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Saturday, July 26, 2008

Interesting Opportunity

Fear of inflation is back. Consumers and investors alike are concerned that higher commodity prices, a weak US dollar, and easy monetary policy are generating a self-reinforcing inflationary spiral. This confluence of events reminds many of the 1970s, and heard so many references to that era in recent weeks that half-expecting bellbottoms and the Bee Gees to make a comeback. The evidence of inflationary angst is everywhere. News reports including the word inflation are up substantially in the last few months. The median household expects 5.2% inflation over the next year and a 3.4% rate over the next five to ten years, according to the latest University of Michigan survey the highest inflation expectations in more than a decade. In the markets, the spread between nominal and inflation-indexed Treasury yields remains over 2.5%, quite high by recent standards. These inflation fears are understandable. Year-over year consumer price inflation is running just under 4%, and has been below 2% for only three months out of the last four years. Gasoline prices and commodity prices more broadly have soared to new records, and the last time that the United States experienced increases of this magnitude in the 1970s they were associated with a decade of rampant inflation and dismal growth.

Several unpleasant similarities between now and 1970 rightfully prompt concern about the inflation outlook. First, inflation was unpleasantly high despite a mild recession both then and now. Second, monetary policy was simulative both then and now, with the real funds rate below zero. Third, productivity slowed from the 3%-4% rates through most of the 1960s to 1½%-2% around the turn of the decade, and has followed a similar pattern over the last few years. Fourth, the dollar has depreciated sharply in the last few years, as it did following the breakdown of the Bretton Woods system in 1971. Finally, and perhaps most concerning, inflation expectations have jumped: the University of Michigan survey showed that households’ average expectation for inflation over the following year rose from about 2½% in 1963-65 to over 6% in early 1970; the same measure shot up to 7% in the May 2008 survey a 27-year high. Although each of these factors suggests that inflation risk is elevated, the differences between 1970 and the present situation are more important:

Capacity was much tighter. The economy had been running hot for several years, with the unemployment rate still 3.9% at the beginning of 1970, near an all-time low.

Wages had accelerated substantially. Average hourly earnings rose at about a 4% pace during 1966, 5% during 1967, and then more than 6% in 1968-69. Then, over the entire decade of the 1970s, wage growth never dipped much below 6%. Currently, average hourly earnings are up only 3.5% over the past year, a deceleration from the pace over the prior two years. The contrast between unit labor cost growth then and now is even greater.

Inflation was broad-based. Inflation was not confined to one or a few parts of the major price indexes; core and headline inflation were both far above desirable levels.

Credit conditions were less of a drag. Although monetary policy is quite accommodative now, it is being offset to a significant degree by tighter credit conditions. In other words, broad financial conditions are not as loose as the funds rate implies in isolation. In contrast, credit conditions were relatively stable in the late 1960s and early 1970s (with the notable exception of the Penn Central bankruptcy in June 1970 and its fallout on the commercial paper market).

Policy choices favored low unemployment over low inflation. Ultimately, price stability is the Fed’s responsibility. Although the Fed did tighten to slow the economy and contributed to recessions in 1969-1970 and 1973-74, it never kept rates high enough for long enough to bring inflation, inflation expectations, or wage growth down to acceptable levels. It took more than a decade of unacceptably high inflation before the Fed, under Paul Volcker’s chairmanship, took the bitter medicine and pushed the economy into the double-dip recession of 1980-82.

Given the number of differences between now and the 1970s, I am not sold on the 1970s being a viable analogy. Although I do believe our economy is in and will remain choppy waters for some time I think the logical trading strategies will be distinctly different from the 1970s. That being said I do believe the recent pull back in commodity prices particularly natural gas may offer the investor an interesting risk/return spectrum. Although the current environment may not be perfectly comparable to the 1970s I do believe that as historically was the case, commodities will outperform in high inflationary environments.

According to Goldman Sachs equity research, energy equities have rallied and corrected 10 times since 2004. Surges averaged 24% and pullbacks averaged 13%. At $129, crude oil trades at the same price as on May 20th, but Energy shares have dropped 14%. Energy earnings season kicks off this week, with 81% of the Energy market capitalization reporting over the next two weeks. Schlumberger (SLB), in the first significant Energy earnings report of the 2Q season, reported above-consensus earnings resulting from better than expected international revenues and in spite of weak results in North America. SLB has served as a bellwether for the sector in past quarters and I expect this quarter to be no different. Emerging market demand for energy, exhaustion of refining capacity, limited sources of new supply, and modest availability of alternative sources should continue to provide support for energy prices. That being said, I personally believe that recent pull back in Exploration & Production E&P natural gas companies offers investors a particularly attractive opportunity. With the E&P group off 28% from its 52-week highs and down 22% month-to-date, the E&Ps are now trading at a 5% discount to gas at $8.00 which is 12% below Friday’s closing prices.

There are a number of reasons I am particularly interested in natural gas. We have a lot of it, it trades at a discount domestically to its UK equivalent, and it is much cleaner than other fossil fuel offerings. In addition to this, T. Boone Pickens recently announced his “plan” which is basically an attempt to wean our country off of oil and onto natural gas and wind energy (both of which T. Boone is heavily long on). Pickens said the plan could cut the amount the country spends annually on foreign oil from $700 billion to $400 billion." He proposed the following steps:

1. Using the United States' wind corridor, private industry will fund the installation of thousands of wind turbines in the wind belt, generating enough power to provide 20 percent or more of the country's electricity supply.

2. Again funded by the private sector, electric power transmission lines will be built, connecting these wind power generating sites with the power grid, providing energy to the population centers in the Midwest, South and Western regions of the country.

3. With the energy from wind now available to serve the large population centers in key areas of the country, the natural gas that was historically used to fuel natural gas fired power plants can be redirected and used as a fuel for private cars and thousands of vehicles in the transportation system. This reduces the need for imported gasoline and diesel fuels.

I like many others am very intrigued by the idea of weaning ourselves off the black gold from the middle-east. As good as this plan sounds; it will likely not pass in anything near its original form. It requires a capital outlay of $1-$1.5 trillion which is too large an amount for our short-sided government to approve. As optimistic as I am, I am also skeptical that private companies will be willing to foot the bill. That being said, I am quite bullish on the long-term prospects of natural gas. The natural gas value chain looks similar to value chains for many other fossil fuels, consisting of exploration & production, transportation, marketing/distribution, and ultimately, delivery to end users. Historically, the natural gas industry has looked a lot like the electricity industry-- a natural monopoly industry (due to the high capital costs of natural gas pipelines and difficulty in storing natural gas), heavily regulated at both the wholesale and retail levels. However, unlike the electricity industry, deregulation has been a boon to the natural gas industry, encouraging innovation and reliability of supply.

The key drivers of the end-user price of natural gas are two-fold. (1) The raw fuel costs account for about 60% of final costs, while (2) the transmission and distribution costs account for the remaining 40%. The raw fuel price is market determined, but is driven by a combination of market demand and both current and future supply of natural gas. Natural gas is unique in that it is challenging both to transport and to store, limiting the short-term flexibility of supply in response to demand shocks.

There are typically two methods of transporting natural gas, both requiring significant investment. The predominant method of transportation in North America is via natural gas pipelines. An increasingly popular method of transport, and one likely to continue to gain traction as the U.S. finds itself importing more natural gas from sources outside Canada, is Liquefied Natural Gas (LNG), which enables gas to be shipped overseas in tankers. LNG requires major investment in both deep-water, sheltered ports to harbor LNG tankers and in liquefaction and gasification plants on both ends of the transport route-- the U.S. only has 5 LNG terminals currently, but plans to nearly double capacity over the next 3-5 years. However this expansion has been met with significant resistance as no one (NYC included) wants to have the new LNG terminals in their city due to noise, pollution, etc.

Gas storage also offers an opportunity to reduce the cost of natural gas. Natural gas prices are typically seasonal, peaking in the winter months and hitting lows in the summer months, when heating needs are least. Though storing gas is challenging, given that it is lighter than air and therefore prone to dissipation, solutions have been found. Typically, gas is stored in depleted natural gas and oil fields or underground aquifers. In times of abundance (i.e., summer) gas can be injected into storage facilities, only to be withdrawn again during times of scarcity. The state of storage capacity and technology has a significant impact on natural gas prices in both the short-term (as stocks of stored natural gas represent the most readily available supply in case of increased demand for natural gas) and the long-term (as increased storage capacity offers the opportunity to build up more substantial reserves of easily accessible natural gas). Natural gas demand observably fluctuates on a seasonal basis, falling in summer months (like it has) and rising in winter months (like it will). The need for heat during the winter and lack thereof during the summer are the primary factors responsible for these fluctuations. Seasonal anomalies, like cooler summers or warmer winters, can dampen this effect and change the amount of gas demanded on a large scale, thereby affecting natural gas prices, revenues, and profits. Utilities that purchase gas when prices are lower during the summer months, in order to keep inventories ready for the winter, also have a muting effect on natural gas seasonality. Now that we have covered a good primer to natural gas, we should look at which companies stand to benefit the most.

As you can see the top four companies are true diversified Oil & Gas giants, although they in themselves might offer an interesting investment opportunity we are primarily interested in pure-play natural gas companies. I have yet to do the heavy lifting needed to identify the best of breed but I should post on it shortly. As always, input would be greatly appreciated.

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