Don Coxe discussed an investment thesis for the oil and gas producers in his commentary this week...among other things...
Don Coxe
December 12, 2003
Conference call from Toronto, Canada
jonesheward.com
Chart: Dow Industrials
Comment: “Another Big Number”
You can’t ignore a week in which we touched 10,000 on the Dow, whether we’ll actually end up closing there or above it is not so important as the fact that it’s a good chance to take stock of what the market believes and what can be wrong with that belief system.
So, first of all you can say: “The Dow isn’t the index you should be using, you should be using NASDAQ which has outperformed the Dow this year and probably the only reason you aren’t doing that is that you haven’t told us to buy tech stocks.” And that’s true. The NASDAQ is having the kind of third cascade triple waterfall crash rally which is a beauty when it happens…but it’s destined to fade.
The Dow on the other hand which isn’t overloaded with NASDAQ stocks – I think they’ve only got two NASDAQ stocks in it, Microsoft and Intel and Microsoft is up about 2% this year – so it doesn’t explain what’s the phenomenon of this.
This has been a year where it’s been the small that outperformed the large, it’s been the undercapitalized that have outperformed the well-capitalized. In other words, this is a typical relief rally situation.
Eventually though, we’re going to have to adjust the reality of being in the middle stages of a recovery, not just in the early stages of a global economic recovery.
We dodged a real bullet this year in terms of SARS. So we’re now coming into the season where we’re going to find out whether it comes back. So everything I say is hedged on the basis that SARS does not come back in the form that it’s going to cause recessions in Singapore, Hong Kong and metropolitan Toronto.
The make up of the Dow Industrials is such is that the biggest stocks (by price not capitalization) have much more weight than the lower priced ones. And one of the phenomenal things in a sense is the huge performance of General Motors. And what drives General Motors, amazingly enough, is not cars, as you would think, but its pension fund
The revelation that General Motors can make all this money in earnings per share by borrowing money huge and then showing that it’s pension fund earns 9% on its portfolio which flows right to the bottom line because of the FASB 87. One would not use this, I would think, as a reason for getting heavily invested in a stock, particularly given the fact that General Motors spends more on drugs for the elderly and their retirees, than it makes out of producing cars. So it does illustrate the quirks that can occur in a market when it’s trying to find something other than tech stocks to buy.
But despite all this, it has been a lousy year for the big oil companies. The independent oil companies have done much better. But the big oil companies have dramatically underperformed, even though they have supplied most of the earnings gains of the total S&P. This has been a year in which if you deliver great earnings – well above forecast - you get punished.
One of my continual favorites, Exxon Mobil, has done nothing this year. Nothing, that is, except make money, much more than analysts had predicted and raised its dividend which of course, it does that every year, so “yawn”…we can ignore it. We’ve got this situation now, where in the second and third quarters of this year the oil and gas group really drove the earnings gains of the S&P…and they continually lost weight in favor of the techs.
So, this shows you the power of the shills and the mountebanks, but it illustrates something else, which is – and I want to spend some time on this because I think it’s important going in to the year 2004 – this week on my plane up to Toronto I read a condensation of the report from the strategist for UBS. And he is quoted as saying underweight the oil and gas stocks and he says, and I quote, “We and the rest of the street believe in lower oil prices.” His forecast is $20 oil next year and $21 oil in 2005.
Now the good thing about this forecast is that this is the eighth straight quarter where the street has had these forecasts. And so the result is that the oil companies are making huge amounts of money but the holders of the stock are selling them because the shills and the mountebanks are telling them to get out of those and telling them to get cyclical. And so a little of their money has dribbled into the mining stocks – we’ll get to that later – but a heck of a lot has gone into tech stocks. Since I was telling you, at the beginning of this year that stocks that grew their earnings and increased their dividends were the right kinds of stocks to own, that did work out well generally. It didn’t work out well with big oil. So, what can we look for in 2004?
I guess I’m stubborn, but we now have, I believe, the biggest discount on the P/E of the oil group, relative to the S&P, in the history of the index. What they’re trading at then, is an extreme cyclical group on peak earnings. This is the equivalent of the steel companies back in the mid-70s, where their P/E ratios would go to single digit levels when a recession loomed. And the trailing 12 month earnings were deemed to be something that were totally going to collapse.
I really do believe that it’s important for all of you to think through what your forecast is for oil and gas prices. Because if you do not agree with the streets estimate, if you think that, like I do, that something north of $25 is going to happen - and maybe even much higher - then what you’ve got is a rare opportunity…to load up.
Now, I have to admit that I have a big disadvantage relative to some of the forecasters. You know I’ve learned in recent weeks, the great advantage of having an MBA and a CFA if you’re a shill or a mountebank. Because you are exempt from criticism then – those of you’ve been carrying, as the street does, $3.75 estimates for natural gas - you’re exempt from any criticism whatsoever when gas goes through $6 in response to cold weather in winter.
Because as an MBA/CFA type, of the shill and mountebank variety, when we get cold weather in winter anywhere other than where one goes skiing, in other words, New Hampshire, Vermont and Colorado, that is not something to be expected and if it occurs and produces higher natural gas prices, you’re exempt from criticism. Isn’t supposed to happen.
We got global warming and so therefore these fluky businesses, which we have had now for the last two winters, are not something that should cause anybody any loss of prestige. And any earnings that the oil companies get from these, must be totally ignored…because you cannot expect cold weather in winter. That is not a reasonable forecast.
So, anyway, this is really an amazing world we live in, where people who have that kind of attitude still have jobs! It shows you that there’s really not a major unemployment problem on Wall Street. Apparently, to be a shill or a mountebank means never having to say you’re sorry. And, that when your forecasts turn out to be absurdly wrong, you totally ignore them and just reinstate them for the next time.
So, what I’m talking to in my touring has been going around comparing Cisco to the two kinds of mining stock groups: the base metals and the golds. Because of this felicitous situation that the value of Cisco is equal either to all the base metals in the world or all the gold stocks in the world. And one of the reasons I’ve been doing this is because of an article, which you must not miss. An article in the current issue of Barron’s which establishes, beyond a shadow of a reader’s doubt, that the gold stocks are the new bubble to replace tech stocks. And it’s had some impact this week, naturally. When Barron’s comes out and tells you not just that these stocks are overpriced but it’s a new bubble situation and obviously everybody who owns them has big profits, there’s a lot of selling.
I’m addressing this to those of you who, particularly who manage money for others, high net worth managers, because you will undoubtedly get questions from your clients if you;ve got a good position in gold stocks (and I assume that a disproportionately high number of the listeners on this call have good exposure to gold stocks, or they’d have hung me up forever long ago).
So, why is this Barron’s story so helpful? Well it illustrates a lot of things at once. First of all, how does a story occur where a Barron’s reporter has an epiphany in which he’s able to calculate all the net asset values of the gold stocks? Well this doesn’t occur spontaneously, this is not a world of the supernatural and the mystical. It occurs because some analyst has alerted his attention to this. Some analyst who undoubtedly has been telling people to sell the gold stocks because of his low net asset value calculation.
So let’s begin with a statement. Any Wall Street, virtually any Wall Street gold analyst who still has his job, after the triple waterfall collapse of gold, has gotten it by not telling clients there’s a long term investment quality to gold and not by using a high forecast price for gold. Because, everybody who had those viewpoints became unemployed.
So what you have is the cautious survivors. The ones who tell you to take money off the table when you make money in gold because it’s going to go back. Precisely the kind of people who helped earn great revenues for their companies by getting the gold companies to hedge.
And that was extremely profitable business for them and when you pointed out to the gold companies, how much money they would make by doing this, you made money for your firm and everybody was happier. They reported higher earnings to stockholders, you were an expert.
Well now of course, with gold trading at $400 an ounce – and that’s the other big number of this week – what we have is a whole bunch of this called into question. So it’s time to get a spontaneous article in Barron’s telling you that The End Is Near.
Now, what this article does not dwell on is why it is that you own gold stocks in the first place. You own them because you believe the US dollar is going down. And you believe that it’s in its own crash situation as the second bubble of the 1990’s, not the new first bubble of the third millennium. And with the dollar at 1.22 on the Euro and .76 on the Canadian dollar, notwithstanding gigantic support operations coming out of Asia, it’s not unreasonable to forecast the dollar’s going to fall a lot further.
This year the US will experience a ½ trillion dollar outflow in the trade account. The US is drawing down over 80% of all cross-border savings to hold the dollar into its currently weak position. It is not unreasonable therefore, for people to want to own gold and gold stocks because of the nearly perfect inverse correlation they have against the dollar.
So therefore to calculate a net asset value for these mines, based on the current price of gold, even at $400 an ounce, is to ignore why it is you bought it in the first place.
You bought it because you had other assets denominated in American dollars and you wanted to have internal portfolio protection. And you also wanted it because you were watching all sorts of other indicators out there that we’ve seen the bottom in inflation and interest rates and that the news going forward on inflation was not going to be as benign as it was. Those are the reasons you bought it in the first place.
You did not buy gold and gold stocks because they looked cheap relative to, say, tech stocks. By the way, the earnings multiples for the gold stocks in this, which are described as bizarre beyond belief, are nowhere near the multiple of what Cisco trades at when you account for stock options. And you must account for stock options because this year alone, the insiders have cashed three quarters of a billion dollars of profits at Cisco on options issued this year. In other words, stuff that they’ve only had for seven months – and they’ve made that much money, which is more money than the company has made.
So, what we’re being told, by this writer, is that, you know, it’s time to get out of these because there’s a crash coming. Well, let’s look at it the other way. Why do you own it in the first place?
Yes, if you bought a gold stock because you were expecting $1,000 gold in three months because of the end of civilization as we know it, then I recommend you not own it any longer. But if you know how it fits into a portfolio construction program then its need, if anything, is rising because we’ve broken 1.22 on the Euro. Notice that I’ve been going through a series of big numbers. The Dow Jones Industrials were my kickoff for this to point out that we’re at some other big numbers out there.
Now within the Dow Industrials, coming back to them, what we see is that they are the classic blue chips and they are economically cyclical more in a sense that the S&P isn’t. So, what is our outlook going forward for the US economy? Well, there’s no reason to believe the US economy’s going to fall on its face, barring one development. That one development is if we have a real crisis develop in the mortgage-backed market.
So I’ve been telling institutional clients the last couple of weeks that - when some occasionally ask me “What is it that keeps you awake at night?” - there’s no question now what it is. It’s the mortgage-backed’s.
And it comes from the fact that the Fed is keeping the Fed funds rate at 1% at a time of 8.2% economic growth rate, which is so amazing as to be almost science fiction. I’ve never known of a sustained Fed funds rate discount to the GDP growth rate, let alone a minute fraction of it. So when the Fed is forced off this stance - sure they’re doing this at a time when the US dollar’s in virtual free fall and the trade deficit is 2.7 billion dollars a day – that is a high-risk strategy. I mean this makes 1987, September and October of 1987, look like a risk-free zone.
So, where, if we do get a real dollar crisis next year, I’m afraid the Achilles Heel for the global system will not be as much the Eurodollar market, although that will get hit but the US mortgage backed market, which is now 36% of the Lehman Aggregate Index and its duration could extend from its current 5 ½ years to 10 years if we have, say, a 225 basis point run up in long rates, which is not too much to expect if we have 4% US economic growth and we have positive (rising) inflation and a weak dollar. All of which aren’t bizarre things to predict.
So, all of these are reasons, I think, why you hold gold and gold stocks.
Now, I’ve spoken only of those commodity groups. Within the base metal category there’s only one base metal stock in the Dow but it’s doing extremely well and that’s Alcoa. Alcoa though, still is trading in response to US economic numbers. I want to reiterate that for the base metals you don’t use the US economic numbers to price them. Because the US economy is no longer, at the margin, sensitive to base metals.
When Americans have more money, they spend it on healthcare, tort lawyers, travel and pornography. That’s the new addition to the group. The Wall Street Journal says that 22% of Internet usage is pornography. So unless you think of naked flesh as a commodity, none of those four groups are commodity-oriented.
What’s driving the base metals is the revival in Asia and this new middle class that we’ve been talking about in these calls for the last few months. On the other hand, if the US economy imploded as a result of a financial crisis that would be different. That would really affect these economies too. So, if we do not have a crash within the US, then what’s happened this year in the base metals is just a foretaste of what’s to come.
So I’ll reiterate my view that the commodities as a group, remain my most favored group.
Now this year, yeah, the golds and the base metals have done splendidly and the big disappointment has been the oils although the major Canadian independent oil and gas companies like Canadian Natural Resources and Encana, these stocks have delivered really great returns. The disappointment has been in big international oil companies.
And I guess I’m beginning to understand one reason why, and it’s my caution on these, is that in the areas they are now developing as they try to replace their current production, what we’re seeing is Islamic terrorists multiplying in these regions and the suicide bomber is a new kind of challenge.
You could protect these installations with the Army, as long as somebody who’s coming in to try to bomb you didn’t want to give up his own life. But when you have people believing that they go instantly to paradise and get an amazing reward, if they get blown up, then that’s a new problem and I think therefore the suicide bombing in Red Square is an illustration of how this kind of war is metastasizing across the world.
All those Caspian Sea reserves The Economist cites as a a reason for the collapse in oil prices, the pipelines go through regions which seem to have Islamic terrorists multiplying like mushrooms. I talked to a Chevron Texaco executive in Paris who had just come back from that region and yeah, they’re worried. But that’s the only place they’ve got to replace their reserves.
So, it may well be that we’re going to have this continued disconnect between the performances of big oil and this broad commodity market. It’s no reason not to own the independents, whose production is based in North America or in regions of the world that are not subject to Islamic terrorists. That may mean they’re still subject to political risk like Nigeria or Angola, but I think that is the big risk that’s out there now.
And just before we finish the call for questions, I might say that I’ve been brooding about the significance of the Al Qaeda attack in Saudi Arabia, which killed mostly Muslims. Because the motivation for that is obscure. As a matter of fact, it seems to have created something of a negative reaction in attitudes toward Al Qaeda within Saudi Arabia, if one can believe the published polls, and one must be extremely cautious about believing things peddled from that region.
But supposing you interpret it, that this was a signal from Al Qaeda to the Saudi government saying: “Look, it shows you what we can do, when somebody’s willing to give up his own life. You had this area protected; we had no problem penetrating it. Next is Dhahran.”
Now Dhahran you’re looking at eight and a half million barrels a day that’s being processed one way or the other and those facilities which are the biggest in the world, yes they’re brilliantly protected but, again, the suicide bomber is such an amazing kind of threat and because such a huge percentage of the workers there are Muslims from other countries, because it’s so hard to get locals to work, it’s hard for me to believe that they couldn’t be penetrated by Al Qaeda.
If that is the case, then sometime, probably in the next 12 months, what we’re going to see is something really serious happen, which is an attack on Dhahran, or on some other major oil facility like this.
And this is not in Iraq anymore, this is somewhere that’s been deemed secure. Then we’d be faced with a nightmare that all the new regions that will involve billions of dollars and enormous risks of all kinds, are exposed to Islamic terrorist risk in getting the stuff delivered and then what we regarded as most secure, becomes insecure.
That would be bad news for the stock market bad news for the global economy, but the interesting thing of course is that would not be bad news for big oil because they were nationalized. That’s it, any questions?
shill
n.
One who poses as a satisfied customer or an enthusiastic gambler to dupe bystanders into participating in a swindle.
moun•te•bank
n.
1. A hawker of quack medicines who attracts customers with stories, jokes, or tricks.
2. A flamboyant charlatan |
