The Crystal Ball
There’s an old saw on Wall Street that every investor gets to call just one top and one bottom in their lifetime; unfortunately, those calls rarely come on the same investment.
In the financial markets there’s no such thing as a crystal ball and a perfect call. Every analyst, no matter how competent, gets some things wrong–especially when it comes to making long-term projections.
Nevertheless, in the first issue of the new year I usually provide a roadmap for the year ahead. This isn’t an investment plan that’s set in stone but a flexible, general guide to what areas will provide the best returns. In this article I also review the past year’s calls–the good, the bad and the ugly–and evaluate how they stacked up against what transpired.
In This Issue
The Stories
Making economic predictions is always a difficult and rather thankless task. Nonetheless, some sort of basic roadmap for the economy and broader market is absolutely crucial if we’re to extrapolate a valid forecast for the prices of oil, gas and other major energy commodities. Here’s my Base Case for the global economy, potential Economic Risks and my Upside Case.
For the year ahead, I recommend that readers focus on stocks with leverage to the following themes: services firms with technology needed to produce complex fields, drilling and equipment firms with exposure to deepwater markets, and oil producers with the potential to meaningfully ramp up production in coming years. See Crude Oil.
One of my top three energy-related themes for 2010 is a rally in natural gas prices. Gas prices should average around USD7 per million British thermal units, a healthy level that will make producers with high-quality assets profitable and encourage an increase in drilling and service-related activity. I also review my top picks. See Natural Gas.
King Coal is the final piece of the energy trifecta for 2010. Here are my favorite coal-levered stocks. See Coal.
The Stocks
Anadarko Petroleum (NYSE: APC)–Buy @ 70, Stop @ 47.50
EOG Resources (NYSE: EOG)–Buy @ 110, Stop @ 57.50
Suncor Energy (NYSE: SU)–Buy @ 43, Stop @ 25.25
Petrobras A (NYSE: PBR A)–Buy @ 50, Stop @ 28.50
Noble International (NYSE: NE)–Buy @ 50, Stop @ 30
Seadrill (Oslo: SDRL; OTC: SDRLF)–Buy @ 25, Stop @ 16.75
Dresser-Rand (NYSE: DRC)–Buy @ 36, Stop @ 24
Schlumberger (NYSE: SLB)–Buy @ 85
Weatherford International (NYSE: WFT)–Buy @ 26
Dril-Quip (NYSE: DRQ)–Hold, Stop @ 50.50
Range Resources (NYSE: RR)–Buy @ 60, Stop @ 40
Petrohawk Energy (NYSE: HK)–Buy @ 30, Stop @ 17.25
Chesapeake Energy Pref D (NYSE: CHK D)–Buy @ 95
Baker Hughes (NYSE: BHI)–Buy @ 49, Stop @ 33
Nabors Industries (NYSE: NBR)–Buy @ 28, Stop @ 17.50
Tenaris (NYSE: TS)–Buy @ 36, Stop @ 24
Peabody Energy (NYSE: BTU)–Buy @ 52, Stop @ 32
Bucyrus (NSDQ: BUCY)–Buy @ 66
Making economic predictions is always a difficult and rather thankless task. And this year, with emotions running high and opinions in no short supply, issuing an economic outlook is fraught with even more peril than usual.
Nonetheless, some sort of basic roadmap for the economy and broader market is absolutely crucial if we’re to extrapolate a valid forecast for the prices of oil, gas and other major energy commodities.
The US recession ended last summer, and the economy will enjoy a weak, cyclical recovery in 2010. Longer-term headwinds abound but are unlikely to manifest themselves this year; with the Federal Reserve likely to maintain a highly accommodative monetary policy, the US won’t experience a double-dip recession. The global economic recovery will accelerate in 2010, led by continued strong growth in emerging markets such as China, India and Brazil. I expect the S&P 500 to stage a typical recovery-year rally to around 1,250 or 1,300.
It’s become fashionable in recent quarters to be a market bear and claim to have called the US recession and financial crisis. Despite the market’s massive rally off the March lows, I find that the bullish view often is greeted with the most skepticism–a reversal of late 2007 and early 2008 when most investors remained relatively upbeat and believed that the financial turmoil would prove short-lived.
Investors have some good reasons for their dour outlooks, but longtime readers know that I eschew both permanent bears and permanent bulls. Although I can’t claim to have a crystal ball or to have “called” the financial crisis (whatever that means), in the Jan. 23, 2008, issue of The Energy Strategist I wrote:
Near-term cash requirements aside, the root cause of what’s really troubling global markets and killing risk appetite is the specter of a US-led recession. Although some investors love to scour every minutiae of economic news released, I prefer to look at just a handful of simple indicators. First, check out the chart of US Leading Economic indicators below.
Source: Bloomberg, The Energy Strategist
The leading economic index (LEI) is actually a composite of 10 key economic indicators. The list includes housing starts, consumer expectations, jobless claims and even the performance of the US stock market.
The chart shows the year-over-year percent change in leading economic indicators. As evidenced from this chart, the LEI tends to turn negative just ahead of or coincident with US recessions.
For example, the LEI turned negative on a year-over-year basis in June 1989; a US recession followed in July 1990 and lasted through March 1991. Similarly, the December 2000 dip in the LEI below zero foreshadowed the March-November 2001 recession.
Like every indicator, the LEI is far from infallible. For example, a short dip below zero in 1996 turned out to be a false alarm. However, the indicator is right more than it’s wrong, and we can’t ignore the slump since late 2007.
The LEI officially broke below zero in November. I believe that this presages at least a minor US recession in 2008.
Contrary to the view publicly espoused by the European Central Bank (ECB), I just don’t see Europe remaining totally immune either. The largest economy in Europe is Germany, and leading indicators in that nation are also deteriorating. For example, retail sales were down 5.6 percent year-over-year in November, the latest month for which we have reliable data.
For what it’s worth, at the time most economists and strategists were still calling for the global economy to avoid recession in 2008, a year that turned out to be the worst for the broader market since 1937 and the deepest recession since at least 1982. My call, while imperfect, served an early warning of what ultimately transpired.
Years ago, after duck-hooking three straight drives in the first few holes of a golf tournament, I was counseled to “dance with the swing that brought me” rather than trying to change my style mid-round. Although I didn’t win the tournament, the advice settled my nerves and I ended up playing one of my best rounds of the year.
I won’t ignore that advice today and embrace some new economic indicator of the moment: The very same indicators that correctly told me the US was entering a recession two years ago tell me that the economy is enjoying a cyclical recovery today.
Let’s start with a look at the year-over-year change in the Conference Board’s Leading Economic Index (LEI) as of the most recent data.
Source: Bloomberg
As this graph illustrates, the LEI is up 6 percent on a year-over-year basis, its highest reading since 2004. And economists expect the forthcoming December data to show evidence of further strengthening. The year-over-year change in LEI crossed into positive territory last July, suggesting that the recession ended in summer 2009.
The indicator could be wrong this time around, but a year-over-year change of 6 percent is a rare occurence–I can’t find an incidence in market history where an improvement of that magnitude didn’t presage at least a short-term economic rebound. A quick snapback from negative readings to levels above 5 percent is typical when recessions draw to a close.
Since 1960 there have been a total of eight instances where LEI turned negative for a string of at least a few months and subsequently rebounded to above 6 percent year over year. Here’s a table that tracks this pattern.
Source: Bloomberg
On average, this pattern occurred roughly eight months after a recession ended, though there are wide variations in the data. For example, in 1967 LEI turned negative, but the US economy saw a soft landing–growth slowed, but the economy never entered a recession. In 1992 LEI took a long time to grow 6 percent; the economy had been out of recession for 20 months when the year-over-year change in LEI finally reached this level.
I also looked at the quarter after the year-over-year change in LEI eclipsed 6 percent. If LEI turned up 6 percent in the first month of a quarter, I looked at the current quarter. As you can see, gross domestic product (GDP) increased an average of 4.6 percent in these instances.
More important for investors, the market fell only once in the 12 months after the monthly year-over-year change in LEI eclipsed 6 percent. And there was only one occasion where the S&P 500 closed lower 24 months after the LEI logged such a reading. On average, the market rose 10.5 percent and 15.7 percent, respectively, in the subsequent 12 and 24 months.
Granted, one should be wary of drawing any earth-shattering conclusions from a sample of this size. However, the table does suggest that the so-called Great Recession of 2007 to 2009 has passed. Further, consensus estimates for US GDP to grow less than 3 percent in the first half of 2010 look to be on the conservative side. The Federal Reserve’s forecast for 3 percent growth for all of 2010 likewise strikes me as conservative.
Precedent also indicates that there’s a good chance the market will trade higher generally over the coming year. Of course, that doesn’t preclude a long-overdue 10 percent correction for the broader market, but it does suggest a bullish bias for 2010.
In recent weeks a number of commentators have compared the current pattern in the S&P 500 to that of 2003 to 2004. The graph below encapsulates this idea.
Source: Bloomberg
It’s always dangerous to blindly compare two different periods in market history, but in this instance there are some striking similarities.
Between 2003 and 2004 the market was recovering from bearish sentiment, the bursting of the technology bubble in 1999 and a relatively mild recession.
Today the market is recovering from another dramatic bear market and another burst bubble, this time in credit and housing. The economy also appears to be exiting the worst recession since at least the recession of the early 1980s.
And I didn’t have to normalize the data one bit in this comparison; the S&P 500 ended 2002 and 2008 at almost exactly the same level.
When graphs like this make their way around Wall Street, they have an odd tendency to become self-fulfilling prophesies. If the pattern holds, we’ll see a rally in early 2010, followed by a lengthy correction over several months as investors fret over the durability of the economic recovery. The final part of the pattern would be a dramatic year-end run-up that propels the S&P 500 up roughly 11 percent on the year. The S&P 500 Energy Index broadly outperformed in 2004, jumping 31.5 percent as the economy improved.
I can almost guarantee you the pattern won’t be identical. But this sort of pattern is broadly consistent with the returns one would expect in the first full year of an economic recovery. And keep in mind that a rally to the 1,250 would simply take the S&P 500 back to levels last seen in September and October 2008. In other words, such a rally would simply erase the market’s decline in the wake of Lehman Brothers’ failure–hardly an outrageously bullish outcome.
Like most investors, I have a healthy skepticism for economic statistics released by the government, including several that underlie LEI. That’s why I examine other indicators, including containership traffic into major US ports and freight traffic data on US railroads.
The graph below depicts total loaded containership traffic–inbound and outbound–from the Port of Long Beach, California.
Source: Port of Long Beach
As you can see, containership traffic slumped in late 2008 but has rebounded quickly recent months. Although traffic hasn’t recovered to the highs reached in 2006 and 2007, volumes have returned to healthy levels.
The Association of American Railroads (AAR) publishes its Rail Time Indicators Report in the second week of each month. In its most recent release, the AAR notes that excluding the typically low-volume Thanksgiving week, November 2009 brought the strongest volume for US railroads since the preceding year. Although freight transported is down from a year ago, the comparison skewed by coal carloadings, which are down sharply from last year’s record levels.
In short, both containership and rail freight traffic indicate a slow-but-steady recovery from a severe recession.
Investors tend to spend an inordinate amount of time focusing on the US economy, but economic growth in the emerging markets is arguably more important for energy-focused investors. After all, most of the growth in global energy demand over the past five years has come from emerging markets such as China, India and Brazil.
Some pundits argue that the synchronized decline in global markets in late 2008 and early 2009 is proof that emerging markets have not decoupled from the US and other developed markets.
I think that pronouncement is entirely too hasty. There’s a big difference between a decoupling in markets and a decoupling in economies. Although markets worldwide declined amid a global credit panic, emerging economies largely held up better than their developed counterparts and rebounded more quickly in 2009.
This superior economic performance translated to market performance. Consider, for example, that China’s Shanghai Composite actually hit its low in fall 2008 and didn’t suffer the body blow that US markets did in early 2009.
Along these lines, one indicator that has served us well in recent quarters is the China Purchasing Managers Index (PMI) for manufacturing. The graph below tracks China’s PMI back to 2005.
Source: Bloomberg
In the above graph, PMI readings below 50 indicate a contraction in the manufacturing component of the Chinese economy; levels above 50 indicate an expansion. PMI dropped rapidly from near 60 in spring 2008 to under 40 in November. But note how quickly PMI bounced back in early 2009; by March PMI indicated a reacceleration in Chinese growth. That quick bounce-back was a major factor behind the recovery in oil prices.
The current PMI points to a further acceleration Chinese growth; the index recently touched 56.6, its highest level since April 2008.
Chinese electricity demand is another indicator to keep an eye on.
Source: Bloomberg
This graph tracks the year-over-year change in Chinese electricity demand since 2000. The stronger the economy, the more electricity consumers use; this relationship has clear implications for Chinese demand for commodities used to produce power.
Chinese electricity demand has improved steadily over the past few months. In the most recent month for which we have data–November 2009–Chinese electricity demand was up close to 30 percent compared to November 2008 and 17 percent from November 2007 levels. That’s impressive growth.
This all bodes well for a global economic recovery that’s led by the developing world.
I’d rather not spend the entirety of today’s issue analyzing the global economy; it would be impossible to address all aspects of my base case in a single issue. For those seeking a more detailed discussion of these matters, I’ve written several articles analyzing various aspects of the economy: the Dec. 26, 2009, issue of Personal Finance Weekly, The Mythical Double-Dip, and the Nov. 28, 2009, issue, Another Look at GDP.
Economic Risks
As I noted at the beginning of today’s report, forecasts are an exercise in probability, not certainty. There are a number of potential downside risks on the horizon, albeit beyond 2010. Nonetheless, investors should always understand what could go wrong and prepare accordingly; eventually some or all of these issues likely will come home to roost.
One of the most important risks facing the US is excessive debt–this applies to both the consumer and the government. The graph below depicts various kinds of debt as a percentage of US GDP.
Source: Bloomberg
A couple of points are worth noting. First, overall US debt has increased steadily over the past 10 years; household debt now hovers around 100 percent of GDP compared to around 60 percent in the early 1990s.
Second, note how quickly the federal government’s debt is rising. As recently as September 2008, the federal government’s debt stood at roughly 40 percent of GDP; now it’s over 50 percent for the first time since the 1950s and is on its way to 70 to 80 percent based on current spending projections. The US is on track for an unprecedented string of budget deficits.
High household debt is a daunting problem. Consumers borrowed money on credit cards and from their homes to fund spending in recent years. In the wake of the financial crisis, consumers are focused on repairing their balance sheets by paying down debt and saving money.
Meanwhile, banks have stopped lending to anyone with a pulse; lending standards tightened measurably since the heydays of easy credit. Contracting consumer credit and a higher savings rate are bad news for consumer spending, which makes up around two-thirds of US GDP.
Rising federal, State and local government debt is also an issue. To date, the US government has been able to borrow cash at extraordinarily low interest rates because foreign central banks have eagerly purchased US government bonds in large quantities. But hefty government deficits spell an ever-rising funding requirement, which implies that these nations will need to keep buying the bonds.
Ultimately, foreign central banks will require a higher interest rate on these bonds to offset the higher risk associated with a country that has a deteriorating fiscal position and a weak currency. This spells rising interest rates, which would be detrimental to overleveraged US economy.
Another potential negative is that rising government participation in an economy is rarely consistent with sustainable economic growth. I outlined this problem at great length in the Dec. 11, 2009 issue of Personal Finance Weekly, A Tale of Two Nations.
Finally, the US recovery depends at least a certain degree on government stimulus and measures put in place to stabilize credit markets and pump liquidity into the system. Each month, the Conference Board releases a table showing the contributions of the 10 individual indicators that make up LEI. The following table presents these contributions over the past six months.
Source: Conference Board
To create the table, I simply added together the monthly percent contributions from each component. As you can see, the most important component by a long shot is the difference between the yield on a 10-Year US Treasury bond and the current federal funds rate. This is essentially a measure of the steepness of the yield curve.
Obviously, there are two factors that affect the steepness of the curve: long-term interest rates and federal funds rate. That the Federal Reserve has kept rates at rock bottom while longer-term rates have inched higher is the prime driver of the steepening yield curve.
Banks tend to benefit from a steep yield curve. Banks take in customer deposits and pay short-term interest rates on those deposits; as short-term rates have fallen you’ve probably noticed the interest you receive on savings accounts and certificate of deposit accounts has also fallen.
The banks turn around and lend that cash out to consumers and businesses at longer-term interest rates. When the yield curve is steep, the spread banks earn between the cost of cash (deposit rates paid) and the interest rates they receive on loans grows, increasing profitability.
When the Fed begins to tighten monetary policy, this interest rate spread will be less of a tailwind for LEI. However, I don’t expect that to happen before the end of 2010 or early in 2011. The central bank has stated it plans to keep rates low for an extended period; this suggests that they’re more likely to err on the side of leaving rates too low for too long than risk a so-called “policy accident.”
Many investors will find the strong contributions from the two employment indicators surprising. After all, the unemployment rate is a lagging or, at best, coincident indicator–in other words, it tends to keep rising after a recovery begins. But average work weeks in the manufacturing industry have bounced off their lows, suggesting that manufacturers are no longer cutting workers’ hours as a means of reducing costs. In addition, jobless claims data has continued to improve steadily, signaling that the pace of layoffs is abating.
Stock prices and building permits round out the list of top, positive contributors. Building permits is another indicator that’s benefited immensely from government support in recent months. The number of programs is too long to list but includes the direct purchase of mortgage-backed securities, tax credits for first-time homebuyers and the rapid expansion Fannie Mae (NYSE: FNM) and Freddie Mac’s (NYSE: FRE) balance sheets.
Ultimately, the government will need to remove these props and allow the private sector to take over. However, the pace at which support for these markets is removed will be tough to get right. If support is removed to early we could see a double-dip in the US housing market; if support is removed too late we could see inflation or, perhaps, another bubble inflated by overly easy money.
My base case remains that the government will err on the side of leaving policy supports in place too long, especially in an election year. And although China and other nations have expressed their concerns about the dollar and the US government’s profligate spending, I don’t anticipate buyers’ strike for purchasing US government bonds–at least in the near term. Most of these countries would rather not risk destabilizing the system or risking another downturn for the global economy.
In short, these risks are longer-term concerns.
I won’t linger on the upside case too long. Suffice it to say that despite widespread reports that the American consumer is dead, consumer spending has been making a slow-but-steady recovery in recent months. This is true even if we exclude the impact of autos and Cash for Clunkers, which artificially boosted the annualized rate to 14 million car sales in August.
Many bears were also quick to observe that sales figures subsequently slumped to an annualized rate of roughly 9 million car sales, suggesting that the government’s program pulled demand from future quarters.
But the bears tend to gloss over healthy sales numbers in October and November. Although an annualized rate of 11 million car sales isn’t necessarily robust, it’s still the strongest level since mid-2008 (excluding the artificial bump that occurred in August 2009). This represents a steady improvement.
The upside risk to the economy is that the American consumer doesn’t contract spending as much as some expect and the economic recovery isn’t quite as anemic as the consensus expects.
Another upside risk is that the developing economies post stronger growth than analysts forecast–a distinct possibility.
All of this could mean the global economy grows faster than expected in 2010. Again, this isn’t my base case but such an outcome isn’t implausible.
My outlook for crude oil proved fairly accurate in 2009. Late in 2008 and early in 2009 I suggested that crude oil would likely find a floor around the low USD30s per barrel and would recover to around USD50 in the first half of the year. At the time many pundits projected that oil would sink to USD25 or even into the teens.
In Stocks Trump Commodities, which came out on Feb. 4, 2009, I stated that oil would remain below USD50 a barrel in the first few months of the year due to concerns about weak global demand. I also noted that I expected oil prices to rally above that level in the latter part of the year and top USD100 in 2010. This forecast was relatively accurate: Oil hit USD40 a barrel by late March and then broke definitively higher by May, hitting USD80 by year-end. At this point oil prices at USD100 per barrel would appear to be on the conservative side.
I still expect crude to eclipse USD100 per barrel in 2010 and foresee oil prices surpassing the previous high set in summer 2008. Consistent with my outlook for a recovery in the US and global economies, I expect oil demand to continue to accelerate in 2010. Data already indicates that US demand is already on the upswing.
Source: Energy Information Administration (EIA)
This graph depicts US inventories of crude oil, gasoline, distillates and other petroleum-derived products. As you can see, inventories built up to glutted levels earlier this year but have declined rapidly in recent weeks.
Although supplies remain on the high side, signs suggest that these levels are normalizing.
US petroleum inventories tend to fall from the beginning of the year into March, then rise into mid-summer as companies prepare for the summer driving season. Inventories then fall again into the autumn and winter months. Although this cycle isn’t as reliable as the storage cycle for natural gas, last year’s pattern appears to correspond with what one would expect in an average year.
Source: EIA
As you can see, the steady increase in inventories from early 2009 through midsummer was much stronger than average. Inventories didn’t suffer the seasonal drop that typically occurs between January and March, and stockpiles built up quickly into the summer.
But the seasonal trend returned in the second half of the year; as you can see in the above graph, the current trend in inventories (blue line) has quickly reverted to levels just above the historical average. If the trend continues into January, total crude oil and product inventories could return normal by February.
Demand statistics likewise indicate that change is afoot.
Source: EIA
This data series rather volatile, but the broad pattern is that of an inverted “V.” US petroleum demand rose generally after the recession of 2001 and reached a peak in 2007 and early 2008.
The graph clearly captures the impact of the recession and financial crisis on oil demand, a major factor behind the collapse in prices.
Oil demand reached a nadir in May 2009. Demand has rebounded subsequently, albeit in volatile fashion, and appears to have spiked higher in recent weeks. Cold weather undoubtedly contributed to this uptick: Frigid temperatures drive heating demand and consumers may be filling up their tanks ahead of winter snowstorms.
Short-term fluctuations aside, it’s fair to say US petroleum demand has stabilized. The Energy Information Administration’s (EIA) most recent Weekly Petroleum Status Report noted the following:
Total products supplied over the last four-week period has averaged 19.1 million barrels per day, down by 0.2 percent compared to the similar period last year. Over the last four weeks, motor gasoline demand has averaged 9.0 million barrels per day, up by 1.1 percent from the same period last year. Distillate fuel demand has averaged 3.7 million barrels per day over the last four weeks, down by 2.8 percent from the same period last year. Jet fuel demand is 3.7 percent higher over the last four weeks compared to the same four-week period last year.
I expect US oil demand to drift higher. But, as I’ve noted before, US demand for oil may have peaked, assuming savings-conscious consumers reduce consumption and drive more fuel-efficient cars. It won’t be any government initiative or fuel economy standard that catalyzes this change; as summer 2008 demonstrated, relatively high oil prices tend to have that effect on consumer behavior.
As I’ve noted before, some analysts’ inordinate focus on US oil demand and inventories makes less sense when you consider that most of the demand growth in recent quarters has come from emerging markets–not the US and Europe. I suspect accelerating oil demand in China represents a secular shift, a function of more consumers reaching that magic tipping point of disposable income that allows them to buy cars. The graph below tracks China’s oil imports since 2004.
Source: Bloomberg
Although China’s oil imports ticked lower in the first few months of 2009, these figures quickly rebounded to new monthly highs by mid-year. And it’s tough to argue with the broad trend depicted in this graph: China’s oil imports have risen steadily over the past five years.
With the demand picture improving, the only question is supply. Longtime readers know that I regard supply an even more important fundamental over the long term. The world’s “easy” oil is largely exploited; as outputs from key existing fields declines, producers increasingly will turn to fields with more complex geologies and fields located in the deepwater to fill the supply gap. This “hard” oil is expensive to produce and will require higher oil prices to be economically feasible.
OPEC is the only source of spare oil production that can be brought online quickly and sustained. The International Energy Agency (IEA) currently estimates that spare capacity will total around 5.67 million barrels per day, roughly 6.6 percent of global demand. But the agency has steadily lowered this figure since June to reflect higher expected demand.
I’ve discussed supply conditions extensively in recent issues and won’t belabor the point here. For a refresher, interested readers should check out my recent analysis of Mexico’s unsuccessful attempts to stem its declining oil output, Down Mexico Way: Oil and Politics South of the Border. In the Oct. 7, 2009, issue, The Golden Triangle, I examine the end of easy oil and the potential of global deepwater production.
For the year ahead, I recommend that readers focus on stocks with leverage to the following themes: services firms with technology needed to produce complex fields, drilling and equipment firms with exposure to deepwater markets, and oil producers with the potential to meaningfully ramp up production in coming years. I offered a detailed rundown of all of my favorites and the investment thesis underpinning each recommendation in Playing the (Oil)Field, published on Nov. 10, 2009. The table below lists my favorite names and provides updated advice.
At the beginning of last year I stated that I preferred gas-levered stocks to oil stocks for 2009. My basic thesis was that the severe drop in the US rig count from August 2008 into early 2009 was unsustainable; eventually, gas production would fall due to the drop-off in drilling activity.
Further, I doubted the US would see a huge surge in liquefied natural gas (LNG) cargoes in 2009 because foreign demand and prices remained favorable. Finally, I expected demand to remain relatively resilient for electricity generation and heat in last year’s relatively cold winter. In early 2009, I recommended that investors add exposure to natural gas producers, and gas-levered services and drilling firms.
At first blush, this advice looks like a bad call; natural gas prices have underperformed oil for most of the past year. My preferred measure of gas prices is the 12-month strip–the average of the next 12 months’ worth of futures prices. Spot gas prices aren’t particularly relevant, as they tend to reflect short-term supply and demand conditions; the 12-month strip tends to dampen this volatility. But even on this basis, gas began 2009 at over USD6 per million British thermal units and ended the year just under that level.
On the other hand, the 12-month strip for crude oil began 2009 at around USD54 a barrel and ended the year close to USD85 a barrel. In the spot market, oil prices rallied from lows in the USD30s at the end of 2008 to over USD80 a barrel in late 2009. The divergence between the strip and spot prices reflects the weakness in oil prices concentrated in near-month futures contracts.
My miscalculations on natural gas were twofold. Industrial demand slumped more than I expected in early 2009, as US industrial production fell at a nearly unprecedented rate. Second, it took a few months longer than I expected for the decline in the rig count to manifest itself in the form of falling production. The result was a much faster-than-expected build in gas inventories in the first half of 2009.
I was correct in my assertion that the US would not see a flood of LNG in 2009. Here’s a chart of total US LNG imports going back to 2005.
Source: EIA
As you can see, imports experienced a normal seasonal bump around midsummer but generally were at depressed levels throughout 2008 and 2009.
And although I was admittedly too bullish on natural gas prices, my call to buy gas-levered names worked out well. My top gas-focused plays in the Portfolios were XTO Energy (NYSE: XTO), which returned 33.6 percent; EOG Resources (NYSE: EOG), which returned 47 percent; Nabors Industries (NYSE: NBR), which returned 82.9 percent; and Chesapeake Preferred D (NYSE: CHK D), which returned 45.2 percent. All handily beat both the S&P 500 and the S&P 500 Energy Index.
These stocks traded at levels that already priced in much lower gas prices in early 2009; by year-end, our natural gas picks began to reflect improving fundamentals for the underlying market. All in all, playing gas-levered stocks was a good strategy last year, despite weakness in the underlying commodity.
One of my top three energy-related themes for 2010 is a rally in natural gas prices–see the Sept. 23, 2009, issue, Top Three Energy Themes for additional details. I’m not necessarily calling for natural gas prices to soar over USD10 per million British thermal units; gas prices should average around USD7 per million British thermal units, a healthy level that will make producers with high-quality assets profitable and encourage an increase in drilling and service-related activity.
I’ve written extensively about gas in recent issues and a must-read Flash Alert issued on Dec. 10, 2009, so I won’t bore readers with a detailed analysis. Instead, here’s a quick rundown of some of the major short- and long-term catalysts I’m watching for gas in 2010:
1. The drop-off in industrial demand for gas last year was a major factor behind the early 2009 decline in prices. But industrial production figures have improved markedly, signaling that a bounce in industrial demand is likely.
2. Extremely cold weather across much of the US is expected to continue for the next two weeks–even Florida hasn’t been immune to the arctic blast. Weather is also cold across Europe and Asia, and some forecasters expect one of the coldest winters since 1977. This drives gas heating demand. Gas in storage, while still bloated, has been falling at a faster-than-average pace in recent weeks.
3. The proposed tie-up between ExxonMobile (NYSE: XOM) and XTO Energy (NYSE: XTO) demonstrates the natural gas’ long-term potential to the market; Exxon projects that gas will see far faster demand growth than oil longer-term. The Exxon deal in December, coupled with Total’s (NYSE: TOT) recently announced joint venture with Chesapeake Energy (NYSE: CHK), signals that there’s a large amount of investment headed into US unconventional gas plays.
4. One of the big points to come out of the Copenhagen Climate Change Conference late last year is that natural gas and nuclear power are two of the only practical near-term ways to reduce carbon emissions. Whether or not carbon regulation is passed in the US this year, utilities are already turning to gas as a precautionary measure.
5. The natural gas lobby is now organized; any energy or climate bill passed by Congress likely would need to have significant incentives for greater gas use–potentially even as a transportation fuel.
6. Data on US gas production is notoriously noisy and volatile. This situation has been complicated somewhat by involuntary natural gas well shut-ins; due to elevated storage levels, gas producers were forced to halt production–there was nowhere to store the gas. Nonetheless, US gas production did hit a high of around 63.6 billion cubic feet per day from the Lower-48 States in February. Although production from certain shale plays–such as the cheap-to-produce Haynesville Shale in Louisiana–is rising, conventional production from Texas has plummeted roughly 2 billion cubic feet per day since hitting a high in January. Bottom line: Falling production is bullish for prices.
Source: Bloomberg
To calculate the data points in this graph, I divided the number of directional and horizontal drilling rigs actively working in the US by the total number of rigs working in the nation. As you can see, less than 30 percent of the rigs working in the US were rigs capable of drilling directional and horizontal wells at the turn of the last decade. Now, close to 65 percent of rigs in the US boast these capabilities.
Also note the pattern in this graph. The line rose rather gradually from 2000 through roughly the beginning of 2007. Since then, however, the ratio has gone parabolic–the tend has accelerated.
This simple chart has two key implications. First, in most cases, successfully producing unconventional natural gas shale plays such as the Haynesville and Marcellus requires the use of horizontal wells and drilling such wells requires rigs capable of drilling horizontally. Historically, land rigs have been thought of as rather low-tech compared to their offshore cousins, but drilling lengthy horizontal well segments through shale requires a powerful rig.
That a larger proportion of US rigs boast these advanced capabilities is simply a reflection of the rising importance of unconventional gas and gas shale plays to US production.
A more important implication from an investment standpoint is that a good deal more work goes into drilling a horizontal well in a shale field than drilling a traditional vertical well in a conventional reservoir. For example, producing shale reservoirs requires the use of fracturing–pumping liquid and sand into a field under immense pressure to improve permeability. Some of the most advanced wells drilled in unconventional gas plays employ fracturing in a series of carefully planned stages.
And there are several other technologies and services that are required to drill unconventional wells.
Each unconventional well drilled in the US spells several times as much business for services and drilling firms than for single conventional well. Although the US total rig count remains well off its 2008 highs, the increasing importance of directional rigs suggests that more activity is being directed toward unconventional fields–and that spells more business for services firms with exposure to gas-levered services.
This is one major reason I added service giant Baker Hughes (NYSE: BHI) to the Wildcatters Portfolio in a recent Flash Alert. Baker provides a number of products and services to oil and natural gas producers.
The list of products includes drill bits under the Hughes Christensen brand. Although drill bits might strike you as a relatively commodity-type business, bits do need to be designed for use in certain geologic formations and conditions. Baker is also known for its artificial lift business, the installation of electric submersible pumps (ESPs) in oil wells to extract oil from mature fields. Baker also provides wireline logging, which help evaluate the quality of a play and where hydrocarbons are located.
In 2008 North America accounted for 44 percent of Baker Hughes’ revenues–double Schlumberger’s (NYSE: SLB) exposure to the region in that same year and roughly the same as Weatherford International’s (NYSE: WFT) exposure . However, Weatherford’s exposure to North America has declined steadily to under 30 percent as of third-quarter 2009.
North America is a huge oilfield services market but has also traditionally been more volatile and commodity sensitive. For one, most producers target gas–a commodity known for its price volatility. In addition, producers in North America tend to focus on relatively small, short-term projects that can be delayed or canceled with little lead time. It’s much harder to cancel or delay a multi-billion dollar, multi-year deal overseas. The company’s pending purchase of fellow service provider BJ Services (NYSE: BJS) will increase Baker’s North American exposure, as BJ derives more than 50 percent of its revenues from North America.
This hefty exposure to North America is one reason shares of Baker Hughes underperformed shares of Schlumberger and Weatherford in 2009. Nonetheless, I believe Baker Hughes’ time has come.
BJ gets close to 70 percent of its operating income from pressure pumping, basically another word for fracturing. This is an absolutely crucial service line for producing unconventional oil and natural gas. The market has been plagued with overcapacity for some time, but rising natural gas prices and a greater concentration on unconventional plays is eliminating that overcapacity.
And there’s another release valve for excess capacity: Pressure pumpers can move equipment overseas. As I noted in Ten Takeover Plays, Exxon owns significant unconventional gas acreage in Europe. One of the reasons it’s buying XTO is to gain expertise in producing these plays that it can apply to these European fields. This is a tremendous opportunity for a company like BJ Services and, by extension, Baker Hughes.
All told, I see BJ Services adding a key service line to Baker’s arsenal, enabling the combined firm to market a compelling package of services to overseas customers–especially those looking to exploit unconventional gas fields.
In addition, Baker already has a solid market position in one of my deepwater markets. I’m raising my buy target on Baker Hughes from 45 to 49 and the stock remains a buy in the growth-oriented Wildcatters Portfolio.
Here’s a table showing my favorite plays on natural gas. I’ve organized the recommendations into two key themes: natural gas producers with exposure to key unconventional fields and natural gas services and equipment firms with the technology to exploit those plays.
King Coal is the final piece of the energy trifecta for 2010. It’s hard to imagine a commodity that was more unloved heading into 2009; at the time all the talk was of the potential for an Obama Administration to destroy the coal industry in its zeal to limit carbon-dioxide emissions.
We correctly ascertained that these fears were overblown and took advantage of high volatility in the sector, recommending a covered call trade in Peabody Energy (NYSE: BTU)–the trade is explained at length in the March 4, 2009, issue, Big Budget Blues. I also updated the recommendation in the May 6 issue, A Turn for the Better. The options sold as part of this trade expire on Jan. 15, 2010; if Peabody’s stock closes above 40 on that date, our total return will be just under 70 percent.
We also correctly identified that there were two coal markets in 2009: the US market and the Asian market. The former was weak all year, as slumping electricity demand in early 2009 led to overstocks of coal at utilities. To make matters worse, natural gas has been cheap; utilities burned more gas and less coal over the summer. Meanwhile, Asian demand for coal imports–particularly from Australia–began to accelerate early in the new year.
I discussed this key differentiation in several issues, but most directly in the June 3, 2009, issue, The New Super-Cycle. My recommendations reflected this Asia-first coal theme. Peabody may be based in Missouri but has huge operations in Australia. I also recommended Felix Resources, an Australian miner acquired by China’s Yanzhou Coal (NYSE: YZC). In September we added Bucyrus (NSDQ: BUCY), a manufacturer of key coal mining equipment.
For 2010 I’m looking for more of the same from the global coal industry. The US will see a gradual normalization in inventories of steam coal; US miners with heavy exposure to metallurgical coal, used in steelmaking, should fare best.
But the Land Down Under remains my favorite coal-related theme. Australia will be the world’s dominant exporter of both metallurgical and steam coal for the foreseeable future. One of the clearest ways to gauge coal demand in Asia is to look at how many ships are waiting to load coal at Australia’s Port of Newcastle.
Source: Bloomberg
The line of ships waiting to load coal in Newcastle keeps growing and now stands at 60. That’s the highest level since 2007, and this congestion suggests that China is desperate to load coal.
Reports also emerged this week that for the first time in history, South Africa likely exported more coal to India than the whole of Europe. The rapid rebound in electricity demand from India and China has undoubtedly ratcheted up demand for coal.
My top picks in coal right now are as follows: Peabody Energy (NYSE: BTU) due to its large Australian exposure and Bucyrus (NSDQ: BUCY), which should benefit from increased demand for coal mining equipment. I’m bumping up my buy target on Peabody to 52 and instituting a stop order at 32.
Bucyrus made a major acquisition last month when it agreed to a $1.3 billion deal to purchase the mining equipment division of Terex (NYSE: TEX). The deal adds several new product lines to Bucyrus’ portfolio and makes it the No. 1 player in the mining equipment business. I like the deal and am raising my buy target on Bucyrus to 66 to reflect the added value.
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