EIS Newsletter #4: September 2007
The Month Just Past
In August the market became frenetic. The Dow moved up or down by more than 1% on 12 out of 23 days of trading, a truly unusual performance. A spike in volatility sometimes presages a change in market direction as Floyd Norris of the Times discussed in detail in his piece on 9/1.
It seems that a new fear began to grip the market last month. I think it may be a fear of the unknown, a sense that the credit market turmoil may not be well contained and could spread into terra incognita. Maybe the fear is related to the fact that, given a clearly weakening U.S. economy, so much of our well being seems to be riding on the continued high growth rate of China and other developing countries. Granted the story is still very compelling — hundreds of millions of peasants trying to claw their way to a measure of prosperity and in the process driving the global economy. But think what the outlook for the U.S. economy would be if suddenly China were to slow it’s growth rate down from 10%+ to, say, 3%. Look out below.
The EIS portfolio was off 7% last month, its worst performance and only down month so far this year. It underperformed the general market, which was up about 1% after all its wild gyrations.
New Conditions Call for a Strategy Revision
Energy Investment Strategies is about the intersecting worlds of energy and investments, but most of the emphasis is on the Energy side — what forces are driving oil and gas prices and the implications thereof for investments and society. But today I am going to focus on the Investment world because that is where I believe the primary portfolio risk/reward drivers are coming from currently.
I’ll get right to the point. Late in August I decided that the risks of a serious U.S. economic decline have become sufficiently high that a new strategy is required to reduce the EIS portfolio’s exposure to a serious market downturn. I sold many non-core holdings and shorted the SPY and OIH ETFs against the remaining core positions. So far, that move hasn’t helped me, but I’m usually early. It could be 3 - 6 months before we know if a serious U.S. recession will occur. I intend to maintain a low investment profile during this period of uncertainty.
Last month I wrote of the subprime problem:
“Nobody can know the impact that sub-prime mortgage defaults will have on the broader stock market and the economy. It’s clearly a negative vector for U.S. economic growth, but the question is whether it is a strong enough vector to outweigh such positive vectors such as excellent foreign growth, especially for Chindia.”
That was okay as far as it went — in fact it’s still quite true — but I was looking at the wrong problem. It’s not about whether subprime defaults and the coming reset of 2 million ARMs in the next 18 months will cause more hedge funds to implode and cause a financial panic like Long Term Credit did in ‘98. The much larger problem is the bursting of the housing bubble that has built up over the past six years and the concomitant risk of recession.
If evidence is needed that a housing bubble exists, look at two recent news items, both from The Wall Street Journal:
1. The graph below shows the most basic of all housing price measures, affordability. It measures the change over the past 35 years in the median house price compared with median family income. As you see, affordability has decreased in two great stages, 1971 through 1980 and 1999 through 2006.
Over the full period housing affordability decreased by 74% with the median home price rising from under 2.3 times to about 4 times median family income. Included in that enormous jump is a 35% increase in the index just during the past 6 years. That looks like a housing bubble.
2. On September 1st, Herb Greenberg wrote in The Journal about the work of a California housing analyst who shows that the median price of houses in California has jumped from about equal to the national median price to a current condition of being 80% higher. In July the median price of a California home was $586,000, which compares with the national average of $228,900. That’s important because it presages a possibly substantial fall in California home prices and California produces 13% of U.S. GDP. Moreover, that housing market is mirrored by many other pockets of high prices in what has been some of the most economically dynamic parts of the country, so they are at similar risks of a substantial decline.
Putting together these two pieces of evidence, we see that a housing bubble has been formed because
A. The whole country is experiencing a vastly decreased ability to afford their housing, and
B. A significant part of the country is experiencing a even greater housing bubble than the median is experiencing.
This evidence, when combined with familiar and long-standing commentary regarding Americans’ slim to negative savings rate, paints a picture of housing as a key — but now faltering — driver of the last six years’ growth in the U.S. economy. Huge numbers of Americans have been pushing their credit to the limit, viewing their homes as appreciating investments, and taking money out of their homes via second mortgages to purchase other goods and services. As many others have noted, if housing prices continue to drop, this entire process could reverse itself.
A housing downturn (which we are already beginning to experience) has enormous inherent multiplier impacts on the economy. Housing directly effects the vast consumer durable sector of the economy that includes home furnishings and appliances. It also directly impacts construction, materials shipping and distribution, intermediary services (like real estate and mortgage sales), other service groups like decorating and architecture, and the demand for retail and commercial real estate. Job losses in these fields then have a multiplier impact on many other types of consumer spending and ultimately on capital spending decisions.
The most serious risk is the possibility that as the housing-driven expansion unwinds, a vicious cycle could form. Lower housing prices beget lower housing sales which beget lower employment, which begets lower consumer spending which beget lower stock prices, which beget lower housing prices, …well, you get it. Not much has yet been written about such a “perfect storm.” My concern is that it will become an important topic. A vicious cycle is particularly scary because, like a huge hurricane, the extent of its damage can only be known in retrospect.
Why might the housing bubble burst? One factor is the subprime issue. The new mortgage lending risk averseness caused by subprime defaults has caused the interest on jumbo 30 year mortgages, which are defined as any mortgage larger than the FHA limit of $417,000, to jump from 5.5% a few years ago to 7.4% as of 8/31. That’s a 52% increase in cost that impacts all buyers of homes priced above $417,000, which is well below the median price of a California home and homes in many other places.
The extremely high relative cost of California housing implies another possible bubble buster: that the higher income parts of the country, who are the super-consumers who have been an outsized influence on economic growth over the past few years may face the most retrenchment. Included are people who buy expensive coffee and food, who vacation on cruises in rising numbers, and who buy shiny new cars at rates much faster than utility requires. To the extent that they are particularly hurt by a housing bust, the economic impact would be magnified.
Of course, the story is not all negative. What about the Fed? Won’t the calvary ride to the rescue? The Fed is the Fairy Godmother in today’s conventional wisdom and indeed it will undoubtedly try to lower rates if the economy begins to tank. But the Fed’s hands could be tied if it encounters a dollar problem. As many wise heads have noted for such a long time that nobody listens any longer, there is an historically excessive quantity of dollars currently being held by foreigners, especially the Chinese and the oil exporting countries. Increasingly these dollars are floating around various overseas markets as opposed to resting safely in the vaults of the centrals banks of China, Indian and Saudi Arabia. If lower U.S. interest rates (which have not yet occurred) lead to additional and persistent dollar weakness, as some economists warn that it could, a stampede out of the dollar could make it hard or impossible for the Fed to maintain low rates. Such a development would cause further anguish in financial markets.
But what about the hugeness of our economy — the millions of people employed in places not impacted by a housing bust — health care, education, government, military, food production and distribution, etc? True enough, but let’s remember that even during the Depression 75% of Americans who wanted to work had jobs.
And what about the strong winds of growth blowing in from Chindia? Let’s hope they keep blowing and don’t get impacted too much by a weak American economy. In the end this is a contest between fear and greed. Whichever side gains the bulk of adherents will become predominate.
How about oil? How would a U.S. or a global recession effect oil and oil related investments? Not well. Lower economic activity suggests lower oil and gas demand and therefore lower commodity prices. That would not help energy related investments.
Stocks, which as of 8/31 were down 5.4% from their July 19th S&P 500 peak, usually fall in advance of a serious decline in economic activity. If the economy does tank, this time will not be different. So the market over the next few months should tell us which side will win — fear or greed. That’s why I want to step aside for now. If the great growth momentum coming out of Chindia, etc. offsets the drag of a housing bust, the worst that will happen is that my portfolio will underperform a rising market. But if fear wins out, stepping aside could save the EIS portfolio from a vastly greater reduction in its value.
Analyzing Energy
Some years ago I started a hedge fund oriented to cable television and other media-related investments when the field was very hot. An old hand on the Street who helped me get started gave me one piece of advice: “I know you love this business, but be smart enough to sell when things turn against it.” Is this the time to sell energy investments?
Natural gas is in a temporary glut, as we’ve discussed before. I don’t own it; let’s go on to oil. Oil is actually more central anyway because my objective is to structure a portfolio to obtain long term gains during a period marked by the approach of Peak Oil. So how close we are to the price of oil spiking higher? There are three key considerations which are, in ascending order of impact and importance:
1. Seasonality. Seasonality impacts are inherently short term and therefore should have little influence on a long term capital gains oriented energy investment portfolio. That said, early September is both the high hurricane season and the weak shoulder season for oil demand. There have been no important hurricanes thus far in 2007, and yet the price of oil is near its historical high in a weak shoulder market. This suggests that underlying supply is tight relative to demand. In October winter heating oil inventory building will begin to increase oil demand, yet oil is priced cheaper in the outer months. This suggests that futures traders believe something is likely to happen to make oil cheaper. A recession?
Conclusion: Seasonality can suggest what the underlying oil supply/demand dynamics are. Otherwise, seasonality impacts should be ignored in terms of making long term oriented stock portfolio decisions.
2. Macro-economics. As discussed above, the sub-prime credit mess and weak U.S. housing sector are fighting against the huge secular growth trend of Chindia to determine if the U.S. and/or global economies will become weaker — and if so by how much.
Conclusion: Current risks call for the exercise of substantial caution in putting on new positions and an effort to build up a cash cushion in the event that both stock prices and oil prices do undergo a major collapse.
3. Secular supply and demand, the influence of the approach of Peak Oil. As discussed above, oil supplies seem very tight at present. Crude oil production has leveled off over the past two years and growing use by developing and industrial countries has been offset by:
• Declining oil use in poor countries and among poorer individuals in wealthier countries who have been priced out of the market as discussed last month, and
• Additional production of natural gas concentrates, oil sands, and bio-fuels.
Oil exporting nations see robust domestic oil demand, fixed domestic oil reserves, and rising global oil prices. Given those conditions why would an oil exporter want to produce at the maximum rate possible? The goal of some exporters, therefore, has become to produce as little oil as is required to keep oil prices in a gently upward trend (see It’s Called Hoarding). How sustainable is the gently upward trend of the past three years?
OPEC has stated that it does not intend to increase production this fall, being concerned about the possibility of recession-driven reduced demand. If a recession does not dampen demand it will likely outpace supply to produce a spike in prices to historical highs. But if there is a deep recession, the oil price picture could do a 180 on us.
Conclusion: The trend of the past two years toward gently rising oil prices will eventually become a more steeply rising trend, possibly in the near term, although a recession would put that off for a while It is appropriate to maintain the core of a long term investment portfolio predicated on higher oil prices.
So, combining the conclusions to the three considerations above, what does the energy analysis say about how we should structure a portfolio in terms of oil-related investments? It is best to ignore seasonal movements in the oil price, sell non-core positions, and avoid buying new positions until the risk of a recession is reduced. But — since the price of oil could rise dramatically at any time — one should maintain core holdings in companies whose earnings are tied to the price oil.
What Segments Are Best for Core Holdings?
Major Oil Companies: When an energy investment is suggested most investors think of major integrated oil companies like Exxon-Mobil (XOM) first, but XOM is a mixed bag. Yes, it has a lot of cash and a lot of oil. Owning oil is good when the price is high and rising; owning cash is good when the price of oil is low and falling because good acquisition opportunities can occur. But asset replacement is a significant weakness for the majors. They have generally failed to replace the oil and gas they have sold over the past two years and the prospects for the future replacement are worse. This makes them sellers of declining inventory positions, not a prospect for growth. Equally important a higher oil price is not totally a good thing for them. Some majors have deals with foreign governments that reduce their reserves as the price of oil increases because a larger percentage of production is allocated to the host country when the oil price rises. Moreover, higher oil prices make it more expensive for the majors to replace their reserves through acquisitions. I want to own oil assets that are leveraged to higher prices for oil because I think much higher prices will come in the future. But the majors have these two negative impacts from higher oil prices, so I avoid owning the major oil companies.
Independent Exploration & Production Companies: These
smaller and more entrepreneurial firms find it easier to replace and
even add to reserves because they are more nimble and can be significantly
impacted by the smaller deals that are available today. On the other
hand, they still have to replace their carbon assets which is an increasingly
difficult proposition. They are not core holdings for me.
Oil Sands Companies: With very long reserve lives, these companies are major beneficiaries of higher oil prices. Moreover, they are prime take-over targets for the major oil companies. They are part of my core oil holdings.
Production and Service Companies: The quest for reserves and the need to maximize production from existing wells will continue regardless of the price of oil. Even if oil were to fall back into the $40s, the hunt for new reserves will continue as the market is well convinced at this point that “high” oil prices are now permanent, given Peak Oil. Therefore, the production and service companies, and particularly those which operate on the frontiers of exploration, are especially attractive as core energy holdings, in my view.
Alternative Energy Producers: Producers of wind, solar, geothermal and bio-based energy are leveraged to the price of oil because the oil price ultimately determines the prices of their alternative end products — fuels or electricity. To the extent that one can identify reasonably priced stocks in this segment, which is not easy, they deserve a place as core long term holdings. On the other hand, they will be particularly vulnerable in a recession-caused market downturn.
In summary, my selection for core energy holdings looking toward rising oil prices in the future are oil sands, drilling and service companies, and reasonably priced alternative energy plays.
Hoping my fears are baseless,
Jim Kingsdale
Editor, Energy Investment Strategies
www.energyinvestmentstrategies.com