Energy – dare to disagree with Goldman

Goldman came out with a note today encouraging clients to dumb their oil holdings and lo and behold, oil is down 4% – correlation, not necessarily causation, I know, but still. Remember the good ol’ days when oil was at $10? Anyway, let’s put today’s move in context (this is the weekly chart through yesterday):

Still quite a bit higher than the roughly $85 we saw at the beginning of the year, not to mention the beginning of 2009. Simultaneously, we have witnessed the energy sector pretty much single-handedly pull the equity markets up, with a 14+% return vs. the S&P 500′s 6% total return.

I actually don’t have much exposure to oil per se, but I’m definitely overweight energy. So why am I NOT selling my NLR and KOL and FCG like I did SLV yesterday and rotating into utilities or healthcare? For one, when you get in at a good price, you can withstand a lot of market volatility. Secondly, the fundamental reasons why I took a position in energy (political instability, risk of rising protectionism, risk of inflation, increased capital investments, solid balance sheet fundamentals, yield, etc.) are all still in place. It’s that simple.

Some might say that a global slowdown will pressure oil, and they are absolutely right. However, I anticipated a slowdown already BEFORE I took a position and it STILL made financial sense. So either, the expected slowdown will come and I’ll generate solid yields with upside optionality in case of inflationary pressures, or a slowdown will not come and I’ll generate solid returns based on analysts mispricing the top line growth potential. In the meantime, I maintain a hedge against an increase in political turmoil, protectionism (that’s why I concentrated on locally available energy) and inflation. So while Goldman can make predictions about where oil is heading in the next day, week, month or year, I prefer to invest with a longer horizon and by looking at the total investment potential and risk as compared to other alternatives.

Relevant ETFs: XLE, USO, OIL, BNO, NLR, KOL, FCG

Japan – it happens

Japan was hit with another earthquake. It happens. I guess it more likely to happen in certain places than others, but such is life. They’ll rebuild, they’ll have more earthquakes. Is there any new story there? Not for me.

The real story is in energy and food. As I write this, oil is trading at $110! Seriously, are equity investors aware? Are government officials aware? I am not so sure.

Not surprisingly, we see that CORN is also making new highs:

Food and energy are inter-related for a whole host of reasons, not the least of which is that current government policies that encourage taking a need (food) and making it into a want (energy) lead to a constrained supply. I’m actually quite concerned about the next shock to the system. I’m not predicting where it will come from, but historical precedent (and Murphy’s Law) suggests that shocks come at the worst time. Fundamentally, with a slowing world GDP, we would expect oil to go down. However, the monetary policies and geopolitical turmoil are trumping the supply/demand dynamics and we’re maintaining our exposure to ag and energy.

Relevant ETFs: OIL, CROP, MOO, DBA, NLR, KOL, FCG, EWJ, DXJ, FXY

A duck on the pond

There’s an old visualization that’s used in different scenarios about a duck floating on a pond. The water looks calm. The duck looks calm. However, underneath the surface the ducks feet are paddling rapidly. The duck paddles and paddles, and yet to the casual observer, the duck isn’t moving fast and seems to be totally at peace. And so it is with our current financial markets.

On the surface, everything seems peaceful and nice. Calm even. Volume is so low, I forgot it was the middle of the week and thought that it was a Friday in summer and everyone except for me had headed out of town. The average are treading water. As I write this, the S&P 500 is showing exactly 0 points up. And yet…

Oil is taking out 2008 highs. Due to the US’s insane ethanol policy, which takes food and makes it expensive, inefficient energy, we have corn rallying almost 5%, and taking the rest of the ag space with it.

As readers know, I’m not in the hyperinflation camp. However, one doesn’t need to believe in hyperinflation to see that certain inputs are slated to rise, while at the same time, stores of wealth will deflate. We’ve spoken about this environment in the past and it has served us well on the whole. In this era of biflation, inputs such as energy and food may continue to see price pressures. An increase in geopolitical tension only serves to embolden politicians to call for “self-sufficiency”, which in turn will lead to higher energy prices and subsequently higher food prices. At the same time, lower consumer spending coming from high unemployment and large debt constraints will continue to pressure retailers and the traditional stores of wealth (real estate, bonds, equities) alike. So investors need to choose their spots.

We already have high exposure to energy and precious metals, and are maintaining it. We recently increased our exposure to the agricultural space through a new ETF, CROP. Its main advantage is that it has small cap exposure to global agribusinesses, lower exposure to chemicals than MOO, and emerging markets exposure. Its main drawbacks are that its new and less liquid, and has a 20% exposure to China, which I am not keen on. Since it is only going in as a small allocation in the portfolio, the exposure to China is worth it for us, but it should be noted by potential investors. This is in no way a recommendation, just a highlight of the implementation vehicle we used. Also, there are rumors of direct farmland ETF’s on the way, which I will keep an eye out for. That being said, they may come at the end of the opportunity and might be a contra-indicator.

Lastly, speaking of the duck’s feet…notice that gold and silver are approaching all-time highs, the yen is finally weakening, and financials haven’t been able to rally. At the same time, multiple articles are being sent to me with headlines screaming that equities are the new safe haven. Absolutely not. Equities are expensive and any valuation metric that uses the current peak margins as a basis will prove misleading in the upcoming quarters. We’ll talk more about this element of the duck’s feet later in the week.

Relevant ETFs: GLD, SLV, CROP, MOO, USO

Japan down 14%

Yes, you read that correctly. Japanese stock markets are down 14% and have in 2 days experience more than half a trillion dollars in wealth destruction. There are separate conversations to be had…

First, there is the human tragedy. On top of losing homes, jobs, schools, etc. in terms of infrastructure, millions are left stranded without water and electricity. To really top it off, now millions will lose invested wealth and face an investors worst-case scenario – permanent loss of capital. No amount of standard deviations does that type of risk justice on the human level.

Second, and a distant second at that, is the conversation about the investment implications. I have viewed Japanese companies as undervalued on their own after being down roughly 75% from their peak in the late 1980′s. On top of that, they are facing favorable headwinds with a relatively strong currency (relative to their tax base, demographics, etc.). So a currency hedged investor should do well in the long term. I continue to view those shares as an opportunity and will look for selective entry points to add exposure.

Lastly for tonight, there are the additional implications felt globally. Nuclear energy firms, a portion of my energy overweight, are under significant stress, while on the flip side, my exposure to natural gas has benefited. Overall, I am maintaining my exposure to energy and will look to gain exposure to specific uranium related companies in the next few days and weeks.

The US equity futures, on the other hand, are pointing to a significant gap down tomorrow morning, and assuming they don’t rally may provide a bounce for the active trader. However, I am short the US indexes, and will not be covering. I will not add to the position here, but my valuation metrics continue to point to increased P/E compression. In a scenario where we face a worldwide economic slowdown, coupled with relatively high energy costs and continued margin compression, inflation fear mongers will look silly. Deflationary pressures continue to be the main risk, and in that scenario, we will first have significant margin and valuation compression, and then will actually bottom on high P/E (low q-ratios). The reason for this counter-intuitive statement is that in a deflationary environment, the E goes down, and for a while the P goes down fast. Eventually, the P stabilizes, while the E continues to go down. In that scenario, P/E will no longer be a good valuation measure, and investors must focus on q-ratios to understand replacement cost, return on assets, and the setup for the eventual price stability and upticks in inflation.

We have years for that to happen. I am not a buyer on the dips.

Relevant ETFs: DXJ, FXY, NLR, RWM, SH, SPY, IWM

Tsunami’s all around

The Japanese stock market is hitting circuit breakers with a 5% drop as Japanese officials scramble to inject liquidity into the system. I’m sorry to say that BoJ has not proven its ability to influence markets over the past couple of decades, so while the liquidity will help the immediate requirements (maybe), I don’t think it will actually make a big difference for Japanese citizens. They’ll get hammered with a double whammy: higher import prices AND higher energy costs specifically from energy strains on the system. And as the third largest economy in the world, the potential for a chain reaction is not insignificant. As I mentioned before, I’m a big believer that the yen is the most vulnerable developed nation currency in the world. Any bounce from repatriations will be short lived and Japanese export-focused firms are trading at relatively low valuations ANYWAY. That’s a powerful combination and I’ll be looking to add to exposure. Easiest way to play this is through DXJ.

Meanwhile, a political tsunami is raging in the Middle East, which is no longer getting front page status. Bahrain invited Saudi troops to help stanch their uprisings. A curious situation: a sovereign nation inviting the military of another nation to use force against its own citizens. Hmmm. Doesn’t sound like a place I want to move to in the near future. Regardless, with Sunni and Shiite friction increasingly tense, look for Iran to ride in to the defense of their brethren. Not sure how it plays out, but it certainly provides a bid for oil. I’m still wary of going long the region and see more downside than upside risk. That also means that domestic energy producers might benefit.

Relevant ETFs: DXJ, MES, EGPT, FCG, NLR, KOL, YCSm FXY

Heretical or just contrarian?

Energy. Everyone wants it; not everyone has it. Once it’s produced (as electricity, let’s say) it’s tough to store, tough to transmit, and tough to price. For the past few months, turmoil in the Middle East has driven the price of crude oil (WTI), the most commonly cited energy commodity, up around 30%. Remember when $90 oil was a threat to the recovery? Anyway, I have been recommending an overweight to energy, but quite honestly, except for a modest allocation to energy, my focus was on the domestic market through nuclear and coal companies. I can’t complain as they’ve done very well over the past 6 months. It did however, lead me to review my underlying thesis on energy. Will my anticipated slowdown (negative for energy) overpower the continued geopolitical turmoil (positive for energy)? Will China’s slowdown (negative for energy)play a larger role than the possible hoarding behavior by governments afraid of supply disruptions (positive for energy)? And the questions go on.

Here’s the short of it. I still like energy. I think the risk of supply disruptions is high, and while I anticipate China, as the marginal buyer of commodities, to face a significant slowdown, I believe the geopolitical situation is worse than most are pricing in, all coupled with a continued devaluation of most world fiat currencies. That being said, look  at the chart below (from BarChart.com). Do you notice any outlier?

Of course natural gas is an outlier. There’s plenty of it – no one is discussing peak natural gas – AND, importantly, there a huge domestic supply. It’s underperformed the rest of the complex by 40-60+% over the last 12 months! For a contrarian like me, it definitely looks interesting.

Now, natural gas happens to be a very difficult market to trade. Even professionals get caught up in spreads, roll issues, extreme moves with little liquidity; for example, that’s what brought down Amaranth for those old enough to remember yesteryear. Also, the active contracts are for the front months, which wouldn’t actually provide me with the long-term exposure I might want. So instead, I need to focus on the companies themselves. For those who have the ability to do the due diligence on individual firms, companies like Calpine or Southwest Energy might be interesting (I don’t have positions in either). For those interested in gaining more broad exposure, check out FCG. I’ve mentioned it in the past and it’s held up well, especially given the recent price history of natural gas. Again, I don’t have any exposure to it at the time of writing, but am looking at it for now. One thing I do know, though, is stay away from UNG. Retail investors love this fund for some reason, but it is fundamentally flawed and I wouldn’t be surprised if we see it close at some point soon if natural gas heads any lower. It might pop on some big moves in the underlying, but the direction is clear. This is not a contrarian play.

So there you have it . . . While everyone is selling natural gas, to me it’s beginning to look like a good place to be. No positions yet, but it’s the type of play I like.

Relevant ETFs/stocks: SWN, CPN, FCG, USO, BNO, XLE, CORN, UNG

Geopolitical turmoil

The Middle East is an informational black hole. Is Libya calmer or not? Is Bahrain flaring up? Are the riots in Saudi Arabia under control? Where’s Iran? All of the unknowns are pushing oil higher, and the threat of supply disruptions are becoming all too real, even as domestic inventories rise.

In the meantime, China currency talk is getting louder as leaders try to push for yuan reserve currency status. Why? At this point, I’m inclined to believe that the Chinese leadership might be thankful for unanswered prayers. With social unrest increasing, the yuan getting revalued higher may increase any slowdown, bring the real estate bubble to its knees, and actually increase social unrest in the short term. True, inflation might be mitigated, but it’s all about the speed and unintended consequences, 2 things that I’m not sure the government will be able to control.

Lastly, I can’t help but be amazed at the big, pink elephant in the room that is being totally ignored: the euro is unsustainable, yet it’s getting stronger!?!? Can anyone say “Ireland”? Great. Now that we know that Irish bondholders are getting a haircut, what about the rest of the complex? Spain is about to go back 30 years in terms of development. With already high unemployment and a real estate bubble that is not being priced on anyone’s balance sheet, Spain is the big risk for the euro now, but no one is talking about it. Instead, the euro is getting some relief bid that it’s not collapsing. Well, it should…and it will – at least in its current form.

Natural Gas

We’ve mentioned energy as a focal point for the past few months and I continue to see it as a net beneficiary for a whole host of reasons; however, for now, I just want to bring your attention to natural gas.

Natural gas is heading lower today by around 3%. I don’t like the commodity, and I like UNG even less, although I do think at some point soon, it might be worth a second look. That being said, we’ve had growing exposure to the energy sector, mainly through nuclear and coal company exposure (relevant ETF’s are NLR and KOL). We also mentioned FCG as a better way to invest in natural gas because through the equity, investors get access to the long term demand structure, rather than exposure to the speculative and highly volatile short term futures. In that light, check out the recent divergence in performance:

On a one year basis, FCG is up around 8-9%, while UNG is down 42%. Natural gas is one of the few commodities NOT feeling the speculative fever. Yet, the companies are holding up and performing well. This will continue to be an area we do more research on, but I wanted to bring it to your attention.

Natural gas/Energy

For the past few months, I’ve been discussing energy as a long term position on the following grounds:

1. Supply constraints in conventional oil will put a bid in the energy complex.
2. Geopolitical risks remain underpriced.
3. Global currency debasement will provide a bid in the energy space, even if global slowdown accelerates.
4. Potential hedge in case global activity actually picks up.

Once we understand the thematic reasons to be long energy, the question remains on how to best implement it and gain exposure.

Starting with the direct exposure to oil and energy futures – I’m very hesitant. Contango in the space means that rolling over futures is expensive, the ETF’s/ETN’s that are in the space are going to face structural problems with rolling over positions, and the inherent leverage in the futures markets make them a difficult long term position.

A few months ago I mentioned NLR, and I continue to view nuclear as a clear beneficiary on multiple levels. It’s cleaner, it’s more efficient after the plants are up, and the political environment is getting more comfortable with building new plants. Additionally, the US has access to the raw materials needed to power the plants, so it would be strategically in our best interests. Coal is similar, except for the whole environment thing, but reading this months Atlantic gave me renewed insight that coal is catching on as a viable alternative. To that end, I’ve been waiting for the right opportunity to gain exposure to KOL.

Moving on in the complex, I’ve been researching natural gas, mostly because everyone else hates it. Natural gas is down 30% YTD, while the rest of the complex is up. More new natural gas deposits seem to be found each passing day, and the current price could easily go down by 40-50% if the combination of new finds and global slowdown materializes. That being said, valuations look pretty attractive with single-digit P/E’s and a lot of producers shutting down operations with the decrease in price. Also, since the direct exposure through UNG has proven such a fatal mistake, many retail traders are starting to stay away. Lastly, natural gas is plentiful, cleaner burning, and already has a viable infrastructure for distribution.

Last year, Exxon went after XTO seeing the potential in the space. Today, GE is buying Wellstream a pipeline producer, realizing that maybe there’s room beyond wind. I have been looking at buying some individual names, but FCG seems to offer a pretty diversified exposure to the space and might be worth a look.

Oil and energy

We’ve been highlighting it for months, and I believe there is a lot more room to the upside. Here are just a few of the places we’re looking (without making any specific recommendation):

I inserted USO as a weekly chart, just to give a longer perspective on the space. I believe that with increasing geopolitical instability, coupled with the peak oil statistics we’ve been discussing recently, the energy space will retain a strong bid, certainly on a relative basis, and has the potential to rise significantly from here.

The end of the relief

It’s 1:25 … do you know where your euro is?

Euro went ballistic on news that the US was backing more money from the IMF for a eurozone rescue. So, yeah, we went back above 1.31, but shifting creditors doesn’t change the fundamental/structural issues facing the euro. Congratulations Portugal on selling a few bonds! But really, who wants to long this currency long term?

We always talk about sifting through the noise, and here’s a perfect example. We haven’t changed our stance on the euro nor the yen, for that matter. Staying short both.

Oil, in the meantime, and energy in general, have been clear winners for us. NLR is up about 15% since we discussed it a few months back. We’re looking to increase exposure to energy through various ETF’s (KOL is an example, but we have no position yet).

Interview on The Wall Street Shuffle

I was interviewed this past week on The Wall Street Shuffle and focused on energy.

The main theme focused on conclusions from the recent IEA Oil Market Report. This was the first year that the IEA discussed the fact that the world probably reached peak production of “conventional” oil in 2006 and that going forward the growth in oil production to meet demand will have to come from “unconventional” oil (ultra deep water drilling, natural gas alternatives, etc.) but that this growth will not make up for the dropoff in conventional production. Which obviously means that shortages are coming in the next few years, prices will remain high even as we go into another recession. Add to that geopolitical conflict and debasement of fiat currencies, and energy looks like it has potential to outperform going forward. I mentioned that i prefer the producers and explorers to the straight commodity for long term investors. Additionally, I prefer coal and nuclear energy companies to oil since I think massive investments will need to be made in those areas.

Related ETF’s: XLE, XES, NLR, KOL (I already have exposure to some of these areas through ETF’s and individual companies).

Going where the crowd isn’t

If you’ve ever watched 6 year olds play soccer, you’ll recognize the phenomenon – 20 kids constantly running towards the ball. Where-ever the ball goes, so do the kids. Investors are often quite similar in their need to go to the ball, and we often discuss some of the heuristic biases that lead us to follow that pattern. While there are numerous studies to support the value of some momentum strategies, I prefer the more staid value strategies that tend to produce better results without as much running.

In that light, let’s examine where the crowd is and isn’t. Certainly, the days of gold being a side-show are over. Can gold go to $5,000? Maybe, but it was easier to get in when it was at $800 than it is now at $1,300 when everyone is talking about it. I still hold gold and gold related shares, but as I wrote about a year ago, I also hold silver, platinum, and palladium. I’m not selling here, but not buying more either.

Where is the crowd definitely gathered? Treasuries are one place. Institutions have no choice but to be buy the little yield that is available to them. So we’re not only staying away, but staying short. It has been a difficult position to hold, but then again, standing alone on the field while everyone is running to the ball can feel lonely. At the same time, everyone is running away from the dollar. And to what? To the yen? To the euro? Well, we should have focused less on G3 and G8 crosses, but I continue to maintain that the picture is worse for Europe and Japan long-term than the US.

So what is the crowd really missing? I think geopolitics continues to be the most underpriced risk/opportunity in the market. Oil, energy, and defense companies are not much appreciated. We have positions in all, including specific names (such as NOV, RTN and others), ETF’s (such as NLR – nuclear – and others, etc. Oil is just starting to awaken, and I think it has a lot more room to go:

Commodities such from corn to coffee have also been all the rage, but I think if you don’t have a position already, you might be late to the party.

In a debt deflation cycle, I think there are also opportunities for companies with strong balance sheets, low debt, and an ability to maintain some margins. Companies that are issuing a lot of debt, even at cheap prices, are putting themselves at risk if their margins get squeezed. In a rising inflation period, levered companies are in a better position, but retailers are dropping prices, which means that the debt will become relatively more expensive. The new debt issues seem like a high risk low return trade to me.

Energy – by the time you read about it…

When the BP spill occurred, I wasn’t able to blink without energy being mentioned. Every article, every economist, and every politician wanted a piece of the PR feeding frenzy. The problem was that the focus was completely misplaced; I said it then and I’ll say it now – a spill was not surprising!

Given our energy dependence, the fact that oil is getting harder to find and extract, and the lax government regulations, it was only a matter of time before some major spill happened somewhere. So it happened to be BP and it happened to be in the gulf. Immediately, everyone wanted a piece of BP’s massive cash hoard. I get it and I’m happy to fine them, but there are bigger issues at stake. No effort has been made to analyze the underlying issues of energy – but a bigger issue is looming and the rest of the world is aware of it more than the US.

Iran is going nuclear, and whether we like it or not, energy dependence will once again take a front row seat, with no one to pay any fines, as we face a massive squeeze in oil prices.The front page of The Atlantic Monthly brings to light one (of numerous) scenarios that might drive this squeeze:

The rest of the world is more aware of it that the US, and is taking the appropriate actions – investing in domestic energy supply through alternatives and nuclear. By far, nuclear energy offers the best option to gain long term energy independence. Even Finland, with its strong environmental and bureaucratic structure has found a way of burying nuclear waste, so how come we can’t?

The geopolitics of energy are about to trump the global slowdown.

World Economic Forum Risks-Report 2010

In anticipation of this years World Economic Forum, the organization put out a report highlighting what they see as the greatest risks to the world, including political, economic, social, military, etc. Here’s an excerpt from their press release, and a link to the full report is at the bottom.

…Daniel M Hofmann, group chief economist of Zurich Financial Services said, “The events of the last year have shown that there are underlying risks within the global economy that need to be addressed. In reaction to the financial crisis, many countries have put themselves at risk of overextending their fiscal positions and being burdened with extremely high levels of debt. This could put upward pressure on real interest rates, rein back growth and lead to protracted high levels of unemployment.”

More widely, the report points to the impact of the global recession on longstanding under-investment in infrastructure, especially in energy and agriculture, and the rising costs of treating chronic disease. These “creeping” risks have not appeared overnight, but the recession has limited the ability of decision-makers to combat them effectively.

This is particularly true for energy with respect to the pressing global need to invest in infrastructure. John Drzik, CEO of Oliver Wyman, an MMC operating company, said, “The recent drop in oil prices has been good for consumers, but has also contributed to a significant cut in much-needed investment in energy infrastructure and renewable energy projects. This comes at a time when governments – as well as business and consumers – are looking for long-term security of an energy supply that is both sustainably-sourced and reasonably priced. The fragile global economy will make itself more susceptible to oil price-related shocks if this underinvestment continues.”

A massive US$ 35 trillion of infrastructure investment is required over the next 20 years, according to the World Bank. “This is particularly acute for agriculture and food security,” said Swiss Re’s Chief Risk Officer Raj Singh. “We need a vast increase in food production to feed the growing world population, and a billion people are already undernourished. Billions of dollars need to be spent on water provision, energy supply, transport and climate change adaptation measures. Governments must work together with the private sector to make it happen. Insurers can provide risk management tools that create greater financial stability for farmers and the agriculture industry.”

The report also highlights risks where the levels of awareness and preparedness are currently very low; these include transnational crime and corruption, cyber-vulnerability and biodiversity loss.

For the full report, click here.

Increasing interest rates, infrastructure, agriculture, energy, disease management. Those seem to be the big ones.