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January 30 — Monday: Natural Gas Glut; China’s Demand for Energy Resources The Financial Times published several charts on the US natural gas sector that supports our comments on the industry made last week in our interview with FSN (link below). The charts speak for themselves:
As we noted in our interview we would avoid companies in the natural gas sector short term. Long term investors might have an interesting opportunty to establish positions in these firms later this summer or fall – with gas storage well above average and production continuing to ramp upward natural gas prices may remain very weak.
Frank Holmes of US Global Investors posted another excellent analysis on the rocketing demand for energy and commodity resources from China. He notes: Increasing Reliance on Energy Imports
You can see in all three how dramatically the energy balance has shifted to an ever-increasing dependence on imports. In each major commodity, after China began importing, growth took off.
China became a net importer of crude oil in 1994, and today, is the second-largest oil importer in the world. BCA forecasts the country is expected to surpass the U.S. as the largest oil importer in only a few years. . . .
Even with these imports, energy consumption is only a fraction of developed countries. The China story is just getting started: Urbanizatin just surpassed the 50-percent mark, hitting what I believe to be the pivotal moment that dramatically shifts buying patterns, driving an enormous demand for housing, consumer staples and durable goods. You ain’t seen nothing yet!
We agree with his assessment on the impact of China and developing economies on the energy and commodity markets. Long term this is a very positive trend for investors in crude oil producers.
January 27 — Friday: FSN Interview: Natural Gas Glut; The Zurich Axioms Book Review We were interviewed by Jim Puplava and the FSN network yesterday on the natural gas sector. The short interview can be accessed at the January 26th tab: FSN Interview We also published a review of the Zurich Axioms: A Study of Risk Management at the FSN site: Zurich Axioms
January 20 — Friday: Equity Ownership & IQ; Investors Flee Stocks; Correlations Remain High—M&A Boom Ahead? Next Monday, January 23, the EU's foreign ministers are expected to officially approve an embargo on Iranian oil after agreeing in principle to the move earlier this month. They'll likely agree to enforce the import ban from July, in order to give countries time to make alternate import arrangements. Iran says they will close the Strait of Hormuz if the embargo passes. Stay tuned. Concerns about global oil prices are about to get ratcheted up another notch.
And Saudi Arabia said earlier this week it wanted to keep crude oil prices at around $100 (U.S.) a barrel, the first time the kingdom has targeted a “triple-digit” price and a quarter above the previous ambition of $75 suggested by King Abdullah in November 2008. The higher price is needed to fund social programs adopted after the recent “Arab Spring” events.
Equity Ownership and IQ. Bloomberg reports on a recent study that indicates “the smarter you are, the more stock you probably own”. Researchers claim that using historical data they found a direct link between IQ and equity market participation. Bloomberg continues:
Intelligence, as measured by tests given to 158,044 Finnish soldiers over 19 years, outweighed income in determining whether someone owns shares and how many companies he invests in. Among draftees scoring highest on the exams, the rate of ownership later in life was 21 percentage points above those who tested lowest, researchers found. The study, published in last month’s Journal of Finance, ignored bonds and other investments.
Economists have debated for decades what they call the participation puzzle, trying to explain why more people don’t take advantage of the higher returns stocks have historically paid on savings. As few as 51 percent of American households own them, a 2009 study by the Federal Reserve found. Individual investors have pulled record cash out of U.S. equity mutual funds in the last five years as shares suffered the worst bear market since the 1930s.
“It’s what we see anecdotally: higher-IQ investors tend to be more willing to commit financial resources, to put skin in the game,” said Jason Hsu, chief investment officer of Newport Beach, California-based Research Affiliates LLC. About $85 billion is managed using his firm’s strategies. “You can generalize a whole literature on this. It seems to suggest that whatever attributes are driving people to not participate in the stock market are related to the cost of processing financial information.” . . .
‘So Strong’
While intelligence influenced things that might naturally increase equity ownership such as wealth and income, the authors said IQ determined who owned the most stocks within those categories as well. Among the 10 percent of individuals with the highest salary, “IQ significantly predicts participation” in the stock market, they wrote. For example, people in the highest-income ranking who scored lowest on the test had a rate of equity market participation that was 15.7 percentage points lower than those with the highest IQ. . . . American economist Harry Markowitz won a Nobel Prize in 1990 for his theory that owning a larger variety of assets tended to maximize returns for a certain amount of risk. The 2009 study by the Fed found that 51.1 percent of American families own stocks directly or indirectly, and of those who do, 36 percent have shares in one company.
‘Difficult to Justify’
“It’s difficult to justify why someone wouldn’t invest in the stock market, knowing what a good deal it has been,” said Linnainmaa, a co-author of the study from the University of Chicago’s Booth School of Business. “The classical explanations for non-participation have been participation costs. It’s not just that it may be expensive to buy stocks and mutual funds, but people may not have enough knowledge about them.” . . .
Social Policy
The study’s authors said the findings have implications for social policy. Avoiding stock investments cuts returns and may widen income gaps, they said. Individuals scoring lowest on the tests who still owned equities earned as much as 33 basis points, or 0.33 percentage point, a year less than the highest scorers. One way governments could promote better savings might be with plans that let people opt out of stocks, like 401(k) plans, as opposed to opting in, said Keloharju.
“If you look at these people over time, people with higher IQ scores and stocks become wealthier and wealthier at a much faster rate than people with lower IQ scores,” said Linnainmaa. “It makes them worse off in the long run, even more so than the difference in income.”
Bottom line is that the equity markets over time have generated substantial excess returns for investors, which in part has driven income disparity. The study also points out the need for investor education on the role equity markets should play in an individual’s asset management strategy.
Investors Flee Stock Funds. USA Today reports that individual investors redeemed more than $400 billion from stock funds the past four years, which has slashed the assets of some funds in half. Instead of stocks investors have been pouring money into bond funds. And due to global uncertainties investors put nearly eight times as much money into bank accounts as they put into bond funds last year.
Like many markets the price of stocks are driven in part by demand. Due to buybacks and retirements Bloomberg reports there has actually been a shrinkage in equities over the last year, but the demand fall-off has insured that equity markets didn’t have the ‘fuel’ to propel them upward. U.S. companies repurchased $397 billion of stock last year, while they issued $169 billion of new equity, data compiled by Birinyi Associates Inc. indicated.
On this topic Dennis Gartman of the Gartman Letter predicted a 25% gain in the stock markets this year, a ‘melt up’ driven by liquidity and the massive amounts of assets in cash equivalent and bond funds earning very meager returns. Don Hays of Hays analytics also sees a similar rise in the market.
USA Today notes that the equity fund outflows are in part due to demographics, in part due to the substantial drop in real estate wealth and the slow growing economy, and in part due to the desire of investors to have a stable, non-volatile, asset on which they can rely.
Correlations remain at record levels. The Wall Street Journal reports that equity correlations have been rising sharply over the last few years, with individual stocks moving with the major indexes in a much closer relationship than they have historically. The article discusses a recent study by BCA Research which examines the causes of this high level of correlation.
The chart, courtesy of BCA, is telling:
With the high degree of correlation it appears some stocks are moving with the market and are becoming mis-priced due to the fact they are much more attractive businesses than your average company. As we progress into 2012 we expect more merger and acquisition activity as firms realize the value, and the ability to add growth at a reasonable price, in a slow growth economy. In this environment we expect to see a takeover boom in the energy sector as assets are valued at levels rarely seen.
January 9 — Monday: Ag Sector Attractive in 2012; LSGI Portfolio Holding Art’s Way Manuf. (ARTW) Best Investment Idea for 2012 Agriculture will be one of the major sector themes of the LSGI Portfolio in 2012. A number of very positive long term global trends are in place in the sector, not the least of which is the fact that farm incomes in the U.S. have rocketed to record levels – great for firms that sell agricultural related products or services.
The U.S.D.A. forecasts U.S. farmers’ net income rose to $100.9 billion in 2011, up nearly 30 percent from 2010, reaffirming the bright spot agriculture represents in an otherwise gloomy global economy. This would be the first time ever that net farm income was above $100 billion. Farm income is expected to continue to grow in 2012. Recent presentations by some of the larger companies in the sector, and USDA reports, paint a very positive picture of current and future trends
The Creighton University Mainstreet economic report indicates that the farm equipment sales index continues to rocket upward. December’s index reading was one of the most bullish in years. The Creighton farm equipment sales index has indicated the sector has grown for 22 straight months (index readings over 50 indicate sales are expanding). A chart of the data illustrates the expansionary mode for the sector: As noted above the U.S. farm economy has been very strong, with cash receipts and farm balance sheets pointing to a very healthy business environment:
(Charts courtesy John Deere & Co.). Farm income and capital expenditures have correlated very closely historically – and with record farm income we would expect robust capital expenditures in 2012:
(chart courtesy of Agco). Meanwhile the global grain inventory stocks-to-use ratio has declined substantially, to levels rarely seen in the last 25 years:
With inventories so low a weather related shock anywhere in the world could cause food prices to rocket upward. Increased global demand have already pushed prices for many agricultural products to levels well over historical norms – increasing farm profitability and a major reason farm income is at record levels:
(Charts courtesy Potash Co.)
LSGI Portfolio. LSGI Portfolio holding and agricultural equipment manufacturer Art’s Way Manufacturing (ARTW) reported extremely impressive third quarter earnings in their last call – no surprise in an environment where US farmers are projected to report record incomes according to the latest USDA report. We have named the company our ‘best investment idea’ for 2012 for the Dick Davis Investment Digest special New Year’s issue.
The company shifted their farm equipment production runs last quarter to focus on higher margin products. With the new West Union, Iowa, plant up and running the company has benefited from operational efficiencies in the agricultural equipment manufacturing division. Historically agricultural equipment has accounted for around 80% of company revenue with the custom lab group (ARTW Scientific / Building for Research division) accounting for around 15% of sales. That will change in 2012—due to new contracts for the custom lab group—and now the company will have two divisions operating in very attractive markets. Both divisions will be profitable.
With regard to the ARTW Scientific / Buildings for Research division the company just announced $7.4 million worth of new contracts last week – compared to $2.3 million worth of projects completed in the first nine months of the last fiscal year. ARTW’s management stated in the last conference call that with these new contracts they think the company and division will be “very profitable in the coming year.” Further they noted that “when Scientific does turn profitable, it turns very profitable” due to the nature of the fixed costs and operational efficiencies that come into play.
ARTW is covered by only one analyst who rates the company a buy. Our spreadsheet for the company is set out above. An analyst who covers the company just increased their 2012 earnings per share estimate to $0.54 per share after the contract announcement, and reiterated a buy rating on the stock. We may upgrade our earnings and revenue estimates but will wait until after the next earnings call.
Overall ARTW management was very positive with regard to the outlook for the coming year. We continue to find the company, and the sector, very attractive from a risk/reward standpoint.
January 1 — Sunday: Arab Spring Impact on Crude Oil Supply; LSGI Portfolio Developments: GeoResources (GEOI) Global supply and demand issues in 2012 are expected to keep crude oil prices higher than historically seen according to many analysts. The ‘Arab Spring’ continues to evolve, along with issues related to the Iranian nuclear program. We think the Arab Spring will be much more disruptive, and last much longer, than many analysts expect—with adverse consequences for crude oil output in 2012 and beyond.
In recent weeks the European Union has discussed imposing a direct or indirect boycott on Iranian oil, and President Obama is preparing to sign legislation that, if fully enforced, could impose harsh penalties on all buyers of Iran’s oil. In theory both actions would severely impeding Iran’s ability to sell crude oil on the global markets. Iran is currently conducting war games in the Gulf region, an area where around 20% of the global crude oil supply is transported via tanker to global markets.
Yemen, and oil exporter, continues to deteriorate towards a civil war. Companies operating in the country have postponed capital expenditures and exploration activities which will impact production. Egypt has also continued to experience unrest and sabotaged pipelines and production facilities, and likewise has seen a marked slowdown in capital allocated to energy investment. Gunfights between factions remains in place in Libya, and movement toward a stable governing body remains elusive although crude oil exports have increased over levels seen last summer. In Yemen, Libya, and Egypt the question of who will govern, and their policies toward the energy sector, remain undecided—not a positive in a world where capital is needed to maintain much less expand crude oil production.
Peter Jones of the Globe & Mail pointed out how no-one saw the Arab uprisings coming as quickly and violently as they did, and forecasting events for 2012 is difficult, but he predicts the following:
Civil war in Syria (likely). Bashar al-Assad’s regime has nowhere to go. Representing a despised minority, it realizes that relinquishing power will invite a bloodbath – so it would prefer that bloodbath on its own terms, in hopes it can survive. But the regime won’t survive, so the big questions are what will emerge afterward, and how many thousands will die to get there.
Something close to civil war in Iraq (likely), and the breakup of the country (possibly). The complete withdrawal of U.S. forces, insisted upon by the Shia political leadership, and the fact that the creation of the new Iraqi federation was a reality more on paper than in anyone’s heart, mean that renewed fighting will intensify in many parts of the country. While the Shiites and Sunnis go at each other, the Kurds in the north will continue to quietly head for the exit.
We agree with his analysis – both of which will not be favorable for crude oil production or exports or for stability in the region. Stable governments and policies are generally considered a precondition to attract capital and technical expertise to countries to develop energy resources.
The New York Times published several charts of longer-term energy pricing trends in an article that noted that high cost oil and gasoline was most likely a given in the coming year:
Charts courtesy New York Times. The National Post published an article on the outlook for crude oil prices and noted that this year quite a discrepancy exists between analysts. They note a Bloomberg survey of 27 oil analysts indicate West Texas Intermediate oil may reach an average of US$100 a barrel in 2012, topping the record high of US$99.75 set in 2008.
Goldman Sachs expects Brent to be at $120, with WTI at $112.5. At the other end of the spectrum, Capital Economics ($88), Petromatrix ($88.75) and Bernstein ($90) expect Brent to slide in 2012.
Other major commodity banks such as Barclays (Brent:$115, WTI: $105), Bank of America Merrill Lynch (Brent: $108, WTI:$101), Deutsche Bank (Brent:$$115, WTI: $105) and Standard Chartered Bank (Brent: $107.5, WTI: $100.25) all are somewhat bullish on the outlook for crude oil. The National Post published the following chart of Standard Charter’s forecast – one that illustrates the generally bullish bent of analysts:
U.S. crude inventories rose 3.9 million barrels to 327.5 million in the week ended Dec. 23, the Energy Department reported – but the longer term downward trend remains in place. A six month chart of U.S. crude inventories from Bloomberg illustrates the point:
LSGI Portfolio Developments. In an environment of rising crude oil prices we think firms with proven reserves in stable political areas should perform well. One such company is LSGI holding GeoResources:
GeoResources, Inc. (GEOI) announced its financial and operating results for the third quarter. The company produced an average of 5,545 barrels of oil equivalent per day in the quarter (65% oil), a 12% increase over the third quarter 2010 and a 17% increase over the second quarter 2011.
The company has one rig working in its Texas Eagle Ford play. Three wells are currently producing in this project area while two wells have been drilled and are awaiting completion. A second rig is contracted and is expected to begin drilling immediately. The Company expects to spud eight or nine wells in the Eagle Ford project area by year end 2011 and expects to have five or six of these online and producing by early 2012.
The company has recently participated in an oily Austin Chalk well in the Eagle Ford prospect area. Depending on well results and economics the company may drill additional wells to this target formation in 2012. Additional rigs may be added to the Eagle Ford project area in 2012 depending on commodity prices, service costs, and resulting well economics.
In the North Dakota Bakken play six operated wells are currently producing in the company’s project area. The company expects to spud 10 or 11 wells in the Bakken area in 2011 that it will operate and expects to have eight or nine of these online and producing by year end. Like the Eagle Ford play the company plans to add additional rigs to this project area in 2012 depending on commodity prices, service costs, and resulting well economics.
After the earnings conference call analysts at Canaccord Genuity initiated coverage with a ‘buy’ rating and a target price of $43. Investopedia Advisor made the following comments on the company on December 28, 2011:
Small Cap Eagle Ford Shale Players To Watch (GEOI, AXAS, PVA, NBR)
The Eagle Ford Shale will see a large amount of development in 2012, as exploration and production companies continue to crowd into this popular play in South Texas. While the large operators that are active here typically get the most attention from investors, there are also small-cap companies that investors should review.
Small Cap Players
GeoResources (Nasdaq: GEOI ) has 25,000 net acres of exposure to the Eagle Ford Shale and is involved in an area of mutual interest in the play with Ramshorn Investments, Inc., an affiliate of Nabors Industries (NYSE: NBR ).
GeoResources plans to drill between 21 and 24 gross wells into the Eagle Ford Shale in 2012, compared to the nine gross wells expected to be drilled in 2011. The company has allocated from $74 million to $86 million in capital for this development in 2012.
GeoResources has 167 drilling locations on its acreage and estimates that its resource potential ranges from 58 million to 83 million barrels of oil equivalent (BOE) . The company expects its wells to have an average estimated ultimate recovery between 350,000 and 500,000 BOE. . . .
December 25 — Sunday: Crude Oil Inventories Tight; Correlations Near Record Levels; LSGI Portfolio Developments Iran begins ten days of war games in the Persian Gulf, including the Straight of Hormuz, this weekend. Reports that inflation in Iran has hit 20%, the currency is dropping in value (with a 10% loss on one day last week), Iranians are exchanging local currency for gold and other foreign assets, a potential Iranian oil boycott proposed by European powers, further global restrictions on the ability of countries and companies to deal with the Iranian central bank and banking system, and impediments to the payments for crude oil exports from Iran point to a potentially dangerous situation for all involved. Keep in mind the events noted above were reported in various news sources, but verification is difficult.
In this environment some commentators have forecast a high probability some type of disruption or potential disruption in oil supplies in the next ten days—or confrontation. If nothing else Iran benefits from higher crude oil prices due to the risk premium that could occur if supplies might be interrupted. The National Post described the situation as follows:
Iran’s nuclear push is rapidly turning into a game of chicken with the world’s economy. Faced with the threat of growing international sanctions and unprecedented economic uncertainty that has seen the value of its currency halved in recent weeks, Iran announced Thursday its navy will stage a 10-day exercise in the Strait of Hormuz, starting Saturday. The move, which increases the risk of military confrontation with the United States, has the potential to temporarily choke off oil exports from the Middle East, drive up international energy prices and damage the global economy.
The entire article can be read at the following link: http://fullcomment.nationalpost.com/2011/12/22/peter-goodspeed-irans-currency-collapse-prompts-fear-of-oil-blockade/
A map of the area, courtesy the National Post, was included in the article to illustrate the bottleneck at the Strait of Hormuz:
Global Crude Oil Inventories Tight. In a stunning report the U.S. Energy Department reported crude oil inventories fell 10.6 million barrels last week – the largest decline in a decade - to 323.6 million. It was the largest decline since Feb. 16, 2001, and almost five times the 2.13 million drop that was the median of 12 analyst estimates in a Bloomberg News survey. The large fall in inventories suggests that the supply and demand balance of the global crude oil market could be much tighter than previously thought – something we have been saying for months. US crude oil inventories are now at their lowest level since late 2008.
The size of the decline in US inventories comes as crude oil stocks in Europe are already at unusually low levels. The International Energy Agency (IEA) publishes monthly estimates of European stocks. In their latest report that European stocks fell to their lowest level in 11 years due to the impact of the supply disruptions in Libya, Egypt, Yemen, Syria, and the North Sea.
The IEA estimates that the world has consumed more oil than produced for the past eight quarters as rising demand from emerging countries such as China and India combined with supply issues reduced global inventory levels.
The falling levels of global inventories point to a supply and demand environment that supports higher crude oil prices. Add in the continuing unrest in the Middle East and North Africa and the chance of additional supply interruptions is not nominal – in fact is increasing as the Arab Spring is lasting much longer and is more disruptive than many have forecast.
A six month chart of US oil inventories illustrates the trend:
A longer term 3-year chart, courtesy Financial Times, illustrates the rapid decline in inventories – driven by supply disruptions as well as robust demand growth:
LSGI Portfolio. The following firm in the LSGI our portfolio appears to be well situated in an environment of rising crude oil prices. The firm will present to institutional investors on January 4th, and the broadcast can be viewed over the Internet from the company’s homepage.
Evolution Petroleum (EPM) is a micro-cap exploration and production company that is on the verge of significant production growth. Nearly 90% of company reserves are crude oil or liquids. Their major asset is a cost free 7.4% over-riding royalty interest in the Denbury Resources Inc. (DNR) operated Delhi enhanced oil recovery project in Louisiana that bears no capital costs or operating expenses until project payout. EPM’s reversionary working interest gives them considerable upside potential in this long-lived oil field.
Production in the Delhi Field should substantially accelerate over the next two fiscal years. At current oil prices, there is a good chance the project will reach payout by mid-2013. At that point, EPM will convert its over-riding royalty interest to a working interest and their net revenue interest in the well will jump to 26.5%, more than triple what it is today.
The company received almost $106 a barrel last quarter for their share of production in the Delhi Field. In the earnings conference call they noted production was up 48% as the carbon dioxide flood begins to impact production volumes. The reservoir quality is better than expected, and the reservoir response has also been better than expected. Management thinks more oil in place in the field exists than originally estimated and that recovery will be better than early estimates, adding to upside potential.
Denbury Resources, the operator of Delhi field, expects production will reach 5,000 to 10,000 barrels per day. At this rate EPM could net roughly 2,500 barrels per day versus a net of 326 barrels per day in the quarter just ended. Management noted that we are still in the very early production growth phase in the Delhi Field.
EPM has positive working capital and no long-term debt. It is currently trading at roughly half the discounted present value of its proved and probable reserves. We see additional upside beyond the Delhi EOR Project: (1) with increasing cash flows, the company can accelerate development of their Texas Giddings and Lopez Fields; (2) they have recently patented an artificial lift technology and are proving it with on-going field testing; (3) their 5,500 net acres in the Woodford Shale in Eastern Oklahoma (Haskell County) has low cost unconventional natural gas potential that the company holds in inventory until the gas markets improve.
TheStreet.com upgraded EPM after the recent conference call:
Evolution Petroleum Corporation (AMEX:EPM) has been upgraded by TheStreet Ratings from hold to buy. The company's strengths can be seen in multiple areas, such as its robust revenue growth, largely solid financial position with reasonable debt levels by most measures, impressive record of earnings per share growth, compelling growth in net income and expanding profit margins. Although the company may harbor some minor weaknesses, we feel they are unlikely to have a significant impact on results. Highlights from the ratings report include:
EPM's very impressive revenue growth greatly exceeded the industry average of 35.6%. Since the same quarter one year prior, revenues leaped by 232.3%. This growth in revenue appears to have trickled down to the company's bottom line, improving the earnings per share.
EPM has no debt to speak of therefore resulting in a debt-to-equity ratio of zero, which we consider to be a relatively favorable sign. Along with this, the company maintains a quick ratio of 6.85, which clearly demonstrates the ability to cover short-term cash needs.
EVOLUTION PETROLEUM CORP reported significant earnings per share improvement in the most recent quarter compared to the same quarter a year ago. The company has demonstrated a pattern of positive earnings per share growth over the past two years. We feel that this trend should continue. . . .
Our spreadsheet and projections for Evolution are as follows:
Correlations Remain Near Record Levels. The correlation of large-cap U.S. stocks has been around 85 percent in recent months -- measured by the percentage of large-cap stocks that rise or fall in sync with the S&P 500 – a record level. In such an environment there is not much room for securities selection to add value to a portfolio – but at some point correlations should decline to levels seen historically.
RBC Capital Markets issued a report last week on correlations and suggested how an active portfolio manager could address such conditions. Some of the graphs in their report are striking. Note the upward trend in the correlation between individual stocks and the S&P 500 index over the last several decades, and the recent record correlation:
High correlations have been historically associated with a market crash or other very swift decline during which all stocks tend to go the same direction. During the Crash of 1987 stock correlations with the S&P 500 index reached 80%. Given the severity and the brevity of that decline, the high correlation made sense. After 1987, the rolling correlation of stocks to the S&P 500 (using a median 60-day rolling correlation), rarely exceeded 60% until 2008 (see chart above – the red line is a 60% correlation).
The correlation with global equity markets has also increased:
Not only is the correlation between large stocks and the S&P 500 index at record levels, the correlation between US and European stocks are also extremely high compared to historical norms:
The report explained at least three factors contributed to this condition: (1) the increase in global trade and economic interaction, (2) the increase in program trading, and (3) the huge surge of ETF’s which are used by some for trading purposes:
The RBC study comments as follows on the situation:
A combination of record-high performance correlation and record-low return dispersion has made stock picking very challenging. We document a more synchronous global business cycle, the proliferation of ETFs, program trading, and rising portfolio turnover as important contributing factors.
To address the situation RBC suggests active managers adopt as follows:
Until correlation moderates, our prescription is to operate with a reduced number of portfolio holdings and to place greater emphasis onsector and style effects. Concentrated portfolios are more likely to offer lower correlation. At the same time, we find that substantial return variation still exists at the sector and style level. . . .
A graphical representation of a Monte Carlo simulation of correlations versus the number of stocks in a portfolio resulted in the following chart:
A very interesting report and suggested approach to deal with the high correlations seen in today’s market. We agree with their analysis – and have implemented their suggested course of action by concentrating our portfolio – over the last 24 months. Two years ago the LSGI portfolio a year ago held 18 stocks, one year ago the LSGI portfolio was comprised of 15 stocks, but as of December 1, 2011 we cut the number of positions back to just 10 – a concentrated portfolio of our ‘best ideas’. Most were in the energy or agricultural sectors. While the portfolio volatility might increase with the reduced number of positions, the chance of outperformance also increases.
December 24 — Saturday: Small Cap January Effect; LSGI Portfolio Developments As we near the end of the year discussions of the “January effect” have appeared in some analyst discussions. As long term investors the tax selling in December in the illiquid sectors of the market create opportunities to acquire attractive firms at compelling prices.
January Effect. Frank Holmes of US Global Investors penned an interesting piece last week on their blog entitled “January Effect Begins Now”. He examines the historical data that shows that small capitalization stocks have outperformed large cap stocks during the first month of the year. What is interesting in the data the ‘January Effect’ tends to start in mid-December, or at least it has historically. He notes as follows:
. . . According to Yale and Jeffrey Hirsch, small-caps have delivered a forceful blow to their larger counterparts in 40 out of 43 years from 1953 through 1995. But if you dissect the performance of the small-cap Russell 2000 Index versus the large-cap Russell 1000 Index from December 15 through the end of February, you’ll see that for the last 30 years, most of the “January Effect” actually occurred within the last two weeks of the year.
Hirsh concludes: “With all the beaten-down small stocks being dumped for tax loss purposes, it generally pays to get a head start on the January Effect in mid-December.” Chart courtesy US Global Advisors.
Richard Bernstein in his 2012 outlook also likes small company stocks. His December 9th publication makes the argument for small cap stocks:
We continue to believe that the best secular investment theme in the global equity markets is US small cap stocks. Smaller US companies are starved for capital much the way that emerging markets, energy, and commodities were ten years ago. By definition, capital starved companies’ higher cost of capital translates to higher expected returns for investors.
Investors appear to be overlooking smaller US companies’ fundamentals. . . ., companies in the Russell 2000 have been producing positive earnings surprises at a better rate than most other regions of the world. Although smaller US companies’ earnings fundamentals are not yet superior to their larger US counterparts, we believe that relationship is likely to reverse.
Some investors are concerned about the valuations of smaller capitalization stocks, but we think those views ignore smaller companies’ earnings potential. Chart 7 shows that US small caps remain one of the fastest growing segments of the global equity markets. In fact, the 2012 projected earnings growth rate for the Russell 2000 is presently three times that of China’s and nearly four times that of emerging markets in general.
The caveat to investing in smaller companies is their stocks’ typical volatility. Smaller companies are extremely sensitive to changes in the macro-economy. In the “risk on/risk off” world, smaller companies tend to significantly outperform when risk is “on”, and significantly underperform when risk is “off”. However, despite the volatility during 2011, the Russell 2000 has nonetheless outperformed the MSCI Emerging Market Index by about 10% so far during 2011.
As we noted in our last LSGI Report the companies in our portfolio on average grew revenues year over year by around 50% - an incredible rate of growth in a slow growth economy where S&P 500 companies are growing revenues by around 11%.
LSGI Portfolio. One of our major holdings, FX Energy (FXEN), was initiated at ING Group as a ‘buy’ last week. Separately, analysts at MLV & Co reiterated a "buy" rating on shares of FX Energy in a research note to investors on Monday, November 28th. They now have a $11.00 price target on the stock. FXEN is selling currently below $5 per share.
Analysts at Rodman & Renshaw raised their price target on shares of FX Energy to $9.50 in a research note to investors on November 10th. Also, analysts at BMC Equities Research initiated coverage on shares of FX Energy in a research note to investors on October 3rd. They set a "buy" rating on the stock.
Thomson Reuters reports the company is covered by eight analysts with a ‘buy’ consensus recommendation. The median 12 month target price of the analysts is $9.00 per share – a 90% gain from the current market price.
FXEN is an independent oil and gas exploration and production company with principal production, reserves, and exploration activities in Poland. It also has oil production and oilfield service activities in the North Dakota/Montana Bakken field. The company has a market cap of only $250 million. Jon Markman wrote a piece on LSGI holding Evolution Petroleum (EPM) last week entitled “Well Recycling’ Works Well at Evolution” at investorplace.com:
Sometimes a company comes along that shakes up an industry that thought it already had all the answers. That’s the way I look at the remarkable energy small-cap Evolution Petroleum. Evolution is a small, Houston-based oil and gas firm that operates production facilities in Texas, Oklahoma and Louisiana. What makes this little gem special is that it operates a model that varies greatly from the traditional drillers of the world such as Apache and Anadarko Petroleum. . . .
This model allows Evolution to spend very little in its quest to make sizable discoveries. Nice business plan. CEO Robert S. Herlin has said the firm is particularly interested in acquiring wells that have been orphaned because of the expectation of low margins and limited upside. . . . This process only works if Evolution can efficiently extract oil and gas where other firms cannot. This is where its proprietary technology comes into play. An example: artificial lift technology developed by operations vice president and inventor Daryl Mazzanti.
Mazzanti’s technology is aimed at extending the life of oil production in horizontal wells, and Evolution estimates that it can recover an additional 10% to 15% at a cost of less than $10 per barrel of oil equivalent. That’s phenomenal, and something no one else is doing. . . . The company is in extremely strong financial shape, with no debt and a cash position of $4.5 million. Evolution is seriously undervalued by the Street, with an enterprise value of only $190 million despite reserves estimated to be worth as much as $375 million.
Evolution has grown revenues by 21.3% annually during the past five years while increasing positive free cash flow each year. The Street is just catching on, as shares are up 44% this year. Analysts are expecting the company to earn 65 cents per share in 2013 for a valuation of 12.5 times earnings. There’s still a lot of room for EPM to advance even if oil prices weaken, so it’s still buyable.
We agree with Jon’s analysis. EPM in our opinion remains very attractive at current market prices. The average analyst rating is a strong buy. The analyst’s median 12 month target price of $10.50. The stock is currently selling for $8.50. The company is very small with a market cap of only $240 million, and has no debt. Our target price, based on company reserves, is higher than the median analyst estimate. LSGI and related entities own more than 1.2% of the company.
US Gasoline Expenditures. The AP reported last week that the typical American household will have spent $4,155 for gasoline in 2011, a record. That is 8.4 percent of median family income, the highest share since 1981. Gasoline averaged more than $3.50 a gallon this year, another record.
The article notes that “next year isn't likely to bring relief”. Because demand for crude oil is rising globally, especially in the developing nations of Asia and Latin America, prices are net expected to decline. This squeezes the U.S. economy, where unemployment is high and income is not rising.
In 1981 the economy was sliding into recession and oil prices were high because of Middle East turmoil. At that time gasoline accounted for 8.8 percent of the typical household budget. Over the past decade, gas has taken up on average 5.7 percent of the family budget. If families had spent 5.7 percent this year, they would have saved $1,300.
Bottom line higher energy prices will not stimulate the economy. On the other hand they are not high enough to stop the economy from growing. As a result investors in the energy sector should do well.
December 22 —Thursday: Foreign Direct Investment Falls Short—Crude Oil Productive Capacity at Risk (continued) Supporting our argument that the Arab Spring will be much more disruptive, and last much longer than many expect, Dr. A. Alhajji (Contributing Editor to World Oil) recently published an article on the subject. As we have, Dr. Alhajji concludes that future oil supplies from the Middle East/North Africa areas will be less than forecast – creating opportunities for North American producers. His comments include the following:
Years-long Arab Spring One of the most important implications of the “Arab Spring” for the oil and gas markets is not only the oil and gas lost this year, but also the loss of production that was expected to come on line in the next few years. . . . political instability in the Middle East might not end with the fall of a dictator or a change of a regime.
As I stated in my column last June, “Demonstrations and turmoil are expected to continue in the foreseeable future, casting their shadow on global oil and gas markets. What we are witnessing is a ‘clash of generations.’ The removal of a president or a regime will not bring back stability. Therefore, the risks that existed before the collapse of the regimes will continue for an extended period of time.”
Some experts believe that the entire Arab World has experienced the Arab Spring in one way or another. They see any increase in government spending, increased subsidies, new training and employment programs, and increased salaries and benefits of government employees as policies needed to avoid an Egypt-like or Libya-like crisis. The threatened governments are responding to the demands of people in their own way.
The massive increase in spending will affect global oil markets in various ways. These countries require higher oil prices than ever to fund their budgets and maintain the peace. If oil prices decline, these countries will cut production to support prices. It just happened that cutting production is also a populist move. As a result, cutting production appears to be beneficial in both economic and political terms. In short, the Arab Spring has created a higher price floor for oil in the coming years. . . .
In conclusion, the amount of oil that will flow out of the Middle East in the coming few years will be less than what was expected, creating opportunities for majors and independents, especially in North America, West and East Africa, and hot spots in Latin America.
The entire Dr. A. Alhajji article can be accessed at: World Oil / December 2011 23— http://www.worldoil.com/December-2011-Oil-and-Gas-in-the-Capitals.html
December 20th—Tuesday: Foreign Direct Investment Falls Short—Crude Oil Productive Capacity at Risk Unrest in the Middle East and North Africa reduces foreign investment in energy projects in the area—investment that is needed to maintain and expand crude oil production capacity. Longer term, the lack of sufficient investment is ominous according to the International Energy Agency (IEA) - and could lead to much higher crude oil prices.
Investment Needed to Maintain Oil Supplies. At a world energy outlook symposium in Singapore last week the International Energy Agency (IEA) stated that world oil prices may jump to US$150 a barrel or higher if investment levels are not increased, or at the very least maintained, in the Middle East and North Africa. Fatih Birol, the Chief Economist at IEA, claims that oil producing countries need to spend $100 billion per year over the next four years to ensure output meets demand. Demand is growing fastest in emerging economies including China and India he noted, and said that current oil prices pose "a major risk for the economic recovery worldwide."
OPEC crude oil production has been stagnant or falling in recent years in Algeria, Ecuador, Iran, Kuwait, Libya, Nigeria, Saudi Arabia, the UAE and Venezuela. According to recent studies depletion is reducing oil output by around 6.7% per year, so capital needs to be invested just to maintain existing productive capacity—much less expand productive capacity.
Stability & Democratic Government. In light of the capital needs for the energy sector in the Middle East/North Africa David Rosenberg of Media Line reports that “as the Arab Spring approaches its first anniversary, the economic costs of toppling autocrats is now growing for countries like Egypt, Tunisia, Libya and Syria. But foreign direct investment (FDI), one important remedy for economic revival, looks like an increasingly distant prospect amid the continuing political turmoil” – an important point we agree with.
Long term capital investments in the energy sector by third parties require a stable operating and political environment – something increasingly rare in the area. Rosenberg continues:
“The return of foreign investment depends on a number of factors the most important of which is the return of a stable security environment. The way things are now investors will be reluctant to make investments where they don’t know what will be happening in the space of weeks,” said Joseph Lee, Middle East and North Africa analyst at London-based Business Monitor International.
“The other problem is policy,” Lee told The Media Line. “Right now, it’s a clean slate. There are political parties that have stated that they will have market- friendly policies, but who knows to what extent they will be enacted.” . . .
The World Bank forecasts declining FDI – the kind of investment used to build factories, infrastructure and homes and buy companies – for the Middle East and North Africa this year and next, with growth resuming in 2013. A survey of 316 senior executives from multinational companies investing in developing countries by the bank’s Multilateral Investment Guarantee Agency, published in a report last week, shows how immense the challenges of luring them back will be.
The poll showed that investors have two tough preconditions before they are prepared to return to the region with their capital – a year of “stability” and a “democratic government.” Those two conditions being met, more than half said they would invest in the Middle East and North Africa. . . .
The World Bank survey found that instability even under a democratic government would cause more businesses to decrease their investments than increase them. Non-democratic governments would deter investment, no matter what the political and security situation is, the poll found.
The World Bank’s estimates are confirmed by the Kuwait-based Arab Investment & Export Credit Guarantee Corp., which in October said the flow of FDI to the Arab world would slump by about a fifth this year to $55.1 billion, compared with $66.2 billion in 2010. It said Egypt would suffer the biggest drop, a 92% plunge to just $500 million in 2011.
In addition to the stability and democratic government structural issues, the political barriers to private oil company equity investment are usually steep. National oil companies are difficult to deal with, and costs from delays and disputes can be substantial.
In addition, in a disruptive environment Middle East governments are allocating more funds toward social purposes in an attempt to maintain stability, reducing government funds available for investment. Further, with strong population growth the revenues per capita received for oil exports is not as high as it has been historically, as can be seen in the following chart:
Iraq War Not Over?. Developments in Iraq this weekend after the U.S. pullout illustrate the lack of stability and democracy and issues companies will face when evaluating investments in the area. A major Sunni dominated party has announced they will boycott participation in the Shiite controlled legislature claiming they are being removed from effective power once the U.S. left, increasing the potential for violence against them. The Washington Post described the problem:
“We think there are new indications of a new attempt to create a dictatorship,” said Deputy Prime Minister Saleh al-Mutlaq. “We are really worried that the country is being led into chaos and division and the possibility of civil war is there.”
A brewing confrontation in the province of Diyala underscored the risk that violence could erupt. After the mostly Sunni leadership of the province declared last week that it intends to seek regional autonomy under the terms of Iraq’s constitution, Shiite militiamen surrounded the provincial council headquarters and set fire to the Sunni governor’s home.
A paper in Saratoga, New York, discussed the outlook for Iraq with some local experts:
. . . Siena College political science department chair Len Cutler agreed that unrest would be an ongoing concern in Iraq. “Certainly the war is not concluded. There is a great deal of internal strife, internal violence and potentially internal disruption that’s going to be endemic for the foreseeable future,” Cutler said. “… Iraq is a very unstable, dysfunctional nation state that is located in a region that is the hotbed of Arab Spring.”
One issue in particular that could cause strife is future oil production, which Cutler said may not reach current global peak production levels as hoped. Potential disputes between regional and national governments over the selection of oil company locations could also arise, he said, in addition to continuing regional power struggles between Sunnis, Shiites and Kurds
“I guess I’m not painting a very rosy picture here with respect to what the immediate future portends for the nation state of Iraq, even though we’re saying the war is over,” Cutler said. “For American fighting forces, the answer is yes. But that’s only part of the story.” [The Saratogian]
Add in the violence last week in Yemen, Egypt, and Syria – all oil exporters - and the uncertainty and risk for investors in the area remains substantial. And hundreds of oil workers held a third day of protests in the capital of Kazakhstan's western oil-producing region after at least 50 people were killed in the state's deadliest riots in decades. The country's crude production is estimated at around 1.6 million barrels per day, similar to Libya's before its civil war. Bahrain has also faced protests in the last week.
Conclusion. Going forward we don’t think many of the political issues in the Middle East/North Africa area will be solved quickly or peacefully. Investments in energy projects will lag what is needed to maintain crude oil output, much less provide the capital needed to increase capacity. The IEA concern about lack of investment – and their concern about ongoing demand growth outstripping supply growth – is valid. Unless things change significantly expect to see higher global oil prices – or economies handicapped by unusually high energy costs.
History has shown when OPEC spare capacity falls oil prices tend to rise – a condition we expect to see over the next several years:
Charts courtesy Steve Yetiv & L. Feld.
December 18th—Sunday: Correlations & Volatility Rocket Upward; Energy Sector Long Term Trends Remain Very Positive This has been a disappointing year for many investors. Year to date the S&P 500 index, the benchmark for many managed funds, is down 3.0%. The Russell 2000 small cap index is down more like 7.9% year to date. Since July market volatility has rocketed to near record levels. Correlations continue to remain much higher than we have seen historically. Politicians and central bankers continue to prove ineffective at addressing global financial issues.
Keep in mind it could be worse. Bank of America is down 60% year to date. CitiGroup down 45%. Goldman Sachs down 45%. Morgan Stanley down 42%. JP Morgan down 24%. The financial sector has taken a tremendous beating—and not without reason. At least the energy/agriculture/commodity sectors produce real products used by real companies and individuals—not derivative products and abstract ‘investment’ opportunities offered by many in the financial sector.
While all these facts are depressing, we think longer term investors should do better in the market—stock prices to valuations are at levels as depressed as we have seen in the last three decades. Keep in mind during the malaise of the 1970’s a similar mind-set evolved toward stocks and the U.S. economy—and that was a good entry point for long term investors. A share in Warren Buffett’s Berkshire Hathaway in the inflationary 1970’s could be bought for $40 a share—the price dropping 50% during the ‘energy crisis’ recession in the early 1970’s. Yesterday you could buy, or sell, that identical share for $112,300.
Correlations & Volatility. Bloomberg reported last month that the Euro has influenced the U.S. stock market more than ever, “a sign that American equities aren't going anywhere until Europe's credit crisis is solved.” The link between the Dow Jones Industrial Average and movements in the Euro currency reached a record on Dec. 2, with the 60 day rolling average correlation coefficient reaching 0.85, the highest level since the Euro was founded in 1999. A reading of 1.00 means assets are moving in perfect lockstep.
The Euro and U.S. stock market is ‘joined at the hip’ due to the high correlation. This situation is frustrating for those who conduct extensive company research to locate undervalued firms with strong growth potential – regardless of the undervaluation or firm’s outlook stocks are all moving with the Euro, and with each other. The frustration increases when you add into the mix the extreme market volatility – driven to a large extent by global and political and economic factors outside an investor’s control. No wonder massive amounts of cash are outside the market, sitting on the sideline.
On the topic of correlation and volatility Frank Holmes, CEO of US Global Investors, made the following comments to their investors earlier this month – US Global does an excellent job describing the current investment environment:
“This year has been extraordinarily turbulent. In fact, 2011 ranks “among the most volatile market years on record,” says Oppenheimer. When you look at the average absolute daily price changes of the S&P 500, you’ll see that the period from July through the middle of November averaged 1.8 percent.
This is about a percent higher than the 60-year average, and just barely above 2008’s daily price changes. The fact is a little less significant when you consider that the 2008 number represents the entire year. Regardless, stock prices have been turbulent.
Note that Frank’s data in the chart above for 2011 was from July through mid-November — not the entire year. Since mid-year 2011 we have seen very high volatility levels, and we expect the volatility will decline from this outlier condition. He continues:
The S&P 500 isn’t the only index with extreme volatility, as stock markets around the world have been extremely correlated. Take a look at the chart below, which tracks the average two-year rolling correlation between the weekly price change of 23 different developed stock markets and the MSCI World Index.
Stock price correlation has remained above 80 percent since 2009—the highest over the 25-year period. Gloom Boom & Doom Editor Marc Faber says that he can’t “recall in the forty years that I have been working in the investment business, equity markets which were this correlated.”
No-one knows when volatility and correlations will return from record levels to the more ‘normal’ historical levels – but we expect they will revert to historical norms over time. As they do we expect undervalued firms with impressive growth potential, like those in the LSGI portfolio, will perform very well. As one commentator noted: “fundamental mispricings” are being “thrown up by high correlations”.
RBC Capital Market Charts. RBC Capital Markets published a report last week with some very interesting charts. Most speak for themselves – of the hundreds of charts we found the following the most interesting, they tend to point to a bullish picture for 2012:
Barron’s on Commodities: Oil, Corn May Be '12 Winners. In this week’s Barron’s they note that the market for crude oil looks very attractive for the coming year – something we agree with:
Commodities are slumping into the end of the year, driven lower by fears that the failure to resolve the mounting debt problems of some European Union members is weighing on global growth and reducing demand for raw materials. . . . .
Beneath that short-term pain, however, commodities bulls have some things to cheer. Oil and corn will enter 2012 with lower stockpiles and resilient demand. Gold could benefit if governments resolve to prime Europe's economic pump. When near-term worries subside in Europe, oil and corn prices could post gains to rival gold and some of its precious-metal peers. . . .
For a commodity with fundamentals that point higher, look no further than oil. This month the Organization of Petroleum Exporting Countries kept production quotas unchanged for its members, and the International Energy Agency said the move could tighten crude supplies.
Barclays Capital analysts said current estimates for growth in global oil demand suggest the world will need more OPEC supplies or be forced to dip into stockpiles. "Either option is likely to be highly price supportive," Barclays said in a recent note. While U.S.-traded crude futures have fallen back to the low $90s, prices could crack through triple digits again next year. . . .
Add into the mix the high probability of continued supply disruptions in North Africa and the Middle East due to the Arab Spring. The supply/demand fundamentals are tighter, and risks of a price spike higher, than many forecasters expect in our opinion.
LSGI Portfolio. We will highlight developments at several LSGI portfolio holdings here later this month. Of the ten companies in the LSGI portfolio three have a consensus rating of ‘strong buy’, six have a consensus rating of ‘buy’, and one has a consensus rating of ‘hold’. The forecasted revenue gains over the next 12 months (48.1%) are especially impressive in a slow growth economy.
The Federal Reserve reports that Americans’ wealth last quarter suffered the biggest quarterly loss in more than two years as stocks, pension funds and home values lost value (see comments and charts below). Household net worth fell 4 percent, the sharpest drop in over two and one-half years and was the second straight quarterly decline. Lower net worth levels can slow spending and hurt the economy – which is why the revenue gains reported by LSGI portfolio firms are so impressive.
December 15th—Thursday: Oil Demand Forecast to Grow in 2012; Oil Price Forecasts Raised; U.S. Gasoline Expenditures Hit Record Positive developments in the energy sector continue—which should be positive longer term for energy sector equities like those held in the LSGI Portfolio:
IEA Crude Oil Report. The International Energy Agency in their monthly report cut their crude oil demand forecasts for 2011 and 2012 – but both years are still expected to show robust demand growth. In 2011 global demand is forecast to reach 89.0 million barrels per day, up 0.7 million per day over year earlier levels. For 2012 demand is forecast at 90.3 million barrels per day, up 1.3 million barrels per day from 2011 levels. Both will be record consumption levels.
The Financial Times carried the following charts illustrating the historical and expected gains in global oil demand, and the historical price:
Keep in mind as global demand is forecast to increase supply interruptions continue in Libya, Yemen, Syria, and several other areas. While Libyan oil is returning to the market exports have come no-where close to pre-revolution levels. Note the spread between Brent crude prices and WTI prices has declined (see chart above) as inventories in Cushing, Oklahoma, have fallen (see chart below) and remain near 52 week lows (chart courtesy Bloomberg):
We expect the Brent/WTI spread to remain well below the $25 a barrel level we saw several months ago, in part due to these lower Cushing inventory levels.
With oil prices pushing $100 a barrel in the face of a slow growing U.S. economy The Wall Street Journal published an article this week on how global demand is pushing crude oil prices higher. U.S. demand has remained relatively stable over the last few years. Bottom line is that prices and demand are being set by factors outside the U.S. A chart of U.S. crude oil demand versus global demand ex-U.S. illustrates the trend – and why growth in China, India, and Asia (should it continue) will drive oil prices higher (chart courtesy Wall Street Journal):
In another article in the Wall Street Journal they noted the oversized impact of economic growth in China on the demand and price for commodities:
Full Speed Ahead If China's consumption of commodities continues to grow at the rate it has over the past 10 years, this is what the world would have to do to meet that demand in 2020, assuming that the rest of the world's collective appetite doesn't change at all:
.• Pump almost as much additional crude oil as Saudi Arabia now provides per year.
• Grow more than three times as many soybeans as currently come out of Iowa, which alone provides 5% of global output.
• Extract nearly three times as much new copper as the current annual production from Chile, which mines about four times as much as any other nation.
And that's just for starters. Vast increases in supply would be needed for all sorts of other commodities as well.. . .
Longer term, global demand for commodities and energy will continue to grow – which should be bullish for these sectors, and for investors.
China Oil Demand. Reuters reported that China's oil demand in November increased to the second highest in history. Refineries in the world's second-largest oil consuming country ramped up production to record high levels to ease domestic diesel shortages. Demand rose to about 9.5 million barrels per day (bpd) last month. For the first 11 months imports of crude oil were up 6.1% over the year earlier period. While volumes of imports were only up 6.1% the cost of the imports was up 46% due to crude oil price increases.
Crude Oil 2012 Pricing Forecasts. Reuters reports that Goldman Sachs is among the most bullish for oil prices over the next 12 months. They expect Brent crude will average $120 per barrel, up from $111 in 2011. The bank's optimism is matched by UniCredit (which is also predicting average prices of $120) and outdone only by CIBC ($123). Goldman has been the most optimistic for the past five years, and was the most accurate forecaster for 2011. Strong demand, coupled with Libyan supply disruptions, sent prices much higher over the last year.
The average Brent price forecast in a poll conducted by Reuters in late November was $107 per barrel in 2012, virtually identical to the prevailing price of $109 and not significantly different from the $111 average in 2011.
Reuters also reported that Citigroup raised its 2012 price forecast for Brent crude oil citing supply disruption outside of Libya, low oil inventories in Europe, and escalating geopolitical tensions. Citi expects Brent crude oil to trade in a range of $100-$120 and to average $110 for 2012, up from its previous forecast of $86 per barrel, which was set in August.
Citi analysts noted that in 2011 “about 1 million barrels per day of supply has been curtailed from Azerbaijan, Canada, China, Colombia, Mexico, the North Sea, Russia, Kazakhstan, Syria, the US, West Africa and Yemen." .
LSGI Trading Room. The LSGI Trading Room was dedicated at the Michigan Technological University School of Business and Economics last month. Students have access to Bloomberg machines and computer databases to assist in their research. The undergraduate finance students manage $1.3 million of the University’s endowment in the Applied Portfolio Management Program.
2012 Gasoline Price Outlook – Record Spending on Gasoline in 2011. An expiring ethanol tax credit will likely boost gasoline prices at the pump by a nickel on New Year's Day. Gasoline prices could rise above the $4-per-gallon mark by spring, said Tom Kloza, chief analyst for Oil Price Information Service. Gasoline at $4 per gallon "is a certainty for a number of states unless we have a financial collapse in Europe or a recession in the U.S.," Kloza predicted.
The Beaumont Enterprise reported that Kloza, who monitors gasoline prices nationwide, forecast prices could rise to the $3.75- to $4.50-per-gallon range. While $4.50 per gallon is unlikely, Kloza said it is the most "apocalyptic view" of gasoline prices. Exports of gasoline and diesel products are at record highs – keeping U.S. inventories relatively modest and product prices higher than they would be otherwise.
With crude oil prices near $100 Kloza thinks gasoline should be selling closer to $3.45 a gallon than the $3.00 a gallon many Texas are now paying. Over the next several months he sees prices moving higher, toward the $3.45 level. We agree with his analysis.
While many forecasters see higher gasoline prices next year the LA Times reports that American drivers broke a record broke a record this week - they collectively spent more than $448 billion on gasoline since the beginning of the year, according to the Oil Price Information Service, beating the previous record for gas expenditures set in 2008 — with weeks of driving left in 2011.
LSGI Portfolio Holdings. Independent energy producer FX Energy (FXEN) was reiterated as a buy with an $11 price target by MLV & Co.. That's more than double what the stock is trading for today. MLV’s note summarized their analysis:
"We recently met with the entire Polish geological/operational executive management team, and we continue to be impressed with FX's approach toward the considerable potential resource in Poland. We discussed several project areas that are not included in our RNAV or the Company's internal valuation, and that will be drill-ready in very late 2012. We have great faith in prospect generation, but not as great a faith in timing, so we reiterate our BUY rating for the long term investor," MLV said in a note.
Dan Steffens of the Energy Prospectus Group also rates FXEN as a buy, and has included the company in their “Sweet 16” portfolio. Dan made the following comments on current energy share valuations:
I have been doing this for eleven years. I have never experienced a more dour mood among investors, except for a few months at the end of 2008 right after the market crashed. I have never seen the share prices of companies with rock solid fundamentals trade at such low multiples for this long.
The upside from here is that it won’t take much good news to move stocks higher. All most investors need to believe is that Europe’s debt issues are not going to push the global economy off a cliff. There is a lot of cash, generating zero returns, sitting on the sideline just waiting to jump back into the markets.
My focus is primarily on near-term production and reserve growth. Commodity prices will take care of themselves. We want to own companies that are building real value for their shareholders. For E&P companies, that means building proven reserves.
Electric Rates & Household Costs. USA Today reports that “electric bills have skyrocketed in the last five years, a sharp reversal from a quarter-century when Americans enjoyed stable power bills even as they used more electricity.”
Households paid a record $1,419 on average for electricity in 2010, the fifth consecutive yearly increase above the inflation rate, the article noted. Electricity is consuming a greater share of Americans' after-tax income than at any time since 1996 USA Today reports — about $1.50 of every $100 in income. The analysis concludes that greater electricity use at home and higher prices per kilowatt hour are both driving the higher costs. The following chart of electricity costs was included in the USA Today article – clearly illustrating the long term trend for higher household costs:
As older coal fired plants are replaced by natural gas units, additional environmental controls are installed on existing plants, and transmission and distribution systems are improved, the cost per kilowatt should continue to escalate along with the household electricity costs. Longer term the shift of generating units from coal to natural gas should be bullish for natural gas prices—but short term we still see natural gas supplies much higher than the market will support at a reasonable price.
U.S. Fed Wealth Survey. The Federal Reserve reported this month that during the third quarter of 2011 the value of household assets – houses, stocks, bonds, and other investments – declined by around 4% from the second quarter. This was the steepest decline since the fourth quarter of 2008, and the second straight quarterly decline.
The report is significant to the extent that rising wealth tends to increase consumer expenditures, and falling wealth has the opposite effect. A chart of the trends was included in a Wall Street Journal article:
Note household wealth is still well below levels seen 5 years ago – and now is trending downward. This is not a good sign for consumers, or the economy.
December 12th—Monday We were interviewed by Jim Puplava on the outlook for the energy sector—long term supply and demand trends are very positive in our opinion. The FSN website carries our interview:
Joe Dancy joins Jim to talk about energy and sees global inventories and supply/demand metrics supporting continued high oil prices. In real terms, 2011 will have the highest average oil price in 147 years: WindowsMedia or Winamp
Details of firms we find attractive—and studies and reports that support our higher energy price thesis—are set out below in postings late last month.
November 30 — Wednesday — Crude Averages Over $100 in 2011; LSGI Portfolio Firms; Mideast Supply Concerns The correlation between individual stocks and the major indexes stand at or near record levels according to a recent report in Barron’s. Since 1972 the median correlation of a stock in the Standard & Poor's 500 index to the S&P index itself over the prior three months has been 0.46, meaning 46% of individual stocks moved the same way as the index. Last month it hit 0.86 – stock prices tracked each other very closely, making it a ‘nightmare for stock pickers’ according to the article.
While stock selection tends to add little value when the market is so highly correlated keep in mind this high correlation is very unusual – and at some point the underlying value of attractive companies will be recognized (if nothing else as a result of acquisitions). The LSGI portfolio performed as follows last month:
In addition to the record correlation between individual stock prices and the S&P 500 index discussed above, the high degree of correlation can also be seen in the large and growing number of days in which at least 90% of all stocks in the broad S&P 1500 moved in one direction. Barron’s notes this happened 14 times in 2006. The next four years' tallies were 23, 39, 44 and, last year, 47. So far this year there have been 58 such days, most of which occurred in the last two months.
Because small company stocks tend to be more volatile, these movements tend to be magnified. But keep in mind in the end we are investing in the underlying company. The high degree of correlation creates investment opportunities to acquire firms at a discount.
Companies in the LSGI portfolio had a median trailing twelve month revenue gains of 27.7% versus the median trailing revenue gain of companies in the S&P 500 of 10.7%. In a slow growth economy these types of impressive gains are not common – and eventually will be reflected in LSGI portfolio share prices.
For the fourth time in five years the video card in our Dell laptop computer failed – so our postings on investment and energy sector developments were delayed a week or so as the equipment was repaired. Some of the more interesting developments in the energy, agriculture, and investment world include the following:
LSGI Portfolio Updates. Dan Steffens of the Energy Prospectus Group has updated his spreadsheet and analysis of LSGI holding Evolution Petroleum Corporation (EPM). Dan continues to find the firm attractive – it has no debt, no capital expenditures required for their major asset (Denbury operated Delhi field) – and production that should double over the next year and continue to expand into 2013. An impressive niche player, a profitable microcap firm in the domestic crude oil market – and production is sold based on the higher Brent crude pricing. Dan’s comments include the following:
We are now convinced that production in the Delhi Field will accelerate over the next two fiscal years. At current oil prices, there is a good chance the project will reach payout by mid-2013. At that point, EPM will convert its ORRI to a working interest and their NRI will jump to 26%, almost triple what it is today. EPM has positive working capital and no long-term debt. It is currently trading at roughly half the present value of its proved + probable reserves. We see additional upside beyond the Delhi EOR Project …
TheStreet upgraded EPM after the recent conference call:
Evolution Petroleum Corporation (AMEX:EPM) has been upgraded by TheStreet Ratings from hold to buy. The company's strengths can be seen in multiple areas, such as its robust revenue growth, largely solid financial position with reasonable debt levels by most measures, impressive record of earnings per share growth, compelling growth in net income and expanding profit margins. Although the company may harbor some minor weaknesses, we feel they are unlikely to have a significant impact on results. Highlights from the ratings report include:
EPM's very impressive revenue growth greatly exceeded the industry average of 35.6%. Since the same quarter one year prior, revenues leaped by 232.3%. This growth in revenue appears to have trickled down to the company's bottom line, improving the earnings per share.
EPM has no debt to speak of therefore resulting in a debt-to-equity ratio of zero, which we consider to be a relatively favorable sign. Along with this, the company maintains a quick ratio of 6.85, which clearly demonstrates the ability to cover short-term cash needs.
EVOLUTION PETROLEUM CORP reported significant earnings per share improvement in the most recent quarter compared to the same quarter a year ago. The company has demonstrated a pattern of positive earnings per share growth over the past two years. We feel that this trend should continue. . . .
In the quarterly earnings conference call last week they noted they received almost $106 a barrel last quarter from Delhi Field production. Volumes from that field were up 48% from the earlier quarter as the carbon dioxide flood begins to yield results. The reservoir quality has been better than expected, and the response has been better than expect to the injections. EPM management has indicated they think the field has upside as management thinks more oil in place exists than originally estimated, and recovery and response to date has better than early estimates.
Denbury, the operator of Delhi field, thinks production will reach 5,000 to 10,000 barrels per day, which could result in a 2,300 barrel per day net to EPM versus a net of 326 barrels per day in the first quarter. We are still in the very early production growth phase in the Delhi Field.
FX Energy (FXEN) made a presentation to institutional investors and updated their corporate presentation. The firm develops natural gas in Poland. It has seven projects expected to be drilled in the next year that could more than double the firms reserves on a risk adjusted basis – and expects production to increase by 40% over the next year as wells already drilled come online. The most recent presentation is at the following link:
http://www.fxenergy.com/files/presentations/FXInvPres20111122.pdf
FXEN is one of the “Sweet 16” companies in Dan Steffen’s Energy Prospectus Group portfolio. Bernstein Research notes that natural gas markets in Europe will continue to tighten in a recent report as development of Poland’s shale reserves have yielded marginal results even using the latest drilling and hydraulic fracturing technology. Declining indigenous production, increasing flows of liquefied gas to higher-priced Asian markets, peaking Norwegian output and gas-fired power demand climbing at a rate of about 1.3% a year will make natural gas markets tighten – and Polish gas sells from roughly $10 mcf (versus roughly $4 a mcf or less in the U.S.).
Bernstein noted:
“Recent data from Poland’s shale gas wells validate our concerns about European shale gas: poor flow rates in over- pressured, hard-to-develop shales,” Bernstein analyst Oswald Clint in London said in the report. “Conventional gas markets should tighten rather weakening on a shale gas boom.” . . . Conventional gas producers will benefit, the report said . . .
If their analysis is correct – and we think it is – FX Energy is in a great position with their huge acreage position and portfolio of conventionally developed natural gas fields. Exploration in Poland has been sparse for years due to political issues, which leaves many impressive prospects for FXEN to drill and develop under the current regulatory and political environment.
The company presentation sets out the long term growth in production – and the robust price paid for natural gas in Poland:
FXEN was upgraded after the recent earnings conference call:
Equities research analysts at Rodman & Renshaw raised their price target on shares of FX Energy (NASDAQ: FXEN ) to $9.50 in a research issued note to investors . . . Separately, analysts at BMC Equities Research initiated coverage on shares of FX Energy in a research note to investors on Monday, October 3rd. They set a "buy" rating on the stock. Analysts at Brean Murray initiated coverage on shares of FX Energy in a research note to investors on Monday, October 3rd. They set a "buy" rating and a $9.25 price target on the stock. Also, analysts at C.K. Cooper initiated coverage on shares of FX Energy in a research note to investors on Thursday, September 15th. They set a "buy" rating and a $9.00 price target on the stock.
Merger & Acquisition Activity. KKR agreed to acquire most of Samson Investment Co. last week for $7.2 billion to capitalize on increased production of domestic shale-based oil and gas. Samson is a private natural gas and oil producer located in Tulsa, Oklahoma.
One report noted that total global oil & gas transaction value for the third quarter 2011 jumped to $43 billion in 166 transactions, up 53% from the second quarter value of $29 billion. The continued deal making and merger activity in the sector should help put a floor under energy sector equity prices.
IEA Report & Crude Oil Inventories. The IEA issued a global energy outlook and made a presentation to the press on long term trends. Some of their more interesting slides speak for themselves:
Meanwhile U.S. crude stockpiles fell 6.22 million barrels in the week ended Nov. 18 to 330.8 million barrels, according to Wednesday’s Energy Department report, the biggest drop in nine weeks. Supplies were expected to climb 500,000 barrels. European crude oil inventories remain at 8 year lows as concerns over supplies disruptions rise with North Africa and Middle East unrest.
Bloomberg reported on how tight the energy markets remain:
Inventories of crude and refined products in industrialized nations fell below the five-year average for a third consecutive month in October, the first time that’s happened since 2004, according to the Paris-based IEA. Stockpiles declined by 11.8 million barrels to 2.68 billion. . . . “Inventory levels and spare capacity in commodities, certainly in the oil sector, are a lot lower than they were in 2008,” said Colin O’Shea, the London-based head of commodities at Hermes Investment Management Ltd., which has about $2 billion in raw-material holdings. “I don’t feel that the demand loss that we could potentially have now is the same as it was in 2008.”
Goldman Sachs Group Inc. raised its forecast for West Texas crude to $102 a barrel for the first quarter based on supply/demand metrics. JP Morgan Chase cut the West Texas Intermediate price forecast for next year to $107 per barrel from $110 and lowered its Brent outlook to $112 per barrel from $115.
Potential Supply Interruptions due to Middle East/North Africa Unrest. Political unrest in oil producing nations has always been a risk to the global energy markets – but current events are much more frequent, and have the potential to be much more disruptive, then we have seen in decades. Recent developments include:
Saudi Arabia. Saudi Arabia is the largest OPEC oil producer with reported production of around 9.5 million barrels of crude oil per day. Four people died in clashes in Saudi Arabia this week between Shiite Muslims and Saudi security forces in the oil-rich Eastern Province. Apparently Shiite protests erupted with security forces and demonstrators clashing, resulting in the deaths and injuries.
The Shiite minority is concentrated in the kingdom’s eastern oil-producing hub. In addition, clerics in Iran called for the government in Saudi Arabia to step down – increasing tensions between the countries. The AP reported as follows:
. . . Interior Ministry spokesman Maj. Gen. Mansour Al-Turki later told a news conference in Riyadh that authorities had to deal firmly with what he described as "rioters and hired elements" to restore security. He said the "escalation of rioting" was systematic. . . .
The Interior Ministry previously blamed what it described as "seditious" residents, saying they attacked security forces with guns and firebombs with the backing of a foreign enemy - an apparent reference to Shiite power Iran. The ministry statement Thursday said the deaths in the new unrest were the result of exchanges of fire since Monday with "unknown criminals," who it said fired on security checkpoints and vehicles from houses and alleyways.
"There was an escalation in the limited rioting. This escalation reached the level of threatening the lives of citizen and national security," Al-Turki told reporters. He said investigation into who was behind the violence was under way. . .
Kuwait. Kuwait produces around 2.9 million barrels of crude oil per day. The ruler of Kuwait ordered the authorities to take “all necessary measures” this week to safeguard national security after dozens of protesters stormed parliament in the most dramatic act yet in a long-running campaign to oust the prime minister. Hundreds of others were outside the government offices.
The order was issued after an emergency cabinet meeting last week amid the most significant protests to hit the Gulf state since unrest began to sweep across the Middle East earlier this year. Forty-five protesters have been arrested.
The protests led to the injury of five police and Kuwait National Guard officers, the Interior Ministry said. Members of the opposition vowed to step up their protests, escalating the conflict. The Financial Times noted:
Protests in Kuwait have taken place at times throughout the year, since before the Arab Spring brought about demonstrations throughout the Arab world. But the anti-corruption protests have turned more violent recently, after members of the Kuwaiti opposition saw revolutions in Tunisia, Egypt, and Libya, and fighting between protesters and government forces in Syria. . . . The Kuwaiti opposition is now pushing not only for the downfall of his government, but for the prime minister himself to step down. Many chanted that they want to "overthrow" him, using iconic slogans of the Arab Spring. The emir, however, is firmly committed to keeping al-Sabah, a member of the royal family, in office.
Kuwait has substantially increased social spending to cope with potential dissatisfaction, raising expenditures to $7.6 billion in an attempt to avoid political upheaval or dissent. The press noted that “the protests signaled that even countries able to distribute such largesse were not immune from the sentiments sweeping the Arab world.”
Many Kuwaitis are upset at what they allege is corruption in the system, criticizing the use of the country’s oil funds and questioning why the country’s economy has fallen behind regional rivals.
Yemen. Yemen produces around 250,000 barrels of crude oil per day. Production has been slipping over the last few years as political unrest takes its toll, and it shut down its Aden 150,000 b/d refinery last month when its crude oil supplies dried up. The country shares a border with Saudi Arabia and has seen numerous attacks on oil and gas pipelines as demonstrators have demanded that President Ali Abdullah Saleh step down. Due to the unrest imports of crude oil or product will have to increase substantially according to some sources.
Last week the resignation of the President failed to end Yemen's violence as security forces killed five protesters demanding that the ousted leader be put on trial for past crimes including corruption and for violence during the uprising.
The AP reports that tens of thousands of protesters in Yemen have distanced themselves from the formal opposition movement and rejected the immunity clause, saying Saleh should face justice. They report demonstrators camped out in the capital of Sanaa chanted "No immunity for the killer" and vowed to continue their protests.
The resignation officially transferred power to his vice president and calls for early presidential elections within 90 days. But analysts note it could open the way to a likely messy power struggle.
While not a major producer, the fact that production has been interrupted and the country has become an importer will add to the demand side of the global ledger. In addition, the fact the country shares a border with Saudi Arabia raises cross border contagion issues.
Egypt. Egypt produces around 525,000 barrels of crude oil per day. Last week protesters demanded an end to army rule and battled police, presenting Egypt's ruling generals with their biggest security challenge yet. Parliamentary elections will occur next week. A number of people were killed and hundreds wounded in the rioting. |
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Joseph Dancy, Adj. Professor Energy & Environmental Law SMU School of Law
Guest Lecturer & Board Member, Michigan Tech Applied Portfolio Management Program (APMP) |
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LSGI Partners
Energy Prospectus Group: |