Click on graph for larger image in graph gallery.
The End of QE2?
The Fed committed to buying $600 billion of Treasuries between the beginning of QE2 in November and the end of June. June is 3 months away. What will happen when that buying goes away? The hope when QE2 kicked off was that it would be enough to get the economy rolling, so that further stimulus would not be deemed necessary. We’ll survey how that is working out, with a quick look at some recent data, and then we go back and see what happened the last time the Fed stopped quantitative easing.First, the guy on the street is getting squeezed. Real US consumer spending slowed in January and looks like it did only marginally better in February. The Fed argues that inflation is mild, as they prefer to look at “core” inflation (inflation without considering food and energy). If you look at it that way, they are right. And in normal times, I can kind of see why we strip out energy and food, as they are very volatile price points and can move a lot from month to month.But that argument gets a lot weaker when your main policy, that of significant quantitative easing, is perhaps CAUSING the rise in food and energy (as well as weakening the dollar)! If the Fed policy is at least contributing to the cause of total inflation, arguing that food and energy don’t count doesn’t hold water. Let’s look at the following chart from economy.com.In particular, notice the rise in the last three months since the beginning of QE2. Inflation is running at over 5% on an annualized basis. Companies like Kimberly (diapers, etc.), Colgate, P&G, and others all announced 5-7% price increases this week. These are companies that provide staples we all buy. Those prices matter. Even Wal-Mart will have to pass those increases on. To say that food and energy don’t matter misses the point. These items have real economic impact.As my friend David Rosenberg wrote this morning:“In February, there was no inflation at all in average weekly wage-based earnings but there was 0.5% inflation in consumer prices, meaning that real work-related income was crushed 0.5% and has now deflated in each of the past four months and in five of the past six months, during which it has contracted at a 2.3% annual rate. Once the effects of fiscal stimuli wear off, this negative income trend will show through in a much more visible slowing in real consumer spending that we doubt the markets have fully discounted. So far, what has happened in equities has been treated as a financial event – just wait until the economic event follows suit. And it’s not only fiscal stimulus that is soon to subside. We still have that 86% correlation over the past two years between movements in the Fed balance sheet and the direction of the S&P 500 – this too will come home to roost before long, whether or not we end up seeing a resolution to the crises in Japan, Libya or Bahrain.”He goes on to give us this chart:How’s that QE2 thingy working for you, Mr./Ms. Average Worker? Prices up, income down? And remember, most workers got the equivalent of a 2% pay hike with the temporary boost in Social Security, which goes away at the end of the year (and without which the economy and consumer spending would be even worse!).Maybe that’s why New York Fed Chief William Dudley got heckled this week. (Courtesy of the Agora 5 Minute Forecast:)“Dudley – a 21-year vet of Goldman Sachs – stepped out of his bubble to explain Fed policy to real people in Queens.“It might not have been the first time Dudley attempted to gain the trust of the hoi polloi, but we’re pretty sure it’ll be the last. The details here were reported widely. We divined the scene from a Reuters report.“First Dudley swore up and down that inflation was no problem. ‘When was the last time, sir,’ came a reply from the audience, ‘that you went grocery shopping?’”“Dudley boldly proceeded to explain the concept of ‘core CPI’ – the cost-of-living measure designed for people who don’t eat or consume energy. Heh, we know firsthand how well that goes over…“Then in a brilliant stroke, he pointed to Apple’s shiny new iPad 2 to illustrate his point. ‘Today you can buy an iPad 2 that costs the same as an iPad 1 that is twice as powerful,’ he gamely explained. ‘You have to look at the prices of all things.’“‘I can’t eat an iPad,’ someone yelled from the crowd.”Ouch. (For the record, I do go to the grocery store and Wal-Mart and Home Depot, as well as other less frugal venues.)And core inflation may soon be under pressure. There were two articles yesterday, one from Yahoo and the other on Bloomberg. Both related to rising pressure on rental costs. (My recent lease renewal increase was significantly above core CPI!) (From http://realestate.yahoo.com/promo/rents-could-rise-10-in-some-cities.html)“Already, rental vacancy rates have dipped below the 10% mark, where they had been lodged for most of the past three years. ‘The demand for rental housing has already started to increase,’ said Peggy Alford, president of Rent.com… By 2012, she predicts the vacancy rate will hover at a mere 5%. And with fewer units on the market, prices will explode.”Look at this graph showing their projections:Here’s what to pay attention to. Notice that since 2002 (or thereabouts) rental costs have been flat, and down of late (inflation-adjusted). If Rent.com projections are anywhere close, we could see a rise in rents of 15% by the end of 2012.Let’s remember that 23% of the CPI and 40% of core CPI is Owner Equivalent Rent. If they are right, that adds about 3% to total CPI and 6% to core CPI! Will the Fed be telling us to focus on core inflation in 12-18 months? And those prices will start to show up steadily.“This is a sharp change from the recession, when many Americans couldn't afford to live on their own. More than 1.2 million young adults moved back in with their parents from 2005 to 2010, said Lesley Deutch of John Burns Real Estate Consulting. Many others doubled up together.“As a result, landlords had to reduce prices and offer big incentives to snag renters. Now that the recession is easing, many of these young people are ready to find new digs, mostly as renters, not owners. Plus, the foreclosure crisis continues unabated, and the millions losing their homes are looking for new places to live.”Producer Prices Up 35-40% in the Last Six Months
Then let’s look at business. The Producer Price Index was out this week, and it was way up – 1.6% for the month, or an annualized 20%+. Even if you look at the last year, it was up a real 5.8%. That is inflation in the pipeline. Look at this chart from economy.com. Notice the trend since QE2 was announced in August and implemented in November.I won’t bore you with the details, but for those interested, go to www.bloomberg.com and search for “Japan supply issues” and further on “semiconductors.” It is clear that, at least for a while, prices of electronics and tools are going to rise as one company after another is shutting its production lines down in Japan. Auto manufacturing plants in the US will have to close soon, as critical parts from Japan are not going to be forthcoming. Flat screen TVs? The iPad 2 I keep trying to find? All sorts of companies are going to get their costs squeezed even further. Remember, the above PPI numbers are from before the Japanese earthquake and tsunami and nuclear disaster.(I was in Tokyo less than two weeks ago. I can’t imagine the stress and anguish going on there. The scope of the disaster is just shattering. I encourage my readers to go to http://american.redcross.org and donate directly to their Japanese fund or the charity of your choice.A few details from Japan, though, gleaned from here and there. Sony alone makes 10% of the world’s laptop batteries. Japan is responsible for 30% of global flash memory, 20% of semi-conductors, and 40% of electronic components.The point is that the Fed has created real pressure in the price pipeline, primarily on basic commodities and energy. “Crude” goods, which is basically materials before there is any value added, are up 28% from a year ago and pushing an annualized 35-40% for the last six months. Those costs are filtering in to final finished products. And when you add in the supply-related problems from the recent disaster? It is not a pretty picture for profits.Let’s go back and look at a graph from friend Vitaliy Katsenelson, from a few weeks ago. It points out that corporate profits are back close to all-time highs as a percentage of GDP.As the brilliant Jeremy Grantham says, and I am paraphrasing, corporate profits are among the most mean-reverting of all statistics. And this makes sense unless capitalism is broke. High profits entice competitors to come in and take market share by selling for less.If corporate profits went back (mean-reverted) to their longer-term average, P/E ratios would be close to 24 at today’s prices. Corporations have some room to absorb some price increases, but at the expense of the bottom line.What Happens When We Come to the End of QE2?
We have only one instance where the Fed cut back on quantitative easing, and that was last year. It is a data set of one, but it is all we have. So, let’s look at what happened. As noted by several sources (but I am looking at Rosie’s list right now), the Fed let its balance sheet contract by some 12% from late April to late August. Quoting:“Now over that interval ...“The S&P 500 sagged from 1,217 to 1,064….The S&P 600 small caps fell from 394 to 330….The best performing equity sectors were telecom services, utilities, consumer staples, and health care. In other words — the defensives. The worst performers were financials, tech, energy, and consumer discretionary….Baa spreads widened +56bps from 237bps to 296bps…CRB futures dropped from 279 to 267….Oil went from $84.30 a barrel to $75.20….The VIX index jumped from 16.6 to 24.5….The trade-weighted dollar index (major currencies) firmed to 76.5 from 75.5….Gold was the commodity that bucked the trend as it acted as a refuge at a time of intensifying economic and financial uncertainty — to $1,235 an ounce from $1,140 and even with a more stable-to-strong U.S. dollar too….The yield on the 10-year U.S. Treasury note plunged to 2.66% from 3.84%…”What will happen this time around? Is the economy strong enough to grow on its own without stimulus, or strong enough that the Fed will be reluctant to continue with QE3?My friends at Macroeconomic Advisors have reduced their first-quarter GDP projection to 2.5%. Morgan Stanley has dropped theirs from 4.5% less than six weeks ago to 2.9% today. That is a huge drop in a short time for a forecasting model. Forecasts at other economic shops are being slashed as well. States and local governments, as I have continuously noted, are cutting more than 1% of GDP from their budgets as I write. That translates into real-world pressure on the GDP (even if it’stemporary, which I believe it to be, we live in the present).I am not ready to use the “R” word, but Muddle Through could show up with a true vengeance this summer, with higher inflation and slower growth. I lived through the ’70s, and frankly, I would just as soon not go see that movie again.The danger here is that the Fed (Bernanke) watches the economy slow and decides we need another round of quantitative easing. I have resisted that idea but, as I have noted, sometimes we need to think about the unthinkable.And thus, I come to the end of the letter with a brief note on a very worrisome conversation I had yesterday with Martin Barnes, editor of the esteemed Bank Credit Analyst. Martin is one of the people I call when I want to know what the Fed might do. I guess I was looking for assurance that the Fed would not do QE3. I did not get it.“Look, John” (insert Scottish brogue as I paraphrase), “if the Fed sees the economy rolling over into recession they will put their mandate for employment ahead of their mandate for stable prices.”“But that would mean higher inflation in the face of a slow economy.”“And?” he shot back. “That would just be the price of trying to increase employment, in their minds.”“But at some point you have to bring out your inner Volker!” I intoned. “What about the future?”The conversation continued, but I never got my warm and fuzzy assurances. For the record, another round of QE, unless there is a true liquidity crisis (and the last QE did not qualify!), would be a disaster, at least from the cheap seats where I sit. There are all sorts of inflationary and stagflationary consequences, none of which I like.
The survey's broadest measure of manufacturing conditions, the diffusion index of current activity, increased from 35.9 in February to 43.4 this month. This is the highest reading since January 1984. The demand for manufactured goods is showing continued strength: The new orders index increased 17 points this month, the sixth consecutive monthly increase.That is mostly good news. This was well above the consensus of 35.9.
...
Firms' responses continue to indicate overall improved labor market conditions. The current employment index fell back 5 points [to 18.2], but for the seventh consecutive month, the percentage of firms reporting an increase in employment (25 percent) is higher than the percentage reporting a decline (7 percent). Over twice as many firms reported a longer workweek (25 percent) than reported a shorter one (12 percent).
Firms continue to report price increases for inputs as well as their own manufactured goods. The prices paid index declined 3 points this month but has still increased 51 points over the past six months. ... Thirty-two percent of firms reported higher prices of their own goods this month, compared with 29 percent in February.
Click on graph for larger image in graph gallery.Brazil - (Kondor Invest) – 2nd largest hedge fund in Brazil with $1.5B AUM. The team previously worked at Safra Bank. Office in Sao Paolo.
Bank Itau (largest holding in the equity fund at 12%) – I will forward analysis
Short Banco Bradesco
“Current equity markets not expensive, but not cheap either.”
Equity fund 20% cash, waiting for time to put money to work, no crash, but better entry points.
Brazil Outlook
Japan – (JH Whitney) – JH Whitney Japan Fund was the largest equity long/short fund in Japan, not sure if this is still the case. Office in Japan and NYC.
Over the past 10 years the Fund has been net short. This past year has seen a dramatic shift and for the first time it is difficult to find valuation shorts.
Japan Outlook
Commodities & Energy – (LuxEn Capital) – Pasha Bahadori, former portfolio manager at Ospraie (one of the largest energy hedge funds in the world before blowing up in 2008). Pasha made money in his strategy during 2008.
• His thesis - need to know commodity market fundamentals and news and money flow to invest in equities in this space
• Space is volatile
• With recent money flows, most commodities are now macro driven and less supply/demand driven, except for Natural Gas
• Natural Gas trades the closest to supply/demand and is non-correlated to any asset class
Oil View –
Global Macro – (CastleRock Macro) – former Fortress Global Macro team
Watch out for “macro consensus from Wall Street”.
Key Themes
View
Gold Won't Repeat 2010's Climb
The precious metal rose slightly on the turmoil in Egypt, but it is unlikely to continue rising at the growth rates it reached—near 30%—last year.
Turmoil in Egypt has given gold back some of its spark. Gold prices have risen 3.1% since the world took notice of unrest in the country. Hosni Mubarak's abrupt resignation is a reminder that even the most accurate political-risk forecasts can't divine everything.
Even before the turmoil in Egypt, reports of the death of gold's rally had been greatly exaggerated. But that fact, along with the very recent rise in prices, doesn't mean gold bulls should expect another year of 30% returns. It's still unclear whether factors that previously supported prices have disappeared, or just gone dormant.
First, broadly speaking, the global economy is humming along. Economic indicators out of Germany are strong, China continues its incremental approach to monetary tightening with little apparent fallout, and the Dow Jones Industrial Average breached 12,000. That's all bearish for gold, as certain investors will reduce exposure to the metal in favor of less volatile assets. But a lapse into weak economic growth—as hinted at by India's reduced industrial output, to its lowest in 20 months—would lend support to gold prices.
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Second, the fears about Europe's sovereign-debt situation, which served as gold's personal booster club in 2010, are no longer on the horizon. The European Union continues to explore ways to head off trouble, such as expanding the size and mandate of the bailout fund. If and when credit-default swaps—the derivatives that indicate the cost of insuring debt—start to blow out, markets will focus on Spain and Portugal, and any accompanying tumult would send money flowing back to gold. However, this has not happened so far.
Third, investors aren't piling in the way they used to. According to Barclays Capital, which tracks 25 gold exchange-traded funds, the amount of physical gold in trust fell to 2,066 metric tons as of Thursday, the lowest level in over six months.
Some would argue this shows the maturity of gold ETFs, which have been in existence for less than a decade. But Evy Hambro, a managing director with BlackRock, points to gold's fundamental supports. It is still valuable because it's scarce and difficult to extract. The trend of central banks becoming net buyers of the metal isn't something that's likely to reverse in the short term.
Hambro, who manages BlackRock's World Gold Fund, recommends that investors have exposure to both instruments that track gold prices, such as ETF's, and shares of gold miners. While the miners' shares largely follow gold prices, they pay dividends and can offset the daily volatility in the commodity.
World Gold Fund had $7.9 million under management as of the fourth quarter, with Newcrest Mining (NCM) being the largest single holding. "Gold acts as an insurance policy for wealth," Hambro says, and that kind of insurance will always be in demand.
CRUDE-OIL FUTURES FELL $3.45, or 3.9%, to $85.58 a barrel this week on the New York Mercantile Exchange as Mubarak's resignation assuaged worries that the turmoil would disrupt key oil-supply routes. Meanwhile, ICE Brent, the European benchmark, gained $1.60 a barrel, or 1.6%, to $101.43, as the price difference between the two continued to widen.
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Whatever Happens in Egypt, Oil Will Hit $300 by 2020
By LAWRENCE C. STRAUSS | MORE ARTICLES BY AUTHOR
Regardless of what path Egypt now follows, a leading analyst says the price of oil is headed toward $300 a barrel based on basic supply-and-demand forces.
The oil market breathed a small sigh of relief Friday after Hosni Mubarak resigned as president of Egypt, sending prices to a 10-week low. But Charles T. Maxwell, an analyst who's been toiling in the energy business since 1957, all but shrugged off the toppling of the dictator. He's sticking with a bold prediction: Prices will climb to $300 a barrel in 2020, or about $225 in today's dollars. The world simply won't have enough oil to meet demand, he says. Barron's interviewed Maxwell, 79 years old, by telephone from the Greenwich, Conn., offices of Weeden & Co.
Barron's: How will Hosni Mubarak's removal from power and Egypt's political unrest affect the global oil market?
Maxwell: Even though Egypt is an oil producer, it is a small one, producing a little bit less than 1% of the world's total. But what is so critical is that roughly 30% of the Arabs in North Africa and the Middle East live in Egypt. So it is terribly important as a population center, and also as the center of publishing, education, medicine, technology and manufacturing in that region. In so many different ways, Egypt represents leadership in various civilized activities in the Arab world, and in keeping the peace in the Middle East, thanks to 30-plus years of agreements between the Egyptian state and Israel. It's been critical to keeping the Middle East stable. So it is in this wider context that Egypt is so important, should its government change over to, say, an Islamist party like the Muslim Brotherhood, and should it in some way begin to default on the diplomatic agreements it has already made.
There's been a lot of talk about the Suez Canal. Is it still significant in shipping oil?
It isn't as important these days. It was very critical in the famous days of the past. These days, the Suez-Mediterranean pipeline does about 1.1 million barrels a day, and the canal itself does about 1.9 million. So putting them together, that's three million barrels a day out of a total of about 88 million barrels around the world every day. So we are looking at about 3.5% of world production. If the Suez Canal were cut off, we could easily get over the problem, but we would have to pay more to carry it around the bottom of Africa, with an extra 12 days on the ocean. I don't think the Suez Canal will be shut down, but if that were to happen, it wouldn't be a disaster.
Oil prices have moved a lot higher lately. West Texas Intermediate, for example, is at around $87 a barrel, versus a shade over $71 last August. What's driving that increase?
There are various reasons given for that, including the economic recovery, which is requiring more crude oil. Another reason would be that Russia had been increasing its production, until just recently, to about 10.2 million barrels a day. But currently they aren't expanding any further, and Russia's oil production will probably be flat or a little down. So that contribution appears to be over for the moment, not for the longer term. And the political problems in Nigeria are coming back. But I think these reasons for the recent spike in oil prices pale in comparison to the true long-term cause, which is that demand for oil continues to rise from greater economic activity around the world. Societies that are modernizing are using more oil for cars, trucks, airplanes and boats and, suddenly, we are back on that growth-of-demand upward ramp. It is pretty obvious to analysts and to the general public that oil companies are straining to get more oil to meet the world's needs. And the question behind it, of course, is this: In three or four years, will the ability to produce the extra barrels needed be met? The answer is increasingly a question mark, and that pushes higher and higher the present values of the oil in the ground and the desire of holders of oil to add to their supplies.
What's the current capacity for global oil production?
We are producing about 87 million to 88 million barrels a day, and I would put global capacity at another five million barrels on top of that. So our capacity is about 92 million to 93 million barrels a day, and I see our capacity as reaching perhaps as much as 95 million barrels a day at the peak in about four or five years, probably around 2015. But I think production will go very modestly above that point, if at all, and, in effect, we will reach a plateau. It will be a little bumpy in 2015, 2016, 2017 and 2018. But by 2020, the first signs will become very evident that we can't go any higher than that in production. So we will begin to settle very slowly and gradually in a world in which we need more oil each year, but we can't get more.
How high will the price of oil go?
By 2020, I'm looking for about $300 a barrel, which is closer to $225 a barrel in today's dollars. So it reaches a production plateau around 2015 or 2016 and stays flattish on a bumpy plateau until about 2020, at which point output starts to recede slowly.
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Peter Murphy for Barron's
Charles T. Maxwell
What about the impact of increasing production?
Let's say you increase production by half a percent. But if your demand is up by 1½%, you still don't have enough to meet your full demand, so then prices have to step in to ration supplies and, in effect, destroy the incremental production by making 1% of the use [too expensive] for those people who can't afford it.
Where do you see oil prices going over the next year or two?
These are guesses, but they are the best I can do. Using West Texas Intermediate, which is the marker for crude in the U.S., it averaged about $78 a barrel in 2010, and I'm projecting it to rise to $85 this year. That's around where it was last week.
Then it goes to $95 in 2012 and $115 in 2013. The following year, 2014, we see the price going to $140 a barrel, followed by $180 in 2015. And then, by 2020, it's at $300, or roughly $225 discounted back to the present.
At what point do those price increases start to put too much pressure on the world economy?
Strangely enough, I don't think that it would bring the economy down. Rather, it is the suddenness of change that does that. That rise we saw three years ago, where in one year it went from $62 a barrel on average to $100, created a huge amount of economic damage. On a more gradual scale, and giving the effect of inflation its due, we will probably simply walk away from two-tenths or three-tenths or four-tenths of a percentage point of potential gross-domestic-product growth, which we will give up by being caught in this energy vise. But the world economy will advance, and it won't be brought down by this. However, it will touch off a huge effort to change the cars and the aircraft engines—and to use a greater amount of substitutes for oil, such as coal and natural gas. And, of course, this has a lot of positive aspects as well, because in the longer term, we would have to begin making these changes anyway. But it seems that we can't be asked to do that. We must be forced to do that, and price is the means by which that force is applied.
But how feasible are some of those alternatives to oil? Consider the concerns about nuclear power, for example.
That's the guts of the whole issue, which is, yes, we all understand that price will make people use oil more efficiently and, in many cases, they will be able to substitute some other fuel for it or find a manufacturing process that doesn't require it. But nevertheless, how do we get out of this problem? If you look at the next 20 years, which are critical to our future, we are going to struggle with this energy problem. So, we have got to recognize that coal is probably not going to be part of the solution, at least for the next 20 years, until the environmental concerns can be addressed.
As for natural gas, technology has made it easier to find it, and the availability has increased. That, of course, has caused a lot of problems for the natural-gas producers, because it has allowed them to produce more gas than we really can use in the near term, and it has brought the price down.
What's the outlook for natural gas as an alternative to oil?
Natural gas is going to be one of the saving graces in this search for substitutes for oil, and we will be learning how to use it for a lot more things, and it will be wonderful. So coal is down as a percentage of the total fuel mix. Oil will be down. Gas will be up, and a help to our energy needs. With nuclear power, it takes so long to develop those machines, equipment and operating stations. But eventually, nuclear power will be part of the solution, but probably somewhere beyond 2030, when it is accepted as being safer and more attractive to individuals. So we will have to go through quite a lot of pain with higher energy costs and restrictions on energy use before we get to nuclear power. But it will be a solution, and it will work wonderfully well. I just don't think it is going to be very much of a solution in the next 20 years, when we need it. So that takes us to alternatives.
Which are?
It includes solar, wind, hydropower, biofuels and geothermal. But the key point is that these sources are so small and they can't be sharply increased. With hydropower, most of the good places are already taken. We obviously have a lot of solar power. But it starts from one-tenth of 1% of our energy supply. So even if we do 10 times better, it doesn't represent something large enough to fill the hole of oil and coal coming down. So alternative energy sources are going to be helpful, but they will be sideshows. But what really counts—and this one isn't talked about too much, because, in fact, it isn't a fuel—is energy efficiency and conservation. That, and the fuel of natural gas, will be the two great solutions to our energy dilemma.
Just One Long-Term Direction
Veteran energy analyst Charles Maxwell sees oil prices rising steadily as world demand tops supply. Energy conservation and natural gas are the two best U.S. alternatives right now, he says.
What do you see ahead for natural-gas prices, which have been under a lot of pressure?
I think that we have seen the bottom. Natural gas is at about $4 per thousand cubic feet; 2009 saw a big drop in prices, with the average price a little under $4. Last year it was around $4.40. This year I expect the price to drop to a little under $4 again. Next year I expect it to be about $4.40 again. Then I think the recovery really begins in 2013, driven by higher demand and less supply. Because this is an industry that needs to straighten itself out and consolidate, it means essentially that fewer rigs need to drill. But this year a lot of rigs will have to continue drilling, because they have been contracted to drill in order to create production to hold the land for the longer term. So it becomes an obligation that they would rather not fulfill, but they must in order to keep the reserves. So that's why we expect this odd drop in prices in the short term.
Let's turn to a few energy companies whose prospects you like.
Our choices are mostly in the oil area, and mostly oil companies with very large and long-life reserves. Most of these companies are going to be running up against the production plateau I mentioned previously, starting around 2015, but these particular companies will be able to meet the needs of their customers by producing substantially more.
Now, the industry as a whole won't be able to do so. In fact, only about 5% or 6% of the companies in the industry will be able to go through this production plateau period and keep their volumes rising. But being able to do just that has several important effects. It gives a handful of companies a lot more actual volume, and—by the industry tightening its whole production—it pushes up prices, so the profits per unit should be higher with those higher prices. And for those companies that are producing a lot more units, they are able to keep their costs under control. But those companies that are flat on units or coming down on units will find it very hard to control their costs, so their profits per unit are likely to decline.
This would suggest, for instance, the Athabasca oil sands producers in Canada. The two publicly owned companies where you get the maximum exposure to the earnings power of the sands are Suncor Energy [SU] and Cenovus Energy [CVE], both of which are based in Canada.
How would you sum up their appeal—that their production costs are under control and their margins will improve?
I've calculated that over the next 10 years Cenovus is going to be able to increase its total production by about 9½% to 10% per year, and Suncor by about 8% to 8½% per year, which will put them No.1 and No. 2 among all major integrated oil companies in terms of oil production.
Thanks, Charley.
A Champ Among Domestic Drillers
Devon Energy's focus on oil and gas assets in the U.S. and Canada could lead to more reserves, bigger profits and higher shares.
Devon Energy, one of the largest independent U.S. energy producers, has transformed itself into a leaner, meaner company, focused primarily on U.S.-shale plays and Canadian oil sands. Wall Street is giving Oklahoma City-based Devon little credit, however, for some savvy moves that could boost reserves and profits in coming years.
Devon (ticker: DVN) agreed last year to sell its international properties and its acreage in the Gulf of Mexico for about $8 billion after taxes. The sales leave it with proved reserves of about 2.6 billion barrels of oil-equivalent, including more than 700 million barrels of Canadian reserves. Crude oil and gas liquids account for 40% of proved reserves, and natural gas, 60%.
Devon is expected to increase production by 6% to 8% this year, focusing on crude and high-margin gas liquids, which could lead to a big jump in earnings in 2012. Analysts have penciled in profits of about $6 a share for this year and last, rising to $7.92 in 2012. Devon is scheduled to report 2010 results Wednesday.
Devon's shares have more than doubled, to near 86, since March 2009. But they aren't expensive at 14 times 2011's estimate and 11 times next year's forecast, given the industry's average price/earnings ratio of 19.
On the basis of enterprise value (market capitalization plus net debt) to Ebitda (earnings before interest, taxes, depreciation and amortization), Devon also looks compelling at a multiple of six. That compares with rival Chesapeake Energy (CHK), whose enterprise value is nearly 6.8 times Ebitda, and Anadarko Petroleum (APC), with an EV/Ebitda ratio of 7.8. Devon's shares are likely to top 100 in the next year as earnings start to rise.
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DEVON HAS ONE OF THE BIGGEST POSITIONS in the Barnett Shale in Texas, and significant acreage in the Permian, Haynesville and other big shale plays. Like other shale producers, the company uses horizontal fracking or "fracing"—a controversial process involving the injection of water and chemicals into rock—to extract oil and gas from shale. The company also owns and operates pipelines to transport oil and gas.
In Canada, Devon has formed a joint venture with BP (BP) to drill new wells. The company estimates its Canadian properties will produce more than 150,000 barrels of oil a day in eight to nine years, up from 30,000 now.
Investors seem to be punishing Devon for its heavy exposure to natural gas, which sells for a deeply discounted $4 per million British thermal units. Yet the diversity of its energy sources, and expanding production of oil and gas liquids give the company greater flexibility than some peers.
The Bottom Line
Devon shares, now nearly 86, could top 100 in the next year as earnings rise sharply. The company currently trades at a discount to other domestic producers.
A healthy balance sheet also is an enviable asset. As of Sept. 30, Devon's long-term debt totaled only 17% of total capital, compared with 43% at Chesapeake.
Devon generates lots of cash, and is using it to buy back up to $3.5 billion of stock. Last year it spent more than $1 billion on share repurchases. CEO John Richels recently told an audience at Credit Suisse that buying back stock amounts to paying about $13 per barrel for proved reserves. That's a discount to the industry's replacement cost per barrel, above $20 and doesn't include considerable potential in new and untapped fields. The company also pays a dividend of 64 cents a share, for a yield of 0.7%.
If Devon keeps buying in shares and buying up acreage, investors could be looking at some slick returns.
Exploring for Value
Devon's reserves are cheaper than some similarly sized peers.
Recent | 12-mo | 2011 E | |||
Company/Ticker | Price | Chg | EPS | P/E | Reserves * |
$77.71 | 21% | $2.31 | 33.6 | 2.4 | |
30.82 | 26 | 2.65 | 11.6 | 2.7 | |
Devon Energy/DVN | 86.88 | 31 | 6.08 | 14.3 | 2.6 |
*Billion barrels of oil equivalent. | |||||
