We’ve expanded our energy portfolio to ride U.S. boom

The U.S. economy continues to crawl along at a slow rate of GDP growth. We have seen sluggish quarterly expansions for several years now. This rate of growth is not sufficient to increase hiring.

For example, September retail sales posted disappointing results even with increased promotions. Back-to-school sales were slower than expected. This is causing some retailers to worry about the upcoming holiday sales. On a broader scale, wages for the middle class have not kept pace with inflation for more than five years.

As a result of this, consumer confidence is at the lowest point in six months. However, if you look closely, there are a few areas of growth. After years of very low interest rates, banks are beginning to see a pickup from commercial real estate loans. The commercial markets for shopping centers, apartments and warehouses are seeing an increase in demand and construction.

Property values are increasing and borrowers are showing an increase in willingness to borrow based on their improving credit quality. Another growth area is U.S. factories which have increased production for five straight months.

The Institute for Supply Management showed the October index rising from 56.2 in September to 56.4. In a further show of manufacturing strength, last week’s Chicago Purchasing Managers index posted much higher numbers than expected. It rose to 65.9%, a 10 point jump.

I have been writing about the middle-tier exploration and production companies for some time. They continue to show large gains in production and reserves.

New statistics from the Energy Information Agency (EIA) show new drilling techniques are greatly increasing well efficiency.  These operating companies are learning more and more about the shale formations and are increasing initial flow rates as well as ultimate production from each well.

The EIA has ranked the Bakken in North Dakota and the Eagle Ford in Texas as the fastest growing production formations. These two formations accounted for 75% of the monthy increase in domestic liquids production in September. The increase in production is expanding faster than the industry has the ability to transport it.

This excess has caused WTI prices to drop, causing a widening spread to Brent prices. This also happened in 2012 and early 2013 until more shipping capacity came on line. In my opinion, the pipe lines and railroads may once again expand and bring prices back into equilibrium.

Until then the lower oil prices have lowered gasoline prices, which will help consumers. Even with a glut of gasoline, refiners are running wide open to produce more diesel fuel. The booming diesel fuel market in Europe, in my opinion, is giving our refiners very good margins on the fuel exported there.

Overseas economies are showing improvement. Spain has recently emerged from two years of recession as their central bank has reported the two year recession in the Euro zones fourth largest economy ended in the third quarter with a 0.1% growth.  Borrowing cost for Spain and others on the weak side of the Euro zone have fallen over the past year and the bloc saw tepid economic growth in the second quarter.

A return to growth in Spain adds to the expectations that the Euro zone is also emerging and will propel it to a positive third quarter expansion. The ZEW Euro zone macroeconomic expectation index rose to a four year high of 59.1 in October. In addition, industrial production expanded slightly more than expected.

Also a sudden surge in Chinese ore purchases has caused shipping rates to increase. Their imports of iron ore soared to a record in September. China has also increased purchases of copper leading to a 10% increase in prices.

Stronger-than-expected third quarter factory activity is lessening fears of a slow down in China. The Chinese official Manufacturing Purchasing Managers index increased to an 18 month high in October. Stronger demand from the industrialized world helped  the Asian economies to expand.

As the U.S. and international markets improve, we are well positioned to supply products to the world market. Globally, energy consumption has been slow to increase during the economic slowdown.

When consumption returns to historic levels, and as this demand drives prices higher, our ability to produce less expensive domestic energy will become an even larger advantage for U.S. companies.  As I stated previously, our domestic production increases from tight shale plays is providing the opportunity for U. S. companies to benefit from a lower energy cost as well as lower raw material cost.

The U.S. refiners are now shipping over 3.5 million barrels per day of refined products overseas. We have also moved up to become the second largest oil producer in the world, passing Saudi Arabia. Expansion of chemical plants to take advantage of lower natural gas and natural gas liquids is continuing at a rapid pace.

As I mentioned earlier, the mid-stream companies are expanding capacity. Natural Gas Liquids (NGL) production is expanding rapidly. Several of our holdings are among the leaders in this area.  Kinder Morgan Partners (KMP) and Enterprise Products Partners (EPD) are adding to their ability to transport, store, separate liquids, and export these products to expanding global markets.

We are adding to several of our positions in the energy sector. We continue to like EOG (EOG), Continental Resources (CLR), Oasis Petroleum (OAS), Sanchez Petroleum Corp (SN) and Whiting Petroleum (WLL).

In the oil field services business, SeaDrill (SDRL) increased their dividend to over 8% and beat the streets estimates on earnings in their most recent quarter. They have three new deep-water, floating drilling rigs being delivered from shipyards this year.

Deep-water drilling activity in the offshore West Africa and offshore Brazil areas should keep this company fully utilized for several more years. The Gulf of Mexico is experiencing a nice turnaround. The government has finally sold new leases. The deep-water rig level has been increasing and will continue to do so.

Just to restate, I believe the economy is slowly expanding in spite of the previously mentioned problems. That is why we are emphasizing investments in companies with good cash flow, good cash distributions and companies that operate in areas where they have a competitive advantage due to much lower energy costs and raw material input costs.

We prefer companies that generate good after tax returns.  With interest rates at historic lows, even as dividend taxes go up, the after tax returns are still higher than most investment grade debt.  There is a growing shift from very low yield bonds into equity. BSG&L is a long term investor. We believe if you are patient, build cash and buy good companies on pull backs, your portfolio has a chance for better-than-average growth over the long term.

The investments discussed are held in client accounts as of October 31, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. Past performance is no guarantee of future results.