Situation: In Q2 of 2014, the trade-weighted index of 19 Futures Contracts for raw commodities peaked (DJCI; see Yahoo Finance), as did the SPDR Energy Select Sector ETF (XLE; see Yahoo Finance). Both hit bottom in early Q1 of 2016. That should have been the end of the Bear Market but prices have not risen much since then. On the plus side, both ETFs tested their early 2016 bottom in Q3 of 2017 and failed to reach it, suggesting that prices for both are in a new (albeit weak) uptrend.
Interestingly, the SPDR Gold Shares ETF (GLD; see Yahoo Finance) has traced a similar track, peaking in Q1 of 2014, bottoming at the beginning of Q1 2016, and failing a test of that low point late in 2016. Other metrics also suggest that the Bear Market has ended. For example, recently posted earnings for Exxon Mobil (XOM) in Q3 of 2018 were robust enough to have reached a level last reached in Q3 of 2014.
Mission: Use our Standard Spreadsheet to track key investment metrics for companies that buy and/or extract raw commodities for processing, transport those by using 18-wheel tractor-trailers or railroads, or manufacture the diesel powered and natural-gas powered heavy equipment tractors that are used to mine and harvest raw commodities. Confine attention to companies that have at least a BBB+ S&P rating on their bonds and at least a B+/M rating on their common stocks, as well as the 16+ year trading record on the NYSE that is needed for long-term quantitative analysis by the BMW Method.
Execution: see Table.
Bottom Line: Near-month futures prices for commodities have come down off a supercycle that blossomed in 1999, and are now back to approximately where they started. This represents a classic “reversion to the mean”, likely due to supply constraints growing out of the somewhat rapid buildout of China’s economy. We’re not at the end of a 4-Yr Bear Market. Instead, we’re in the long tail of a remarkably strong 2-decade commodities Bull Market. It is important to note that commodity production is changing away from fossil fuels. However, petroleum products still represent more than 30% of trade-weighted commodity production. Going forward, the composition of that production will shift toward environmentally cleaner transportation fuels. Gasoline and diesel will yield dominance to CNG (compressed natural gas) and hydrogen (sourced from natural gas). This will mirror the shift toward clean electrical energy that has replaced coal with natural gas during the build-out of wind and solar sources, along with the necessary enhancements to electricity storage and transmission.
Risk Rating: 8 (where 10-Yr US Treasury Notes = 1, S&P 500 Index = 5, gold bullion = 10)
Full Disclosure: I dollar-average into CAT, XOM, R and UNP, and also own shares of NSC, BRK-B and CMI.
"The 2 and 8 Club" (CR) 2017 Invest Tune Retire.com All rights reserved.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Showing posts with label futures. Show all posts
Showing posts with label futures. Show all posts
Sunday, December 9
Sunday, July 29
Week 369 - High Quality Producers & Transporters of Industrial Commodities in the 2017 Barron’s 500
Situation: Here in the U.S., debt/capita is growing at an alarming rate and is now greater than $60,000. U.S. Government debt is almost $20 Trillion and has been growing at a rate of 5.5%/yr (i.e., twice as fast as inflation) since 1990. By 2020, the Federal budget deficit will start to exceed $1 Trillion/Yr and the dollar’s status as the world’s reserve currency will be threatened. The gold reserves that stand behind the U.S. dollar (currently worth ~$185 Billion) would have to be increased on a regular basis, as would foreign currency reserves (currently worth ~$125 Billion)
The US economy is no longer capable of growing fast enough to balance the budget for even a single year, without introducing draconian measures. Nonetheless, it is worth noting that those can be effective given that Greece appears to have emerged from that process successfully. But the U.S. could not go through that process and still remain the “top dog” militarily. So, the trade-weighted value of the U.S. dollar will fall at some point, and we will no longer be able to afford imported goods and services. Before that happens, U.S. citizens will need to gradually move their retirement savings into commodity-related investments, as well as bonds and stocks issued in reserve currencies other than the U.S. dollar.
Mission: Use our Standard Spreadsheet to highlight large U.S. and Canadian companies that produce, refine and transport raw commodities, i.e., materials that are extracted from the ground. Select such companies from the 2017 Barron’s 500 list, but exclude any that issue bonds with an S&P rating lower than A- or stocks with an S&P rating lower than B+/M.
Execution: see Table.
Administration: The S&P Commodity Index has the following components and weightings:
Natural Gas (17.66%)
Unleaded Gas (12.16%)
Heating Oil (12.13%)
Crude Oil (11.41%)
Wheat (5.15%)
Live Cattle (4.87%)
Corn (4.48%)
Coffee (3.88%)
Soybeans (3.84%)
Sugar (3.80%)
Silver (3.67%)
Copper (3.39%)
Cotton (3.22%)
Soybean Oil (2.98%)
Cocoa (2.79%)
Soybean Meal (2.57%)
Lean Hogs (2.04%)
53.36% of the index represents petroleum products, 32.71% represents row crops, 7.06% represents industrial metals, and 6.91% represents live animals. Ground has to be mined, drilled, or planted & harvested with the help of heavy equipment to yield raw commodities. Those have to be transported by barge, rail, truck, or pipeline before being processed for market.
We find 8 companies that warrant inclusion in this week’s Table. Seven are obviously appropriate, but the presence of Berkshire Hathaway (BRK-B) needs some explanation (unless you already know it owns the Burlington Northern & Santa Fe railroad). Berkshire Hathaway is the largest shareholder of Phillips 66 (PSX), which has 13 oil refineries and supplies diesel for the largest marketing outlet of that fuel: Pilot Flying J Centers LLC. Berkshire Hathaway purchased 38.6% of that company’s stock on October 3, 2017, and plans to increase its stake in 2023 to 80%.
Bottom Line: Commodity futures haven’t been a good investment, given that their aggregate value is back to where it was 25 years ago, given that the most recent 20-year supercycle recently finished and another is just starting. Nonetheless, the companies that produce, process, and transport those commodities did well over those 25 years (see Column AB in Table). The problem is the volatility of their stocks (see Column M in the Table), and the extent to which their stocks get whacked when commodities become oversupplied relative to demand (see Column D in the Table). If you choose to own shares in these companies (aside from CNI, BRK-B and perhaps UNP), you’d be flat-out gambling.
Risk Rating: 7-9 (where US Treasury Notes = 1, S&P 500 Index = 5, and gold bullion = 10)
Full Disclosure: I dollar-average into UNP, ADM, CAT and XOM, and also own shares of CNI and BRK-B.
"The 2 and 8 Club" (CR) 2018 Invest Tune Retire.com All rights reserved.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
The US economy is no longer capable of growing fast enough to balance the budget for even a single year, without introducing draconian measures. Nonetheless, it is worth noting that those can be effective given that Greece appears to have emerged from that process successfully. But the U.S. could not go through that process and still remain the “top dog” militarily. So, the trade-weighted value of the U.S. dollar will fall at some point, and we will no longer be able to afford imported goods and services. Before that happens, U.S. citizens will need to gradually move their retirement savings into commodity-related investments, as well as bonds and stocks issued in reserve currencies other than the U.S. dollar.
Mission: Use our Standard Spreadsheet to highlight large U.S. and Canadian companies that produce, refine and transport raw commodities, i.e., materials that are extracted from the ground. Select such companies from the 2017 Barron’s 500 list, but exclude any that issue bonds with an S&P rating lower than A- or stocks with an S&P rating lower than B+/M.
Execution: see Table.
Administration: The S&P Commodity Index has the following components and weightings:
Natural Gas (17.66%)
Unleaded Gas (12.16%)
Heating Oil (12.13%)
Crude Oil (11.41%)
Wheat (5.15%)
Live Cattle (4.87%)
Corn (4.48%)
Coffee (3.88%)
Soybeans (3.84%)
Sugar (3.80%)
Silver (3.67%)
Copper (3.39%)
Cotton (3.22%)
Soybean Oil (2.98%)
Cocoa (2.79%)
Soybean Meal (2.57%)
Lean Hogs (2.04%)
53.36% of the index represents petroleum products, 32.71% represents row crops, 7.06% represents industrial metals, and 6.91% represents live animals. Ground has to be mined, drilled, or planted & harvested with the help of heavy equipment to yield raw commodities. Those have to be transported by barge, rail, truck, or pipeline before being processed for market.
We find 8 companies that warrant inclusion in this week’s Table. Seven are obviously appropriate, but the presence of Berkshire Hathaway (BRK-B) needs some explanation (unless you already know it owns the Burlington Northern & Santa Fe railroad). Berkshire Hathaway is the largest shareholder of Phillips 66 (PSX), which has 13 oil refineries and supplies diesel for the largest marketing outlet of that fuel: Pilot Flying J Centers LLC. Berkshire Hathaway purchased 38.6% of that company’s stock on October 3, 2017, and plans to increase its stake in 2023 to 80%.
Bottom Line: Commodity futures haven’t been a good investment, given that their aggregate value is back to where it was 25 years ago, given that the most recent 20-year supercycle recently finished and another is just starting. Nonetheless, the companies that produce, process, and transport those commodities did well over those 25 years (see Column AB in Table). The problem is the volatility of their stocks (see Column M in the Table), and the extent to which their stocks get whacked when commodities become oversupplied relative to demand (see Column D in the Table). If you choose to own shares in these companies (aside from CNI, BRK-B and perhaps UNP), you’d be flat-out gambling.
Risk Rating: 7-9 (where US Treasury Notes = 1, S&P 500 Index = 5, and gold bullion = 10)
Full Disclosure: I dollar-average into UNP, ADM, CAT and XOM, and also own shares of CNI and BRK-B.
"The 2 and 8 Club" (CR) 2018 Invest Tune Retire.com All rights reserved.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, January 4
Week 183 - Buffett Buy Analysis of Oil and Natural Gas Companies
Situation: Oil and natural gas companies account for 8% of US GDP. Their stock prices mainly reflect 3 factors: 1) the pricing of front-month futures contracts, 2) the amount of proven and economically recoverable reserves in the ground, and 3) the expected rate of growth in the world’s appetite for oil. All of those numbers will fall if there is a recession in one of the world’s major economies. Europe is now on the brink of entering its third recession in 10 yrs (triggered by the crisis in Ukraine), which is one reason why the price of oil fell 40% between June and December. But there are two other reasons to consider.
The US is becoming the dominant oil and gas producing country by rapidly exploiting the twin technologies of hydrofracking and horizontal drilling. This is now causing a price war with the about-to-be-eclipsed countries (Russia and Saudi Arabia). Their strategy is to continue maximal production with traditional technology, which is cheaper than hydrofracking. That means their oil and gas has a lower price point (for making a profit) than US oil and gas. We’ll see who wins, but in the meantime the US consumer gets to have a better Christmas!
The remaining reason why the price of oil is falling is that vehicles are getting better fuel economy. And, $4.00/gal gasoline has changed people’s driving habits, e.g. fuel economy is now the most important consideration when buying a car. More importantly (for the long term), natural gas is starting to replace gasoline and diesel fuel in commercial and municipal vehicles, and even in locomotives and jet fighters. The revolution doesn’t end there, because electric motors will likely power most highway vehicles by 2050, given the current pace of research into battery development. Natural gas will remain an important feedstock for electrical power plants but there will be little need for oil other than as a lubricant and a source of asphalt.
Caveat Emptor: The “story” that supports the prices of energy stocks is always in flux, as well as being complex.
Given that oil and natural gas companies will increasingly emphasize natural gas production over oil production, is this a good time to invest in these suddenly cheap companies? By now, of course, you realize this would be more of a gamble than prudently investing for retirement. Normally, one makes this decision by estimating future earnings (or cash flows), then applying the growth rate for that industry to discount earnings back to the present. That gives an estimate for Present Value for the stock (i.e., what the current price should be). That Discounted Cash Flow (DCF) method has never worked very well for volatile (cyclical) stocks. Those are the ones that track the ups and downs of the economy too closely, such as oil and gas “exploration and production” stocks.
Instead, let’s use our old standby of the Buffett Buy Analysis (BBA). It simplifies the DCF method by projecting the trend-line for the past decade’s growth in core earnings (as calculated by S&P) to the end of the next decade (see Week 30, Week 94 and Week 135). That number is then multiplied by the worst P/E seen in the past decade. Mr. Buffett adds on the value of its current annual dividend multiplied by 10, since he doesn’t assume the company will be growing its dividend. Voila! He has a price prediction for 10 yrs from now and can calculate the BBA, which is total return/yr over the next 10 yrs (see Column T in the Table).
How has that worked out for him buying oil and natural gas stocks? He bought 18 million shares of ConocoPhillips (COP) early in 2006 for Berkshire Hathaway but soon thereafter decided he’d bet on the wrong horse. Now he’s down to 1.4 million shares of COP and 6.5 million shares of Phillips 66 (the recent spin-off of ConocoPhillips’ refinery operations). With the proceeds from those sales, he bought 41 million shares of ExxonMobil (XOM) and 7.3 million shares of National Oilwell Varco (NOV). In other words, he changed his mind when the Great Recession exposed the underlying value of specific energy companies (see Table).
The Buffett Buy Analysis starts by determining whether the company has a Durable Competitive Advantage (DCA). Mr. Buffett defines a DCA as a decade’s worth of steady growth in Tangible Book Value (TBV) at a rate of at least 9%/yr, with no more than two down years (see Column S in the Table). We’ve used his method to analyze the 40 oil and natural gas stocks in the Barrons 500 List of the largest US and Canadian companies. After excluding companies that don’t have the required DCA, plus an S&P investment-grade bond rating (i.e., BBB- or better) and an S&P stock rating of at least B+/M, we are left with the 9 companies in the Table.
Bottom Line: Only two of these 9 oil and natural gas companies had a Buffett Buy Analysis that projected returns higher than 7%/yr over the next decade, namely, Cameron International (CAM) and National Oilwell Varco (NOV). Both are too risky to include in a retirement portfolio. However, ExxonMobil (XOM) is worth considering because it has the largest investment in natural gas production and is projected to have a total return close to 5%/yr over the next 10 yrs. Most importantly for you, XOM does satisfy our requirements for inclusion in a retirement portfolio:
1) the stock has a Finance Value (Column E in the Table) that beats our key benchmark (Vanguard Balanced Index Fund - VBINX);
2) the stock is an S&P Dividend Achiever;
3) the company’s bonds have at least a BBB+ rating from S&P;
4) the stock has at least a B+/M rating from S&P;
5) the stock has had dividend growth of at least 5%/yr for the past 14 yrs, and
6) the company is large enough to be included in the Barron’s 500 List published each year in May. The Barron’s 500 List is particularly useful because it ranks companies by sales growth and cash flow-based ROIC (Return On Invested Capital) for each of the two most recent years.
Risk Rating: 6
Full Disclosure: I dollar-average into XOM and also own shares of CVX.
Note: metrics in the Table are current as of the Sunday of publication. Red highlights in the Table denote underperformance vs. VBINX.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
The US is becoming the dominant oil and gas producing country by rapidly exploiting the twin technologies of hydrofracking and horizontal drilling. This is now causing a price war with the about-to-be-eclipsed countries (Russia and Saudi Arabia). Their strategy is to continue maximal production with traditional technology, which is cheaper than hydrofracking. That means their oil and gas has a lower price point (for making a profit) than US oil and gas. We’ll see who wins, but in the meantime the US consumer gets to have a better Christmas!
The remaining reason why the price of oil is falling is that vehicles are getting better fuel economy. And, $4.00/gal gasoline has changed people’s driving habits, e.g. fuel economy is now the most important consideration when buying a car. More importantly (for the long term), natural gas is starting to replace gasoline and diesel fuel in commercial and municipal vehicles, and even in locomotives and jet fighters. The revolution doesn’t end there, because electric motors will likely power most highway vehicles by 2050, given the current pace of research into battery development. Natural gas will remain an important feedstock for electrical power plants but there will be little need for oil other than as a lubricant and a source of asphalt.
Caveat Emptor: The “story” that supports the prices of energy stocks is always in flux, as well as being complex.
Given that oil and natural gas companies will increasingly emphasize natural gas production over oil production, is this a good time to invest in these suddenly cheap companies? By now, of course, you realize this would be more of a gamble than prudently investing for retirement. Normally, one makes this decision by estimating future earnings (or cash flows), then applying the growth rate for that industry to discount earnings back to the present. That gives an estimate for Present Value for the stock (i.e., what the current price should be). That Discounted Cash Flow (DCF) method has never worked very well for volatile (cyclical) stocks. Those are the ones that track the ups and downs of the economy too closely, such as oil and gas “exploration and production” stocks.
Instead, let’s use our old standby of the Buffett Buy Analysis (BBA). It simplifies the DCF method by projecting the trend-line for the past decade’s growth in core earnings (as calculated by S&P) to the end of the next decade (see Week 30, Week 94 and Week 135). That number is then multiplied by the worst P/E seen in the past decade. Mr. Buffett adds on the value of its current annual dividend multiplied by 10, since he doesn’t assume the company will be growing its dividend. Voila! He has a price prediction for 10 yrs from now and can calculate the BBA, which is total return/yr over the next 10 yrs (see Column T in the Table).
How has that worked out for him buying oil and natural gas stocks? He bought 18 million shares of ConocoPhillips (COP) early in 2006 for Berkshire Hathaway but soon thereafter decided he’d bet on the wrong horse. Now he’s down to 1.4 million shares of COP and 6.5 million shares of Phillips 66 (the recent spin-off of ConocoPhillips’ refinery operations). With the proceeds from those sales, he bought 41 million shares of ExxonMobil (XOM) and 7.3 million shares of National Oilwell Varco (NOV). In other words, he changed his mind when the Great Recession exposed the underlying value of specific energy companies (see Table).
The Buffett Buy Analysis starts by determining whether the company has a Durable Competitive Advantage (DCA). Mr. Buffett defines a DCA as a decade’s worth of steady growth in Tangible Book Value (TBV) at a rate of at least 9%/yr, with no more than two down years (see Column S in the Table). We’ve used his method to analyze the 40 oil and natural gas stocks in the Barrons 500 List of the largest US and Canadian companies. After excluding companies that don’t have the required DCA, plus an S&P investment-grade bond rating (i.e., BBB- or better) and an S&P stock rating of at least B+/M, we are left with the 9 companies in the Table.
Bottom Line: Only two of these 9 oil and natural gas companies had a Buffett Buy Analysis that projected returns higher than 7%/yr over the next decade, namely, Cameron International (CAM) and National Oilwell Varco (NOV). Both are too risky to include in a retirement portfolio. However, ExxonMobil (XOM) is worth considering because it has the largest investment in natural gas production and is projected to have a total return close to 5%/yr over the next 10 yrs. Most importantly for you, XOM does satisfy our requirements for inclusion in a retirement portfolio:
1) the stock has a Finance Value (Column E in the Table) that beats our key benchmark (Vanguard Balanced Index Fund - VBINX);
2) the stock is an S&P Dividend Achiever;
3) the company’s bonds have at least a BBB+ rating from S&P;
4) the stock has at least a B+/M rating from S&P;
5) the stock has had dividend growth of at least 5%/yr for the past 14 yrs, and
6) the company is large enough to be included in the Barron’s 500 List published each year in May. The Barron’s 500 List is particularly useful because it ranks companies by sales growth and cash flow-based ROIC (Return On Invested Capital) for each of the two most recent years.
Risk Rating: 6
Full Disclosure: I dollar-average into XOM and also own shares of CVX.
Note: metrics in the Table are current as of the Sunday of publication. Red highlights in the Table denote underperformance vs. VBINX.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, November 20
Week 20 - Mining & Drilling for Key Commodities: Oil & Gas
Situation: The key commodities extracted from the ground (oil, natural gas, copper and gold) are heavily traded on regulated futures exchanges. Open interest amounts to almost $100 billion but many more contracts trade “over the counter”, i.e., removed from the prying eyes of competitors and regulatory agencies. Some of the companies that find and extract commodities also refine, transport, and/or sell their product. Other companies provide additional services and equipment.
Goal: Orient the ITR investor to dividend-paying companies that produce (or support the production of) key commodities.
This week’s blog takes the ITR investor beyond the Master List into cyclical companies that take more chances with more up-front money. Why? Because these companies supply us with essential commodities. High fixed costs characterize every company that extracts materials from the earth by mining or drilling. When commodity prices are high, new companies are tempted to enter the fray, which then drives prices down. The companies that survive the melee can’t afford to continue innovating and expanding; production remains flat or declines until the economy re-expands enough for the survivors to “pick up the slack”. Most companies that dig commodities out of the ground are dependent on investors who are willing to lose everything in the hope of a big return. If it’s a young company that hasn’t had a chance to expand into safer sidelines (refining, transporting, merchandising), it will likely fail. However, these “junior miners” have enormous upside potential and therefore attract investors who want to gamble.
To analyze companies that mine gold & copper, or drill for oil & gas, it is helpful to focus on a particular geological province that attracts a typical grouping of companies. The Western United States is rich in such provinces with the current favorite being the shale formations that mainly yield natural gas. The recoverable oil & gas in these formations is 3 times that known to be present in Saudi Arabia.
To take a closer look, we will focus our attention first on natural gas plays west of the continental divide. Drilling activities there have expanded rapidly for two reasons: new discoveries and technological breakthroughs that allow formerly marginal geology to be drilled anew. Drilling has increased dramatically since the advent of horizontal drilling and hydraulic fracturing (“fracking”). The Piceance Basin in NW Colorado is the most active recent find but production is rapidly expanding in the well-mapped Green River Basin in SW Wyoming and NE Utah.
The accompanying spreadsheet <click here to open> provides information about 9 companies active in exploration and production (E&P), plus 4 others that provide services and equipment (CAT, NOV, BHI, and SLB). The 6 pure E&P companies are riskiest (APC, NBL, EOG, DVN, ECA, COG) but the 3 companies with refineries (XOM, CVX, and RDS-B) do well through thick and thin, with significant fluctuations in share price because of being tightly tied to the economic cycle. The 4 servicing companies show the fastest earnings growth in each business cycle but with even more marked fluctuations in share price. This pattern (of mining & drilling suppliers reaping the most profit) has held true since as far back as the 1849 California Gold Rush.
All 13 companies pay dividends and are followed by S&P. XOM, ECA, CVX, and NBL are active in Piceance Basin; DVN, RDS, COG, EOG, APC, APC, and CVX are active in Green River Basin. The drilling activity is hard to miss if you’re driving along I-70 in Colorado between the towns of Rifle and Grand Junction. You’ll see many oil service trucks plus the roadside buildup of servicing depots (e.g. near DeBeque). Driving I-80 west of Rawlins, Wyoming, is even more revealing because there is little else to see. An entire city (Wamsutter) has been built for oil workers where only a single gas station existed 15 years ago. Driving through that barren stretch at night is otherworldly because of lights and mists around drilling rigs that are hard to see by daylight.
The big problem with investing in E&P companies is that there always seems to be a wide variation in the quality of management and a shortage of skilled workers. These problems are related because good workers tend to follow good managers. If you’re investing in Exxon (XOM), Chevron (CVX), Shell (RDS-A) or Schlumberger (SLB), that problem has likely been solved. Here at ITR, we’ve been trying to get a handle on the others. We’ll keep you informed of our progress looking at shale plays.
Bottom Line: Drillers have to make a large up-front investment in order to make a lot of money several years down the road (living with a big “maybe”). Most drilling companies are small and don’t last long but do start strong by using money from impatient investors who are attracted to the potential for great rewards. The drillers that do succeed typically look for sidelines with more stable revenues, i.e., lay pipelines, refine petroleum & develop commodity chemicals, transport those products, and open service stations to fuel planes, ships, trucks, and cars.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Goal: Orient the ITR investor to dividend-paying companies that produce (or support the production of) key commodities.
This week’s blog takes the ITR investor beyond the Master List into cyclical companies that take more chances with more up-front money. Why? Because these companies supply us with essential commodities. High fixed costs characterize every company that extracts materials from the earth by mining or drilling. When commodity prices are high, new companies are tempted to enter the fray, which then drives prices down. The companies that survive the melee can’t afford to continue innovating and expanding; production remains flat or declines until the economy re-expands enough for the survivors to “pick up the slack”. Most companies that dig commodities out of the ground are dependent on investors who are willing to lose everything in the hope of a big return. If it’s a young company that hasn’t had a chance to expand into safer sidelines (refining, transporting, merchandising), it will likely fail. However, these “junior miners” have enormous upside potential and therefore attract investors who want to gamble.
To analyze companies that mine gold & copper, or drill for oil & gas, it is helpful to focus on a particular geological province that attracts a typical grouping of companies. The Western United States is rich in such provinces with the current favorite being the shale formations that mainly yield natural gas. The recoverable oil & gas in these formations is 3 times that known to be present in Saudi Arabia.
To take a closer look, we will focus our attention first on natural gas plays west of the continental divide. Drilling activities there have expanded rapidly for two reasons: new discoveries and technological breakthroughs that allow formerly marginal geology to be drilled anew. Drilling has increased dramatically since the advent of horizontal drilling and hydraulic fracturing (“fracking”). The Piceance Basin in NW Colorado is the most active recent find but production is rapidly expanding in the well-mapped Green River Basin in SW Wyoming and NE Utah.
The accompanying spreadsheet <click here to open> provides information about 9 companies active in exploration and production (E&P), plus 4 others that provide services and equipment (CAT, NOV, BHI, and SLB). The 6 pure E&P companies are riskiest (APC, NBL, EOG, DVN, ECA, COG) but the 3 companies with refineries (XOM, CVX, and RDS-B) do well through thick and thin, with significant fluctuations in share price because of being tightly tied to the economic cycle. The 4 servicing companies show the fastest earnings growth in each business cycle but with even more marked fluctuations in share price. This pattern (of mining & drilling suppliers reaping the most profit) has held true since as far back as the 1849 California Gold Rush.
All 13 companies pay dividends and are followed by S&P. XOM, ECA, CVX, and NBL are active in Piceance Basin; DVN, RDS, COG, EOG, APC, APC, and CVX are active in Green River Basin. The drilling activity is hard to miss if you’re driving along I-70 in Colorado between the towns of Rifle and Grand Junction. You’ll see many oil service trucks plus the roadside buildup of servicing depots (e.g. near DeBeque). Driving I-80 west of Rawlins, Wyoming, is even more revealing because there is little else to see. An entire city (Wamsutter) has been built for oil workers where only a single gas station existed 15 years ago. Driving through that barren stretch at night is otherworldly because of lights and mists around drilling rigs that are hard to see by daylight.
The big problem with investing in E&P companies is that there always seems to be a wide variation in the quality of management and a shortage of skilled workers. These problems are related because good workers tend to follow good managers. If you’re investing in Exxon (XOM), Chevron (CVX), Shell (RDS-A) or Schlumberger (SLB), that problem has likely been solved. Here at ITR, we’ve been trying to get a handle on the others. We’ll keep you informed of our progress looking at shale plays.
Bottom Line: Drillers have to make a large up-front investment in order to make a lot of money several years down the road (living with a big “maybe”). Most drilling companies are small and don’t last long but do start strong by using money from impatient investors who are attracted to the potential for great rewards. The drillers that do succeed typically look for sidelines with more stable revenues, i.e., lay pipelines, refine petroleum & develop commodity chemicals, transport those products, and open service stations to fuel planes, ships, trucks, and cars.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, September 11
Week 10 - Commodity-related Stocks
Situation: Industrial and/or agricultural commodities represent the necessary feedstocks (i.e., inputs) for producing the items that are sold by many companies. The “spot price” for a commodity can vary widely, often driven by scarcity. Other influencing factors include production bottlenecks, transportation problems, weather, war, and changes in currency valuation that the commodity is priced in - usually the US dollar. For many commodities, prices are set for future sale through “futures contracts” using formal clearinghouses and regulated futures exchanges. For other commodities, an informal “forward contract” between parties is arranged through a bank. Additional companies have sprung up around production and/or transportation of key commodities, and have learned to factor in the many problems entailed. These are the types of companies we will examine for investment value this week.
Goal: To orient the investor to the few commodity-related companies that meet ITR’s investment criteria.
Such commodity-related companies are a key category of stock ownership. Why? Because most commodities are priced in US dollars (but produced elsewhere), which becomes a major factor driving total return for those stocks. Owning stock in such a company gives the investor insurance against devaluation of the dollar (currently running +5% per yr). Another reason is that economic activity is, in large part, a function of commodity consumption. For example, you may have heard the term “Dr. Copper” thrown around by market pundits on TV shows. It simply means that a change in the price of copper foretells a change in GDP of countries that require large amounts of copper to expand their infrastructure. So the most credible “weatherman” for predicting the economic climate in China, for instance, is the price of copper from mines in Northern Australia and Indonesia.
Futures exchanges trade the most common raw commodities (e.g. oil, natural gas, corn, wheat, copper, gold). Roughly half of the companies in these markets process and/or transport raw commodities. The others are end-users or speculators who bet on price changes. ExxonMobil (XOM), Chevron (CVX), and Occidental Petroleum (OXY) are commodity-related stocks that meet our investment criteria. Two foreign stocks BHP Billiton (BHP, an Australian mining company) and Total SA (TOT, an integrated oil company in France) also appear to meet our criteria. Neither has been assigned a quality rating by S&P but both have total returns, large and growing dividends, and bond ratings consistent with our criteria (see the ITR Mission & Goals).
Two other economic sectors contain some companies that are commodity-related:
Goal: To orient the investor to the few commodity-related companies that meet ITR’s investment criteria.
Such commodity-related companies are a key category of stock ownership. Why? Because most commodities are priced in US dollars (but produced elsewhere), which becomes a major factor driving total return for those stocks. Owning stock in such a company gives the investor insurance against devaluation of the dollar (currently running +5% per yr). Another reason is that economic activity is, in large part, a function of commodity consumption. For example, you may have heard the term “Dr. Copper” thrown around by market pundits on TV shows. It simply means that a change in the price of copper foretells a change in GDP of countries that require large amounts of copper to expand their infrastructure. So the most credible “weatherman” for predicting the economic climate in China, for instance, is the price of copper from mines in Northern Australia and Indonesia.
Futures exchanges trade the most common raw commodities (e.g. oil, natural gas, corn, wheat, copper, gold). Roughly half of the companies in these markets process and/or transport raw commodities. The others are end-users or speculators who bet on price changes. ExxonMobil (XOM), Chevron (CVX), and Occidental Petroleum (OXY) are commodity-related stocks that meet our investment criteria. Two foreign stocks BHP Billiton (BHP, an Australian mining company) and Total SA (TOT, an integrated oil company in France) also appear to meet our criteria. Neither has been assigned a quality rating by S&P but both have total returns, large and growing dividends, and bond ratings consistent with our criteria (see the ITR Mission & Goals).
Two other economic sectors contain some companies that are commodity-related:
(a) railroads and other shipping companies
(b) electric utilities
Most of the bulk cargo carried by freight trains and river barges is either a commodity or a commodity chemical. One of the railroads, Norfolk Southern (NSC), meets our quality criteria.
Some electric utilities source energy directly from their own wind farms and solar arrays instead of relying 100% on outside energy sources, such as natural gas, coal, and processed uranium. Wattage obtained from wind or solar is undependable and difficult to store (batteries aren’t yet big enough), so excess power is promptly sold to other power companies on the grid: A modern electric utility consists of a state-regulated monopoly alongside an unregulated subsidiary that markets electricity to the highest bidder anywhere in the US. The leading electric utility in North America in sourcing energy from wind and solar is NextEra Energy (NEE) and it meets the ITR quality criteria.
Finally, there are two companies that produce and transport various industrial gases, Praxair (PX) and Air Products (APD). Their products are vital to a wide range of industrial processes and are in almost constant demand. These gases are marketed through forward contracts on a custom basis, much like an unregulated commodity.
Bottom Line: We have introduced 9 companies that produce, transport or market commodities as their key business and also meet the ITR investment criteria:
Some electric utilities source energy directly from their own wind farms and solar arrays instead of relying 100% on outside energy sources, such as natural gas, coal, and processed uranium. Wattage obtained from wind or solar is undependable and difficult to store (batteries aren’t yet big enough), so excess power is promptly sold to other power companies on the grid: A modern electric utility consists of a state-regulated monopoly alongside an unregulated subsidiary that markets electricity to the highest bidder anywhere in the US. The leading electric utility in North America in sourcing energy from wind and solar is NextEra Energy (NEE) and it meets the ITR quality criteria.
Finally, there are two companies that produce and transport various industrial gases, Praxair (PX) and Air Products (APD). Their products are vital to a wide range of industrial processes and are in almost constant demand. These gases are marketed through forward contracts on a custom basis, much like an unregulated commodity.
Bottom Line: We have introduced 9 companies that produce, transport or market commodities as their key business and also meet the ITR investment criteria:
- Exxon Mobile (XOM)
- Chevron (CVX)
- Occidental Petroleum (OXY)
- BHP Billiton (BHP)
- Total SA (TOT)
- Norfolk Southern Railroad (NSC)
- NextEra Energy (NEE)
- Praxair (PX)
- Air Products (APD)
Sunday, July 10
Week 1 - An Introduction to Our Blog
Who benefits from reading our ITR blog every week?
That would be the recently burned, casual investor - let's say a career woman who thought of herself as being risk averse (until the recent crash). She doesn't hold an MBA or work in a bank but does find investing to be a fascinating and useful hobby. She expects an asset will pay her rental income, interest, or a dividend, so she cannot be called a speculator. She may have owned a capital appreciation stock mutual fund but probably learned her lesson in the recent downturn. You would find her in a casino only to use the bathroom, or have a meal washed down with iced tea, and on a brokerage office Risk Questionnaire, she will score as a solid "growth & income investor". Her investment style is probably "capital preservation", where her main strategy is to protect her core investment monies.
That would be the recently burned, casual investor - let's say a career woman who thought of herself as being risk averse (until the recent crash). She doesn't hold an MBA or work in a bank but does find investing to be a fascinating and useful hobby. She expects an asset will pay her rental income, interest, or a dividend, so she cannot be called a speculator. She may have owned a capital appreciation stock mutual fund but probably learned her lesson in the recent downturn. You would find her in a casino only to use the bathroom, or have a meal washed down with iced tea, and on a brokerage office Risk Questionnaire, she will score as a solid "growth & income investor". Her investment style is probably "capital preservation", where her main strategy is to protect her core investment monies.
The ITR target investor is one who finds the information provided about stock mutual funds to be inadequate. While bond mutual funds describe investment style in terms of both the credit risk and average time to maturity (risk of loss in value of long-term bonds due to inflation), similar information can be difficult to ascertain with stock mutual funds. Even when a company issues bonds, as most do, it is difficult to access that information. This is probably because many companies issue bonds that carry high credit risk and have long maturation periods. Standard & Poor's (S&P) rates each company's common stock and bond portfolio but that information is not required in a stock mutual fund prospectus. Managers of stock mutual funds like to invest in riskier stocks because in a “bull market” those stocks make the fund perform better than the relevant benchmark index. This is good for advertising because it suggests that the fund manager is a brilliant stock picker. But such is not the case: in a “bear market”, losses will be greater than for the benchmark. This is why the large majority of stock mutual funds lost more in 2008 than the standard benchmark – the S&P 500 Index, which lost a whopping 37%. And that 37% loss is just too great for our ITR reader. Having been burned, she will now shy away from stock mutual funds and wants to learn to invest directly in company stocks on her own.
This is best achieved by using a company's Dividend Re-Investment Plan (DRIP). Using a DRIP keeps trading costs low (you don't pay fees to a broker) and allows you to capture the power of compound interest through automatic re-investment of dividends. A monthly electronic purchase plan results in “dollar-cost averaging”, giving a certainty of buying cheaply during market down-turns. This type of an investment strategy lets our ITR investor develop a portfolio of 5-10 stocks with dividend re-investment, just as a bond mutual fund manager reinvests interest payments.
Now the problem for our investor becomes one of concentration: holding fewer than 50 stocks in a portfolio exposes the portfolio to market risk. There are two things that offer protection. One is to confine purchases to stocks that carry S&P Quality Ratings of A- or above, and the second is to choose only those companies that have increased dividends annually for at least 10 years. Stock in dividend-paying companies has been shown to hold up better in market downturns, thus some "insurance" is obtained by choosing stocks that yield more than an S&P 500 Index Fund (an example is SPY, an exchange-traded fund; current yield 1.8%).
Stock market risk can also be reduced (or hedged) using two other tools: diversification of holdings across industries, and by investing in other markets: foreign stocks, bonds (both US and foreign), rental properties and commodities markets. Problems arise though: commodity futures contracts pay no interest or dividends, and charges are steep, making these instruments suitable only for short-term investing by expert traders. Rental properties also carry significant charges. Unless one owns a Class A apartment building in a growing town, rental income isn't going to help in a stock market crash because occupancy will likely fall. Risks from owning a single apartment building can be diffused by owning a real estate investment trust (REIT) that invests in a number of Class A apartment buildings in different regions of the country, but value will still fall in a difficult economy. Thus, REITs are not a useful asset for someone who emphasizes capital preservation.
Let's take a closer look at companies that produce, package, transport, and market commodities. Some of these have S&P Quality Ratings of A- or better, yield as much or more than SPY, and have increased that payout annually for at least 10 years. (Whoa! Now our investor is tuned in . . .) These companies have found a way to develop raw commodities and consistently produce reliable streams of cash flow for reinvestment (after dividends are paid to stockholders and interest to bondholders). The major traditional commodities with a regulated "futures" market include corn, soybeans, wheat, live cattle, lean hogs, cocoa, coffee, sugar, gold, silver, copper, crude oil, heating oil and natural gas. There are 6 companies meeting our criteria that manage these feedstocks as their primary line of business. A future blog will identify and discuss these companies. All 6 had a 10-year total return of at least 7.7%/year, whereas, the median total return of a Fortune 500 company over that period was 6.7%/year (Fortune Magazine, May 23, 201, volume 163, no. 7, pp F2-F32) and the total return for the S&P 500 Index was 1.3%/year (moneychimp.com). However, commodity producers like these 6 companies suffer during stock market pull-backs, such as the one we've just experienced. A future ITR blog will discuss how to manage this risk.
Commodity markets are priced in dollars and globally sourced, which is the main support for their investment value. Therefore investments that are tied to a commodity represent a hedge against dollar depreciation. For that reason alone, it is worthwhile to buy stock in companies that can pass changes in valuation along to end-users. Future installments of our blog will address other key inputs to the economy that behave similarly, such as electricity.
Bottom Line: Our weekly ITR blog will provide you with tools that allow you to become your own fund manager. We know it’s a complicated undertaking and difficult for new investors to feel comfortable with these concepts. Each week we will post our take on the topics we’ve introduced to you and provide further analysis and tools for you to use in managing your portfolio.
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