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How to Get Rich Investing in Stocks by Riding the Electron Wave

Energy and Financial Investing Themes 2008: A Tale of Two Halves - Part2

Stock-Markets / Investing Jan 16, 2008 - 02:09 PM GMT

By: Hans_Wagner

Stock-Markets Best Financial Markets Analysis ArticleThe beginning of a new year is a good time to make a new assessment of the important investment drivers and themes for the year. If you want to beat the market it is important to understand what is driving the markets and where the best sectors are to find good opportunities. By identifying these factors you will have a solid framework to assess the impact market movements and news events on your investment strategy. This is the first of a five part series on the outlook for the 2008 markets. The first part discussed the key drivers ending with a mention of what sectors will benefit and those that will be hurt. This Part discusses the Energy and Financial sectors. The remaining three parts will review each of the remaining sectors in more detail.


For those interested in making money in this market you might want to read Active Value Investing: Making Money in Range-Bound Markets (Wiley Finance) by Vitaliy Katsenelson. The core of Katsenelson's strategy is to break down into three key pieces what you need to look at when analyzing a company: Quality, Valuation, and Growth (QVG).

The chart below from StockCharts.com shows the performance for 2007 of the nine S&P 500 sectors. What is interesting is that seven of the sectors beat the S&P 500 for the year, with Financials and Consumer Discretionary being the laggards.

Energy Investing Themes

For the last three years the energy sector has been one of the best performing places for investors to place their capital. In 2007 the XLE, the Select Sector Energy SPDR was up 35.3%, by far the best performing sector for last year.

In a recent report published by the International Energy Agency (IEA), the world needs to spend $20 trillion to meeting surging, global energy demand. Even with energy doing so well last year I expect it to continue in 2009 to beat the market as defined by the S&P 500. For our purposes we will examine oil, coal and alternative energy sub-sectors.

Oil

The IEA sees demand rising by 2.1 million barrels per day in 2008, an increase of 200,000 barrels per day from its previous forecast. The IEA has also warned of a "supply crunch" coming within the next five years. While the price of oil is around $100 a barrel, the best opportunities in the energy sector are in the oil service firms and the refiners, face seasonal changes in their profits.

While oil prices fluctuate from day to day, the capital budgets of oil exploration companies do not. According to a recent Lehman Brothers annual survey of the exploration and production companies, world wide spending on exploration and production should rise by 11% to $369 billion in 2008. That is good news for the oil service firms that provide seismic data, drill, test and complete wells, provide pumps and valves, and supply rigs and drilling materials. Most of this growth is concentrated outside of North America, which is only showing a 3.5% increase. Of interest these companies are basing their budgets on an average price per barrel of $68.

The oil-services group is trading at less than 14 times 2008 earnings, which is less than the overall market. I believe this sub-sector offers good investment opportunities in 2008. Look for companies that have substantial exposure to the global exploration and production fields. Some of the companies I like in this area are Schlumberger (SLB), Weatherford International (WFT), Baker Hughes (BHI), Halliburton (HAL) and Flowserve (FLS).

The refiners have performed poorly in the last six months falling from their highs toward the end of the summer driving season. The key to the performance of the refiners is the crack spread they are able to generate. Basically the crack spread is the prices they can get for the refined product from the oil they use as input. The term comes from the fact that refiners are said to "crack" a barrel of crude to make products. The crack spread is generally calculated by comparing the cost of crude oil futures with the price of refined products futures--typically gasoline and heating oil futures.

The standard 3-2-1 crack spread—based on three barrels of oil refined into two barrels of gasoline and one of heating oil—is currently trading just shy of $7, down from more than $20 at the end of June and more than $30 back in May.  The price of crude oil is currently about 20 percent higher than it was at the end of June. But during the same time period, the price of gasoline has actually declined. Therefore, the refiners' input costs are rising while the value of the products they produce is in decline, squeezing their profit margins.

The second factor at work is that the spread between the costs of light, sweet and heavy, sour crude oil has also narrowed considerably from high levels earlier in the year. Refiners capable of processing the heavy, sour crude have typically experienced cost input advantages over those that only process the light, sweet crude. Although that spread has improved somewhat, even refiners with highly complex operations aren't deriving the feedstock cost benefits they were in the spring.

A large part of this decline in refining profitability is seasonal. Refining margins tend to start to rise in late winter, usually around the middle of February and peak around mid-July. This is the height of the summer driving season. In six of the past seven years, refining margins have trended lower from midsummer into fall.

And this effect was exacerbated in 2007. A series of refining outages meant that stocks of gasoline in the US were at multi-year record lows heading into summer. That sent gasoline prices and crack spreads to very high levels in the middle of the summer of 2007.

So will we a repeat of the expansion in the crack spread in 2008? The answer is yes. However, I do not expect it to reach the levels it reached in 2007. First of all the U.S. is experiencing an economic slowdown and most likely a recession. This will cause less growth in the demand for gasoline in the summer driving season as people look for ways to cut back on their expenses. Also, ethanol will continue to offer a competitive alternative since the federal, state and local governments subsidize ethanol. In fact the International Institute for Sustainable Development (IISD) estimates that such subsidies currently add up to $1.05 to $1.38 per gallon of ethanol. But not many vehicles can use ethanol yet. Those cars and trucks that can use ethanol get fewer miles per gallon, offsetting much of the subsidy.

Last year the higher run up in the crack spread was due to unplanned shutdowns of refineries in the summer months causing brief shortages. On the other hand we did not experience any hurricanes that closed the refineries on the gulf coast. If we do get any such storms then it might drive up the price of gasoline. Finally, the U.S usually receives imports of gasoline when the price climbs helping to improve the supply imbalance. For example, India has excess refinery capacity and is a significant exporter of refined products. They are expanding their capacity and we might see more imports of gasoline from them. However, China and other growing economies are experiencing growing demand for gasoline, so they will help to increase global demand for refined products.

The point is I expect the seasonal trend to continue again in 2008, beginning in late winter. Refining companies such as Alon USA Energy (ALJ), Frontier Oil Corporation (FTO), Holly Corporation (HOC), Tesoro Corporation (TSO), Valero Energy Corporation (VLO), and Western Refining Inc. (WNR) to benefit.

Coal

Coal is still a major source of energy world wide. In North America approximately half of the electrical energy is derived from coal. And energy companies have plans to build additional coal fired plants to help meet the demand for electricity. While coal is a major contributor to green house gases, there are significant engineering efforts underway to dramatically reduce or capture these gases from burning coal. In fact there are several large scale tests underway to evaluate some of these alternatives. If they prove successful, then I expect to see the demand for coal to rise. However, it will be a year at least before we know how well they are performing.

Coal is also widely used in developing economies, especially China and India. Recently the Chinese Ministry of Finance stated that the current export taxes on coal, metal ore and crude oil will remain in place through 2008. According to Reuters the tax is to curb exports of “energy-co0nsuming, polluting products.” China, with hundreds more coal-fired plants planned for construction in the next decade or so, is now the world's largest coal producer, and it's about to turn from a net exporter into a net importer.

As a result coal will continue to an important source for energy. As a result companies that hold large coal reserves and mine coal should continue to do well, though they will experience more volatility as the green movement tries to limit its use. Companies such as Peabody Energy Corp (BTU), Arch Coal Inc. (ACI), Fording Canadian Coal Trust (FDG), and Tech Cominco Ltd (TCK) offer potential on dips in their price.

Alternative Energy

As part of the 822-page Energy Bill that was just recently signed by President Bush, the 100-watt incandescent bulbs will be banned in ten years. All light bulbs must use 25% to 30% less energy than today's lights by 2012.

By doing so, the U.S. would reportedly cut light electricity use by 60% by 2020, and cut U.S. electric bills by up to $18 billion a year. This is an industry expected to exceed $1 billion by 2011, a 388% jump from the $205 million market value in 2005.

Other key provisions of the measure include:

  • Requiring automakers to boost fleet-wide fuel economy for cars and light trucks to 35 mpg by 2020. 

  • Asking for an increase in the amount of biofuels (ethanol, for example) to 36 billion gallons by 2022. 

  • Increasing federal research into how to trap carbon dioxide emissions from power plants and store them in the earth. 

  • Encouraging geothermal energy use, or energy from the Earth's heat.

Investing in alternative energy holds great promise. But just like other new, rapidly growing technologies it also holds many pitfalls for investors. For example, solar panels require polysilicon. Recently this material has been in short supply creating opportunities for companies that supply the material, such as silicon producer MEMC Electronic Materials (WFR) and Hoku Materials.

There are about 50 polysilicon plants waiting to be constructed worldwide, and they are all competing for financing. The polysilicon shortage will continue to choke the growth of solar unless these plants are constructed as soon as possible.

Hoku Materials, a wholly owned subsidiary of Hoku Scientific, recently amended their polysilicon sales agreement with SANYO Electric by extending Hoku's date to complete financing for a new polysilicon production plant until December 31, 2007. Previously SANYO required Hoku to obtain $100 million in financing for the polysilicon plant before October 17, but challenging conditions in credit markets have forced the deadline to be extended.

This brief story should make investors realize they need to carefully evaluate any investment in the alternative field before making a commitment of their capital.

The story should not take away from the potential of alternative energy. Afterall First Solar (FSLR), Suntech Power (STP)SunPower Corp (SPWR) and JA Solar (JASO) have enjoyed an excellent run in price per share recently. There future holds excellent promise for investors preapred to take the risk.

Back to where we started this segment, talking about the changes coming in lighting. Companies that provide light emitting diode (LED) technologies should also do well, such as Cree Inc. (CREE) and Royal Philips electronics, who just announced they are acquiring Genlyte for $2.7 billion to position the company in the LED-related industry. The only problem with CREE is some people believe they are using outdated technology.

Financial Investing Themes

The financial sector was the worse performing sector in 2007, falling 23.48% as measured by the XLF, the S&P 500 Financial SPDR. Banks, brokers and mortgage lenders have seen their stock prices plummet in 2007 in response to huge losses tied to the mortgage problems and resulting credit crunch. The question is when it will be safe to buy stocks of banks, brokerages and other financial institutions.

It is always tempting to buy when a quality company falls in price. The issue facing investors who want to buy is it too early? Are all the problems known and have then been disclosed?

First not all of the problems have been disclosed, since the banks do not know all the problems. There are several reasons for this situation. Firs of all, it will take a number of months to fully investigate the full extent of the problem. Most of these loans have been packaged and sold as new securities. Complete documentation of these mortgages either is not available to the holder of the new security or documentation was not properly created in the first place by the mortgage company.

Second, there are many more mortgages that have yet to fail since the rates have not adjusted up yet. When mortgages adjust in 2008 a number of the borrowers will be unable to pay off the loan. Yes, there is a bailout program designed to help these borrowers. The program asks the holder of the mortgage to maintain the current interest rate and not to let it adjust. As a result this holder of the mortgage will not receive the income originally expected when the mortgage was written. Someone has to eat the loss in profits and that will be who ever holds the mortgage, such as an investment bank, a hedge fund, a pension fund, an insurance company and even a bank.

In other cases, many borrowers still trying to pay the existing loan and they face poor job prospects. If the lose their job due to the current economic slow down, they will be unable to pay off their mortgage increasing the default rate.

It is always tempting to start buying when there is a big sell off. Sometimes it pays to look at history for some perspective. In 1989 – 1991 financial institutions went through a similar write off process that took place in waves. After each wave of write-offs investors thought that then was the time to buy. Then another wave of write-offs was announced and the prices of the financials fell further. This continued several times before the bottom was reached. The point of this is we need to avoid the value trap that might exist in the financials. It is best to wait for them to turn up, since once they do it should last for quite a while.

So what does this mean for the financial sector? Before I begin, I encourage anyone who is considering the financials to look at what is called Fail Value of Financial Instruments in their prepared quarterly statements. Fair value is defined as the price at which an asset or liability could be exchanged in a current transaction between knowledgeable, willing parties. Where available, fair value is based on observable market prices or parameters or derived from such prices or parameters. Where observable prices or inputs are not available, valuation models are applied. These valuation techniques involve some level of management estimation and judgment, the degree of which is dependent on the price transparency for the instruments or market and the instruments' complexity.

Beginning December 1, 2006, assets and liabilities recorded at fair value in the Consolidated Statement of Financial Condition are categorized based upon the level of judgment associated with the inputs used to measure their fair value. Hierarchical levels – defined by SFAS 157 and directly related to the amount of subjectivity associated with the inputs to fair valuation of these assets and liabilities – are as follows:

Level I – Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date.

The types of assets and liabilities carried at Level I fair value generally are G-7 government and agency securities, equities listed in active markets, investments in publicly traded mutual funds with quoted market prices and listed derivatives.

Level II – Inputs (other than quoted prices included in Level I) are either directly or indirectly observable for the asset or liability through correlation with market data at the measurement date and for the duration of the instrument's anticipated life.

Fair valued assets and liabilities that are generally included in this category are non-G-7 government securities, municipal bonds, structured notes and certain mortgage and asset backed securities, certain corporate debt, certain private equity investments and certain derivatives, including those for commitments or guarantees.

Level IIIInputs reflect management's best estimate of what market participants would use in pricing (highlight added) the asset or liability at the measurement date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model.

Generally, assets and liabilities carried at fair value and included in this category are certain mortgage and asset backed securities, certain corporate debt, certain private equity investments and certain derivatives (highlight added ) .

Note that Tier III is the category for the credit problems on the banks books. When this category is large relative to the institutions capital base, it becomes a big concern. This is where the future write-offs will be. Assets here are generally difficult to value as there is no available market that trades them. So it is left up to management's judgment. Rarely, have se seen management value assets lower and then raise them later when more information is available. Usually we see more write-offs as time passes. Again take a look at this part of the institutions financial statements (it is usually found in the Notes section at the back). If it is significantly larger than the institutions capital base it is a very big concern as the bank may not be able to absorb the potential losses. Also if Tier III is growing from quarter to quarter it is also a concern.

I believe the investment banks (broker/dealers) will be the first to turn up, especially the ones that have strong non-fixed income businesses. In particular Goldman Sachs (GS) should do well as they have been able to fully offset their sub-prime mortgage exposure when they went short in the market earlier in 2007. Also, look for financial institutions that do not have exposure to the credit problems such as Bank of New York Mellon (BK). Be careful of any investment bank that has substantially large Tier 3

The next financial sub-sector to recover will be the regional banks. For the most part they did a better job of avoiding the sub-prime mortgage mess and should benefit the most from a steeper yield curve as the Fed lowers rates. One place to look here is through the regional bank ETF SPDR KBW Regional Banking (KRE).

Finally the big money center banks should recover as the full extent of the credit crisis unfolds. They are bearing the brunt of the current problems and will face more problems before it is over. Many will have to shore up their capital base, like Citicorp has begun. Many will also cut their dividends. All of them will tighten up their credit authorization process which will slow up the growth in loans. While this will be good in the long run, it will take awhile for the big banks to start to grow again.

The Bottom Line

The energy sector was the best place to be in the last three years and especially in 2007. On the other hand the financial sector was the worse place to be in 2007. In 2008 energy should continue to outperform the S&P 500, though I do not expect it to do as well as it did in 2007. The refiners should do well in the first half of the year. After that look to the oil service firms that have substantial international exposure. One could also own an energy ETF such as XLE to gain exposure to a broad part of the sector.

The alternative energy market should experience significant volatility which will present opportunities to buy on dips. However, many of these companies have appreciated significantly already. That doesn't mean they won't continue, it is just that it is prudent to be cautious. It also will pay to look more deeply into the fundamentals of the sector plays you are considering. For example as already mentioned the tightening of credit is having a negative impact on smaller companies' ability to borrow. This can hurt their ability to grow. It also might change the circumstances for other companies that have a strong presence in a market that is experiencing shortages such as polysilicon.

The financial sector is still experiencing weaknesses as they work through the current credit problems. It usually takes longer than people expect for the financials to resolve credit problems and we should expect more write offs in the future, especially during the next earnings season. As a result it is best to avoid most financials at this time. However I believe that this sector has the potential to be the best performing one in the second half of 2008. I also am looking at those financial institutions that have avoided the impact of the credit problems such as Goldman Sachs (GS) and the Bank of New York Mellon (BK).

Both the energy and the financial sectors should outperform the S&P 500 in 2008. It will just take the financials several more months to begin their turn around.

Readers interested in learning more about Sector investing should read Sector Investing, 1996 by Sam Stovell. It discusses how to use sector rotation in your investing endeavors. An expensive book, but worthwhile for those interested in using sector rotation strategies to improve the performance of their portfolios.

Look for the next edition where I will review in more detail my prospects for the Technology and Consumer Staples. The remaining sectors will be covered in Parts Four and Five.

By Hans Wagner
tradingonlinemarkets.com

My Name is Hans Wagner and as a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market at http://www.tradingonlinemarkets.com/

Hans Wagner Archive

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