Sunday, January 11, 2015

Oil Spill

The decline in gasoline prices was the big story during the fourth quarter.  Crude oil prices began that downward move earlier in the year.  The price per barrel was more than $100 before prices gradually started to fall.  Many industry analysts pointed to the U.S. Dollar's surge in value as the culprit.  That reinforced downward pressure on commodity prices in general.  Some commodity exporters reduced gasoline subsidies as a way to help balance their budgets.  That caused consumption to drop in several countries that buy political support with energy and food subsidies.  Worldwide growth was moderating anyhow due to sanctions against Russia in Europe, a completely new government strategy in India, and a transition towards a more consumer based economy in China.  The United States and the more with-it parts of Africa, Southeast Asia, and South America continued to expand, keeping the worldwide numbers reasonably intact.  But crude production outpaced demand, fueled by predictable gains in the United States and more sudden bursts in Libya and Iraq.  Those countries have massive reserves and moved fast to make some money as military hostilities abated.

Saudi Arabia and its Middle East partners were expected to cut output to keep supply in balance and prices steady.  That's their traditional role and there was no indication they wouldn't do it again.  Of course, they kept output running at full blast this time around.  It was so out of character and economically unnecessary a lot of people, ourselves included, assumed the Saudis had an ulterior motive.  We figured it was exerting pressure on Iran to agree to an ironclad nuclear treaty, and was helping the U.S. force Russia into a Ukraine deal in the bargain.  That still seems like a logical explanation although a second narrative has emerged.  That one describes Saudi Arabia as becoming fed up with the United States policy towards Syria and Iraq and the rest of the Middle East.  And as retribution it's crushing the American energy revolution.

More likely, the whole thing has just spun out of control.  None of it was planned to go the way it did.  The worldwide supply and demand equation for crude oil remains pretty close.  Inventories built up in 2014 due to Libya and Iraq moving into the market, combined with modestly slower consumption growth.  Some technical factors added to the imbalance.  For instance, natural gas liquids (NGLs) are a fracking by-product.  They get mixed in with gasoline and other crude based products.  Ethanol production increased, too.  But the size of the supply-demand imbalance is far smaller than the price decline would suggest.  Wall Street and the hedge funds perhaps amplified the move.  But that tail could wag the dog in a completely different direction if sentiment changes.

It's impossible to predict how the situation will be resolved.  American drillers seem to require $75 oil just to break even with their existing cost structure.  Those costs are coming down in a hurry, though.  Some basins already enjoy lower break even points.  It's extremely unlikely that the market price will return to $100 a barrel any time soon.  Indeed, triple digit oil prices may not be seen again for years.  The marginal cost of production is coming down due to America.  And offshore reserves are being developed at $50-$60 break even points.  Prices eventually will have to rise above those break even points to allow for some profit.  Otherwise the development won't occur.  But the industry is poised to remain on course.  Today's low prices will bolster economic activity and build demand.  They'll also stimulate innovation and cost reduction.  No doubt some jackass companies will help Iran and Russia and Venezuela and Iraq to modernize their energy industries.  But most of the investment almost certainly will gravitate to America.  The outlook is a little crazy today but $1.79 a gallon is an interesting place to start.

All of the energy related stocks we follow were impacted by the plunge in crude oil prices.  Those declines were amplified, moreover, by further weakness in the U.S. natural gas market.  Prices in that segment are below replacement cost these days, as well.  Computer Modelling, a long time favorite, is experiencing an upturn in business among a lot of its customers.  Alternatively, orders are falling in the Canadian tar sand segment due to the high cost structure there.  The Keystone XL pipeline might improve the situation.  Just as likely, U.S. frackers in North Dakaota will hijack the pipeline for their own benefit.  The company supplies software that helps oil and gas producers maximize production from the fields they're working on.  The fracking revolution already has improved the hit rate on new drilling to 90% compared to 10% in the old days.  Even so, the formations are complicated.  Computer Modelling helps producers attack their fields efficiently, getting more bang for the buck.  A more traditional oilfied supplier, Profire Energy, offers computerized hardware systems that remove impurities when oil and gas (either) are lifted out of the ground.  Business has moderated temporarily as customers husband their financial resources.  But Profire has penetrated a very small part of the market to date.  It faces little competition.  And it has developed two more high potential products using the positive cash flow it generates from its core business.

Green energy investments have been hammered, too.  Highpower International is a leading manufacturer of lithium-ion batteries used primarily in consumer electronics at this stage.  But the company is expanding quickly into the electric vehicle market in China.  That business is being stimulated by poor air quality in many Chinese cities.  The government has made it a top priority to eliminate as much of that pollution as it can by converting from gasoline to electric and hybrid vehicles.  Sevcon is involved in that business, as well.  Both companies have partnered with top tier bus and car manufacturers.  That's critical because everybody and their Uncle Wang is diving into the business.  Building poor connections could lead to disaster.  Making good ones could propel financial performance to spectacular levels.  Both companies have solid foundations but have seen their shares fall of late due to the oil price pressure.

The drop in energy related shares exerted a drag on our performance during the December quarter.  Up to that point we had been ahead of the market, despite significant headwinds that dimmed overall small cap performance.  Last year investors swarmed into index investing.  The macroeconomic scene remained difficult to fathom.  So investors found safety in numbers.  Rather than pick stocks they invested in the market.  That flow of funds lifted prices for those stocks that were part of the indexes.  The ones that didn't belong, though, their performance lagged.  Statisticians use a measure termed "relative strength" to compare how an individual stock performs against a particular index, like the S&P 500.  A rating of 100 means the stock appreciated the exact same amount.  A value of 110 means it outperformed by 10%.  Last year the average relative strength rating of all U.S. stocks was 91.  That means the average stock appreciated 9% less than the S&P 500.  The big cap index, which attracted all that money, was up 11% for the year.  The average individual stock, though, rose a mere 2%.  That trend is continuing so far in 2015.  But value is value and money is money.  A slingshot in the other direction seems inevitable.

It's hard to say what will trigger that.  Wall Street analysts live and die in the short term.  The first thing an aspiring stockbroker learns to say is, "You have to buy this today!"  They earn their keep on commission.  "Steady as she goes" isn't a money making sales pitch.  We were disappointed when the American people rejected Mitt Romney and re-upped with The Obamanomics in 2012.  But that was their right.  And here we are, slogging to the finish line.  We've discussed the administration's "Groundhog Day" economic policy several times in the past.  The American people finally have started to fight back and push forward despite the obstacles it creates.  But nothing has changed enough to make us think a meaningful improvement will occur before the next president takes over in 2017.  It could take even another year for that group to re-tool everything.

The recent stock market volatility seems like much ado about nothing.  Oil prices will recover somewhat but they likely will stay low by historical measures.  Interest rates will stay low unless the Federal Reserve artificially drives them higher.  Everybody thinks the Fed is aggressively holding rates down today by intervening in the Treasury market.  The data suggest otherwise.  Money supply growth is 4%-5%.  The velocity of money is at 60 year lows.  No wonder there is no inflation.  The U.S. Dollar is up because the amount in circulation isn't growing nearly as fast as before.  The underlying economy is okay, which provides a nice cover story.  But incomes aren't going up.  And the rich have so much money, the supply of capital far exceeds the investment opportunities that are available.  Dodd-Frank legislation stymied housing investment.  It also reduced new business formation, typically the biggest engine supporting jobs, income, and economic expansion.  Barack Obama attached a tax hike and a bullet train to every piece of highway and airport legislation that was proposed.  The only thing everyone did agree on was to spend more on fighting wars in the Middle East.  That could have produced a high rate of return, if we had managed the outcome the way Harry Truman did in Germany and Japan.  Unfortunately, a different approach was followed.

More positive news is being reported in the developing world.  Back in 1998 currency woes drove most emerging nations into deep recessions.  That's occurring again in some cases.  Russia, Nigeria, Venezuela and a few other dictatorships that rely on commodity exports are in trouble.  But many lesser followed nations have modernized their economic and legal systems, becoming more business friendly in the process.  Large swaths of Africa and South America have reduced their dependence on exports and diversified with greater emphasis on services and local directed manufacturing.  Less graft has allowed infrastructure investments to flourish, as well.  Foreign investors have moved into countries like Zambia and Chile, insulating them from the latest currency and commodity moves.  Larger countries like India and China are transitioning in that direction, too.  While worldwide economic growth is sure to slow a bit as a result of recent events pockets of strength are likely to hold up, keeping the overall picture intact.

Several stocks we follow have been impacted by knee-jerk reactions to the general currency and commodity trends.  LRAD, for example, is bidding on several Middle East projects.  Investors are worried the decline in oil money coming in will cause the projects to be cancelled or delayed.  But Saudi Arabia is committed to maintaining 4%-5% GDP growth even if oil prices remain at depressed levels.  A political transition is underway there, as well.  Domestic spending is virtually certain to be maintained by the new leadership to preserve political support.  SuperCom also is pursuing several emerging market contracts.  The company implements digital identification systems that help countries collect taxes and keep track of their citizens' comings and goings.  Some projects probably will be delayed until economic conditions stabilize more.  But a number are moving forward, laying the groundwork for sustained sales and earnings growth.  SuperCom also is developing a mobile payment system for less developed economies, allowing users to spend and collect digital funds using old fashioned cell phones that cost much less than the iPhone-6.  Evolving Systems also emphasizes the Third World.  One prospective contract, aimed at Russia, might go forward despite the recession that is occurring there.  More likely, that project will slip as the government marshals its diminishing cash reserve.  Still, Evolving is closing in on several other contracts in better situated nations.Those deals, like SuperCom's, foreshadow extended recurring revenue streams.  They also encourage competitors and nearby countries to adopt the technologies, providing additional leverage.

Slow economic growth combined with abundant capital promises to keep the stock market in good shape.  Big Cap stocks have become overvalued with the index style investing of the past several years.  A return to a more logical approach that looks at individual performance is brewing.  Don't worry about the general market.  Stay invested in a diversified portfolio of Special Situations.

Walter Ramsley
Executive Editor

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