Stock market pullback misses economic strengths

Financial markets have been volatile over the last few weeks, especially oil. Equities have sold off while the Treasury market has been strong.

Several factors have contributed to this market shift. With global turmoil as a backdrop, investors have become more risk averse. Large demonstrations in Hong Kong, Ukraine unrest, the ISIS conflict and overall European stagnation have all contributed.  


Strong fundamentals

A little perspective is called for in my opinion. While fear usually wins in the short term, fundamentals usually prevail in the long term.

There are several reasons the markets should return to growth in the coming months. The September jobs report showed good gains, an additional 248,000 jobs with an upward revision to the August numbers. Wage increases and hours worked were flat.

From the perspective of the U.S. Federal Reserve, this data suggest no inflation and moderate growth. The economy expanded at an upwardly revised 4.6% in the second quarter which is a good sign.

Since the dismal first quarter, the economy seems to be improving. The increase in second quarter was due to stronger exports than originally thought as well as more business spending.

This is a good omen. When businesses increase spending on plant and equipment, they must see improvements in the economy. Businesses increased spending on plant, equipment and office buildings at a 12.6% rate, larger than the initial estimate of 9.4%.

Robust exports

Additionally, our exports grew more than our imports during the quarter. One area of exports that have expanded rapidly is the sales of refined petroleum products. Gulf coast refiners are running wide open. With the lower oil prices, their margins are very wide in overseas markets.

Additionally consumers have been held back by slow wage increases. However, falling oil prices will be a boost to the average consumer.

What has caused oil prices to fall and can they stay at these levels long?

Oil prices have traded in a range of the low $90s to around $106.00 per barrel for several years. West Texas Intermediate (WTI) broke below $90 per barrel and Brent broke below $97 per barrel.

There are several factors contributing to this decline. Oil is priced around the world in US dollars, a currency that has been appreciating. As the American currency has increased in value compared to all other currencies, the number of dollars to buy a barrel of oil decreases.

Oil Prices

The value of the dollar has risen 10% this year against other major currencies, while oil prices have dropped 13% this year. I do not believe the dollar can remain this strong for a long period.

Another contributor to falling oil prices is this is the time of the year when refiners have their switch over from required summer blends to winter blends. Refiners used over 500,000 barrels of crude per day less last week as several refineries were down for “turnarounds.”

By late October these changes will be over and our refineries will be back to an increased need for crude.  Even if oil prices increase, gasoline prices should not increase as fast because in winter months refiners can blend Natural Gas Liquids (NGLs) in with gasoline lowering the cost.

Thirdly, even though our production has increased, the amount of oil in storage is not growing.  Our demand for products derived from petroleum is increasing here and around the world.

We continue to see increased output from producers in the Bakken and Eagle Ford shale and the Permian basin.

As these energy and production (E&P) companies learn more about the geological structures they are drilling in, they have modified their methods by adding an increased amount of sand per foot of lateral in the fracturing process.

Energy plays

This is increasing the initial flow rate and lessening the decline rate of production. This is increasing their profit per well. This is good news for the E&P companies we follow. For these reasons we view any pullback in stock prices of these companies as a buying opportunity.

Several names we are considering looking into in this area are Continental Resources (CLR), EOG Resources (EOG), Oasis Petroleum (OAS), Whiting Petroleum (WLL) and a new addition: SM Energy Company (SM).

For an investment on the Marcellus shale, I have chosen Gastar Exploration (GST) . As new chemical plants start coming on line, there will be an increased need for NGLs which will further increase the profitability of these companies.

Several mid-stream companies I follow are building capacity to take advantage of this expansion in production and demand in the NGL space. One of these is Enterprise Products Partners (EPD).

The company’s management realized the need for infrastructure in the area and they recently announced the building of their ninth liquids fractionator at their Mont Belvieu facility.

This is good timing as they just finished the first phase of the AEGIS pipeline which will bring ethane from the Marcellus and Utica shale down to the Gulf Coast.

The company’s executives also see the increased potential for exporting refined products, gas condensates and liquids as they just announced they are buying Oiltanking Partners (OILT) to enhance their capacity in this area.

EPD is working with Pioneer Natural Resources in condensate exports now. Pioneer recently announced they expect to double the volume of condensate export next year.

Another company I follow in the mid stream area is Kinder Morgan (KMI).

The company is also buying up all the units in their MLPs, primarily Kinder Morgan Partners (KMP), to form a C Corp. The company is also expanding at a rapid rate and has exposure to the Canadian heavy oil.

Large caps

In the chemical sector, there will be continued production increases due to lower input cost in my opinion. Westlake Chemicals (WLK) and LyondellBasell (LYB) are still my favorites in this sector.

Large cap industrials have exhibited weakness in recent months due to the strengthened dollar and a slowing of demand from overseas. I am not adding to our positions until the markets resolve themselves. With lower energy cost, when demand returns, they should maintain good profits in my opinion.

Emerson Electric (EMR), Honeywell International (HON) and United Technology (UTX) have recently pulled back with the general market decline. If their earnings remain strong, and I anticipate they will, this should give us a very good entry point in the near future.

DISCLAIMER: The investments discussed are held in client accounts as of September 31, 2014. 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.