Raked over the Coals
Lingering concerns about the health of the US and other developed economies have weighed on equity markets since spring. My economic model continues to peg the chances of the US lapsing into recession over the next six to 12 months at one in three.
At this point, all indications point to slow growth for the US and other major industrialized economies. Gross domestic product will grow about 2 percent annually, though economic activity will accelerate in some months and grind to a halt in others. Housing and other hard-hit industries will continue to struggle against recession-like conditions.
The ongoing saga of the EU’s sovereign-debt debacle continues to weigh on the stock market. If one of the fiscally weak EU members defaults sovereign bonds, the repercussions could be severe. Despite the stream of headlines warning that the current crisis could precipitate a global credit crunch, this doomsday scenario appears unlikely.
Meanwhile, all hope isn’t lost. Robust economic growth in China and other key emerging markets should support the price of Brent crude oil, a benchmark that better reflects global supply-demand conditions than West Texas Intermediate crude. I also remain bullish on names that stand to benefit in the near term from rising demand for liquefied natural gas (LNG) in Asia. In this issue, I’ll highlight my favorite plays on the long-term bull market for coal in China, India and other emerging economies.
In This Issue
The Stories
1. The EU sovereign debt crisis continues to weigh heavily on investor sentiment, though the contagion has yet to spread to credit markets outside the eurozone. See Europe in Crisis: Credit Check.
2. Shares of coal mining companies have sold off indiscriminately amid concerns that a global economic downturn will sap demand from Chinese steel producers. We check up on the supply-demand balance in the markets for metallurgical and thermal coals. See The Case for Coal.
3. In a market riven with uncertainty, shorts season extends into fall. See Shorts Season.
4. We drill down into the fundamentals for offshore drillers and equipment suppliers, focusing on two appealing names on the Energy Watch List. See Drilling Equipment and Contract Drillers.
5. Want to know which stocks to buy now? See Fresh Money Buys.
The Stocks
Peabody Energy Corp (NYSE: BTU)–Buy < 72.50
Joy Global (NSDQ: JOYG)–Buy < 99
Penn Virginia Resource LP (NYSE: PVR)–Buy < 29
Natural Resource Partners LP (NYSE: NRP)–Buy < 30
Alliance Holdings GP LP (NSDQ: AHGP)–Buy < 55
First Solar (NSDQ: FSLR)–Hold; Cover Half of Original Short Position for 43 percent Gain
First Trust ISE Revere Natural Gas (NYSE: FCG)–Sell Short above 15.50
Schlumberger (NYSE: SLB)–Buy < 100
Weatherford International (NYSE: WFT)–Buy < 28
Core Laboratories (NYSE: CLB)–Buy < 115
Petroleum Geo-Services (OTC: PGSVY)–Buy < 17.50
Dresser-Rand (NYSE: DRC)–Buy < 55
Cameron International Corp (NYSE: CAM)–Buy < 62
National-Oilwell Varco (NYSE: NOV)–Buy in Energy Watch List
Transocean (NYSE: RIG)–Buy in Energy Watch List
1. Europe in Crisis: Credit Check
The sovereign-debt crisis has escalated since the spring, spreading from the periphery (Greece, Ireland and Portugal) toward the core (Italy and Spain). Nevertheless, the contagion hasn’t infected credit markets outside the EU. Concerned investors should focus on a handful of indicators to gauge the health of the interbank lending market, the US corporate bond market and EU sovereign-debt markets.
Interbank Lending
The TED spread, or the difference between what banks and the US government pay to borrow for three months, rose from obscurity in 2008 and 2009 to become the most popular way to gauge the health of the financial system and the interbank lending market. After Lehman Brothers declared bankruptcy in fall 2008, financial institutions hoarded cash and restricted interbank lending because of concerns about the solvency of their counterparties. The US TED spread spiked to more than 4.5 percent in mid-October 2008.
To keep tabs on the health of the EU financial system, we monitor the spread between the three-month Euro Interbank Offered Rate (EURIBOR)–the rate major financial institutions in Europe charge each other to borrow money–and the yield on three-month German government debt. Check out this graph of the US and EU TED spreads.
Source: Bloomberg
The US TED spread currently stands at 35 basis points (0.35 percent). This reading is above the long-term average but well under the high of almost 50 basis points registered in summer 2010. Though elevated relative to historic norms, the US TED spread is well short of its all-time high of more than 450 basis points.
On the other hand, the EU TED spread has spiked to more than 100 basis points in recent months–a higher reading than summer 2010, when the sovereign-debt crisis first made headlines. The EU interbank lending market has tightened, but conditions have yet to deteriorate to the point that banks effectively refuse to lend money to one another for fear of counterparty risk.
Thus far, the spillover from the EU interbank lending market to its US counterpart has remained muted. Investors should become more vigilant if the US TED spread breaks above 50 basis points in coming weeks
US Corporate Credit Markets
At the height of the 2008-09 financial crisis, the bond market was closed to rock-solid, investment-grade corporations. From September through November 2008, US corporations raised an average of just $37.5 billion per month by issuing bonds. That compares to an average of over $100 billion per month in the first six months of 2008. Check out this graph of monthly corporate bond issuance from early 2010 to present.
Source: Bloomberg
Some of the monthly variation in bond-market capital raised by US corporations reflects seasonal patterns. For example, issuance tends to tail off over the summer and during months with major holidays. But many corporations took a wait-and-see approach to raising debt capital this summer. In August, junk-rated companies issued a little more than $1 billion in total debt–easily the weakest month over this period.
Corporations tapped the bond markets regularly in the first half of the year, taking advantage of extraordinarily low borrowing rates to issue long-term debt. Even firms with credit ratings well into junk territory were able to raise debt capital at historically low rates. In short, many firms addressed their borrowing needs earlier in the year and took a break from the capital markets.
But corporate debt issuance has rebounded in September. Through Sept. 16, US corporations have already raised as much debt capital as they did in all of August.
When evaluating the health of corporate bond markets, you should also pay attention to the cost of credit.
Source: Bloomberg
This graph tracks the average yield on bonds issued by US industrial companies with AA, A-, BBB and BB- credit ratings from Standard & Poor’s. Corporate bond yields spiked across the board in late 2008 and early 2009, but junk-rated firms bore the brunt of the crisis. At one point, the average yield on a bond rated BB- hit almost 15 percent. Bond yields ticked higher in late 2010, reflecting an improvement in economic conditions that pushed up interest rates throughout the economy.
Although the cost of debt capital has increased slightly in recent months, the yields on investment-grade bonds are still lower than they were at the beginning of 2011. At these levels, even lower-quality borrowers can raise capital at reasonable rates.
EU Sovereign Debt and Financial Institutions
European banks are the latest casualties of the crisis, reflecting fears that these institutions have too much exposure to sovereign bonds issued by the fiscally weak PIIGS (Portugal, Italy, Ireland, Greece and Spain). Investors worry that a sovereign default could overwhelm these banks’ capital reserves, necessitating another government bailout.
Source: Bank of International Settlements
This table breaks down of foreign claims of banks from the US, UK, Germany and France. These claims include direct exposure to sovereign bonds and debt issued by European corporations.
US banks have total foreign claims of almost $3.1 trillion, roughly 45 percent of which are from Europe. The majority of this exposure is to core EU economies such as Germany and France. As you can see, US banks’ direct exposure to the PIIGS is modest.
German and French banks, however, have far more direct exposure to the PIIGS. Note that this data is from March 31, 2011, and doesn’t reflect any moves financial institutions may have made to reduce their exposure to these fiscally challenged nations. Based on this data, it’s easy to understand why shares of prominent EU banks have sold off precipitously over the past few months.
Let’s consider the worst-case scenario. If Greece fails to secure its next tranche of aid, the country would be forced to default on its debt. Not only would this default ratchet up the pressure on the other fiscally weak nations in the eurozone, but banks would also be forced to raise significant amounts of capital after taking a haircut on these sovereign bonds. Some of these financial institutions would likely require a government bailout.
Although US banks’ have less direct exposure to the PIIGS, questions about the stability of Europe’s major financial institutions would heighten concerns about counterparty risks and push up borrowing costs in the interbank lending market.
Fortunately, this worst-case scenario likely won’t come to pass. EU leaders understand the potentially severe repercussions of a disorderly Greek default and will continue to address the problem. Although unpopular austerity measures have deepened Greece’s three-year recession, Prime Minister George Papandreou recently announced another round of budget cuts that will enable the country to meet the deficit reduction goals required by international lenders.
Moreover, the EU has already agreed to enhance the powers of the European Financial Stabilization Fund (EFSF), enabling the bailout fund administrators to reduce these nations’ borrowing costs by buying their sovereign bonds in the secondary market. Now, individual parliaments must approved the measure. On Sept. 29, the German parliament will vote on whether to approve this plan to expand the EFSF.
The European Central Bank (ECB) has already started to purchase Italian and Spanish government debt on the secondary market in an effort to reduce the embattled nations’ borrowing costs.
Source: Bloomberg
The ECB’s efforts have paid off. When the yield on 10-year sovereign bonds issued by Italy and Spain topped 6 percent, the central bank entered the market and its purchases have lowered these yields to sustainable levels. Until European parliaments authorize the enhancements to the EFSF, the ECB has the wherewithal to combat pressures in these critical bond markets.
Although the EU and European banks would be able to weather a Greek or Portuguese default, the potential effects on Italy and Spain would prove too much to bear. Expect the ECB and EFSF to do what it takes to prevent the credit contagion from endangering Europe’s core economies and financial system. The approval of an expanded EFSF would be a welcome upside catalyst for European equities and would likely alleviate fears of a global credit crunch.
Bottom line: The potential fallout from a European sovereign default is frightful to ponder, but credit markets outside Europe haven’t ceased to function yet.
Thermal Coal
Although shares of coal mining firms have sold off over the past few months, a surge in metallurgical (met) coal prices had enabled the group to outperform handily in the second half of 2010 and early 2011.
The met coal used in steelmakers’ blast furnaces contains much more energy per ton than the thermal coal that power plants burn to generate electricity. Australia accounts for roughly two-thirds of global seaborne exports of met coal and is a key supplier to Asia. About 85 percent of the nation’s met coal output comes from the Bowen Basin in Queensland; operational disruptions in this region can send the price of met coal soaring.
Source: Earthbyte.org
In late 2010 and early 2011, severe flooding from torrential rains forced many coal mines to halt production. Not only did producers have to pump water from their mines before resuming operations, but damage to the region’s railroads and ports also crimped exports. At the height of the crisis, seaborne shipments of Australian coal declined by as much as 40 percent from year-ago levels.
Source: Bloomberg, Australian Bureau of Agriculture and Resource Economics
With Australia’s largest producers declaring force majeure to relieve themselves of contractual obligations, their customers scrambled to secure sufficient supplies. This touched off a global supply squeeze. US coal exports to Europe boomed, as countries that historically exported met coal to the EU diverted their cargos to Asia.
In the third quarter of 2010, the contract price for met coal exported from Australia to Asian customers was USD209 per metric ton. This price surged to USD225 per metric ton in the fourth quarter, before topping out at roughly USD330 per ton in the first and second quarters of 2011. This sharp increase in contracted prices offset lost tonnage for many Australian producers.
Not all of Australia’s coal exports are priced according to quarterly contracts. Some producers have long-term supply contracts with their customers; others sell a percentage of their output on the spot market for immediate delivery. Meanwhile, higher grades of met coal tend to command a significant price premium. Dividing the total value of Australian met coal exports by the total volume yields the average price per ton and provides a good indication of the industry’s profitability.
Source: Bloomberg
The data depicted in these graphs explains why met coal prices have moderated in recent months. In July 2011, Australian exports of met coal had declined by 16.6 percent from year-ago levels, while coal production has continued to recover from the devastating floods. Producers generally expect met coal production and exports to normalize gradually in coming months. This dynamic has lowered the contract price for the fourth quarter of 2011 to USD285 per metric ton. Meanwhile, the average price of Australian exports of met coal declined to roughly AUD228 in July from AUD260 in May. Although the price of met coal has declined from the stratospheric levels that prevailed in the first and second quarters, both the contract and average prices are significantly higher on a year-over-year basis.
Nevertheless, shares of coal mining firms have pulled back amid fear that slowing economic growth in the developed world will erode demand for seaborne met coal.
But the Federal Reserve’s Beige Book noted that steelmakers’ capacity utilization rate remained at a record high and that inventories remained tight in the Federal Reserve Bank of Chicago’s district. In August, US steel production rose to the highest level in three years.
And China is the primary driver of global met coal demand: Not only does the US produce far less steel than China in a given month–8 million metric tons versus almost 60 million metric tons–but US steelmakers tend to rely more heavily on electric arc furnaces that use scrap metal to produce steel. As you can see, Chinese steel production continues to hover near its record high.
Source: Bloomberg
The relative resilience of Chinese steel production at the height of the Great Recession demonstrates that the country’s met coal demand is a secular–not a cyclical–growth trend. Although China is the world’s largest steel producer, the nation consumes only 466 kilograms (kg) of steel per capita–compared to more than 800 kg in both Japan and South Korea. China’s population of more than 1 billion people means that a small increase in per capita steel demand produces an outsized effect on global consumption. India’s annual steel demand amounts to only 55 kg per capita. Over the next three decades, China, India and other Asian emerging markets are expected to account for more than 90 percent of the growth in global coal demand.
In the short run, the price of Australian met coal exports was bound to moderate as production recovered. Further downside may be in the cards, but met coal prices may not return to their year-ago levels because of permanent damage to some mines.
Meanwhile, the tight supply-demand balance in the market for seaborne met coal means that another major supply disruption could send prices through the roof. Long-range weather forecasts indicate that Queensland and the Bowen Basin are at elevated risk of above-average precipitation during this year’s rainy season.
Source: Bloomberg
Nevertheless, short-term demand trends are notoriously difficult to forecast. Despite robust steel production, US-based coal mining outfit Alpha Natural Resources (NYSE: ANR) on Sept. 21 lowered its met and thermal coal production forecast. The firm cited production issues at two major mine complexes, a major customer reneging on its contract by declaring force majeure, and softening Asian demand for met coal.
While plenty of news services seized on management’s comment about demand for met coal, other producers that have lowered forecasts have cited production shortfalls or mining problems–not a lack of demand. Some of this weakness may stem from the quality of the coal. Demand for lower grades of met coal tends to fluctuate more frequently than demand for high-quality varietals.
In a demonstration of how worried investors are about Asian coal demand, shares of Alpha Natural Resources lost 11 percent of their value after the company announced its disappointing production forecast. Although the traumatic memories of the Great Recession and credit crunch loom large in many investors’ minds, Asian demand for met coal remains robust.
The recent drop in Chinese consumer prices is another positive development for Australia’s coal mining industry. If the government’s efforts to cool the country’s overheated economy continue to lower the inflation rate, the monetary authorities won’t face as much pressure to implement additional restrictions. If economic activity in the developed world continues to slow, China might dip into its 2008-09 playbook and implement stimulative policies to protect its domestic economy.
Thermal Coal
For the past several years, Australia and Indonesia have battled for the title of the world’s leading exporter of thermal coal. The same flooding that disrupted Australia’s met coal production also reduced its output of thermal coal, pushing up prices for Asian utilities. That being said, this price increase wasn’t as pronounced because Australia’s share of the thermal-coal market pales in comparison to its dominance of the market for met coal.
Over the long term, rising demand from India will drive Asian demand market for thermal coal. To meet rapidly increasing demand for electricity, India continues to construct a system of massive coal-fired power plants as part of a USD1 trillion investment in critical infrastructure over the next five years. Although India may not build as many coal plants as China, its middling domestic supply of thermal coal forces it to rely heavily on imports.
Thermal coal prices in the US had been depressed because of excess inventories that utilities built up during the great recession. Although the hottest summer in recent decades led to increased electricity demand and helped to normalize utilities’ glutted coal inventories, persistently low natural gas prices mean that power companies with flexible plants are unlikely to switch to coal.
Nevertheless, the US market for thermal coal has its pockets of strength.
Operators in Central Appalachia (CAPP) have shifted their focus from mining thermal coal to targeting met coal in recent years. In addition, CAPP is home to a large number of older underground mines. As coal seams thin and regulatory costs increase, profit margins have deteriorated substantially; operators have shuttered many smaller coal mines in recent years. This trend should continue.
Rising output from the Illinois Basin and the Powder River Basin (PRB) should offset this weakness. Coal deposits in the PRB are closer to the surface and haven’t been mined as extensively, leading to solid profit margins. Although PRB coal contains less energy than other varietals, this thermal coal is extremely low in sulfur.
The US Environmental Protection Agency (EPA) introduced the Cross State Air Pollution Rule to reduce emissions of sulfur dioxide and nitrous oxides. This controversial regulation included larger emission reductions than many power companies had expected and shorter time frames to bring their facilities into compliance. Some industry observers estimate that compliance costs could lead to a 10 percent increase in power prices.
Burning low-sulfur PRB coal is one way utilities can decrease their sulfur emissions; on the margin, these regulations should boost demand for PRB coal.
Coal produced from the Illinois Basin tends to more energy and sulfur. Historically, market for this coal has been limited because there weren’t enough plants with scrubbers that could burn high-sulfur varietals and comply with emission regulations. But many utilities have added these scrubbers to their power plants, enabling them to burn coal from the Illinois Basin.
Raked over the Coals
With the EU sovereign-debt crisis and slow growth in developed economies weighing on investors’ minds, the S&P 500 has pulled back by roughly 8.5 percent in the third quarter. Generally regarded as a cyclical group, the S&P 500 Energy Index has given up more than 12 percent of its value since June 30, 2011. Coal-related stocks have fared even worse over this period.
Source: Bloomberg
This table lists the quarter-to-date performance of coal mining stocks in the model Portfolios and some of the largest US-based coal mining names.
The Portfolio’s master limited partnerships–Natural Resource Partners LP (NYSE: NRP), Penn Virginia Resources LP (NYSE: PVR) and Alliance Holdings GP LP (NSDQ: AHGP)–have handily outperformed the S&P 500 and the S&P 500 Energy Index. Shares of Peabody Energy Corp (NYSE: BTU) have pulled back by 27.1 percent thus far in the third quarter. Although we’re never happy with a loss, the company’s extensive operations in Australia and superior exposure to emerging-market demand have enabled the stock to outperform its US-centric peers.
Fortunately, we booked a 105 percent gain on our sole pure play on US coal in May, when Arch Coal (NYSE: ACI) acquired US-based International Coal in a deal worth $13.4 billion.
The severe drop in coal mining stocks has priced in a lot bad news. The Portfolios currently include five stocks with significant exposure to the coal industry. Here’s a quick look at each name’s near-term and long-term prospects. We’ll closely scrutinize these company’s third-quarter results for signs of weakness as they come out over the next two months.
Peabody Energy is the largest pure-play coal mining firm in the world and the best of its breed. Over the past eight years, management has transformed the company from a pure-play on the US coal market to a global powerhouse that boasts extensive operations in Australia. In 2003 the company generated 99 percent of its pre-tax income in the US; today, these operations account for only 48 percent of its pre-tax income.
The firm spun off its CAPP assets as Patriot Coal (NYSE: PCX) to focus on taking advantage of low-cost production from the PRB and Illinois Basin. To unlock additional value from these operations, management continues to explore ways to boost exports of PRB coal to Asia.
Peabody Energy has amassed extensive operations in Australia through a series of acquisitions and expansions of existing mines. The company has two new projects underway at its Burton and North Goonyella met coal mines, each of which will increase productive capacity by at least 1 million metric tons. The firm is also adding significant export capacity at its Wambo and Wilpinjong mines in New South Wales. Commensurate with these expansions, the firm also continues to invest in infrastructure projects to ensure that its coal reaches export markets in a timely and efficient fashion.
All told, Peabody Energy plans to grow its Australian coal production to as much as 40 million metric tons by 2015–a substantial increase from the 27 million metric tons that the firm produced in 2010. Output of met coal would increase from 10 million metric tons to as much as 15 million metric tons.
A number of recent developments also warrant investors’ attention.
Peabody Energy and steelmaker ArcelorMittal (Amsterdam: MT, NYSE: MT) have launched a joint USD5.2 billion bid for Australia’s Macarthur Coal (ASX: MCC), the world’s leading pulverized coal injections (PCI). This type of coal is crushed into a fine powder and injected into blast furnaces as a partial replacement for met coal in the production of pig iron.
Macarthur Coal’s board has advised shareholders to approve the deal before the Oct. 14 deadline. Some analysts have complained that Peabody Energy is overpaying for Macarthur Coal, but the involvement of one of the world’s involved suggests that the long-term demand is there.
In July 2011, Peabody Energy reported had secured a 24 percent stake in Mongolia’s Tavan Tolgoi mine, an undeveloped met coal deposit that’s ideally situated to supply the red-hot Chinese market. However, the Mongolian government rejected this deal in early September. Regardless of this latest delay, Peabody Energy should ultimately win an interest in this potentially lucrative mine. The project’s delay is also an incremental positive for met coal prices.
Finally, Peabody Energy reported that the roof collapsed at its North Goonyella met coal mine, temporarily blocking the entrance. In September, management indicated that the mine would be out of production for four to six weeks and lowered its full-year production estimate accordingly. This minor incident is part and parcel with coal mining and shouldn’t have a dramatic effect on the company’s earnings.
Shares of Peabody Energy trade at about 7.25 times analysts’ consensus 2012 earnings estimate–the low end of its historical valuation range. Although the stock could sink lower, the current quote represents a solid entry put for investors with a longer time horizon. Buy Peabody Energy Corp under 72.50.
Joy Global (NSDQ: JOYG) manufactures the heavy machinery and equipment that miners use to extract coal. These products include equipment to cut coal from the walls of underground mines, roof supports, conveyor belts and draglines.
In June 2011, the company announced the acquisition of Le Tourneau, formerly a subsidiary of offshore contract driller Rowan (NYSE: RDC). Le Tourneau manufactures some surface-mining equipment but built its reputation designing jack-up rigs used to drill for oil and natural gas in shallow water. Le Tourneau also produces parts and equipment used on offshore drilling rigs.
Although the stock has also pulled back substantially in recent months, the company recently announced third-quarter earnings that topped analysts’ consensus estimate. Management also boosted its guidance for the fiscal year ending October 31, 2011.
More important, Joy Global’s existing operations received 46 percent more new orders than in the third quarter ended July 29, 2011. Orders for surface-mining equipment skyrocketed by 98 percent over this period. The company continues to receive new order faster than it can complete them. Management also noted that major mining firms have reaffirmed their expansion plans for 2012.
The company also reached a deal to sell Le Tourneau’s noncore offshore drilling operations to Wildcatters Portfolio holding Cameron International Corp (NYSE: CAM). Shares of Joy Global are well off their high, but the company’s prospects remain undimmed. Buy Joy Global up to 99.
We expect the three coal-related MLPs in the model Portfolios to continue to outperform during these uncertain times. These names have less near-term exposure to coal prices, making them a safe haven for investors worried about the direction of global commodity prices.
Penn Virginia Resource Partners LP operates two business units: coal royalties and natural gas gathering and processing. The firm owns 900 million tons of primarily thermal coal reserves in the Illinois Basin and Central and Northern Appalachia. The MLP leases its acreage to miners for a royalty fee–usually a fixed minimum, plus additional fees related to volumes of coal produced and the value of coal mined. Although this approach offers some upside and downside exposure to commodity prices, the fixed minimums ensure a steady base income. Meanwhile, the firm’s acquisitions of coal-producing properties in the Illinois Basin should also grow its distributable cash flow.
Gas gathering systems transport natural gas from individual wells via a network of small-diameter pipelines, while gas processing involves separating natural gas liquids such as ethane and propane from the raw gas. Penn Virginia Resource’s gathering and processing assets include 4,200 miles of pipelines and seven processing facilities in the Texas Panhandle and Pennsylvania’s Marcellus Shale.
The firm reported a 43.8 percent jump in throughput on its natural gas gathering and processing system in the second quarter. With drilling activity in the Marcellus ramping up because of the play’s attractive wellhead economics, Penn Virginia Resource’s midstream assets should enable the company to grow its cash flow.
The MLP increased its quarterly distribution to $0.49 per unit, equivalent to an annualized yield of over 7.8 percent. Buy Penn Virginia Resource Partners LP under 29.
Natural Resource Partners LP generates about three-quarters of its distributable cash flow from coal-related royalties. The MLP operates primarily in Appalachia and the Illinois Basin and owns a mix of thermal coal and met coal reserves. The firm also has a small base of operations in the southern PRB that could become a platform for expansion when the supply-demand balance in the US thermal coal market improves.
The firm generated about 47 percent of its second-quarter royalties from its met coal reserves. Met coal accounted for 37 percent of coal produced on its acreage. These royalty contracts are multiyear deals that offer fixed minimum payouts regardless of quantities mined; continued weakness in met coal prices would have only a modest impact on the outfit’s results. Yielding about 8 percent, units of Natural Resource Partners LP rate a buy under 30.
Unlike other coal-related MLPs, Alliance Resource Partners LP (NSDQ: ARLP) actually produces its own coal and is the fourth-largest US coal miner. About 80 percent of the firm’s output comes from the Illinois Basin, making Alliance Resource Partners one of the purest plays on this region.
The company sells the majority of its planned coal production under long-term contracts that include fixed prices, limiting its exposure to recent weakness in the US thermal coal market. In fact, the firm reported record results in the second quarter because its contracts reset at higher prices.
As Alliance Resource Partners’ general partner, Alliance Holdings GP LP is entitled to receive incentive distributions from the LP each quarter. Incentive distributions paid from the LP to the GP are based on the size of the underlying LP’s payout. Units of Alliance Resource Partners offer a higher percentage yield, but Alliance Holdings GP offer the potential for rapid distribution growth. Yielding more than 5 percent, units of Alliance Holdings GP LP rate a buy under 55.
3. Shorts Season
In a Flash Alert issued on Aug. 23, 2011, I outlined a three-pronged approach to taking advantage of the volatile market:
- Buying high-yield safe havens such as the MLPs covered in this issue;
- Buying high-quality growth names on the cheap; and
- Considering a few short positions or hedges to limit your downside risk.
This strategy has paid off over the past month. Our high-yield plays have outperformed and our hedges have also worked out, particularly our short position in First Solar (NSDQ: FSLR).
Based on our original entry price of $128.48, we’ve earned a profit of more than $55 per share–a roughly 43 percent gain. Shares of First Solar could sink even further, as cash-strapped governments continue to cut subsidies for alternative energy. In a weak market, the stock could decline to less than $50.
But the stock has been on an extended losing streak and is long overdue for a bounce. At these levels, even the slightest hint of good news could provide some support for the stock. Buy enough shares of First Solar to cover half your original position. In other words, if you sold 200 shares of First Solar short, buy 100 of those shares at any price below $77. The remaining short position rates a hold; investors shouldn’t commit any new money to this short play.
The previous issue of The Energy Strategist outlined our bearish outlook for natural gas prices in the fall. Although natural gas-focused producers are vulnerable, these names are dangerous to short because of the potential for a major acquisition. Recent takeovers have been completed for premiums of 40 to 70 percent–a major loss for any short seller.
First Trust ISE Revere Natural Gas (NYSE: FCG) is an exchange-traded fund (ETF) that tracks the performance of a long list of natural gas producers.
Shorting this ETF isn’t an ideal solution the portfolio includes a 3.4 percent stake in ExxonMobil Corp (NYSE: XOM) and a 3.3 percent stake in longtime recommendation EOG Resources (NYSE: EOG). But the fund invests primarily in gas-heavy producers such as Ultra Petroleum (NYSE: UPL), Range Resources (NYSE: RRC) and Quicksilver Resources (NYSE: KWK) that could be vulnerable on the downside. We expect the fund to pull back as hurricane season comes to an end, removing one of the few factors propping up gas prices.
The latest addition to the Gushers Portfolio is a short-term trade for aggressive investors–not a long-term holding. Sell First Trust Natural Gas Fund short above 15.50.
4. Drilling Equipment and Contract Drillers
One of the founding precepts of this publication’s investment strategy hinges on the end of easy oil, or the reality that the massive fields that have supplied much of the world’s crude oil have reached maturity and are in decline. On the other side of the equation, global demand for oil and natural gas continues to rise, led by consumption trends in China, India and other fast-growing markets. Energy producers are faced with a daunting (albeit profitable) challenge: Replacing existing reserves and growing production incrementally.
These trends have forced independent producers, the majors and national oil companies (NOC) to invest heavily in complex, unconventional fields such as North America’s shale oil and gas plays and the deepwater reserves offshore Brazil and West Africa.
This massive industrial transition–which will unfold over the next few decades–promises to be a boon for well-positioned services and equipment firms. Not only did the shale oil and gas revolution enabled the US to supersede Russia as the world’s leading producer of natural gas in 2010, but stepped-up drilling in liquids-rich plays has also transformed the domestic petrochemicals industry and increased the country’s annual oil output for the first time in 18 years.
Source: Energy Information Administration
Although the US is the center of shale oil and gas development, services firms and equipment providers also stand to benefit over the long term from increased investment in international shale plays. This global revolution will take place over a much longer time frame because of infrastructure and capacity constraints.
Meanwhile, exploration and production in deepwater and harsh environment–the final frontier for major oil finds–has continued apace. In 2008-10, operators announced an annual average of 23 discoveries in water depths of at least 4,500 feet, compared to 16 in 2002-04 and four in 1996-98. We expect this trend to accelerate dramatically in coming decades, as producers push into ultra-deepwater and Arctic regions in search of output growth. All of this adds up to a long-term bull market for well-positioned services firms and equipment suppliers.
The Energy Strategist’s model Portfolios offer ample exposure to these massive shifts in onshore and offshore activity through positions in services giants Baker Hughes (NYSE: BHI), Schlumberger (NYSE: SLB) and Weatherford International (NYSE: WFT). As we noted in the Aug. 24, 2011, issue, Playing It Safe, these stocks have sold off considerably amid concern that weak economic growth in developed economies will weigh on energy demand.
The trauma of the credit crunch and Great Recession, which catalyzed a stunning year-over-year decline in primary energy demand, has stuck with investors and reminded them that macro challenges can temporarily overwhelm long-term supply and demand trends.
Although these macro risks warrant close scrutiny, the tight supply-demand balance in global oil markets suggests that the price of Brent crude oil should remain at levels that incentivize investment in exploration and production (E&P).
With Brent oil prices well above $100 per barrel and unlikely to fall below $95 per barrel, international oil and gas producers will continue to spend on new oil production projects.
Solid second-quarter earnings and an uptick in international markets haven’t spared the group from the carnage in the broad market. Panicked investors have also overlooked the relative resilience of Brent crude oil prices in this fraught environment.
Patient investors should continue to regard weakness in these growth-oriented names as a buying opportunity. Among the majors, Schlumberger rates a buy up to 100 and Weatherford International is a buy up to 28. Niche players Core Laboratories (NYSE: CLB) and Petroleum Geo-Services (OTC: PGSVY) rate a buy under 115 and 17.50, respectively. We discussed these companies’ growth prospects and second-quarter results at length in the Aug. 4, 2011, issue, Turning the Corner.
Although services names figure prominently in the model Portfolios, we also have exposure to these long-term trends through offshore equipment provider Cameron International and Dresser-Rand (NYSE: DRC), a leading supplier of turbines and compressors to the energy sector. Both names stand to benefit from the industry’s ongoing efforts to upgrade their offshore drilling and production fleets to comply with post-Macondo safety requirements and endure the unique rigors of ultra-deepwater and harsh-environment drilling.
For example, Dresser-Rand CEO Vincent Volpe told attendees of the Barclays CEO Energy-Power Conference that over 130 floating production and liquefied natural gas (LNG) projects are scheduled for the next five years–a huge growth opportunity. During his presentation, Volpe also revealed that Brazilian NOC Petrobras (NYSE: PBR) had selected the firm as the likely provider of advanced compression systems for eight floating production, storage and offloading vessels (FPSO).
Dresser-Rand also stands to benefit from continued investment in US midstream infrastructure to support production in emerging shale oil and gas fields and the ongoing build-out of refineries by national oil companies.
Both Wildcatters Portfolio holdings would benefit from the size and diversity of their backlogs in the event that the market does go sidewise. Meanwhile, their long-term growth stories remain intact. Dresser Rand rates a buy up to 55, while Cameron Internationa Corp is a buy up to 62. We discussed Cameron International at length in the June 22, 2011, issue, In Review.
National-Oilwell Varco (NYSE: NOV), which currently appears in The Energy Watch List, offers exposure to key onshore and offshore growth trends associated with the end of easy oil. A leading producer of components for rig equipment–management estimates that the firm’s products are on 90 percent of the world’s drilling rigs–National-Oilwell Varco has made over 200 acquisitions over the last 12 years, amassing an operation that spans 800 locations in 60 countries. In 2010 the company generated about 39 percent of its revenue in the US and Canada, while its international operations accounted for 51 percent of its sales. With a whopping market share of 60 percent, National-Oilwell Varco has earned the nickname “No Other Vendor (NOV).”
The company posted a blowout second quarter, growing its revenue by 12 percent sequentially to $3.51 billion and adding $2.96 billion in new rig equipment orders. A backlog of $7.76 billion provides plenty of protection if oil prices decline to $40 to $60 per barrel again.
At the height of the credit crunch and Great Recession, the company only lost 1 percent of its order book to cancellations, thanks to a progressive billing program and the strength of its customer base. Management expects to complete about $2.8 billion worth of its currently backlogged work in 2011, $4.5 billion in 2012 and $600 million in 2013.
The company received 13 new orders for complete land rigs over this three-month period, which contributed $1.2 billion to the backlog.
The firm also benefited from robust demand for fracturing and pressure pumping components, particularly its stimulation charge and top-drives. With operators shifting their focus from dry-gas shale plays to liquids-rich fields, demand for high-horsepower pressure pumping systems will only increase over the next few years. Meanwhile, the extreme wear and tear that these rigs endure should also ensure plenty of recurring revenue related to maintenance and replacement parts.
National-Oilwell Varco’s global operations and sales-force network position the firm to reap the rewards when the shale oil and gas revolution goes international, though infrastructure constraints make this a long-term opportunity.
But the evolution of offshore drilling offers the most potential upside. Whereas the company books about $15 to $20 million in revenue on each US land rig, a high-specification jack-up rig amounts to about $50 million in sales and a sophisticated drillship involves $200 to $300 million in revenue. A harsh-environment rig–a unit capable of drilling in arctic conditions–generates almost $1 billion in revenue for the firm.
National-OilWell Varco specializes in comprehensive top-side drilling systems that have become the standard on many rigs. The scope of the firm’s operations enables it to offer customers single control system that oversees all of the different drilling equipment on an offshore rig–a huge advantage over its competitors.
In the second quarter, the company booked drilling packages for eight new drillships and six jack-up rigs, largely from Western operators seeking to revitalize their fleets with high-specification models. With the price of newly built models offering solid returns at current day rates, many contract drillers have indicated that they will take advantage of outstanding options to order additional units.
The outlook for the third-quarter looks even brighter: In mid-August, Petrobras awarded National-Oilwell Varco a contract worth USD1.5 billion to produce top-side systems for the NOC’s first tranche of seven drillships. This win not only provides a welcome boost to the equipment provider’s backlog after a bit of a slowdown in the third quarter but also puts the company in pole position to win future business from Petrobras.
Nevertheless, National-Oilwell Varco CEO Merrill Miller told attendees of the Barclays CEO Energy-Power Conference that the company will experience periods of weakness during the current cyclical uptrend:
The fact is this: The world needs these rigs and the world needs more rigs. When you take a look, you have a tendency–you have to kind of shift your paradigm on this thing, because what are there going to be, 100 deepwater rigs out there.
So, 60 percent of the world’s surface is deepwater. Okay. There are 150 rigs working in the state of Oklahoma right now. And there are only 100 rigs to work in 60 percent of the rest of the world.
So you know, the fact of the matter is if you go out to about 2020 and take a look at what the needs are going to be to keep oil flowing and to keep hydrocarbons in place…you’re going to have to have more rigs.
Does that mean everybody’s going to continue to order rigs every month, boom, boom, boom? Not at all. You’re going to see an ebb and flow in orders. But the fact of the matter is when we get an order today on a deepwater rig, we’re not delivering it for three years and so you’re having to think about what the world’s going to need three years from now….
You know, the word I use all the time is bifurcation of the rig market–and [the] bifurcation of the rig market is happening. And the best rig wins and that’s what you’re seeing. You’re going to see a lot of rigs that have to be retired and you’re going to see a lot of rigs that have to be built and we’re in a position to be able to take care of that.
In short, investors should expect temporary weakness in new orders from time to time. However, by the end of 2014, when shipyards deliver all the new rigs currently on older, the market will still have only 220 jack-ups younger than 30 years old. The current cycle of rig upgrades will take some time to play out.
In addition to the secular growth trends in onshore and offshore drilling, National-Oilwell Varco has a long history of growing through acquisitions. For example, in 2010 the company purchased Norwegian FPSO designer Advanced Production and Loading for USD500 million, a deal that should give the company a foothold in what promises to be a lucrative business line. FPSOs receive and store hydrocarbons from nearby platforms for delivery to an oil tanker, eliminating the need for local pipelines. This technology is essential to exploiting frontier oil plays.
The firm’s biggest deal thus far in 2011–the $772 million all-cash acquisition of Ameron International–will be accretive to earnings in 2012. The purchase will make National-Oilwell Varco the premier provider of fiberglass-composite pipes. This material is lighter-weight and boasts a longer life span than conventional steel.
With a solid backlog, exposure to key long-term growth trends and a cash balance of $3.4 billion, National-Oilwell Varco rates a buy in the Energy Watch List.
Transocean (NYSE: RIG), a contract driller that boasts the world’s largest fleet of offshore rigs, is another name in the Energy Watch List that we’d consider adding to the model Portfolios.
At present, our only exposure to offshore drillers is Gushers Portfolio holding SeaDrill (NYSE: SDRL), a highly leveraged name that has bet heavily on the growing bifurcation in the rig market. We discussed SeaDrill’s second-quarter earnings and its prospects at length in the previous issue of The Energy Strategist, Step Off the Gas.
As with many established contract drillers, Transocean is in the process of increasing its exposure to the ultra-deepwater (water depths of 7,500 feet or more), harsh-environment and high-specification jack-up markets through a combination of new-builds and acquisitions. The firm recently invested $7 billion in the construction of new rigs and acquired Aker Drilling in an all-cash deal worth $1.46 billion–a 96 percent premium to Aker’s market value. The deal nets Transocean two harsh-environment, ultra-deepwater rigs and two new drillships slated for delivery in 2013.
Transocean’s CEO Steven Newman neatly summed up this bullish outlook for this segment of the market at the recent Barclays Capital CEO Energy-Power Conference:
[We have] lots of optimism about the strength of the ultra-deepwater market. It is, for all intents and purposes, sold out in 2011 and continuing demand this year on into next year. So the customers are already talking about 2012 availability and starting to think about 2013 availability…Utilization today is over 95 percent, and that’s always a positive signal for the contractors. The pace of tendering has improved, there are more discussions going on today. Day rates are improving and short-term availability is decreasing. So these are all very, very positive signs for the ultra-deepwater market.
Management has also noted that it’s encouraged by the recent uptick in permit approvals for new wells in the deepwater and shallow-water Gulf of Mexico, though the present rate of issuance isn’t enough to prevent rigs from leaving the region. Newman told the audience at this conference that he “take[s] a lot of comfort from our customers who tell me that the Gulf of Mexico remains a core component of their Portfolio.” However, activity in the region likely won’t return to pre-Macondo levels for some time.
Although the management team noted that the supply-demand balance in the deepwater market (water depths of 4,500 to 7,500) remains challenge–particularly for moored rigs that lack advanced features–day rates and contract durations continue to improve for jack-up rigs. Newman highlighted these positive developments during an Aug. 24, 2011, conference call to discuss second-quarter results.
[A]s we discussed last quarter, the contracting pace in this segment, especially the premium market, has significantly picked up. This has not only exerted upward pressure on the day-rate for premium equipment, but has also provided contracting opportunities for the standard jackups. This positive development is underscored by us being able to secure a significant number of contracts across our jack-up fleet, adding $684 million in contract extensions during the quarter. This reflects a total of five rigs returning to active duty for the second quarter 2011.
Based on ongoing discussions with our customers, we’re very confident that this trend will continue and we will be able to secure additional contracts for our active fleet, as well as reactivate some of our stacked units under attractive commercial conditions.
Nevertheless, even with these improvements, 24 of the company’s 50 jack-up rigs were idle or stacked (removed from service and stored onshore) as of June 30. To worsen matters, the contracts on 15 of these working rigs expire in the first half of 2012. Investors should also note that the firm faces unknown liabilities related to the Macondo spill.
The being said, the company’s board continues to discuss strategies for rationalizing the underperforming segments of its fleet. In recent conference calls, several analysts asked whether the company might spin off these less-desirable assets. Management hasn’t tipped its hand regarding what course of action it will ultimately take. In the first half of 2011, ultra-deepwater rigs generated about 41 percent of the company’s revenue. We expect this percentage to increase over time as management executes its strategy.
Meanwhile, Transocean’s defensive qualities commend the stock to investors. Not only does the company boast a revenue backlog of $23.8 billion, but major oil companies and NOCs also account for 69 percent of its revenue. This visibility provides ample support for the company’s recently initiated quarterly dividend of $0.79 per share.
Yielding 5.6 percent at current levels, Transocean rates a buy in the Energy Watch List.
5. Fresh Money Buys
The stocks recommended in the three model Portfolios represent my favorite picks. The three Portfolios are designed to target different levels of risk: Proven Reserves is the most conservative; the Wildcatters names entail a bit more volatility; and Gushers are the riskier plays but have the most potential upside.
I realize that this long list of stocks can be confusing; subscribers often ask what they should buy now or where they should start. To answer that question, I’ve compiled a list of Fresh Money Buys that includes both stocks and some hedge recommendations designed to limit your risk amid market downturns.
I’ve classified each recommendation by risk level–high, low or moderate. Conservative investors should focus the majority of their assets in low- and moderate-risk plays, while aggressive investors should layer in exposure to my riskier and higher-potential plays. Hedges are appropriate for investors looking to offset exposure to energy stocks.
Also note that stocks that exceed my buy target for more than two consecutive issues will either be removed from the list or the buy target will be increased.
Source: The Energy Strategist
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