By Brian Nelson, CFA
US natural gas prices (NGAS) recently dropped to the lowest level in nearly 14 years. Unseasonably warm weather may be to blame for the near-term drop, but we point to more structural concerns that may keep natural gas prices low for some time. Including both unconventional and conventional global natural gas resources, for example, there are more than 200+ years’ of supply based on the current trajectory of demand, and that doesn’t account for technology advances that will inevitably be made in the coming decades. Can you believe it?
The situation with crude oil prices is not much better. West Texas crude oil prices (USO) dipped below $35 per barrel recently, still the high end of the historical range of $10-$35 from the period 1870-1970 (100 years), suggesting in our view that further declines may still be ahead, if history is any guide. Many “peak oil” enthusiasts have become so used to the prices of the recent past, a form of recency bias, that many still can’t come to grips that the energy bull market may be permanently over – that the reversion to the mean may actually be a reversion to the historical crude-oil mean ($10-$35), not just that of the past decade or so, which saw crude oil prices frequently over $100 per barrel. There’s nothing that says we can’t revisit 1998 levels, for example, which saw crude oil average ~$12 per barrel.
What has changed in this cycle? For one, OPEC continues to produce to put US shale oil independents out of business in a strategy that has morphed into market-share retention as opposed to supporting the price of crude, as the cartel has done in so many previous downturns. Many say member nations of OPEC “smell blood,” and they might be right – if only they can hold out for another 12-18 months, they may say, supply in the US will slow as many independents are inevitably forced into Chapter 11, then putting into jeopardy the midstream sector, a scenario we have been warning about quite extensively. US commercial supplies in the US, for example, remain at 80+ year highs for this time of year. Perhaps the right question is not when will crude oil prices go back up again, but why haven’t we hit $20 per barrel or lower yet? I’m worried – executive teams are not prepared, in my opinion.
The high-yield bond markets continue to be on life support. The major credit rating agencies are anticipating a surge in defaults in this “junk-rated” segment, and we believe they are right. Many low-quality upstream exploration and production entities may be first to fold in the event energy resource pricing remains low for most of 2016, bringing down several leveraged names in the energy services space, and we even think the dividends of the largest majors may eventually come under pressure – the payouts of firms that nobody could possibly have imagined when crude oil prices were $100+ per barrel – we’re talking about Chevron (CVX) and ConocoPhillips (COP). For income safety, there’s really only one true idea within the energy sector, in our view, and that’s ExxonMobil (XOM). The energy giant’s integrated business helps shield energy price volatility to a degree, and its pristine AAA credit rating can be used to solve a lot of problems, even those remaining on the horizon. Though even Exxon’s balance sheet has ballooned as of late, we hold it in the Energy Sector SPDR (XLE), a position in both newsletter portfolios.
The metals and mining arenas may be in the worst shape of all. Export dependent countries such as Brazil and Canada continue to languish in recession, as global growth slows across much of Asia, including China and Australia. The last time we checked iron ore prices were at 10-year lows, and BHP Billiton (BHP) and Rio Tinto (RIO) continue to produce to their respective heart’s content (not a good thing for prices). Many have started to question the sustainability of their dividend payouts, and frankly, their respective Dividend Cushion ratios aren’t great either. We believe 2016 will usher in an even more punitive “trickle down” impact on several energy services names and engineering and construction companies as business dries up in light of slower emerging market growth. Caterpillar (CAT) could be in for a world of hurt, and many that are counting on its dividend may be sorely disappointed in coming years.
Without a doubt, the biggest news to those not following our research of the past month was the cut in Kinder Morgan’s (KMI) dividend. We’ve done our best to throw all of our human-capital resources behind helping investors get ahead of this dividend cut and also ahead of the collapse in the prices of many in the master limited partnership (MLP) arena. We know there are competing voices and opinions out there, but I believe our team did the best anyone could do in highlighting these risks and saving members a significant amount of capital. One of our members even noted, “I think you saved me enough money in this instance alone to pay my Valuentum subscription for the next 160 years. My great-great-great-great-great grandchildren thank you.” Words like this keep us going when everyone tells us how wrong we are. It almost never fails. They told us we were wrong on the mortgage REITs, on SeaDrill (SDRL), and on Kinder Morgan. Many still believe we’re wrong. I guess I’ll never get used to it.
On December 6, we wrote a piece recapping the performance of the Best Ideas Newsletter portfolio on a year-to-date basis, calculating the average and median performance of those constituents that were in the portfolio at the beginning of the year and weren’t removed subsequent to that (we’ll do a similar calculation for the Dividend Growth Newsletter portfolio when it is released early January). We found that the average and median returns of constituents in the portfolio were 7.7% and 9.3%, respectively, exceeding the return of the S&P 500 (SPY), which stood at ~3.5% at the time of measurement. Nearly two thirds of ideas that were included in the Best Ideas Newsletter portfolio at the start of the year outperformed the market benchmark. In the difficult market of 2015, it certainly wasn’t an easy task, with most of the energy and commodities complex collapsing around us.
Before we part in this intro of the December edition of the Best Ideas Newsletter, I want to emphasize something that I’ve been saying for some time, especially to those just putting their hard-earned money to work in the market now. I have to tell you that the end of 2015 may mark the sixth consecutive year that the market has advanced since the March 2009 panic bottom that marked the depths of the Financial Crisis. Broad market benchmarks, including the S&P 500, have literally tripled since that time, and we’d be foolish to believe that 2016 will be a repeat of the past six years. In our view, it’s growing increasingly more likely that next year will be a down year and 2017 may be an even bigger down year after that. The repercussions of weakening energy and commodity markets coupled with lower emerging market growth and the beginning of a contractionary monetary policy cycle in the US could make this happen all too easily.
A more conservative outlook to market returns in coming years is why we continue to hold ~30% of the Best Ideas Newsletter portfolio in cash, even as we hope to put much of this excess capital to work in coming years in the event the equity market does swoon. I wish I could leave you on a more cheery note, especially this time of year, but I do sincerely care. I can’t simply omit letting you know where we are in the stock market cycle, and the increased likelihood that the market may put up negative absolute returns in 2016 and 2017. From this humble newsletter writer’s perspective, I believe it’s more likely than not. That doesn’t mean the Best Ideas Newsletter won’t do well, however. It just means indexers could be in for some pain. Let’s not dwell on that. Happy holidays everyone!