- 2009: Stuck In A Multi-year Oil Demand Downturn?
- Energy Companies and Returns To Shareholders
- Punxsutawney Phil: Springtime and Global Warming
- Energy Stocks May Be Returning to Favor
- Random Thoughts About Energy Markets?
2009: Stuck In A Multi-year Oil Demand Downturn? (Top)
Increasingly the economists and politicians discussing the current economic downturn are referencing the early 1980s recession, or in some cases the 1973-74 recession. Both of these recessions were hard and lasted about 16 months, whereas the current recession is only 13 months old, but is already a challenging one. There has also been talk by economists and stock market seers about how the current recession could morph into the next Great Depression. Unfortunately, a Great Depression comparison provides little help for investors trying to understand how energy markets might be affected. The International Energy Agency (IEA) in its recent oil demand forecasts has been commenting that the back-to-back declines of 2008 and 2009 would mark the first time for that to occur since 1982-1983, some 25 years ago
Exhibit 1. The 1980s Marked By Years of Demand Declines
Source: EIA, PPHB
In our November examination of the possible future course of the U.S. drilling rig count, we used the 1980s downturn to plot how the current rig count downturn might unfold if this one were similar. At the time, we speculated that if this cycle’s rig count fall followed the 1980s downturn pattern, we were at risk of losing about 1,000 rigs from peak to trough. Now, we are seeing and hearing estimates that this rig downturn will be so severe, largely because of how low natural gas prices have fallen and the absence of a catalyst for them to rise soon, that the rig count could fall to a low of 800 active rigs. We have had discussions with various drilling company management teams who suggest, based on the rate of weekly rig count declines that we could reach that target sooner rather than later. It’s amazing how, when things come unglued, the outlook rapidly shifts to the catastrophe scenario. Maybe it’s because people want to emulate President Obama.
If the U.S. rig count reaches the 800 working rig number sometime this year, the drilling industry will have lost about 1,200 active rigs from its peak activity level last fall. With that many rigs going idle, it will be extremely difficult for drilling contractors to sustain profitability and if a contractor has significant debt levels, companies may have issues with remaining in business. On the other hand, the level of optimism within the drilling contractor fraternity that this downturn will be quick to rebound is keeping managements focused on where the geographic strength will be on the upside.
The key question, however, is will the global economy remain depressed for several years making the energy demand forecasts of almost all analysts wrong, and suggesting that 2010 will be another down year for energy consumption rather than a year of demand recovery? As we have pointed out before, the 1980s downturn actually lasted for four years. The peak in oil demand came in 1979 and growth resumed in 1984. It was not until 1989, however, that global oil use exceeded the total consumed in 1979. Could a multi-year oil consumption downturn happen today?
There were several factors at work in the early 1980s downturn that contributed to it lasting as long as it did. First was the scope of the economic problems that led to the recession. Second was the energy-consumption adjustments undertaken by the United States, Europe and Japanese economies in response to the dramatic climb in oil prices that began in 1973. Third was the oil supply response driven by the fear of oil shortages and the correspondingly high oil prices experienced throughout the ‘70s. Let’s examine these issues and whether any of them exist today.
The 1970s was a decade marked by seismic social and economic shifts that radically altered the global status quo. The social stresses and economic turmoil that came from the Vietnam War and the various attempts to resolve it resulted in an accelerated inflation rate by the end of 1960s. Early in the 1970s, the automatic inflation-protection clauses incorporated into union labor contracts in the late 1960s in response to that period’s increase in inflation began to pressure the economy, even though the actual inflation rate, as measured by the consumer price index (CPI), was moderating. In fact, in 1970, the inflation rate flirted with 6% before falling back, but it remained above 4%, a rate thought to be intolerable. On August 15, 1971, President Nixon instituted wage and price controls on the United States economy along with ending the exchangeability of dollars for gold bullion. These were unique acts in peace-time, but they were supposed to only last for 90 days, but instead ended up lasting for 1,000. With the August pronouncement, the future course of the United States economy, and that of the world, was altered permanently. The change set in motion actions and reactions that have shaped our world.
Exhibit 2. High Inflation In Late ‘60s Set Off The ‘70s Era
Source: The Econ Review
In the energy world, seismic shifts were also occurring at this time. The low and regulated natural gas prices of the 1960s contributed to the U.S. beginning to run out of gas supply. To offset that eventuality, gas consumers began substituting oil for gas. The growth in global oil consumption began to strain supplies, especially as the United States, the world’s largest oil producer, hit peak production and began to decline. As these shifts were occurring, the Seven Sisters international oil companies commenced efforts to reduce the Middle East posted price for crude oil on which the royalties owed to the host producing countries, primarily those countries that were members of the Organization of Oil Exporting Countries (OPEC), were based. This effort angered those countries and, as the global oil supply/demand balance tightened, emboldened them to push for higher prices, increased taxes and eventually the partial nationalization of the production concessions. The shift in oil supply/demand fundamentals was altering the power in the global energy market in favor of OPEC.
While most people associate the Arab oil producers’ embargo of those western countries that supported Israel in the 1973 Six Day War, as the start of the rise in oil prices, the reality is that underlying oil market supply/demand trends had become sufficiently tight that producers could begin to extract economic rent for providing their oil to the market earlier in the decade. From $1.80 a barrel in 1970, posted oil prices rose to $2.55 by early 1971 and were then pushed up to $3.45. In response to rising inflation and depreciation of the U.S. dollar, OPEC members lifted oil prices and tax rates higher, and increasingly gained more control over the oil producing concessions they had granted to the international oil companies decades earlier. By the start of the fourth Arab-Israeli war on October 6, 1973, posted oil prices had climbed to $5.12 a barrel. A couple of weeks after the war, Arab oil producing countries imposed their embargo and in December, OPEC boosted oil prices to $11.65 a barrel, effective January 1, 1974.
In response to these energy industry dynamics, the Nixon Administration moved to put controls on oil prices leading to the August 17, 1973, announcement of a new, two-tier pricing regime – “old” oil, that oil produced at or below 1972’s average production level and sold at a March 1973 prices plus $0.35 a barrel and “new” oil, or the oil produced in excess of 1972’s average production level that was sold at uncontrolled prices. This intersection of politics and regulation distorted the oil market pricing mechanism and triggered the 1970s oil boom, which ultimately led to the industry’s 15-year recession.
Exhibit 3. 1970s Oil Prices Driven By Fundamentals First
Source: EIA
Most people remember the 1970s as a period of escalating oil prices, accelerating inflation, and severe government regulation. The reality is that oil prices jumped fourfold in 1973, remained essentially flat until 1978 when the Iranian revolution overthrew that
country’s government and resulted in the removal of its oil from the world market sending oil prices from the mid-teens to the mid-thirties. The subsequent Iran-Iraq war sent global oil prices to the upper thirties per barrel. This explosion in oil prices, coupled with the psychological impact of the Malthusian view of the globe’s future – too many people, not enough food nor sufficient raw materials to support them – contributed to a bleak outlook for living standards.
Out of the explosion of oil prices early in the 1970s emerged a huge energy conservation effort throughout the western world – the globe’s primary consumer of oil and gas. More efficient automobiles and household appliances; increased energy efficiency building standards; and greater use of nuclear and non-hydrocarbon fuel sources for power generation marked the world of the 1980s. That can best be seen in the United States by the impact of the amount of liquid petroleum fuel used to generate electricity compared to that sourced from natural gas. Coal also increased its contribution to the power generation mix.
Exhibit 4. Oil Supplanted By Gas For Electricity
Source: EIA, PPHB
This is a reason why the world’s demand for oil fell in the early 1980s and was slow to recover as the decade wore on. These energy conservation and fuel-switching trends were in addition to the decline in oil demand due to the economic recession set in motion by the harsh monetary policies implemented at the start of the 1980s in an attempt to break the back of the rampant inflation in the United States that had spread globally. The U.S. Federal Reserve took actions to push short-term interest rates above 20%, crippling manufacturing and commerce and undercutting consumer demand. The effect, however, was to cut the inflation rate in half to 6.2% in 1982 from 13.2% in 1980 and cut it in half again to 3.2% in 1983. But the resulting revival in economic activity did not reverse the energy efficiency gains put in motion during the second half of the 1970s.
For the four years 1980-1983, global oil consumption fell by a cumulative 6.5 million barrels a day. This consumption fall amounted to 7.5% of global oil consumption from 1979’s peak. Had this been the only oil market dynamic at work, the members of OPEC may have been able to compensate and prevent the cataclysmic fall in oil prices experienced in the mid 1980s as oil fell from $38 a barrel to $28 and then collapsed to near $10 before the bottom was reached. The other significant dynamic at work during this period was the growth in non-OPEC production stimulated by the twin factors of oil supply shortages and high prices.
The 1973 oil embargo set off alarm bells within the oil industry and governments that the world’s consumers could potentially be held captive to politically motivated oil supply shortages. Coupled with high oil prices, the petroleum industry embarked on a global exploration surge that resulted in the development of the hydrocarbon resources on
Exhibit 5. North Slope and North Sea New Basins in ‘70s
Source:
While these new supply basins had begun production during the 1970s, they matured as large and sustainable supply sources in the 1980s. The fall in global oil demand and the rise in OECD oil supplies combined to pressure OPEC’s share of world oil production. The loss of oil sales because of growing non-OPEC supplies created economic problems for the OPEC member countries. Those OPEC countries facing the greatest economic pressures from falling oil prices cheated on the reduced OPEC production quotas designed to help stem the oil price decline. As oil supplies in the global market grew, oil prices collapsed. This price collapse was a contributing factor in the battle to reestablish low inflation worldwide and it helped to stimulate a global economic recovery that eventually became one of the longest sustained economic growth periods in history.
Exhibit 6. 1980s Recession Weakened OPEC Power
Source: BP, PPHB
When we look at the global energy market today what do we see? Demand is falling, and each month the demand forecasts are ratcheted down as global economic growth projections are revised lower. Since February 2008, the IMF has reduced its 2009 outlook for world economic growth from 3.0% to 2.2% and now to 0.5%. Traditionally, a 2% growth rate has been considered the point below which the world enters a recession. For 2010, the IMF expects worldwide economic growth of 3.0%, but it calls for the advanced economies of the world, which includes the OECD countries, to recover but their growth will still be less than half the growth rate experienced in 2007. The developing Asian economies are expected to have a dramatic snapback in growth in 2010, but it also will be meaningfully less than in 2007.
The question for the energy market is whether the 2009 economic growth forecast holds at its barely positive rate and 2010’s projection is revised meaningfully lower. At the moment, the more negative economic forecasters seem to be driving the outlook for the world’s growth, or lack thereof. If there is a recovery in global economic activity that is above 2.0%, then we should probably be looking for higher oil demand. Just how high is debatable.
The other side of the oil demand coin is oil supply, and here the case for higher oil prices is stronger. While the world had about six countries experiencing oil production declines in 1980, today that number is more like 25 with a growing number of countries
Exhibit 7. IMF Revises Global Growth Lower
Source: IMF
struggling to avoid falling into that category. In five years, we could have another 15-30 countries that have gone beyond their peak production capacity. That outlook begs a question: Where are the next North Slopes and
By examining the production history and projected future production of one of the key non-OPEC basins, one can see the challenge facing the oil industry, and in turn, the world’s economy. Norway commenced offshore oil production in 1970. Production grew fairly steadily until it reached peak production about the turn of this
Exhibit 8. From Contributor To Drag On Production
Source:
century. From that point, Norway’s oil production has been in a steady decline that, with the help of some new discoveries and enhanced production, may be arrested for a brief time before then resuming its projected rapid rate of decline. Whether the oil industry is able to bring forth these additional resources or not will depend upon both technology and economics, each of which has their own unique challenges at the present time.
Exhibit 9. Norway Shows Challenge of Peak Oil
Source: Prof. Olav Hassens
Maybe offshore Brazil will be the new North Slope and North Sea, but it will be a long time in coming and the oil will be expensive to produce. The country has found several potentially huge new oil discoveries in deep water and under salt formations, but no one is completely sure how easily these reservoirs will be developed and at what cost. In the mean time, the issue is whether global demand will continue to fall as it did in the 1980s. Most authoritative forecasts call for an upturn in oil consumption beginning in 2010, but those forecasts are predicated on economic projections calling for the current economic recession to end by then, also.
Exhibit 10. Oil Demand Fall Doesn’t Look Like 1980s
Source: BP, IEA, PPHB
We believe that unless a worldwide global initiative to address the global warming concerns is undertaken and it leads to everyone radically changing energy consumption habits, energy demand growth will resume with a recovery in economic activity. Cap-and-trade or a carbon tax have the potential for raising the cost of carbon associated with hydrocarbon resources and altering the desirability of particular fuels, but probably not lowering total energy demand.
Until these systems are in place and functioning well, the needs and desires for improved lifestyles driven by population growth will push increased energy consumption. All the best forecasts predict that the maximum effort from alternative fuels will not displace a significant volume of hydrocarbon fuel. While natural gas might displace a certain volume of oil used for gasoline the transition will not happen in a meaningful way anytime soon. The issue for the oil industry will be capital availability to fund the development of the world’s known resources. The future for oil and gas prices is tied to supply and demand fundamentals and an indicator of where oil prices may be headed in the near term is tied to OPEC’s surplus productive capacity. At the moment with rapidly falling demand, OPEC is facing a growing production surplus.
Compared to the surplus productive capacity OPEC battled in the mid 1980s, this surplus is not serious and will probably turn out to be a transitory trend. The forecast surplus should be about five million barrels per day of capacity in 2010 compared to over 10 million
Exhibit 11. OPEC Surplus Capacity To Grow
Source: EIA
barrels per day in 1985 when world oil consumption was substantially lower than today. Moreover, that surplus was the result of growing oil supplies from new producing basins.
Exhibit 12. 1980s OPEC Surplus Was Serious Challenge
Source: Dr. Bassam Fattouk
The 1980s were marked by growing non-OPEC oil supplies and radically altered demand patterns that hampered the ability of OPEC to deal with the rapid and large production surplus. Those two key conditions do not exist today, and from all the available evidence are not likely to emerge anytime soon. In the near-term, demand is the critical issue, but barring another Great Depression killing economic activity for a number of years, the global oil market will be self-correcting, and quite possibly faster than many people think.
Energy Companies and Returns To Shareholders (Top)
In the last Musings we highlighted the stock performance and investment strategy of ExxonMobil (XOM-NYSE) in returning value to its shareholders. The company, through stock repurchases and dividends, returned $154 billion to its shareholders while holding its capital spending flat and continuing to build cash balances to fund significant long-term oil and gas development projects and possibly future acquisitions. On February 3rd, British energy company, BP plc (BP-NYSE) increased its quarterly dividend rate to $0.14 (9.8 pence) up from $0.135 (6.8 pence) last year. Management indicated it wanted to maintain its capital investing and dividend rates and is willing to borrow additional funds to support those objectives in the coming year given its view that energy prices (and thus earnings and cash flow) will improve in the future. According to Morgan Stanley analysts in the U.K., based on consensus estimates, energy companies will account for 24% of all dividends paid in 2009 by U.K.-listed companies.
In the United States, dividends have become much more important and a growing focus of investors in light of the drop in equity values last year and the prospect suggested by investment broker strategists that this year may not provide significant capital appreciation. Dividend income has accounted for roughly one-third of the total return for the index since 1926 with capital appreciation accounting for two-thirds. Dividends have received a high level of investor attention in recent months given the dividend cuts and eliminations driven by the economic environment. More cuts and reductions are likely as the economy forces companies to retrench further. In fact, according to Standard & Poor’s (S&P) analysts, dividends paid by the S&P 500 Index companies are expected to decline by 13.3 % in 2009 for the worst performance since WW II.
A new study conducted by researchers at the
The trend in importance of dividends was even more significant for British investors. With reinvested income, UK equities returned an average of 5.1% annually since 1900, but in terms of capital appreciation only, the return was a dismal 0.4% per year, which is lower than bills (1.0%) and bonds (1.4%).
A more telling analysis of the importance of dividends for investors is to look at the government figures on U.S. personal income.
Exhibit 13. Dividend Income Is More Important To Incomes
Source: S&P
Dividends as a percentage of personal income climbed steadily over the 20-year period from 1987 to 2007. As a percent of per capita income it rose from 2.8% to 6.7%. Interest income as a percent of per capita income fell from 15.0% to 10.4% over the same time period. On an absolute basis, using 2000 dollars, dividend income grew from $129.7 billion to $785.8 billion, over a 600% increase, while interest income only grew by 189%.
Exhibit 14. Dividends Have Grown More Than Interest Income
Source: S&P
S&P has created a portfolio of companies they call Dividend Aristocrats to capitalize on the impact dividends have on investor returns. To justify their effort, S&P has shown the impact of dividend payments reinvested in the S&P 500 Index since 1929. The results over the ensuing 77 years show that merely owning and not reinvesting dividend payments there was only a 42 times return on a $1 invested in the index. In contrast, by reinvesting dividends, the return would have been 1,052 times the initial $1 investment.
Exhibit 15. Reinvested Dividends Key To Performance
Source: S&P
S&P also examined the impact of dividends on the monthly returns of the S&P 500 Index during past decades. Over the entire time period of 1926 through November 2008, dividends accounted for 35% of the monthly returns. The lowest period was the 1990s when dividends only accounted for 14%. That decade was dominated by the technology stock phenomenon when growth was the only consideration that seemed to count with investors. On the other hand, the two periods showing the greatest dividend assistance for monthly returns were the 1940s and 1970s with 50% or greater contributions. The 1970s decade was marked by two severe recessions associated with sharply higher energy costs each time and high and accelerating inflation rates as a result.
Exhibit 16. Dividend Income Helped Investors In ‘40s and ‘70s
Source: S&P
To become a member of S&P’s Dividend Aristocrats portfolio, a company has to be a member of the S&P 500 Index and have a record of having increased its dividend for 25 consecutive years. The 2009 portfolio, as of December 2008, consisted of 52 companies, but only one, ExxonMobil, was an energy company. In examining the list of companies, we believe the portfolio has shrunk by at least one company – State Street Bank (STT-NYSE) and is at risk of having others fall out such as General Electric (GE-NYSE) who suggested it may cut its dividend in the second half of 2009.
It is interesting to examine the composition of the portfolio by sector and the number of companies in each sector. Energy has only recently made it into the portfolio, and at the time S&P rebalanced the portfolio in 2007, it represented 1.92%. We are sure that percentage is higher today, especially if other companies start to fall out of the portfolio.
Exhibit 17. Energy Barely Registers On Dividend Scale
Source: S&P
One of the key investment characteristics of this portfolio of dividend-growing companies has been that their stock prices have consistently outperformed the broad market and with less volatility. This is a desirable investment characteristic for long-term investors. It is also what one would logically think – if current income provides a meaningful portion of total return, then investors should be more tolerant of share prices lagging the market and less concerned about selling rallies in share prices.
Exhibit 18. Dividends Make Stocks Steadier Performers
Source: S&P
Our reason for focusing on the S&P 500 Index and its characteristics came from a tiny newspaper item discussing how S&P analysts are looking for only $10 billion or so in share repurchases this quarter. Stock buybacks appear to have been a factor in the rise of the broad stock market from 2001. From 2001 through the middle of 2003, stock buybacks really were not a significant dynamic in the market as many of the share repurchase programs were undertaken by technology companies hoping to mitigate the impact of earnings dilution from stock option grants. But starting in the summer of 2003 and then accelerating in the fall of 2004, stock buybacks became a strong factor in the overall market’s performance. On the other hand, dividends steadily grew through the 2001-2008 period.
As we pointed out in our last Musings when we discussed ExxonMobil and its shareholder return record for 2008, management has elected to use both share buybacks and dividends as vehicles to reward shareholders. But as the stock market collapsed during the second half of last year, company managements that had been buying back their stock in earlier years became scared to use their cash to buy back shares. ExxonMobil, on the other hand, continued to be an aggressive buyer of its own stock spending $8.7 billion in the third quarter of 2008 and $8 billion in the fourth. The money ExxonMobil spent in the third quarter was $2.2 billion more than second place Microsoft (MSFT-NASDAQ) and almost 10% of the $89.7 billion spent on stock buybacks by all the S&P 500 Index companies. For the four-year period Q4, 2004 to Q3, 2008, ExxonMobil is the number one buyer having spent over $110 billion, some $37 billion more than Microsoft. ExxonMobil plans to spend $7 billion in the first quarter of 2009, which we expect will put it not only in first place by a wide margin, but also accounting for a huge share of total stock buyback spending.
The reluctance of companies to buy back their shares has to reflect a certain amount of fear and trepidation by managements and boards of directors about the potential for sharply lower future earnings and cash flows and the potential, given the current credit crisis, of being caught without access to bank lines and/or other sources of outside capital. This lack of cash and/or credit has translated into paralysis, which is part of the problem with the functioning of today’s economy. Until confidence about credit markets is restored, this paralysis will likely continue.
The issue with managements stopping buying back their shares is a confirmation of the view that corporate executives are terrible stock market timers. One can certainly pick on any number of companies that bought back shares when their stock prices were very high and now are reluctant to buy back shares at very depressed prices. The issue is why they are now reluctant, especially when their share prices are much better values today at the lower prices. In some cases the earlier purchases were driven by other considerations – trying to offset dilution from earlier stock option grants; responding to pressure from activist shareholders; and trying to keep their balance sheets from becoming “lazy” due to large cash balances.
Exhibit 19. Dividends Have Been Overwhelmed By Buybacks
Source: S&P, PPHB
In order to see how the stock buyback phenomenon drove managements, we plotted the S&P 500 Index company data on reported earnings versus the amount of money these companies spent on share repurchases and dividends since 2001. As can be seen, the combination of the uses of cash overwhelmed the reported earnings. We recognize that reported earnings include non-cash charges distorting the amount of cash a company might be
Exhibit 20. Buybacks Have Soared In Recent Years
Source: S&P, PPHB
Exhibit 21. Dividends Have Grown Steadily Over Time
Source: S&P, PPHB
generating for use in paying dividends and buying back shares. The S&P operating earnings data is only available starting in 2005, reflecting the distortion in reported earnings from non-cash charges such as from employee stock option expense. When plotted against the combined payments for dividends and buybacks, operating earnings were not exceeded until early 2007. We anticipate that phenomenon ending either with the fourth quarter of 2008 or definitely the first quarter of 2009.
As we look to the future, we suspect that until confidence about the ability of the United States, and the world for that matter, to emerge from the current recession and establish a level of consistent growth, managers and boards of directors will be reluctant to use their company’s capital to buy back shares. The optimism of a year ago about the future has been replaced by a significant level of pessimism. The ‘glass half empty’ view of the future may mean a
Exhibit 22. Dividends and Buybacks Exceed Reported Earnings
Source: S&P, PPHB
Exhibit 23. Payouts Exceed Operating Earnings
Source: S&P, PPHB
lost opportunity for managers to buy back their company shares when it looks like they truly are a good value.
The big question in our mind is whether executives will re-examine their attitude toward dividends as the record shows that they have been the key to outperformance of equities over the long haul. As citizens strive to rebuild their balance sheets and retirement income portfolios, companies offering dividends, we believe, will be favored, translating into a lower cost of capital that will be important for an industry requiring substantial capital for future investment.
Punxsutawney Phil: Springtime and Global Warming(Top)
On Monday morning, February 2, officials and curiosity seekers assembled to hear the verdict of the most famous weather-forecasting marmot, Punxsutawney Phil, of Gobbler’s Knob in central
Exhibit 24.
Source: Groundhog.org
The ceremony was started in 1886 and is managed by the Punxsutawney Groundhog Club. According to the club’s records, Phil has seen his shadow 97 times, hasn’t seen it 15 times and there are no records for nine years. Some climate blogs and columnists have picked up on the fact that of Phil’s 15 warnings of an early spring, nine have come since 1975 – a sign according to them of Phil’s recognition of the global warming trend. We’re not quite sure that clouds blocking the sun on February 2nd are tied to global warming.
Investigative reporters at the Atlanta Journal-Constitution compared Phil’s predictions against data from the National Weather Service since 1994. For the past 15 years, according to the analysis, Phil’s predictive ability is 50-50, or the same as flipping a coin. That may still be better than the forecasting record of your local television weather person though. The reality is that there are seven weeks between February 2nd and March 21st, the Spring Equinox, so the odds greatly favor extended winter weather predictions.
We are intrigued that Phil now has many imitators, as obviously weather forecasting has become a social event.
Exhibit 25. Chuck Wasn’t Interested In Offering An Opinion
Source: silive.com
Joining Punxsutawney Phil in his longer winter prediction are Woodstock Willie of Woodstock, Illinois, Jimmy the Groundhog of Sun Prairie,
Six more weeks of winter would not be surprising as this year has been cooler than previous years this decade. In fact, this January was the 10th coldest on record for
Energy Stocks May Be Returning to Favor(Top)
A recent column by Jason Zweig in The Wall Street Journal focused on the best investment performers after the Crash of 1929. His inquiry was prompted by repeated comments from investors that the nation is headed into another Great Depression and what they should do with their investments. His quest was to find out which were the best stock market sectors had someone invested money on January 1, 1930, after the crash already had destroyed a third of the stock market’s value. He found out that the answer to his question was none. In 1930, 1931 and 1932 there was no place to invest successfully. During the three-year period only one industry provided a positive investment return – logging. This industry within the S&P 500 Index consisted of two stocks – Diamond Match and Mengel Co. Diamond Match converted timber into match sticks while Mengel made packing materials from trees.
In order to find a major industry sector with a positive return, Mr. Zweig had to stretch the study’s measurement period into a fourth year, 1933, when the market finally rebounded partway from its earlier losses. By the end of that four-year measurement period, there were only 13 of the 120 industries able to generate gains. Energy, in the form of crude petroleum and natural gas, was the fifth-best industry generating a cumulative 34.6% return, barely beating cigars/tobacco and slightly trailing personal credit institutions.
Energy is doing slightly better in recent weeks. Measured over the 13 weeks ending February 6, 2009, the energy sector of the S&P 500 Index was in fourth place out of ten with a 0.4% return, the last of the sectors with positive returns. It is interesting to speculate on whether there may be any positive correlation between today’s broad industry sectors and those successful industry investments of the 1930s.
From a quick perusal of the list of top performing industries in the 1930-1933 period, it seems there are a number that would fall into today’s broad consumer staples sector, which for the past 13 weeks has produced a negative 7.2% return. We are sobered by an investment study that shows that five-year returns following the 20 worst stock market loss years of the 20th century were no better than the returns following the strongest years by any statistically significant margin. What that means is that the Dow Jones Industrial Average has a 50% chance of getting back to its October 2007 record high by 2017.
One thing we have been paying attention to is the revision of company earnings estimates as they impact current and future price-to-earnings stock valuations that influence investors. Wall Street analysts, who focus on estimating company future earnings per share, always tend to be optimistic and late in recognizing both industry downturns and the magnitude of the downturn’s negative impact on earnings. Based on recent data, the adjustment to the estimate of 2008 earnings per share for the S&P 500 Index has collapsed from $92 in March 2007 to $29.57 a little over a week ago. The same trend has been evident in the 2009 earnings per share estimate that has fallen from $81.52 to $41.88. This fall in earnings partially explains the drop in the stock market, and it shows that the market is once again prescient about the economy and earnings.
Exhibit 26. Few Industries Had Positive Returns In 1930-1933
Source: WSJ
Ed Yardeni, chief investment officer of Yardeni Research described the recent performance of the stock market in light of the earnings per share revisions this way. “Industry analysts are getting even more bearish on the fundamentals of their companies, while investors are looking past the bad news or concluding that it is already priced in the stock market.”
Exhibit 27. 2008 S&P 500 Earnings Estimates Have Fallen
Source: Prieur du Plessis
Exhibit 28. 2009 Estimates Are Falling
Source: Prieur du Plessis
We have examined the valuation change underway for the oilfield service stocks over the past year. To examine the change in greater detail, we selected the universe of oilfield service companies followed by one of the major energy research teams on Wall Street to study. We compared their estimates for 2009 earnings per share for roughly three dozen companies – both oilfield service and contract drilling companies. We looked at the valuations based on price to earnings per share (P/E) and enterprise value to earnings before interest, taxes, depreciation and amortization (EV/EBITDA). The stocks were priced on January 11, 2008 and February 3, 2009. Given the early February 2009 date, we assume that not all the companies have reported and likely not all the earnings estimate adjustments that will be made have been incorporated in the estimates we had available. As a point of reference, the Philadelphia Oil Service Stock Index (OSX) on those two dates was: 291.99 (Jan. 11, 2008) and 124.42 (Feb. 3, 2009).
Exhibit 29. 2009 Oil Service Valuations Fall Less Than Stocks
Source: Yahoo Finance, PPHB
The decline in the OSX between the two measurement dates was 57.4%. At the same time, the decline in the P/E ratio for the total group of oilfield service companies was only 24.7% while the decline for the EV/EBITDA ratio was 31.7%. The fact that valuations have not declined as much as the OSX index may suggest either that these stocks are oversold, or that the analysts’ estimates haven’t fallen enough to make the stocks cheap enough to attract investors. We suspect the explanation may be a combination of the two conclusions, but it appears the stocks are not cheap enough yet to attract a broad swath of investors.
We remain positive about the outlook for the oilfield service stocks, at least through the early part of this year, because we recognize their strong historical performance record during the first five months of the year. We also think it is possible that oil prices strengthen more than people expect and that the economy does not fall into another Great Depression. We also take comfort in the fact that all the bad economic and oil industry news has failed to send the stocks to the lows experienced in early December.
Random Thoughts About Energy Markets(Top)
Does Baltic Index Signify Anything About Oil Market?(Top)
In the last Musings we commented about the recovery in the Baltic Dry Index that appeared to be underway. This measure of the cost for moving raw materials around the world had bounced up from its early December low through the end of January. It has continued to climb in February until the last several days when both bad global economic data was released and investor profit-taking may have occurred.
As the Baltic Dry Index moved sharply higher over the past two weeks, the rationale behind the move was reports from China pointing to its resumption of iron ore purchases. Some shipping
Exhibit 30. Baltic Dry Index Rally Accelerated In February
Source: StockCharts.com, PPHB
analysts pointed out that the Chinese government’s economic stimulus plan may have been behind the increased iron ore purchases. Much of the government’s spending is directed at infrastructure construction that requires steel and other basic materials. It was also pointed out that companies allowed ore inventories to fall to extremely low levels because of concern about the growing global economic crisis and its impact on steel demand which was collapsing.
Exhibit 31.
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Source: U.S. Global Investors
On the other hand, some analysts called the Baltic Dry Index rally merely a “dead cat bounce” (apology to cat lovers) that would soon evaporate. They point to the past couple of days as confirmation of their view as the index has fallen. They further support their “bounce” argument by citing China’s most recent trade data showing exports declined 17.5%, year over year in January marking the worst decline in more than a decade. January’s decline marked the third month in a row of falling Chinese exports. Equally significant was the dramatic 43.1% decline in imports into China, partially due to falling raw material costs but also due to an absence of need for components to be assembled into final goods to be then exported from China.
Since late last fall, the Chinese government has embarked on a strong economic stimulus plan with a program to inject 4 trillion Yuan ($584 billion) into the national economy. The response has been meaningful including an 18.8% year-over-year increase in money supply as of the end of January, following a 17.8% increase as of the end of December. Bank lending is exploding with loans extended growing by 1.62 trillion Yuan ($237 billion) in January, about a third as much as the banks lent in all of 2008, according to data from the People’s Bank of China. This lending spree compares with the 771.8 billion Yuan ($113 billion) loaned in December and October’s paltry 181.9 billion Yuan ($27 billion) loan volume. Analysts have expressed some concern about the amount of bad loans that will come from this lending explosion, but since bank lending reforms were undertaken in 2006 and 2007, the banks appear to be better positioned to handle the loan surge. At the end of 2008, the overall non-performing loan ratio of banks in China was only 2.45%, down 3.71 percentage points from the prior year-end ratio.
Some of the lending has filtered into the Chinese stock market as reflected by the
Exhibit 32. China’s Oil Imports Growing
Source: U.S. Global Investors
increased confidence by investors that the stimulus efforts of governments, especially the Chinese, are going to be successful.
Another sign that China’s recovery may be showing signs of strength is the oil market. The January oil figures showed that oil imports fell by 8% from a year ago to a 15-month low. What is not captured by the government’s customs data, however, is the oil purchased for the country’s new strategy petroleum reserve (SPR). According to a report from Medley Global Advisors, oil going into the SPR flowed in at a 240,000-barrels-per-day rate over the past two months. This means China added nearly 15 million barrels of oil to storage over December and January and the country plans to add an additional 7 million barrels by mid-March. That will completely fill the phase one of the SPR program of 105 million barrels. Sinopec and PetroChina are accelerating plans to build additional storage of up to 100-110 million barrels, some of which will be ready by 2010. Additionally, domestic petroleum retailers and chemical companies are planning to purchase additional oil for their commercial reserves as well as the military adding to its strategic reserves, too.
Exhibit 33. China’s Strategic Oil Storage Facilities Program
Source: 3E Information and Development Consultants
Malcolm Southwood of Goldman Sachs JB Were made the point about the economic significance of China’s economic recovery when he said, “China holds the key to an improvement in sentiment on demand for raw materials and, as best we can judge at the moment, this is unlikely to occur before the [second quarter] at the earliest and possibly not before the second half.” If China’s economic stimulus shows demand results, the oil market should recover.
Exhibit 34. China’s Growing Oil Storage Facilities
Source: 3E Information and Development Consultants
Sovereign Wealth Fund Shifting To Natural Resources?(Top)
Two weeks ago, Temasek Holdings Pte. Ltd., Singapore’s sovereign wealth fund, announced it had appointed Charles “Chip” Goodyear to its board and also that he would replace the current chief executive, Ho Ching, the wife of Singapore’s prime minister, in October. The $134 billion fund, one of the oldest (founded in 1974) and most respected sovereign wealth funds, appears to be shifting gears after significant hits to its portfolio primarily focused on financial institution investments. Until recently, the fund had established a long and profitable investment record – averaging 17% per year returns since its founding.
Mr. Goodyear is the former chief executive of mining and resource giant BHP Billiton (BHP-NYSE). He was originally an investment banker with Kidder Peabody and then moved to copper producer Freeport-McMoran (FCX-NYSE) and joined BHP as its chief financial officer in 1999. He was one of the team of executives who spearheaded the merger of BHP with Billiton of South Africa in 2001. In 2003 he was promoted to the post of CEO at BHP. During his tenure as CEO the global commodities boom commenced enabling BHP to make several acquisitions including Australia’s WMC Resources in 2005. He stepped down from his CEO post in September 2007. His legacy with the company is its strong balance sheet and diversified portfolio that is helping BHP weather the current commodities downturn.
Temasek made a number of high profile investments in global financial institutions – Merrill Lynch, Barclays (BCS-NYSE), Standard Chartered and Bank of China. Based on outside estimates, the fund may have unrealized losses of $2.3 billion just from its Merrill Lynch investment that has now become Bank of America (BAC-NYSE) stock. At the present time, Temasek has about two-thirds of the fund invested in the financial and telecom sectors but only about 5% in natural resources. Last year, the fund recruited Marcus Wallenberg to the board, which may indicate it is preparing to invest in industrial companies, which represents only about 6% of the portfolio.
Given Mr. Goodyear’s background, the fund’s recent investment experience and the opportunities existing in the natural resource and industrial sectors due to the collapse in commodity prices and the global economic and credit crisis, we suspect Temasek might become a new investment force in these latter sectors. We rate the odds of natural resource sector investments higher than industrial companies because of the new CEO’s background and the knowledge of the opportunities by the Singapore government.(Top)
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Parks Paton Hoepfl & Brown is an independent investment banking firm providing financial advisory services, including merger and acquisition and capital raising assistance, exclusively to clients in the energy service industry.
