Improving Tone
The US economy continues to show signs of a cyclical recovery; I expect the US recession to end over the next few months if, in fact, that hasn’t happened already.
Although crude could still retest its July lows, economic stabilization in the US combined with resurgent growth in emerging markets is bullish for energy commodities and related stocks through year-end.
In the near term, the stock market will be focused on second-quarter earnings. In today’s issue I take a detailed look at earnings releases from railroad CSX Corp (NYSE: CSX), coal-mining giant Peabody Energy (NYSE: BTU) and fast-growing oil services player Weatherford International (NYSE: WFT). All three firms shed light on some key investment themes in their recent earnings releases and conference calls.
In This Issue
Each passing month brings new economic data that complicate our understanding of the global slowdown and its implications for energy demand–the key driver of commodity prices. I break down the latest economic indicators and outline my expectations for a US recover. I also examine emerging markets’ role in the ever-evolving economics of energy demand. See It’s the Economy, Stupid.
In the second part of this issue, I analyze the second-quarter earnings reports issued by three key companies and discuss the implications for the firms in question, their industries and other energy-related stories. See Earnings, Earnings, Earnings.
It’s The Economy, Stupid
The primary drivers of global energy markets remain demand and the state of the US and global economies. It’s simply not possible to make meaningful projections about energy prices or related stocks without considering the economic data.
Longtime readers of The Energy Strategist and my free e-zines The Energy Letter and Personal Finance Weekly know that I pay close attention to the Conference Board’s Index of Leading US Economic Indicators (LEI), an index that summarizes the performance of ten widely watched economic indicators. The index is released monthly with a one-month lag; the most recent number hit newswires on Monday and covers June 2009.
The latest LEI reading showed a 0.7 percent jump over the prior month. In addition, the Conference Board revised the May month-over-month reading higher, from 1.2 to 1.3 percent. As I’ve noted before, the two consecutive monthly gains of more than 1.0–logged in April and May of this year–have significant implications; this marks the first time that’s happened in the history of the LEI index. Three consecutive monthly gains of more than 0.5 percent also occur relatively infrequently.
Source: NBER, Bloomberg, The Energy Strategist
Since 1959 the LEI jumped more than 0.5 percent in three consecutive months on just 22 occasions. But most of these consecutive monthly gains have occurred in the clusters outlined in the above table. To simplify the results, the left column records only one date for each grouping.
The table’s second column records the nearest business cycle. The business cycles listed in the table are the official dates published by the National Bureau of Economic Research’s business cycle dating committee, the official arbiter of the beginning and end of US recessions. I have listed each cycle from trough to peak.
A quick perusal of this table reveals that clusters of LEI readings over 0.5 percent tend to occur in two economic environments: the middle of a strong economic expansion or a few months before or after the end of a recession. For example, the LEI jumped 0.9, 0.6 and 0.5 percent in April, May and June 1975; these gains occurred just after the end of the vicious 1973/74 recession, a contraction that resembles the most recent economic decline in duration and magnitude. The LEI actually jumped more than 0.5 percent for four consecutive months back in 1975, followed by a series of smaller monthly gains. This jump in LEI occurred just as the 1973/74 recession was ending.
Starting in May 2003, the LEI jumped more than 0.5 percent in nine consecutive months. This impressive string occurred long after the end of a brief recession in November 2001 but coincided with the start of a major run-up in the S&P 500 that began in the spring of 2003 and ended in late 2007. The 2001 through 2003 cycle was unusual because stocks continued to fall long after the economy began to improve; the market was still wringing out the valuation excesses built up during the 1990s boom.
Rather than simply looking at the overall LEI index, I usually review the performance of each component indicator. In particular, I prefer to see a broad swath of indicators carrying their weight rather than a single index pushing up LEI. In June, seven of the ten LEI indicators added to the index’s performance; positive contributors included an uptick in building permits, a slightly longer workweek and a fall in initial jobless claims. For those interested in how the LEI index is calculated, see the January 30, 2009 issue of Personal Finance Weekly, Follow the Economy’s Lead.
Some will be surprised that the employment picture is actually positive for LEI. We’ve all read the headlines about the weak June employment report and the near double-digit US unemployment rate. However, it’s important to remember that the unemployment rate is actually a lagging indicator of US economic health. The LEI considers initial jobless claims–the number of people filing for first-time unemployment benefits. Historical data for that number is tracked in the
Source: Bloomberg
As you can see, although the US unemployment rate continues to rise and the June non-farm payrolls data was negative, the number of US initial claims has declined in recent months. I explain the disparate US employment statistics in the most recent issue of Personal Finance Weekly, The Employment Picture.
Another leading indicator that’s showing some encouraging trends is building permits, a measure of the number of new residential construction permits being issued around the US. If consumers are filling for building permits, it typically means they’re planning construction projects. The filing for permits actually leads construction demand by several months. Here’s a chart of US building permits.
Source: Bloomberg
Although the number of new building permits remains near a historic low, the index has started to swing to the upside. But we don’t necessarily want this index soar; a big rise in building permits would indicate a flurry of new home construction. The reason that home prices have been dropping in the US is that there are too many homes and too few buyers–a major increase in construction activity would add to that glut.
However, it’s an encouraging sign that this indicator has stabilized at a low level, which suggests that homebuilders may be seeing some light at the end of the proverbial tunnel.
There are other signs that the US housing market is beginning to normalize. The following chart tracks US existing home sales over the past few years.
Source: Bloomberg
Existing home sales remain in negative territory on a year-over-year basis, but it’s clear that sales have improved as the vicious credit crunch of late 2008 has receded. For qualified borrowers, mortgage interest rates are exceedingly low. And although marginal “subprime” borrowers don’t have easy access to financing, it’s healthy that the residential mortgage market has become more rational. After all, many of the subprime buyers who purchased homes during the mortgage boom weren’t qualified or able to afford the loans they were taking on. These poorly underwritten loans were the epicenter of the credit crunch and subsequent economic contraction.
Another factor driving sales is the decline in home prices. Falling house prices makes buying a home more affordable. Granted, an unusually large number of the sales we’ve seen in recent months have been foreclosures, houses seized by lenders when the original borrowers failed to service their debt. Foreclosed homes typically transact at a discount to market value.
But there is a bright side to the trend of rising foreclosures. Although the banks usually lose money in the deal and the borrowers lose their home, foreclosure sales do help to clear the nation’s housing market. In a foreclosure, the home in question essentially passes from weak hands to someone who can afford to stay in the home. Not a pretty picture perhaps, but it represents the invisible hand of the market at work.
This confluence of low mortgage rates and falling home prices and the corresponding uptick in existing home sales is beginning to clear some of the inventory overhang. The graph below depicts this progress.
Source: Bloomberg
This chart indicates the number of months’ worth of residential housing supply available in the US market. Economists calculate this figure by dividing the number of unsold homes by monthly home sales. (Sales are seasonally adjusted to account for the fact that the spring is prime time for US home sales).
The inventory of unsold homes currently stands at 9.6 months. This is well above the normal range of five to six months, but the indicator is moving in the right direction and is well off its high of around 11 months. The housing market will likely take some additional time to normalize; however, it isn’t unreasonable to say that the worst is over for residential housing. In fact, the pace of national home price declines continues to moderate, and prices are actually rising in some markets.
Source: Bloomberg
This chart shows the year-over-year decline in home prices for the 20 largest metropolitan areas in the US. House prices are still falling year-over-year at a rate of about 18 percent. But the pace of that decline appears to have bottomed out earlier this year and is now moderating. And the year-over-year comparisons will continue to improve through the summer and into the fall; I expect the rate of decline in the Case-Shiller index to continue to moderate.
It’s also important to note that the data are somewhat skewed by a few particularly weak markets–namely, Las Vegas, Miami and Phoenix. And prices actually increased between March and April in nine of the 20 largest metropolitan statistical areas; home values in Dallas led the way on the upside, advancing 1.7 percent, prices in Cleveland were up 1.2 percent, and Denver and Washington likewise performed well.
There’s an old saw on Wall Street that the most expensive words in the business are “this time it’s different.” I am certainly not willing to fight historical trends: This evidence further supports my running hypothesis that the US recession will end either late this quarter or early in the coming quarter.
A few analysts recently published reports suggesting that the recession may have already ended; based on historical trends in monthly LEI data, there is some weight to this argument. But I regard the year-over-year change in the LEI–not month-to-month movements–as the best means of identifying the start and end of a recession; over the past four decades, this methodology has proved its validity. The graph below tracks the year-over-year change in LEI.
Source: Bloomberg
LEI is currently down about 1.2 percent from a year ago. This is well off the lows set late last year and in early 2009 but still consistent with a mild contraction in economic activity. It will probably take another month or two for this year-over-year index to turn positive; from my perspective, August or September is the recession’s most likely endpoint.
Earlier this year few analysts called for the US recession–or, for that matter, the global slowdown–to run its course by year-end. Now, even some prominent bears have shifted gears and are calling for the economy to grow again. One bear I greatly respect is Nouriel Roubini. Although Roubini is often premature in his calls, investors can learn a great deal by listening to both prominent bulls and prominent bears; no one ever made money by ignoring alternative opinions.
Suffice it to say that Roubini was dead-on identifying some of the problems facing the US economy and the resulting market and economic dislocations. In a recent interview for CNBC, Roubini suggested that the worst is over for the US economy. In this interview he also forecast that the markets would not test March lows and even predicted that the US would be the first advanced economy to exit the recession–probably by the end of 2009.
Roubini somewhat tempered his enthusiasm, pointing out that unemployment will likely peak at 11 percent next year and stocks have rallied too far too fast. These qualifications might undercut the endorsement for many investors, but those who follow Roubini know that this ultimately qualifies as a bullish statement–especially given the dour nature of his previous pronouncements.
Roubini also noted that the global economy is benefiting from strong growth in China, India and other emerging markets–a point I’ve made on several occasions in this newsletter. At the beginning of 2009 many analysts forecast that China’s economy would growth roughly 5 percent this year; several economists have issued reports estimating that expansion could approach 9 percent.
Longtime readers know that two of the indicators I watch carefully with regards to China are the Purchasing Managers Index (PMI) and statistics on Chinese bank lending. Let’s start with a look at PMI.
Source: Bloomberg
This chart shows Chinese Manufacturing PMI. Without delving into too many details, an index reading above 50 indicates that the Chinese manufacturing industry is expanding. As you can see, the PMI has reverted to levels before the late 2008 credit crunch, a sure sign that Chinese manufacturing activity is reaccelerating.
Chinese bank lending is another key indicator to watch. Because the Chinese government still exerts a major influence over lending at the nation’s largest banks, a major jump in activity suggests that the government is attempting to stimulate the economy.
Source: Bloomberg
Much of the jump in Chinese bank lending stems from the stimulus package implemented late last year. My colleague Yiannis Mostrous, Editor of the Silk Road Investor, believes China could pass another round of stimulus over the next few months to ensure the recovery remains on track and shore up confidence in the strength of the Chinese economy.
Unlike the US stimulus package, which I discussed at length in The Leviathan and Energy, the Chinese stimulus package entered the economy quickly, providing a real boost to demand. Meanwhile, it’s estimated that only 15 percent of the US fiscal stimulus package has entered the economy thus far; the tax rebates and unemployment benefits included in the bill have had an impact, but most of the public works and infrastructure spending won’t come into play until late this year or early in 2010. In fact, the bulk of the stimulus probably won’t hit the economy until after the recovery is already underway.
Although the Chinese stimulus package aimed primarily to promote domestic demand, these efforts are materially impacting companies worldwide. Consider what the management of Caterpillar (NYSE: CAT), the US-based equipment giant, had to say in the company’s most recent conference call:
Nevertheless, he acknowledges that demand is picking up somewhat in emerging markets such as China and Brazil. This is real-world evidence that these economies are improving.
Global energy companies have also benefited from the resurgent Chinese economy. China is the world’s fastest-growing oil importer; there’s little doubt that some of the run-up in oil prices over the past few months is due to China’s recovering appetite for natural resources. Coal producers with exposure to Australia, a key exporter of coal to Asia, should also reap the rewards. Topping the list are TES Portfolio recommendations Peabody Energy and Felix Resources (Australia: FLX, OTC: FLRFF).
Bottom line: a recovery in the US and global economies is a major positive for energy demand and, accordingly, stocks in this sector. I’ve warned of a potential pullback in commodities prices and related stocks since late May and early June; such a pullback began in mid-June and persisted through mid-July. I sent out Flash Alerts on July 6 and July 14 to explain the forces behind these pullbacks and how subscribers should respond to these moves.
I’m not convinced the downward pressures have on crude oil prices have abated; oil could at least retest its July lows before mounting any year-end advance. As a hedge for the TES portfolios, I’m maintaining our recommended position in the PowerShares Double Crude Oil Short (NYSE: DTO), an echanged-traded fund (ETF) designed to rise when oil prices fall. I don’t recommend that new subscribers enter the PowerShares ETF because I see the downside for oil limited to the mid to upper USD50 range. Subscribers with a position should maintain a stop-loss order as recommended in the Gushers Portfolio table and a limit sell order for half their position at USD100. For further explanation of this advice, please consult last week’s Flash Alert.
The primary risk for crude oil remains further volatility in economic data. As I have noted in previous issues of TES, economic indicators don’t always agree. Undoubtedly, any US recovery will be uneven; certain segments of the economy will recover long before others. Expect further growth-related scares over the next few months. Combine those fundamental factors with the seasonal weakness characteristic of August through mid-October, and you have a recipe for plenty of volatility.
I am far more confident that energy-related stocks have seen their summer lows. Energy stocks began to correct some weeks before crude oil prices. Although crude oil touched USD74 a barrel on both June 11 and June 30, hovering near its multi-month highs, energy stocks were hit hard in late June. Crude oil finally caught up in the first few weeks of July. Bottom line: it appears that most energy stocks began to price in USD60 oil before crude traded anywhere near that level.
Valuations for the energy patch remain undemanding. The S&P 500 Energy Index currently trades at 5.4 times trailing cash flow and 7.6 times estimated cash flow. While this is well off the all-time lows of around 3.7 times set in March of this year, it remains under the long-term average which is closer to 9 times.
It’s worth making one final macroeconomic point: I am calling for a cyclical recovery in the US economy and a rally in the US stock market that will probably last into 2010, taking oil back over USD100 a barrel and the S&P 500 back to around 1,200 or higher. But there is a big difference between a cyclical recovery and a major economic expansion.
I suspect that the US the economic recovery will ultimately disappoint many investors. Historically, the economy has posted impressive growth in gross domestic product (GDP) in the wake of deep recessions. In this case, however, I’m looking for a more subdued rebound. The US economy might grow 2 to 3 percent next year, but I don’t expect a surge similar to the ones that occurred in late 1975 and 1976 when the economy recovered from the vicious 1973/74 contraction. Unemployment is likely to remain stubbornly high well into the coming expansion.
The US economy faces a number of long-term challenges that are beyond the scope of today’s issue. Interested subscribers can get my take ton some of these structural challenges in upcoming issues of my free e-zine Personal Finance Weekly. However, these concerns are longer term in nature and shouldn’t impede the upside I am forecasting into the first half of 2010.
Going forward, I continue to expect emerging markets to become an increasingly important driver of global commodity markets. Even as the US economy stumbles along with sub-par growth, a continued surge in demand from the developing world will be the key to long-term demand upside in commodities. The other issue that I have written about extensively in TES over the past few years is supply. Specifically, it is becoming much harder and more expensive to produce the crude oil the world needs to meet rising demand. Oil and other commodity prices will need to remain elevated in coming years to incentivize needed investment in new production capacity.
The supply issue will emerge as a key driver for oil to reach USD100 a barrel next year. The massive cuts to spending on exploration and development preciitated by the commodity price crash from July through December of 2008 means fewer new oil developments will online over the next few years and presages a continued fall-off in supply. Months of reduced activity will ultimately exacerbate the supply crunch. And whereas demand can bounce back quickly in the context of a global recovery, it takes far longer for producers to gear up new projects and ramp up oil supplies.
Earnings, Earnings, Earnings
Over the next month, the big driver for energy stocks will be second-quarter earnings. I expect most energy stocks to post earnings that appear weak on a year-over-year basis; after all, commodity prices have plummeted year-over-year despite a nice rally in the second quarter.
Much of this decline is expected and fully priced into the stocks. Broadly speaking, the tenor and content of management’s conference calls are, in many instances, more important than the numbers. The big question is whether any prominent energy firms are forecasting a surge in activity–such statements could be suggestive of a profitable investment theme.
Here’s a look at a number of stocks in my coverage universe that have already reported results and some of the points I gleaned from their reports and conference calls.
CSX Corporation (NYSE: CSX)
CSX Corp is a so-called Class I US railroad ranked alongside Union Pacific (NYSE: UNP), Burlington Northern Santa Fe (NYSE: BNI) and Norfolk Southern (NYSE: NSC). These four companies are the largest US rails with the most extensive track networks.
New subscribers might wonder why I follow rails in an energy newsletter. The answer is three-fold: the biggest cargo for railroads is coal; rails are a great indicator of US economic health; and rails also carry agricultural products and ethanol (a biofuel).
CSX reported earnings of $0.72 per share, roughly $0.10 better than analysts had expected, and the stock has generally rallied since the release. Nevertheless, CSX continues to suffer substantial declines in the volume of goods moving across its network–hardly a surprise given the weakness in the economy over the past year. Last quarter CSX’s volumes declined 21 percent from a year ago.
As one might expect, this volume drop-off spells lower transport fees for CSX and lower revenues. The upshot of this volume decline was a near $600 million hit to the rail’s top line. But there was some encouraging news: The railroad managed to offset some of the negative impact by charging customers higher rates and, perhaps more importantly, reducing its costs to reflect weaker volume trends. These initiatives included putting locomotives and railcars into storage, and trimming the workforce through layoffs and furloughs.
These cost-cutting measures appear to be the main source of CSX’s better-than-expected earnings. Investors were also likely encouraged by CSX’s pricing power; even amid a nasty economic downturn, the company managed to raise its core prices (excluding fuel surcharges). This is further proof of the renaissance in rails, the most economic and fuel-efficient form of long-distance transport.
For energy investors, the most important take-away from the CSX conference call relates to the coal market. CSX saw a 21 percent year-over-year decline in coal shipments in the second quarter compared to just a 7 percent year-over-year decline in the preceding quarter.
Source: CSX Second Quarter Earnings Presentation
This chart shows that for most cargo categories, the rate of year-over-year decline in volumes actually moderated between the first and second quarter. Coal was the lone exception; volumes in this category fell precipitously.
Management indicated that the decline in coal volumes for the quarter was broad-based, as US coal exports declined sharply due to weaerforeign demand. Meanwhile, US utilities have large stockpiles of coal at their facilities and little near-term reason to order additional shipments of coal to meet demand.
For TES readers, this decline in coal volumes isn’t a huge surprise; I’ve written about the bearish near-term conditions in US coal markets on several occasions over the past few months. More important is management’s assertion that the coal market may have hit a bottom in the second quarter in terms of the rate of year-over-year decline. When an analyst asked about the rationale for this expectation, the management team responded:
Fuel switching will likely continue for some time to come. But as I outlined in last week’s Flash Alerts and recent issues of The Energy Strategist, I’m looking for gas prices to rebound by year-end to well over $5 per million British thermal unites. If that projection is correct, fuel switching would become less of a headwind.
Second, electricity demand is down overall, primarily because of US economic conditions. Still, as I outlined in the first part of today’s report, I expect that situation to improve over the next few months. Electricity demand should begin to grow again. Third, exports are down largely due to weak economic conditions overseas.
There are a few counterbalancing factors. First, most utilities sign long-term contracts with coal mining firms to secure supplies; in other words, they are contractually obligated to take a certain volume of coal at a certain preset price. This is bad news for utilities because they are forced to buy coal they don’t need; if they signed coal contracts last year, they are also likely paying prices that are far above current market rates.
Coal mining firms have been willing to negotiate limited delays or volume adjustments to contracts; it’s in their best interests not to build up huge inventories at their customers sites. But mining firms typically demand a fee for larger adjustments. These contracts are good news for coal-mining firms like Peabody Energy because they’re guaranteed a certain minimum volume and price regardless of near-term market conditions.
It’s also interesting to note CSX’s comments about a slight but meaningful uptick in the export market. This is likely due to resurgent demand for coal from emerging countries like China. For more on this, consult the June 3, 2009 issue of TES, The New Super-Cycle, where I recommend a direct play on Asian demand for coal–Australian producer and Gushers Portfolio denizen Felix Resources.
All told, the CSX release paints a grim picture of US coal demand near-term but offers a glimmer of hope that the worst is in the rear-view mirror for this market.
Peabody Energy (NYSE: BTU)
Management echoed some of these sentiments in Peabody Energy’s second quarter call earlier this week. Peabody reported earnings of $0.49 per share, slightly above the consensus of $0.48. The market’s reaction was negative, and the stock declined about 5 percent on the session.
But that negative reaction is tempered by the fact that Peabody is up 21 percent in just the past two weeks, vastly outperforming the 11 percent gain in the S&P 500 Energy Index and the 16 percent jump in the Philadelphia Oil Services Index over the same time period. In addition, Peabody Energy’s stock closed well off its session lows, a sign that buyers looked at the post-earnings dip as a buying opportunity.
The most striking facet of the Peabody call was the amount of time management spent discussing overseas coal markets rather than domestic markets. Just a few years ago, the investment story for Peabody was that the company focused on mines in the western US where coal seams are larger and easier to mine. Whereas miners in the eastern US struggled with ever-more onerous environmental regulations, growing safety concerns because of the need to exploit deeper mines, and higher labor costs associated with underground mining, Peabody could increase production effortlessly from its vast mines in the western US and Illinois Basin.
This basic story remains intact for Peabody’s US operations; however, Peabody’s real opportunities lie in Asia. In the opening comments to Peabody’s conference call, CEO Gregory Boyce indicated that the company is seeing signs of stabilization and early recovery in the Asia-Pacific region but no such indications in the domestic US coal market or the market for coal exports to Europe.
In particular, these comments stood out to me:
Meanwhile, India is a market that gets far too little attention from investors. But India is also a major consumer of coal and needs to build out considerable capacity to meet growing demand for electricity. As Mr. Boyce points out, the Indian electric grid is notoriously unreliable, partly due to its insufficient generating capacity. And while US coal inventories are bloated, Indian utilities face record-low stockpiles. According to Peabody, Indian officials state the nation will need as much as 200 additional tons of coal imports over the next five years, making the country the world’s fastest growing importer.
All told, Peabody now gets more than half its earnings from outside the US, thanks in large part to its purchase of Australia’s Excel Coal a few years ago; as I noted in the June 3 issue, Australia is likely to be the world’s largest exporter of both metallurgical coal used in steelmaking and thermal coal used in power plants. Peabody is also establishing a trading hub in Australia and has invested in joint ventures in China and Mongolia.
Management made a few additional points worth noting. First, the company sees the coal mining industry in the eastern US entering a period of long-term decline as mining costs rise and are increasingly replaced by volumes from the west and Illinois Basin. The company also suggested that the US could experience a prolonged decline in coal consumption as industrial coal demand bounces back only weakly in the coming recovery.
Even though I suspect US coal demand will eventually bounce back along with the economy, there’s no near-term catalyst for upside given high inventories. At best, coal volumes in the US will stabilize as CSX indicated in its call. This is why I continue to recommend avoiding US-focused mining firms, especially those with heavy exposure to the eastern US. Although these stocks have rallied along with improving prospects for the US economy, I see far more upside for Peabody and other miners focused on Asian demand.
Based on comments from Peabody and CSX, I am also reiterating my buy recommendation on Australian coal mining firm Felix Resources. Felix is a pure play on Australian coal exports and has a number of new mines coming online over the next few years that will allow Felix to increase production dramatically. I am raising my recommended buy under price on Felix Resources to AUD 18.50 to reflect recent upside in the stock and strong near-term prospects.
Peabody’s comments concerning the US climate bill passed by the House of Representatives in late June also offer some interesting insights. Specifically, Peabody’s CEO noted:
Undoubtedly, the Democratic leadership in the House could have pushed more members to vote in favor of the bill. What the close vote implies is that there are a large number of members in competitive districts who don’t want to vote in favor of the bill for fear that it will negatively impact their reelection prospects. The leadership in the House apparently allowed these members the cover of a down vote on the Bill so long as its passage were guaranteed.
As Peabody’s CEO suggests, the climate legislation faces much tougher sledding in the Senate and will undergo serious revisions before it has any chance of passage. My guess is that the US will not pass climate legislation this year.
Another factor that doesn’t favor US climate legislation is the failure of the G8 nations to persuade developing countries such as China and India to commit to targets to reduce carbon-dioxide emissions. I outlined some of my take-aways from the G8 conference in the July 10, 2009 issue of Personal Finance Weekly, “G8 Reflections.”
However, if a climate bill does eventually pass along the lines of the House legislation, it’s not a total negative for the coal industry; lawmakers appear to recognize that there is no way the US is going to wean itself from coal overnight.
At the G8 in L’Aquila, as well as in the US climate bill, there has been considerable discussion surrounding the need to develop carbon capture and storage (CCS) technologies that would allow carbon emissions from coal plants to be captured and permanently stored underground. Several such projects are now receiving funding and are progressing all over the world. This is a positive for the coal industry in a world where carbon emissions are limited.
Weatherford International (NYSE: WFT)
My favorite long-term play on upside in the energy patch is the oil services sector; I currently recommend both Schlumberger (NYSE: SLB) and Weatherford International in the TES Portfolios.
The basic rationale for owning oil services firms is simple: Producing oil and gas is becoming increasingly technically complex as producers go after fields that are tough-to-produce or located in hostile environments such as the deepwater. The oil services industry provides producers with the technical know-how and skills needed to produce such fields.
As you might expect, the oil services industry was hard-hit by the commodity price collapse in the latter half of 2008. These companies don’t produce oil and gas and, therefore, aren’t directly impacted by lower commodity prices; small changes in pricing have limited impact on their profitability. But, oil services firms are sensitive to oil and natural gas drilling and exploration activity. As commodity prices fall, activity levels decline and that hits earnings.
As a rule of thumb, prices between USD70 and USD80 a barrel is key for international oil markets. Above that price range, activity should be relatively robust; below that range, producers cut back on projects and capital spending. Activity collapsed last year as oil plunged below USD40 a barrel but appears to have stabilized in some markets since oil prices rebounded.
The North American market is the most volatile of all and is heavily levered to natural gas drilling activity. For gas, the key price point is likely around USD6 to USD7 per million British thermal units. Above that price range, activity levels would be solid; below that range, activity remains weak. With current gas prices hovering below USD4 per million British thermal units, North America has been among the weakest markets in the world this year.
Weatherford reported second quarter earnings of $0.10 per share, below consensus forecasts for $0.15 per share. The stock reacted negatively to the news, falling intraday in the wake of the report. But that reaction was tempered somewhat by the fact that Weatherford closed at its intraday highs on the day it released earnings and has been a stellar performer so far this year. As with Peabody, investors appeared to regard Weatherford’s post-earnings selloff as an opportunity to buy into the stock.
As expected, North America was a weak spot for Weatherford in the second quarter, especially Canada. None of this was totally unexpected, and I have written about weakness in North America on countless occasions over the past few months.
I am always amused by stories that emerge in the mainstream media suggesting that Weatherford and other oil companies should be avoided because of weakness in North American drilling activity. Given that this weakness is already well known and well understood, it shouldn’t really factor into your investment decisions–the stock market is a forward-looking animal and this is old news. This is reflected in the fact that buyers quickly bought Weatherford in the wake of its post-earnings knee-jerk dip.
A few points are worth noting about the North American market. First, pricing trends continue to be weaker than expected, and Weatherford continues to downsize its operations in the region and cut costs. Although cost-cutting along has not been enough to offset the decline in demand, my longer-term take remains that Weatherford is increasingly becoming an internationally levered company–not a play on North America. This bodes well for its long-term profitability.
In addition, the massive decline in service costs in North America is a big positive for oil and natural gas producers in this market. This means that producer’s costs should fall sharply, lowering break-even price for natural gas. In that regard, Weatherford’s call is a positive for TES recommendations XTO Energy (NYSE: XTO), EOG Resources (NYSE: EOG) and Chesapeake Energy Preferred D (NYSE: CHK D). All three picks remain Buys.
The news from Weatherford’s international business lines was positive. The company’s strong position in resilient Latin American markets fueled an 84 percent increase in that region’s revenues for the first half of this year. Weatherford’s long-term deal to develop Mexico’s Chicontepec field offers the company a stable base of revenues in Latin America.
More broadly, Weatherford indicated that while visibility and growth prospects for North America remain weak near-term, conditions are improving internationally. Management was constructive on prospects for the latter half of this year and into 2010 based on trends observed in the second quarter. In fact, Weatherford indicated that growth and pricing trends outside of North America likely troughed in the second quarter; going forward, these markets should see a resumption of growth and better pricing.
In the second-quarter conference call, Weatherford CEO Bernard Duroc-Danner stated described pricing trends outside of North America as follows:
I will have more to say about the oil services industry in the next issue of TES after services giant Schlumberger releases its results. But my early read is that it’s a mistake to focus too much attention on the weak North American market. The big story is the trough in international profit margins.
I continue to recommend buying both Schlumberger and Weatherford and would look on any dips as a gift to investors.
Although crude could still retest its July lows, economic stabilization in the US combined with resurgent growth in emerging markets is bullish for energy commodities and related stocks through year-end.
In the near term, the stock market will be focused on second-quarter earnings. In today’s issue I take a detailed look at earnings releases from railroad CSX Corp (NYSE: CSX), coal-mining giant Peabody Energy (NYSE: BTU) and fast-growing oil services player Weatherford International (NYSE: WFT). All three firms shed light on some key investment themes in their recent earnings releases and conference calls.
In This Issue
Each passing month brings new economic data that complicate our understanding of the global slowdown and its implications for energy demand–the key driver of commodity prices. I break down the latest economic indicators and outline my expectations for a US recover. I also examine emerging markets’ role in the ever-evolving economics of energy demand. See It’s the Economy, Stupid.
In the second part of this issue, I analyze the second-quarter earnings reports issued by three key companies and discuss the implications for the firms in question, their industries and other energy-related stories. See Earnings, Earnings, Earnings.
It’s The Economy, Stupid
The primary drivers of global energy markets remain demand and the state of the US and global economies. It’s simply not possible to make meaningful projections about energy prices or related stocks without considering the economic data.
Longtime readers of The Energy Strategist and my free e-zines The Energy Letter and Personal Finance Weekly know that I pay close attention to the Conference Board’s Index of Leading US Economic Indicators (LEI), an index that summarizes the performance of ten widely watched economic indicators. The index is released monthly with a one-month lag; the most recent number hit newswires on Monday and covers June 2009.
The latest LEI reading showed a 0.7 percent jump over the prior month. In addition, the Conference Board revised the May month-over-month reading higher, from 1.2 to 1.3 percent. As I’ve noted before, the two consecutive monthly gains of more than 1.0–logged in April and May of this year–have significant implications; this marks the first time that’s happened in the history of the LEI index. Three consecutive monthly gains of more than 0.5 percent also occur relatively infrequently.
Source: NBER, Bloomberg, The Energy Strategist
Since 1959 the LEI jumped more than 0.5 percent in three consecutive months on just 22 occasions. But most of these consecutive monthly gains have occurred in the clusters outlined in the above table. To simplify the results, the left column records only one date for each grouping.
The table’s second column records the nearest business cycle. The business cycles listed in the table are the official dates published by the National Bureau of Economic Research’s business cycle dating committee, the official arbiter of the beginning and end of US recessions. I have listed each cycle from trough to peak.
A quick perusal of this table reveals that clusters of LEI readings over 0.5 percent tend to occur in two economic environments: the middle of a strong economic expansion or a few months before or after the end of a recession. For example, the LEI jumped 0.9, 0.6 and 0.5 percent in April, May and June 1975; these gains occurred just after the end of the vicious 1973/74 recession, a contraction that resembles the most recent economic decline in duration and magnitude. The LEI actually jumped more than 0.5 percent for four consecutive months back in 1975, followed by a series of smaller monthly gains. This jump in LEI occurred just as the 1973/74 recession was ending.
Starting in May 2003, the LEI jumped more than 0.5 percent in nine consecutive months. This impressive string occurred long after the end of a brief recession in November 2001 but coincided with the start of a major run-up in the S&P 500 that began in the spring of 2003 and ended in late 2007. The 2001 through 2003 cycle was unusual because stocks continued to fall long after the economy began to improve; the market was still wringing out the valuation excesses built up during the 1990s boom.
Rather than simply looking at the overall LEI index, I usually review the performance of each component indicator. In particular, I prefer to see a broad swath of indicators carrying their weight rather than a single index pushing up LEI. In June, seven of the ten LEI indicators added to the index’s performance; positive contributors included an uptick in building permits, a slightly longer workweek and a fall in initial jobless claims. For those interested in how the LEI index is calculated, see the January 30, 2009 issue of Personal Finance Weekly, Follow the Economy’s Lead.
Some will be surprised that the employment picture is actually positive for LEI. We’ve all read the headlines about the weak June employment report and the near double-digit US unemployment rate. However, it’s important to remember that the unemployment rate is actually a lagging indicator of US economic health. The LEI considers initial jobless claims–the number of people filing for first-time unemployment benefits. Historical data for that number is tracked in the
Source: Bloomberg
As you can see, although the US unemployment rate continues to rise and the June non-farm payrolls data was negative, the number of US initial claims has declined in recent months. I explain the disparate US employment statistics in the most recent issue of Personal Finance Weekly, The Employment Picture.
Another leading indicator that’s showing some encouraging trends is building permits, a measure of the number of new residential construction permits being issued around the US. If consumers are filling for building permits, it typically means they’re planning construction projects. The filing for permits actually leads construction demand by several months. Here’s a chart of US building permits.
Source: Bloomberg
Although the number of new building permits remains near a historic low, the index has started to swing to the upside. But we don’t necessarily want this index soar; a big rise in building permits would indicate a flurry of new home construction. The reason that home prices have been dropping in the US is that there are too many homes and too few buyers–a major increase in construction activity would add to that glut.
However, it’s an encouraging sign that this indicator has stabilized at a low level, which suggests that homebuilders may be seeing some light at the end of the proverbial tunnel.
There are other signs that the US housing market is beginning to normalize. The following chart tracks US existing home sales over the past few years.
Source: Bloomberg
Existing home sales remain in negative territory on a year-over-year basis, but it’s clear that sales have improved as the vicious credit crunch of late 2008 has receded. For qualified borrowers, mortgage interest rates are exceedingly low. And although marginal “subprime” borrowers don’t have easy access to financing, it’s healthy that the residential mortgage market has become more rational. After all, many of the subprime buyers who purchased homes during the mortgage boom weren’t qualified or able to afford the loans they were taking on. These poorly underwritten loans were the epicenter of the credit crunch and subsequent economic contraction.
Another factor driving sales is the decline in home prices. Falling house prices makes buying a home more affordable. Granted, an unusually large number of the sales we’ve seen in recent months have been foreclosures, houses seized by lenders when the original borrowers failed to service their debt. Foreclosed homes typically transact at a discount to market value.
But there is a bright side to the trend of rising foreclosures. Although the banks usually lose money in the deal and the borrowers lose their home, foreclosure sales do help to clear the nation’s housing market. In a foreclosure, the home in question essentially passes from weak hands to someone who can afford to stay in the home. Not a pretty picture perhaps, but it represents the invisible hand of the market at work.
This confluence of low mortgage rates and falling home prices and the corresponding uptick in existing home sales is beginning to clear some of the inventory overhang. The graph below depicts this progress.
Source: Bloomberg
This chart indicates the number of months’ worth of residential housing supply available in the US market. Economists calculate this figure by dividing the number of unsold homes by monthly home sales. (Sales are seasonally adjusted to account for the fact that the spring is prime time for US home sales).
The inventory of unsold homes currently stands at 9.6 months. This is well above the normal range of five to six months, but the indicator is moving in the right direction and is well off its high of around 11 months. The housing market will likely take some additional time to normalize; however, it isn’t unreasonable to say that the worst is over for residential housing. In fact, the pace of national home price declines continues to moderate, and prices are actually rising in some markets.
Source: Bloomberg
This chart shows the year-over-year decline in home prices for the 20 largest metropolitan areas in the US. House prices are still falling year-over-year at a rate of about 18 percent. But the pace of that decline appears to have bottomed out earlier this year and is now moderating. And the year-over-year comparisons will continue to improve through the summer and into the fall; I expect the rate of decline in the Case-Shiller index to continue to moderate.
It’s also important to note that the data are somewhat skewed by a few particularly weak markets–namely, Las Vegas, Miami and Phoenix. And prices actually increased between March and April in nine of the 20 largest metropolitan statistical areas; home values in Dallas led the way on the upside, advancing 1.7 percent, prices in Cleveland were up 1.2 percent, and Denver and Washington likewise performed well.
There’s an old saw on Wall Street that the most expensive words in the business are “this time it’s different.” I am certainly not willing to fight historical trends: This evidence further supports my running hypothesis that the US recession will end either late this quarter or early in the coming quarter.
A few analysts recently published reports suggesting that the recession may have already ended; based on historical trends in monthly LEI data, there is some weight to this argument. But I regard the year-over-year change in the LEI–not month-to-month movements–as the best means of identifying the start and end of a recession; over the past four decades, this methodology has proved its validity. The graph below tracks the year-over-year change in LEI.
Source: Bloomberg
LEI is currently down about 1.2 percent from a year ago. This is well off the lows set late last year and in early 2009 but still consistent with a mild contraction in economic activity. It will probably take another month or two for this year-over-year index to turn positive; from my perspective, August or September is the recession’s most likely endpoint.
Earlier this year few analysts called for the US recession–or, for that matter, the global slowdown–to run its course by year-end. Now, even some prominent bears have shifted gears and are calling for the economy to grow again. One bear I greatly respect is Nouriel Roubini. Although Roubini is often premature in his calls, investors can learn a great deal by listening to both prominent bulls and prominent bears; no one ever made money by ignoring alternative opinions.
Suffice it to say that Roubini was dead-on identifying some of the problems facing the US economy and the resulting market and economic dislocations. In a recent interview for CNBC, Roubini suggested that the worst is over for the US economy. In this interview he also forecast that the markets would not test March lows and even predicted that the US would be the first advanced economy to exit the recession–probably by the end of 2009.
Roubini somewhat tempered his enthusiasm, pointing out that unemployment will likely peak at 11 percent next year and stocks have rallied too far too fast. These qualifications might undercut the endorsement for many investors, but those who follow Roubini know that this ultimately qualifies as a bullish statement–especially given the dour nature of his previous pronouncements.
Roubini also noted that the global economy is benefiting from strong growth in China, India and other emerging markets–a point I’ve made on several occasions in this newsletter. At the beginning of 2009 many analysts forecast that China’s economy would growth roughly 5 percent this year; several economists have issued reports estimating that expansion could approach 9 percent.
Longtime readers know that two of the indicators I watch carefully with regards to China are the Purchasing Managers Index (PMI) and statistics on Chinese bank lending. Let’s start with a look at PMI.
Source: Bloomberg
This chart shows Chinese Manufacturing PMI. Without delving into too many details, an index reading above 50 indicates that the Chinese manufacturing industry is expanding. As you can see, the PMI has reverted to levels before the late 2008 credit crunch, a sure sign that Chinese manufacturing activity is reaccelerating.
Chinese bank lending is another key indicator to watch. Because the Chinese government still exerts a major influence over lending at the nation’s largest banks, a major jump in activity suggests that the government is attempting to stimulate the economy.
Source: Bloomberg
Much of the jump in Chinese bank lending stems from the stimulus package implemented late last year. My colleague Yiannis Mostrous, Editor of the Silk Road Investor, believes China could pass another round of stimulus over the next few months to ensure the recovery remains on track and shore up confidence in the strength of the Chinese economy.
Unlike the US stimulus package, which I discussed at length in The Leviathan and Energy, the Chinese stimulus package entered the economy quickly, providing a real boost to demand. Meanwhile, it’s estimated that only 15 percent of the US fiscal stimulus package has entered the economy thus far; the tax rebates and unemployment benefits included in the bill have had an impact, but most of the public works and infrastructure spending won’t come into play until late this year or early in 2010. In fact, the bulk of the stimulus probably won’t hit the economy until after the recovery is already underway.
Although the Chinese stimulus package aimed primarily to promote domestic demand, these efforts are materially impacting companies worldwide. Consider what the management of Caterpillar (NYSE: CAT), the US-based equipment giant, had to say in the company’s most recent conference call:
Machinery volume was down $4.5 billion excluding the impact of CAT Japan. Broadly, you can look at the drop in machinery volumes in two major chunks: weak end-user demand and the change in dealer inventories. End-user demand was down quarter-to-quarter across the board geographically and by major industry. However, we did begin to see some improvement later in the quarter in countries like China and Brazil and in parts of the Middle East.The market for earthmoving equipment was among the hardest hit by last year’s economic contraction and credit crunch. Caterpillar’s CEO Jim Owens has been vocal in saying that he feels the US stimulus package was not large enough to help the economy and continues to call for a second round of stimulus.
Nevertheless, he acknowledges that demand is picking up somewhat in emerging markets such as China and Brazil. This is real-world evidence that these economies are improving.
Global energy companies have also benefited from the resurgent Chinese economy. China is the world’s fastest-growing oil importer; there’s little doubt that some of the run-up in oil prices over the past few months is due to China’s recovering appetite for natural resources. Coal producers with exposure to Australia, a key exporter of coal to Asia, should also reap the rewards. Topping the list are TES Portfolio recommendations Peabody Energy and Felix Resources (Australia: FLX, OTC: FLRFF).
Bottom line: a recovery in the US and global economies is a major positive for energy demand and, accordingly, stocks in this sector. I’ve warned of a potential pullback in commodities prices and related stocks since late May and early June; such a pullback began in mid-June and persisted through mid-July. I sent out Flash Alerts on July 6 and July 14 to explain the forces behind these pullbacks and how subscribers should respond to these moves.
I’m not convinced the downward pressures have on crude oil prices have abated; oil could at least retest its July lows before mounting any year-end advance. As a hedge for the TES portfolios, I’m maintaining our recommended position in the PowerShares Double Crude Oil Short (NYSE: DTO), an echanged-traded fund (ETF) designed to rise when oil prices fall. I don’t recommend that new subscribers enter the PowerShares ETF because I see the downside for oil limited to the mid to upper USD50 range. Subscribers with a position should maintain a stop-loss order as recommended in the Gushers Portfolio table and a limit sell order for half their position at USD100. For further explanation of this advice, please consult last week’s Flash Alert.
The primary risk for crude oil remains further volatility in economic data. As I have noted in previous issues of TES, economic indicators don’t always agree. Undoubtedly, any US recovery will be uneven; certain segments of the economy will recover long before others. Expect further growth-related scares over the next few months. Combine those fundamental factors with the seasonal weakness characteristic of August through mid-October, and you have a recipe for plenty of volatility.
I am far more confident that energy-related stocks have seen their summer lows. Energy stocks began to correct some weeks before crude oil prices. Although crude oil touched USD74 a barrel on both June 11 and June 30, hovering near its multi-month highs, energy stocks were hit hard in late June. Crude oil finally caught up in the first few weeks of July. Bottom line: it appears that most energy stocks began to price in USD60 oil before crude traded anywhere near that level.
Valuations for the energy patch remain undemanding. The S&P 500 Energy Index currently trades at 5.4 times trailing cash flow and 7.6 times estimated cash flow. While this is well off the all-time lows of around 3.7 times set in March of this year, it remains under the long-term average which is closer to 9 times.
It’s worth making one final macroeconomic point: I am calling for a cyclical recovery in the US economy and a rally in the US stock market that will probably last into 2010, taking oil back over USD100 a barrel and the S&P 500 back to around 1,200 or higher. But there is a big difference between a cyclical recovery and a major economic expansion.
I suspect that the US the economic recovery will ultimately disappoint many investors. Historically, the economy has posted impressive growth in gross domestic product (GDP) in the wake of deep recessions. In this case, however, I’m looking for a more subdued rebound. The US economy might grow 2 to 3 percent next year, but I don’t expect a surge similar to the ones that occurred in late 1975 and 1976 when the economy recovered from the vicious 1973/74 contraction. Unemployment is likely to remain stubbornly high well into the coming expansion.
The US economy faces a number of long-term challenges that are beyond the scope of today’s issue. Interested subscribers can get my take ton some of these structural challenges in upcoming issues of my free e-zine Personal Finance Weekly. However, these concerns are longer term in nature and shouldn’t impede the upside I am forecasting into the first half of 2010.
Going forward, I continue to expect emerging markets to become an increasingly important driver of global commodity markets. Even as the US economy stumbles along with sub-par growth, a continued surge in demand from the developing world will be the key to long-term demand upside in commodities. The other issue that I have written about extensively in TES over the past few years is supply. Specifically, it is becoming much harder and more expensive to produce the crude oil the world needs to meet rising demand. Oil and other commodity prices will need to remain elevated in coming years to incentivize needed investment in new production capacity.
The supply issue will emerge as a key driver for oil to reach USD100 a barrel next year. The massive cuts to spending on exploration and development preciitated by the commodity price crash from July through December of 2008 means fewer new oil developments will online over the next few years and presages a continued fall-off in supply. Months of reduced activity will ultimately exacerbate the supply crunch. And whereas demand can bounce back quickly in the context of a global recovery, it takes far longer for producers to gear up new projects and ramp up oil supplies.
Earnings, Earnings, Earnings
Over the next month, the big driver for energy stocks will be second-quarter earnings. I expect most energy stocks to post earnings that appear weak on a year-over-year basis; after all, commodity prices have plummeted year-over-year despite a nice rally in the second quarter.
Much of this decline is expected and fully priced into the stocks. Broadly speaking, the tenor and content of management’s conference calls are, in many instances, more important than the numbers. The big question is whether any prominent energy firms are forecasting a surge in activity–such statements could be suggestive of a profitable investment theme.
Here’s a look at a number of stocks in my coverage universe that have already reported results and some of the points I gleaned from their reports and conference calls.
CSX Corporation (NYSE: CSX)
CSX Corp is a so-called Class I US railroad ranked alongside Union Pacific (NYSE: UNP), Burlington Northern Santa Fe (NYSE: BNI) and Norfolk Southern (NYSE: NSC). These four companies are the largest US rails with the most extensive track networks.
New subscribers might wonder why I follow rails in an energy newsletter. The answer is three-fold: the biggest cargo for railroads is coal; rails are a great indicator of US economic health; and rails also carry agricultural products and ethanol (a biofuel).
CSX reported earnings of $0.72 per share, roughly $0.10 better than analysts had expected, and the stock has generally rallied since the release. Nevertheless, CSX continues to suffer substantial declines in the volume of goods moving across its network–hardly a surprise given the weakness in the economy over the past year. Last quarter CSX’s volumes declined 21 percent from a year ago.
As one might expect, this volume drop-off spells lower transport fees for CSX and lower revenues. The upshot of this volume decline was a near $600 million hit to the rail’s top line. But there was some encouraging news: The railroad managed to offset some of the negative impact by charging customers higher rates and, perhaps more importantly, reducing its costs to reflect weaker volume trends. These initiatives included putting locomotives and railcars into storage, and trimming the workforce through layoffs and furloughs.
These cost-cutting measures appear to be the main source of CSX’s better-than-expected earnings. Investors were also likely encouraged by CSX’s pricing power; even amid a nasty economic downturn, the company managed to raise its core prices (excluding fuel surcharges). This is further proof of the renaissance in rails, the most economic and fuel-efficient form of long-distance transport.
For energy investors, the most important take-away from the CSX conference call relates to the coal market. CSX saw a 21 percent year-over-year decline in coal shipments in the second quarter compared to just a 7 percent year-over-year decline in the preceding quarter.
Source: CSX Second Quarter Earnings Presentation
This chart shows that for most cargo categories, the rate of year-over-year decline in volumes actually moderated between the first and second quarter. Coal was the lone exception; volumes in this category fell precipitously.
Management indicated that the decline in coal volumes for the quarter was broad-based, as US coal exports declined sharply due to weaerforeign demand. Meanwhile, US utilities have large stockpiles of coal at their facilities and little near-term reason to order additional shipments of coal to meet demand.
For TES readers, this decline in coal volumes isn’t a huge surprise; I’ve written about the bearish near-term conditions in US coal markets on several occasions over the past few months. More important is management’s assertion that the coal market may have hit a bottom in the second quarter in terms of the rate of year-over-year decline. When an analyst asked about the rationale for this expectation, the management team responded:
…the third quarter it [the year-over-year decline in coal shipments] will be somewhere between what it was in the first quarter, meaning lower than the first quarter and higher then it was or better than what it was in the second quarter. What we’ve seen is when those gas prices first fall below $5 and then below $4, the marginal dispatch units come off line.This quote confirms that US coal demand is wea three main reasons. First, with gas prices under $4 to $5 per million British thermal units, natural gas plants become more economic to operate than coal plants. This reality has prompted some utilities to shift power generation from coal-fired plants to gas-fired facilities, a phenomenon known as fuel switching.
Secondly, in the southeastern part of our network and in general, electric generation has been down about 7 percent. And I don’t have the coal burn number right off the top of my head, but it’s almost double what that is where it’s been surpassed by natural gas…and the third factor is the utilities are essentially taking what they’re contractually obligated to take.
…Some of the utilities have told us they have to pick up their deliveries in the second half of this year versus what they had in the first half to meet their obligations. So we’re seeing that happen. There’s been a little uptick in the export market, not much, but a slight uptick that’s come through what our customers are giving us in terms of projections.
Fuel switching will likely continue for some time to come. But as I outlined in last week’s Flash Alerts and recent issues of The Energy Strategist, I’m looking for gas prices to rebound by year-end to well over $5 per million British thermal unites. If that projection is correct, fuel switching would become less of a headwind.
Second, electricity demand is down overall, primarily because of US economic conditions. Still, as I outlined in the first part of today’s report, I expect that situation to improve over the next few months. Electricity demand should begin to grow again. Third, exports are down largely due to weak economic conditions overseas.
There are a few counterbalancing factors. First, most utilities sign long-term contracts with coal mining firms to secure supplies; in other words, they are contractually obligated to take a certain volume of coal at a certain preset price. This is bad news for utilities because they are forced to buy coal they don’t need; if they signed coal contracts last year, they are also likely paying prices that are far above current market rates.
Coal mining firms have been willing to negotiate limited delays or volume adjustments to contracts; it’s in their best interests not to build up huge inventories at their customers sites. But mining firms typically demand a fee for larger adjustments. These contracts are good news for coal-mining firms like Peabody Energy because they’re guaranteed a certain minimum volume and price regardless of near-term market conditions.
It’s also interesting to note CSX’s comments about a slight but meaningful uptick in the export market. This is likely due to resurgent demand for coal from emerging countries like China. For more on this, consult the June 3, 2009 issue of TES, The New Super-Cycle, where I recommend a direct play on Asian demand for coal–Australian producer and Gushers Portfolio denizen Felix Resources.
All told, the CSX release paints a grim picture of US coal demand near-term but offers a glimmer of hope that the worst is in the rear-view mirror for this market.
Peabody Energy (NYSE: BTU)
Management echoed some of these sentiments in Peabody Energy’s second quarter call earlier this week. Peabody reported earnings of $0.49 per share, slightly above the consensus of $0.48. The market’s reaction was negative, and the stock declined about 5 percent on the session.
But that negative reaction is tempered by the fact that Peabody is up 21 percent in just the past two weeks, vastly outperforming the 11 percent gain in the S&P 500 Energy Index and the 16 percent jump in the Philadelphia Oil Services Index over the same time period. In addition, Peabody Energy’s stock closed well off its session lows, a sign that buyers looked at the post-earnings dip as a buying opportunity.
The most striking facet of the Peabody call was the amount of time management spent discussing overseas coal markets rather than domestic markets. Just a few years ago, the investment story for Peabody was that the company focused on mines in the western US where coal seams are larger and easier to mine. Whereas miners in the eastern US struggled with ever-more onerous environmental regulations, growing safety concerns because of the need to exploit deeper mines, and higher labor costs associated with underground mining, Peabody could increase production effortlessly from its vast mines in the western US and Illinois Basin.
This basic story remains intact for Peabody’s US operations; however, Peabody’s real opportunities lie in Asia. In the opening comments to Peabody’s conference call, CEO Gregory Boyce indicated that the company is seeing signs of stabilization and early recovery in the Asia-Pacific region but no such indications in the domestic US coal market or the market for coal exports to Europe.
In particular, these comments stood out to me:
China’s GDP continues to surprise the world. China is also importing coal at a record rate. May had been the highest month so far this year until June numbers came in overnight. China’s net imports were up an amazing 15 million tons in June, 36 million tons now year-to-date, as China set a 12-year low mark in exports last month.As Peabody’s CEO points out, China is currently importing coal at a record pace–in fact, an an all-time high. Meanwhile, China has cut its exports of coal to record lows, so net imports are rising rapidly.In India, rolling blackouts remain commonplace, coal stockpiles are again at critically low levels, and the imports are rising. Our view is that India will be the fastest growing coal importer over the next decade.
Now as we look to the Atlantic, we’re not yet prepared to say that a rebound is taking hold. Steel plant output remains weak, electricity generation is soft, and inventories are high. The strong export story of 2008 is unwinding this year due to lower European demand and the fact that the U.S. is positioned high on the global cost curve. The U.S. needs to work through reduced generation, industrial use, and exports. So demand for U.S. coal is likely to be some 115 to 125 million tons lower this year. And at the same time, we’re seeing coal stockpiles 15 to 20 days above normal.
Meanwhile, India is a market that gets far too little attention from investors. But India is also a major consumer of coal and needs to build out considerable capacity to meet growing demand for electricity. As Mr. Boyce points out, the Indian electric grid is notoriously unreliable, partly due to its insufficient generating capacity. And while US coal inventories are bloated, Indian utilities face record-low stockpiles. According to Peabody, Indian officials state the nation will need as much as 200 additional tons of coal imports over the next five years, making the country the world’s fastest growing importer.
All told, Peabody now gets more than half its earnings from outside the US, thanks in large part to its purchase of Australia’s Excel Coal a few years ago; as I noted in the June 3 issue, Australia is likely to be the world’s largest exporter of both metallurgical coal used in steelmaking and thermal coal used in power plants. Peabody is also establishing a trading hub in Australia and has invested in joint ventures in China and Mongolia.
Management made a few additional points worth noting. First, the company sees the coal mining industry in the eastern US entering a period of long-term decline as mining costs rise and are increasingly replaced by volumes from the west and Illinois Basin. The company also suggested that the US could experience a prolonged decline in coal consumption as industrial coal demand bounces back only weakly in the coming recovery.
Even though I suspect US coal demand will eventually bounce back along with the economy, there’s no near-term catalyst for upside given high inventories. At best, coal volumes in the US will stabilize as CSX indicated in its call. This is why I continue to recommend avoiding US-focused mining firms, especially those with heavy exposure to the eastern US. Although these stocks have rallied along with improving prospects for the US economy, I see far more upside for Peabody and other miners focused on Asian demand.
Based on comments from Peabody and CSX, I am also reiterating my buy recommendation on Australian coal mining firm Felix Resources. Felix is a pure play on Australian coal exports and has a number of new mines coming online over the next few years that will allow Felix to increase production dramatically. I am raising my recommended buy under price on Felix Resources to AUD 18.50 to reflect recent upside in the stock and strong near-term prospects.
Peabody’s comments concerning the US climate bill passed by the House of Representatives in late June also offer some interesting insights. Specifically, Peabody’s CEO noted:
The U.S. House eked out passage of what is commonly called the Waxman-Markey bill, after changing it considerably. It now faces a likely uphill battle in the Senate. We view the House bill as a potential cup half full. On the plus side is growing recognition of coal’s importance in energy security and affordable electricity. We also saw major support for carbon capture and storage [CCS]. Significant changes, however, will be required in the Senate to produce a passable bill.These comments echo some of the points I made in the most recent issue of TES, The Politics of Carbon. Specifically, although the bill’s passage before the end of June was widely seen as a victory for President Obama, the most striking fact about that vote is just how close it was.We’ve also been encouraged by the acceleration of CCS projects. FutureGen has new momentum. GreenGen has started construction. Gasification and retrofit projects are advancing in multiple countries. The U.S. and U.K. are expanding their funding, and many new companies are entering the CCS space. Peabody continues to participate in more than a dozen initiatives across the U.S. and globe to accelerate CCS deployment.
Undoubtedly, the Democratic leadership in the House could have pushed more members to vote in favor of the bill. What the close vote implies is that there are a large number of members in competitive districts who don’t want to vote in favor of the bill for fear that it will negatively impact their reelection prospects. The leadership in the House apparently allowed these members the cover of a down vote on the Bill so long as its passage were guaranteed.
As Peabody’s CEO suggests, the climate legislation faces much tougher sledding in the Senate and will undergo serious revisions before it has any chance of passage. My guess is that the US will not pass climate legislation this year.
Another factor that doesn’t favor US climate legislation is the failure of the G8 nations to persuade developing countries such as China and India to commit to targets to reduce carbon-dioxide emissions. I outlined some of my take-aways from the G8 conference in the July 10, 2009 issue of Personal Finance Weekly, “G8 Reflections.”
However, if a climate bill does eventually pass along the lines of the House legislation, it’s not a total negative for the coal industry; lawmakers appear to recognize that there is no way the US is going to wean itself from coal overnight.
At the G8 in L’Aquila, as well as in the US climate bill, there has been considerable discussion surrounding the need to develop carbon capture and storage (CCS) technologies that would allow carbon emissions from coal plants to be captured and permanently stored underground. Several such projects are now receiving funding and are progressing all over the world. This is a positive for the coal industry in a world where carbon emissions are limited.
Weatherford International (NYSE: WFT)
My favorite long-term play on upside in the energy patch is the oil services sector; I currently recommend both Schlumberger (NYSE: SLB) and Weatherford International in the TES Portfolios.
The basic rationale for owning oil services firms is simple: Producing oil and gas is becoming increasingly technically complex as producers go after fields that are tough-to-produce or located in hostile environments such as the deepwater. The oil services industry provides producers with the technical know-how and skills needed to produce such fields.
As you might expect, the oil services industry was hard-hit by the commodity price collapse in the latter half of 2008. These companies don’t produce oil and gas and, therefore, aren’t directly impacted by lower commodity prices; small changes in pricing have limited impact on their profitability. But, oil services firms are sensitive to oil and natural gas drilling and exploration activity. As commodity prices fall, activity levels decline and that hits earnings.
As a rule of thumb, prices between USD70 and USD80 a barrel is key for international oil markets. Above that price range, activity should be relatively robust; below that range, producers cut back on projects and capital spending. Activity collapsed last year as oil plunged below USD40 a barrel but appears to have stabilized in some markets since oil prices rebounded.
The North American market is the most volatile of all and is heavily levered to natural gas drilling activity. For gas, the key price point is likely around USD6 to USD7 per million British thermal units. Above that price range, activity levels would be solid; below that range, activity remains weak. With current gas prices hovering below USD4 per million British thermal units, North America has been among the weakest markets in the world this year.
Weatherford reported second quarter earnings of $0.10 per share, below consensus forecasts for $0.15 per share. The stock reacted negatively to the news, falling intraday in the wake of the report. But that reaction was tempered somewhat by the fact that Weatherford closed at its intraday highs on the day it released earnings and has been a stellar performer so far this year. As with Peabody, investors appeared to regard Weatherford’s post-earnings selloff as an opportunity to buy into the stock.
As expected, North America was a weak spot for Weatherford in the second quarter, especially Canada. None of this was totally unexpected, and I have written about weakness in North America on countless occasions over the past few months.
I am always amused by stories that emerge in the mainstream media suggesting that Weatherford and other oil companies should be avoided because of weakness in North American drilling activity. Given that this weakness is already well known and well understood, it shouldn’t really factor into your investment decisions–the stock market is a forward-looking animal and this is old news. This is reflected in the fact that buyers quickly bought Weatherford in the wake of its post-earnings knee-jerk dip.
A few points are worth noting about the North American market. First, pricing trends continue to be weaker than expected, and Weatherford continues to downsize its operations in the region and cut costs. Although cost-cutting along has not been enough to offset the decline in demand, my longer-term take remains that Weatherford is increasingly becoming an internationally levered company–not a play on North America. This bodes well for its long-term profitability.
In addition, the massive decline in service costs in North America is a big positive for oil and natural gas producers in this market. This means that producer’s costs should fall sharply, lowering break-even price for natural gas. In that regard, Weatherford’s call is a positive for TES recommendations XTO Energy (NYSE: XTO), EOG Resources (NYSE: EOG) and Chesapeake Energy Preferred D (NYSE: CHK D). All three picks remain Buys.
The news from Weatherford’s international business lines was positive. The company’s strong position in resilient Latin American markets fueled an 84 percent increase in that region’s revenues for the first half of this year. Weatherford’s long-term deal to develop Mexico’s Chicontepec field offers the company a stable base of revenues in Latin America.
More broadly, Weatherford indicated that while visibility and growth prospects for North America remain weak near-term, conditions are improving internationally. Management was constructive on prospects for the latter half of this year and into 2010 based on trends observed in the second quarter. In fact, Weatherford indicated that growth and pricing trends outside of North America likely troughed in the second quarter; going forward, these markets should see a resumption of growth and better pricing.
In the second-quarter conference call, Weatherford CEO Bernard Duroc-Danner stated described pricing trends outside of North America as follows:
It’s a complicated issue because you have so many different markets and so many different contracts. We do the best job we can to measure analytically where pricing has occurred, why it has occurred and what the timing is for any kind of other pricing changes. Because of that analysis, which is about as real time as you can have, we’ve come to the conclusion that there is about more than two-thirds of our business, maybe 70 percent of our business, in international market, which has been in one way or the other, either mechanically or by negotiation or simply new business, are repriced.Weatherford’s prediction that international margins and activity have troughed is based on actual price renegotiations and conversations with customers. This bodes well for the oil services sector generally in coming quarters.And the remaining, let’s just say, 30 to 35 percent of our business is not likely to be repriced in ’09 and therefore by the time it gets repriced, market conditions may be different. So, it strikes us that by and large the pricing effect in the international markets, with a few exceptions, there are always exceptions, is behind us.
That’s statement one. Two, in general, I don’t think the market is red hot, not at all, but the tone is decent in the international markets, the tone is better, which is also an environment which is less conducive to major pricing concessions. So between the analytical work and then the tone, I feel reasonably confident that pricing changes, at least insofar as Weatherford is concerned, are behind us.
I will have more to say about the oil services industry in the next issue of TES after services giant Schlumberger releases its results. But my early read is that it’s a mistake to focus too much attention on the weak North American market. The big story is the trough in international profit margins.
I continue to recommend buying both Schlumberger and Weatherford and would look on any dips as a gift to investors.
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