liquids (NGL). Even though the recovery looks weak, any stabilization in petrochemicals demand is a positive for oil and natural gas.
Second, plastics and chemicals are basic commodities used in a wide variety of industries. The fact that there’s been a turn to the upside in demand suggests these industries are reviving.
All of this is consistent with the outlook I’ve outlined in the past few issues of TES:
The US will likely see a tepid recovery either late this year or early in 2010. The quality of this growth is low, and we’re hardly going back to boom times, but it will be enough to stabilize US oil demand.
Meanwhile, the recovery overseas and, more particularly, in China and other key emerging markets, has legs. I’m looking for oil to trade back into the USD60 to USD70 area by the end of 2009. We’ll likely see triple-digits again sometime in 2010.
The Energy Information Administration (EIA) and the crude oil market itself have begun to reflect this economic stabilization. In its April Short-Term Energy Outlook, the EIA revised upward its 2009 average crude oil price assumption from USD42 to USD53 and its 2010 assumption from USD53 to USD63. The EIA bumped up these estimates despite the fact the same report mentions bloated global oil inventories and continued demand destruction, particularly in developed markets.
I’ll add that the EIA’s estimates of total global oil production are overly optimistic. The EIA admits this, saying that “…even this pessimistic forecast [on global oil production] still contains considerable downside risk, especially from additional project delays and higher-than-anticipated decline rates.” This is why I’m more bullish on oil prices than the EIA; I suspect that the longer oil trades below USD70, the more global oil supply will surprise investors on the downside.
More importantly, consider the action in the crude oil market itself. Crude continues to follow the stock market to some extent. Both the S&P 500 and crude oil prices reflect traders’ attempt to forecast future economic conditions. But it’s encouraging to see crude shrug off continued negative news on US oil inventories. This suggests that news is already priced into the market.
From an intermediate-term perspective, I always look to buy markets that rally on what appears to be “bad” news. This is a key characteristic of washed-out markets at key turning points.
Finally, on the demand front I found another point from this year’s Beige Book particularly striking; consider this comment from the Federal Reserve Bank of San Francisco, the 12th District:
While demand for new automobiles continued to be feeble, sales strengthened further for used vehicles, especially large pickups and SUVs. Unit sales of gasoline have firmed and were running slightly above their levels from 12 months earlier.
This is further evidence that US consumers largely view the USD4-plus gasoline prices of last summer as a temporary, one-off phenomenon, not a long-term condition. My guess is that consumers have bought hook, line and sinker the political line that last summer’s oil spike was due solely to excess speculation and the activity of “greedy” speculators, not fundamentals of supply and demand.
Consumers are in for a nasty shock once again in 2010 when demand for oil returns with a vengeance and supplies remain curtailed because of lingering impacts of this year’s slowdown in exploration and development activity.
This is also a bullish development for longer-term prices. Last summer’s rush for fuel-efficient small cars and hybrids was just a blip.
Views on the natural gas market tend to extremes. Some analysts believe natural gas will continue to trade under USD4 per MMBtu for a prolonged period, while others will tell you it’s headed back above USD6, or even USD8, within the next six months.
The bearish outlook seems to be most prevalent among industry participants. For example, consider this passage from the Beige Book:
The demand for oil services and drilling equipment continues to shrink with the rig count. Over the past six weeks the number of US working rigs is down by 300 or 22 percent. Texas, New Mexico and Louisiana all had significant losses, especially Texas which lost 168 rigs–over half the national total. Respondents indicated that a number of gas wells drilled in nonconventional shale are cased and will be re-entered when natural gas prices improve and will give a quick and large boost to supplies.
The comments published in the Beige Book typically come from discussions among Fed officials and industry participants. Completing a gas well involves lining the well with a heavy pipe known as casing. This quote suggests that some producers have completed gas wells in shale plays but haven’t put those wells into production because they’re waiting for a recovery in natural gas prices.
The implication is that this would keep natural gas prices lower for longer. As soon as prices tick higher, companies will put those new shale wells into production, quickly swamping demand with excess supplies.
As I noted in the April 8 Energy Letter, the consensus among panelists at an early April EIA conference was that US gas prices will average in the USD4 to USD6 per MMBtu range for years to come. Their rationale was fairly straightforward: Strong production growth from these vast deposits of US shale gas will be enough to keep the US in an oversupplied market for years to come.
This is true; the US and Canada have plenty of gas to meet demand for decades locked up in prolific unconventional plays. However, I do maintain my out-of-consensus take on gas prices.
Source: Bloomberg
The chart above shows two pieces of data overlaid for easy comparison. The white line is the Baker Hughes (NYSE: BHI) gas-directed rig count, a measure of how many rigs are actively drilling for natural gas in North America. This data is released weekly. The red line is the 12-month New York Mercantile Exchange (NYMEX) natural gas strip price.
I’ve normalized both data to make comparison easier.
These two lines are closely tied. When gas prices fall, the US gas-directed rig count tends to follow a few months later as producers wind down drilling activity. Ultimately, however, a drop-off in the rig count leads to a drop-off in gas supplies. The consequence: a large jump in gas prices.
Back in 2001 and 2002, the last major gas cycle, prices more than doubled off their lows. I’m looking for a move of similar magnitude over the coming 12 months. My basic argument is simple: Although demand for gas remains weak because of the economy, the falloff in supply will be a lot sharper than most analysts imagine and will surprise the market. The fact is the overwhelming consensus right now is for low gas prices over a prolonged period; it won’t take much of a supply shortfall to catch many investors leaning the wrong way.
There are certainly cased wells waiting to go into production, but such a surge in supply is unlikely to be enough to offset ongoing declines in drilling activity. Moreover, I suspect the risks of a major inflow of natural gas from abroad in the form of liquefied natural gas (LNG) is overblown due to the fact that US gas prices are depressed relative to prices in other countries. LNG cargoes will tend to move to the markets offering the highest potential prices.
Last week’s read on the Baker Hughes rig count showed a 30-rig drop in total gas-directed rigs working in the US. The total gas-directed rig count now stands at 760, down more than 50 percent from its late-August high of 1,606, and there has been little slowdown in the rate of decline.
The Baker Hughes report also indicated a further 11 rig drop in horizontal rig count to 399 total active rigs, down from a high of 650 in late October 2008. The latter data point is key because it offers a good indication of activity in the unconventional shale plays; such fields require horizontal drilling techniques to be produced effectively.
This is a huge decline in drilling activity, much larger in percent terms than the 2001-02 bust. Current rig counts are just not consistent with growth in US gas production. This is reflected in Form EIA- 914 Monthly Natural Gas Production Report. EIA-914 offers data on total US gas production by region with a roughly three-month time lag. It’s a volatile series, and the EIA recently altered the way it calculates the data; some market participants have since discounted its relevance.
That being said, the trends are clear. The EIA revised December production estimates lower and reported January 2009 production at 63.01 billion cubic feet per day (bcf/d) from the Lower 48. This is off 0.5 percent from downward-revised December 2008 production.
And even that doesn’t tell the whole story. US natural gas production figures have been skewed in recent months by volumes coming back online as wells and other infrastructure damaged by last summer’s hurricanes are repaired. Excluding the impact of Gulf of Mexico volumes in December 2008, US production fell by 0.5 percent, with Texas production off 1.1 percent as producers scaled back activity in the prolific Barnett Shale.
In January, the EIA numbers show a 1.4 percent decline in L-48 production. Even Louisiana, home to the much-touted Haynesville Shale, saw production decline a robust 2.3 percent. And in January the rig count was far higher than it is today. My guess is that the rate of production decline continues to accelerate.
If production from the L-48 excluding the Gulf of Mexico continues to decline by 1.4 percent per month for the next year, US gas production will drop to the low-50 bcf/d range by early 2010. Consumption of gas is dropping due to the weak economy, but I doubt it’s dropping by that amount.
From a slightly longer-term perspective, note two other key points in favor of natural gas: It’s absolutely crucial to integrating renewable resources, and the lack of gas infrastructure will slow development of some of the more promising plays. Both were key topics at this month’s EIA conference.
In late March the North American Electric Reliability Corporation (NERC) published the latest version of its long-term reliability assessment. One of the big issues discussed in this assessment was the ability to integrate larger amounts of wind, solar and other renewable resources into the current grid system.
The problem is simple: Power isn’t stored on the grid. That means electricity demand and supply must balance out at every given moment or the entire electric system can fail, as happened back in the summer of 2005 across most of the Northeastern US. The problem with wind and solar power is that they’re highly variable–the output from a wind turbine varies wildly depending on the speed of the wind. Unlike a gas, nuclear or coal-fired power plant, wind plants rarely operate at a level at all close to their full-rated capacity.
As a result producers often install shadow capacity, traditional fossil-fuel-fired plants that can be brought online quickly to balance power supply and demand. In most cases, shadow capacity would be gas-fired plants. Growing wind power capacity means growing gas-fired capacity; the two technologies go hand-in-hand.
A technology that would allow large-scale power storage on the grid could offset the need to use shadow capacity, but these technologies are still in their infancy.
Another potential solution is to install a huge amount of new transmission equipment. This would allow the grid to be balanced over a much larger geographic area. Turbines in areas getting a lot of wind could help offset weak output from power plants in regions with little wind at any given time. But building out all that transmission capacity would take years and is only a partial solution, at best, to the inherent variability of renewable energies.
Another point that garnered a great deal of interest at the EIA conference is that fact that US natural gas infrastructure isn’t sufficient. For example, pipelines moving out of key unconventional plays in Louisiana, and Northeast Texas to demand centers along the Eastern Seaboard are already full. Capacity out of exciting plays such as Canada’s Montney Shale is even more limited. This lack of capacity will delay development of these fields and the onset of supplies.
Examining the latest economic data and rig count reports is essential, but earnings reports are the most relevant and important numbers of all for consumers. Over the past few weeks we’ve heard earnings reports and conference calls from a number of energy-related companies, though we’re still just getting started with the season for my coverage universe. As of the close of trading April 21, only four of the 15 stocks in the Philadelphia Oil Services Index and two of the names in the S&P 500 Energy Index had reported results.
So far, however, my general sense of things can best be described as “cautiously optimistic.” While energy companies across almost every subsector are seeing significant weakness and declining earnings, this negativity was already baked into analysts’ estimates. The stocks were already pricing in a bleak outlook and, therefore, have managed to outperform the market despite what look like weak results.
I’ve gone through more than a dozen earnings releases and conference calls so far this season. Although I always note whether a company has beaten or missed estimates, this generally isn’t the most important fundamental point to glean from an earnings release. My favorite part of every earnings release is the conference call and, in particular, the question-and-answer period that follows the prepared remarks; in these sessions, management teams often provide a good rundown of business conditions and prospects.
Here’s a rundown of some of the major reports I’ve analyzed and what I’ve learned from conference calls.
Shaw Group (NYSE: SGR) is an engineering and construction (E&C) firm I’ve recommended as part of my nuclear field bet.
Shaw performs E&C work for a number of different end-markets but its most important business is building power plants. Shaw’s Fossil & Nuclear division accounts for 54 percent of the company’s total backlog of booked but not yet completed projects. In the second quarter, F&N also produced about a third of total company revenue, more than any other division.
In addition to power plants, the firm has two other major divisions worth noting, Environment & Infrastructure and Energy & Chemicals. The former is what most investors would consider a traditional infrastructure business; more than 90 percent of the division’s backlog is work for the federal government. The latter division builds and maintains primarily refineries and chemical plants. These two smaller divisions account for a combined 40 percent of Shaw’s total backlog.
At first blush, Shaw appears to have missed its earnings estimates due primarily to a USD31.1 million quarterly loss in Fossil & Nuclear. But that loss was due to a one-off USD79.3 million charge to account for a troubled coal plant construction project that’s experienced numerous delays and cost overruns. Normally, I’d be wary; poorly performing contracts can be a sign that a company is being too aggressive in terms of pricing new projects and is therefore vulnerable to similar shortfalls from future deals.
In this case, however, that’s unlikely.
Shaw’s management highlighted the fact that this particular coal plant was contracted on a fundamentally different basis than its other power plant construction deals. It appears this plant contract doesn’t include as many protections for Shaw as its other deals; the project doesn’t include clauses to allow Shaw to claw back against cost overruns and certain types of delay. I don’t think this shortfall indicates any underlying business problem at Shaw.
The more important point is that Shaw’s nuclear construction business appears to be healthy and growth is more robust than management’s expectations. Backlog for the F&N division jumped to a record USD10.3 billion as of the end of the calendar first quarter of 2009, driven largely by the fact that Shaw has booked an engineering, procurement and construction (EPC) contract for two nuclear reactors in Florida.
After the end of the quarter, Shaw received further approvals for a nuclear EPC deal in Georgia; this deal will add further to Shaw’s backlog this quarter and isn’t yet reflected in that USD10.3 billion. Management said it feels that the nuclear business is even stronger overseas, where it’s currently bidding on several more deals.
This bodes well for Shaw, but it’s also a major positive indicator for the nuclear industry as a whole; nuclear is seeing a comeback in many parts of the world. The recent acceleration in bookings for plant construction projects confirms this trend.
Outside F&N, Shaw also showed some signs of a pickup in business conditions. In Energy and Chemicals (E&C) Shaw noted:
…lower oil prices certainly has had some economic conditions slowing that has had an effect on the new bookings [for the E&C division]. However, the client activity in the last three or four weeks has accelerated and it’s very, very significant at this time. In fact, it’s the largest amount of inquiries we’ve had for some time. The polysilicon business is emerging as a strong growth opportunity for our business and the demand for petrochemicals in Asia, in particular, is starting to pick up.
Chemicals production is a cyclical business that’s undoubtedly been hit by the recent economic downturn and plunging commodity prices. It’s significant that Shaw has suddenly begun to receive so many inquiries for building new chemical plants. This looks like further evidence that an economic recovery in Asia is really beginning to take hold.
Finally, if you’re looking for a way to play all the “stimulus” money the Federal government is throwing at the US economy, Shaw is a great place to start. The company’s two largest deals in its Environmental & Infrastructure division are a Mixed Oxide (MOX) fuel fabrication plant being built in conjunction with the US Dept of Energy and levee work in Louisiana for the Army Corps of Engineers.
MOX fuel plants take surplus weapons-grade uranium and mix it with spent fuel rods from nuclear plants. The resulting product can be used as a nuclear fuel. The South Carolina plant has been operating since 2007.Most investors know that the Army Corps of Engineers has been shoring up levees in Louisiana since the devastating 2005 hurricane season.
Shaw’s E&I division remains well-placed to win engineering and construction projects due to be funded by the recent stimulus package. Click here for a full rundown of this package and what it means for investors. Buy Shaw under 30.
CSX Corp (NYSE: CSX) is a Class I (major long-haul) railroad company with operations spanning primarily the eastern half of the US. I don’t have any particular affinity for CSX as compared to the other US Class I’s such as Union Pacific (NYSE: UNP), Norfolk Southern (NYSE: NSX) and Burlington Northern Santa Fe (NYSE: BNI); in fact, at this time I don’t recommend any of the railroad firms. (I last covered the sector in the July 2, 2008 issue.)
But just because the rails aren’t in the Portfolio doesn’t mean they aren’t a useful indicator of economic conditions and activity in several key energy markets. Railroads are one of the most important links in the nation’s transportation network, moving manufactured goods as well as basic commodities. Two of the most important markets for rail are sectors covered by TES: coal and agricultural products.
The relationship between coal and an energy-focused newsletter is self-apparent. I also monitor agricultural markets due to the importance of biofuels such as ethanol and biodiesel to crop demand.
To get an idea of what’s happening with the rails, check out the chart of CSX.
Source: StockCharts.com
The charts for all of the major rails look similar to CSX. As you can see, the group entered a steep selloff in September 2008. Up until mid-summer it appeared that strong volume growth in coal and agricultural products would help to offset weakness in shipments of consumer goods, housing-related products including lumber, and autos. But the economy hit a wall in September, and rail carloads fell off the cliff.
Source: Association of American Railroads, Bloomberg
This chart shows total US freight volumes in terms of carloads over the past few years. There was a clear deterioration in the final quarter of 2008 that’s become a trend into 2009.
It shouldn’t come as a big surprise that CSX reported weak volumes; total carloads were off 17.4 percent, with all of its major markets showing a marked decline. Of course, not all markets performed the same in the quarter–markets related to industrial production, consumer spending and housing were hit hardest.
Chemicals and metals volumes were both off by more than 30 percent overall in the quarter. Intermodal (primarily consumer goods imported into the US) volumes were off only 13 percent; however, CSX experienced heavy competition from trucking firms on price. Therefore, revenue in the division was off 22 percent compared to the same quarter a year ago. On the upside, coal volumes were off only 7 percent, with revenue off just 2 percent.
CSX was able to offset some of the declining volume by cutting back on costs and raising prices. One of the main rationales for investing in the group in recent years has been a pricing renaissance. Because rail freight offers benefits in terms of speed, efficiency and fuel efficiency over other forms of transport, the big rail operators have been steadily raising prices. This has been a positive for the industry overall, allowing the big Class I rails to invest in upgrading their networks to handle more traffic.
Excluding fuel surcharges that are totally dependent on crude pricing, CSX pricing was up about 6.5 percent in the quarter, in line with recent quarterly results. In addition, by idling and storing railcars, laying off or furloughing workers and other steps, CSX was able to significantly cut its costs and preserve profitability.
This is all good for the rails, but the obvious question concerns volume and when the rapid drop-off in railcar volumes will reverse. The chart above shows that over the past few weeks, CSX stock has rallied on good volume. The stock broke out of its downtrend that began last summer. I don’t discuss technical analysis much in this newsletter, but this action clearly indicates that some market participants are banking on an improvement in volumes over the next six months.
There’s nothing specific in the CSX report to support this perception. The company forecasts a double-digit decline in volumes for the second quarter and that volume “will remain unfavorable throughout the year.”
Management indicated that of its 10 largest markets only one, agricultural products, was expected to show favorable revenue trends in the second quarter. This comment suggests the agricultural recovery I outlined in the March 18, 2009 issue is underway.
One market that’s worrying from a volume standpoint is coal. Although volumes have held up well so far in this cycle, CSX management said that its major utility customers tend to cut back on output from coal plants and fire up gas-burning facilities when the price of gas drops below USD5 per MMBtu. Obviously, this fuel switching occurs on the margins only, but it’s enough to have a real impact on demand for coal and coal transportation.
CSX also noted that some of its domestic utility customers have healthy inventories or inventories of coal actually above their targets. Unless a hot summer drives significant incremental demand, this could mean utilities cut back on contracting new coal volumes and simply draw down their stockpiles.
Offsetting this is the fact that CSX has conservative estimates as to demand for coal exports from the US. While there obviously will be a decline this year, it’s possible that a recovery in emerging market economies will mean the coal export market surprises to the upside.
All told, the sense I get from the CSX call is that volumes will remain weak through the second quarter; either the first or second quarter of this year is likely to mark a bottom in terms of the decline in carloads. Somewhat like the economy as a whole, I suspect the rate of decline in volumes–the second derivative–will begin to improve markedly heading into the back half of the year.
In short, my three key takeaways from the CSX call are: the agricultural recovery is on track; coal demand domestically looks weak; and the rail pricing story remains intact despite the weak economy.
Kinder Morgan Energy Partners (NYSE: KMP) is a master limited partnership (MLP), an income oriented group I discussed at some depth in the November 5, 2008 issue.
MLPs typically own energy midstream assets such as oil and gas pipelines, storage and terminal facilities and gas processing plants. Because midstream asset owners typically don’t own the oil or gas they transport, these assets have little commodity price volatility.
MLPs don’t pay corporate taxes but pass through the majority of their income to unitholders (shareholders) as distributions. Those distributions aren’t dividends and won’t be reported on a Form 1099 at tax time but on a Form K-1.
The advantage of this is that much of the distributions you receive are taxed as a return of capital; this means that you won’t have to pay taxes on that portion of your income until you sell the MLP. As tax rates increase under the current administration, I suspect this feature will become ever more attractive. The disadvantages: K-1 forms complicate tax preparation and shouldn’t be owned inside retirement accounts.
Another extremely important point to note about MLPs is that you should totally ignore reported earnings figures for the group. “Earnings” is an accounting measure that includes non-cash charges like depreciation and depletion; these aren’t actually costs but a method for accounting for the cost of an asset over a long time frame. MLPs actually pass along these charges to you as a unitholder; depreciation and depletion allowances are exactly what allow you to treat much of the distributions you receive as a return of capital. Therefore, lower earnings are, in many cases, a good thing for MLP holders.
Instead, I focus on distributable cash flow (DCF), an earnings measure that backs out non-cash charges like depreciation. It’s a much more accurate measure of an MLP’s actual distribution capacity than earnings per share (EPS).
Kinder Morgan Energy Partners earned DCF of USD0.97 per unit in the first quarter, less than the distributions it paid of USD1.05. This is obviously not sustainable longer term–you can’t pay out more in distributions than you generate in cash flow forever without risking a distribution cut. However, this shortfall wasn’t unexpected, and it appears Kinder will generate plenty of cash for the full year 2009 to make its annual USD4.20 in distributions. Even if it’s a bit short on that score, I suspect Kinder would continue to pay the USD4.20 unless there is an outright depression in the US. The current yield of just shy of 9 percent is sustainable.
The general tenor of Kinder’s call was positive. CEO Richard Kinder sounded far more upbeat about the company’s prospects than in January’s fourth quarter call. Here are some of the key points from the call.
Kinder Morgan Energy Partners owns a vast network of refined products pipelines and volumes are down across the board by around 5 percent. This is due simply to the fact that a weak economy has consumers using less gasoline, while jet fuel volumes are down because of weak travel trends. However, taken as a whole Kinder’s refined products business is expected to be on plan for the year except for a line that moves propane from Canada into the Midwest.
The problem with that line wasn’t that demand for propane is weak in the Midwest; actually demand was high due to a cold winter there. Rather, volumes of propane just weren’t available at good prices in Canada for export; much of it remained north of the border last winter.
Another interesting comment from the call came during the Q&A session, when Mr. Kinder was asked about any potential uptick in refined products volumes that might signal a recovery. Mr. Kinder hedged in his comments, saying that it was lumpy regionally–solid or recovering demand in Arizona and Florida, sustained weakness in other markets. More importantly, however, Mr. Kinder stated that he felt the situation wasn’t getting any worse. I see this as consistent with my view that the economy hasn’t mounted a durable recovery but has stabilized.
Kinder’s liquid terminals business remains solid. Terminals store oil and handle ancillary services such as blending and mixing fuels. Kinder does have some terminals that handle steel exports. While this business is weak due to lower demand for steel, some of that impact has been offset by lower diesel fuel prices; Kinder consumes large amounts of diesel fuel in cranes and equipment for moving heavy bulk commodity products around its terminal operations.
The only aspect of Kinder’s business with direct commodity sensitivity is its carbon dioxide (CO2) segment. This division includes reserves of carbon dioxide (trapped underground) and pipes to move that CO2 to oilfields where it’s used in tertiary recovery operations. Basically, tertiary recovery involves injecting the gas into a field to help repressurize the field and boost recovery.
Kinder is paid both based on the volumes of CO2 moved through its pipes and based on its ownership stake in two major tertiary recover oilfields, the Yates field and SACROC. Kinder had budgeted for oil prices to be in the high USD60s for this year whereas they’re currently closer to USD50, based on the 12-month NYMEX strip. The effect of sharply lower commodity prices on Kinder’s CO2 business was the largest negative impact on the cash flow picture.
But Kinder has offset much of this weakness. The company has been able to cut drilling and service costs within its two oilfields; providers are willing to discount rigs and services because demand has weakened. Much of these reduced costs didn’t show up in the third quarter but will begin to impact results more meaningfully in this quarter.
Even better, Kinder is having success in its fields. Production volume from the two fields is running more than 1,500 barrels a day above Kinder’s original plans. Taken together, lower costs and higher production will offset much of the shortfall in the CO2 business. And, if I’m right about oil prices, the business should improve markedly by year’s end. Still a headwind for now, the CO2 business’s weakness wasn’t much of a surprise.
Kinder’s natural gas pipelines segments continue to post positive results. The MLP is looking for this business to strengthen all year as it brings new pipelines into service.
Kinder has three major new gas pipelines in the works: the Rockies Express (REX), MidContinent Express (MEP) and Fayetteville Express pipelines.
REX is designed to move natural gas from the Rockies east to the Pennsylvania/Ohio border. REX is in high demand because there’s a chronic glut of gas in the Rockies, leading to depressed local prices. Producers want to move this gas east, where prices and demand are better. And remember, these are strictly volume contracts–the value of the gas that passes through the lines is immaterial to Kinder.
Kinder recently decided to expand the capacity of the western section of the REX line, known as REX-West. To expand the capacity, Kinder won’t be changing the diameter of the pipe but increasing the compression; by putting the gas under pressure, Kinder can put a higher volume of gas into a smaller pipe.
The important point to note is that Kinder’s expansion project has already been fully subscribed, meaning a producer has already paid to reserve this additional capacity. It’s an essentially risk-free project for Kinder and highlights the value of this pipe.
MEP and the Fayetteville pipe are also progressing. Weather and regulatory delays have pushed up the cost of these projects from original expectations, but Kinder indicated that going forward there’s far less room for price overruns due to the type of contracts the MLP has signed with the companies constructing he lines. Both pipes are designed to serve unconventional shale gas plays that have seen strong volume growth in recent years. Clearly, Kinder is a major player in the gas infrastructure business. All three new pipes will be in service by the end of 2009.
Bottom line: Kinder has a well-diversified mix of business lines that, for the most part, don’t have significant sensitivity to commodity prices. Of course, the company does face headwinds due to the weak economy. But key cost and efficiency offsets should allow Kinder to maintain its distributions this year with little difficulty. Buy Kinder Morgan Energy Partners under 65.
If you’re interested in holding Kinder in a tax-advantaged account such as an IRA or 401(k), consider buying Kinder Morgan Management (NYSE: KMR) instead of Kinder Morgan Energy Partners (NYSE: KMP). Because Kinder Morgan Management pays dividends in the form of shares rather than cash, it isn’t subject to Unrelated Business Taxable Income (UBTI).
Another possibility is to purchase a closed-end MLP-focused fund such as Proven Reserves Portfolio recommendation Tortoise Energy Infrastructure (NYSE: TYG). Closed-end funds pay distributions on a 1099, not a K-1, and aren’t subject to UBTI. In addition, for those unwilling to spend the time needed to handle K-1 filings, the Tortoise fund can be a great alternative to owning individual MLPs.
Here’s a list of all of the buy-rated MLPs recommended in the three TES Portfolios. The group remains among my favorite plays due to tax-advantages, high income potential and growing demand for energy midstream infrastructure assets.
- Duncan Energy Partners (NYSE: DEP)
- Enterprise Products Partners (NYSE: EPD)
- Kinder Morgan Energy Partners (NYSE: KMP)
- Natural Resource Partners (NYSE: NRP)
- NuStar Energy (NYSE: NS)
- Teekay LNG Partners (NYSE: TGP)
- Tortoise Energy Infrastructure (NYSE: TYG)
- Linn Energy (NSDQ: LINE)
- Eagle Rock Energy Partners (NSDQ: EROC)
- Sunoco Logistics (NYSE: SXL)
- Williams Partners LP (NYSE: WPZ)
Peabody Energy (NYSE: BTU) missed first quarter earnings estimates by a significant margin. But this isn’t at all surprising given the fact that the coal mining giant hasn’t been providing much guidance to analysts because of rapidly changing industry fundamentals. The stock reacted poorly after the earnings release but has since stabilized above USD25.
I don’t recommend Peabody outright in the TES Portfolios, although I do recommend a Peabody covered call trade. That trade is currently showing a nice profit.
Peabody painted a fairly dire picture of global coal markets generally during its call but highlighted a few reasons it’s more resilient than most mining firms. The hardest hit market is metallurgical coal, which is used to make steel. The industry is down globally by around 23 percent, while US steel production is off by half. Obviously, this has reduced demand and prices for met coal.
There are a few offsets for Peabody. First, unlike most of the other US-based coal-mining firms, Peabody has an extensive mining position in Australia–it sells directly into the Asian markets. As I’ve noted on several occasions, the Chinese economy shows real signs of a turn. Moreover, China’s stimulus package focuses heavily on construction projects, many requiring steel. China is one of the only bright spots in the world today when it comes to steel demand and production, and Peabody is well-placed to benefit from this demand.
Management did note that there have been a few signs of a potential turn for the global steel industry. For one thing, steel stockpiles have been significantly drawn down, so inventory de-stocking shouldn’t be as big a negative going forward as it’s been of late. Moreover, met coal producers have cut back production, helping to firm prices.
Demand for thermal coal used in power plants has also fallen significantly. US electricity generation is likely to fall again in 2009, which would complete the first back-to-back years of falling electricity demand in history.
Falling electricity demand is only one reason for the coal price decline. As I noted with regard to CSX, US utilities have more-than-healthy inventories of coal on site. Those that have any flexibility to do so will likely look to defer some coal shipments to avoid stockpiling excess quantities of coal.
And, as I also discussed in reference to CSX, there’s been some switching of coal for gas volumes. With natural gas prices trading under USD4 per MMBtu, many utilities with the flexibility to burn more gas and coal will choose the former over the latter.
The final element in the puzzle: declining coal exports. Coal exports boomed in 2008 as European utilities struggled with feeble coal inventories and high global prices for coal. Many signed contracts to import US coal. But with European demand for electricity also falling thanks to the global recession, demand for electricity is in decline. Thus US coal exports are expected to fall to around 50 million to 55 million short tons compared to about 82 million last year.
Emerging markets are also a positive on the thermal coal front. Peabody says it expects demand in the Pacific to remain relatively flat with 2008, which was a solid year. China could be a net importer of as much as 10 million to 20 million tons of coal in 2009. And Peabody points out that in India many plants are still sitting on less than seven days of supply, an extraordinarily tight inventory situation. The nation could see coal imports grow by as much as 25 million tons per year over the next several years. Peabody’s position in Australia sets it off from just about every other US-based producer in this regard.
Another point I’ve made before is that Peabody has much of its production over the next two years sold out under contracts. That means that it’s locked in favorable prices regardless of what happens to spot coal prices.
In fact, in its quarterly call the company announced further production cutbacks such that it now has covered 100 percent of its expected 2009 production under contract and 90 percent of 2010 production. The company is renegotiating some of these deals with customers, but such renegotiations typically involve the customer buying out part of the contract or temporarily deferring delivery. Peabody expressed its intention to get the full value of its signed firm contracts.
It’s also worth noting that while spot coal prices are well off their 2008 highs, Peabody continues to see its price realizations rise. The reason is that many of the contracts it’s now selling to are contracts signed last year at near-record price levels.
In Australia, Peabody is now rolling over contracts signed by Excel Coal–a firm Peabody acquired–four or five years ago at much lower prices than are available today. These contracts were signed at USD35 to USD55 per ton against current prices in Asia of closer to USD70.
Finally, there’s a debate between coal analysts as to how quickly producers will announce production cutbacks of the level necessary to rebalance US coal supply and demand. Here’s what Peabody has to say about that:
…it’s our view that we’re going to have to start to see more significant and steeper declines. Now, whether those are imposed because of issues relating to permitting, whether those are individual production problems but you take the whole high end of the cost curve and those guys are under pressure today…it [production reductions] will accelerate in the near term rather than extend until later in the year.
Peabody clearly believes that more large production cutbacks are likely among the US coal producers. This should also help to keep supplies and inventories from running too far out of control.
The highest-cost producers in the US would be those focused in the Eastern US and, in particular, regions such as Central Appalachia. This includes companies such as International Coal Group (NYSE: ICO) and James River Coal (NSDQ: JRCC).
Peabody Energy has unique positions in both the US and Australia and a solid contracting position. Despite still-weak fundamentals in some aspects of the coal market, I’m maintaining the Peabody covered calls in the Portfolio. The next upside catalyst for the stock would be further announced production cutbacks from the other US miners.
Weatherford International (NYSE: WFT) was featured in the April 1 TES; as I expected, Mexico and Brazil were to islands of growth for Weatherford amid a sea of weakness elsewhere around the world.
Brazil continues to pursue its massive deepwater oil and gas finds in the Santos Basin. In fact, the country’s national oil company (NOC) just announced yet another big discovery of light oil. While the company hasn’t announced just how big the discovery is, it has called it viable.
Meanwhile, I outlined the rationale for Mexico’s continued investment in Chicontepec in the last issue. Weatherford says that project is performing either in-line or better than it originally expected. That’s all good news.
Management described Russia, North America and Continental Europe as collapsing in the first quarter. That’s obviously not great news but was totally expected; again, I suggested that would be the case in the last issue. The company also noted that the big intergrated oil companies–firms like ExxonMobil (NYSE: XOM) and Chevron (NYSE: CVX)–are demanding price concessions on some international contracts. This is a negative for margins.
The good news is that Weatherford believes its international revenue will rise at a double-digit pace this year, on the rationale that Latin America will be strong, led by Mexico and Brazil.
Meanwhile, Weatherford is hearing from some of its big clients that Russia and select markets in Africa and the Middle East may have already troughed. What appears to have happened is that companies cut back activity too far amid the credit crunch in the fourth quarter and are now having to adjust activity levels to more normal levels.
Weatherford sold off initially on its release but outperformed the market amid Monday’s market bloodbath. The stock then rallied strongly yesterday, a sign that investors appreciate its superior growth characteristics.
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