Tag Archives: industry

As Producers Get Out, You Should Get In: Why I’m Long XLE

Summary WTI crude in the mid-30s is close to the cash operating cost of many high-cost oil producers. As oil trades in the mid-30s, production will be shut in and supply will fall, in theory creating a floor in the price of oil. Continued low oil prices will likely create an underinvestment in oil production, and could create risk to the upside in future oil prices. Investors should consider buying XLE, as it will likely be able to weather the storm, and avoid XOP, as it contains much smaller producers that may not survive. Investors should avoid USO as it is subject to the decay associated with negative roll yield in WTI futures contracts. On December 15th, West Texas Intermediate Crude traded through $35 a barrel. This is close to the variable operating cash cost of many high-cost producers operating out of North America. At these prices, producers potentially stop pumping crude from their wells because it is more expensive to pull it out of the ground than the oil is worth. North American rig counts have already fallen precipitously; at these levels, they are likely set to fall even more. As rig counts fall, supply lessens from this area, and investment in future productive capacity also likely falls. This may set the oil market up for much higher prices in the future, repeating past energy cycles. Investors should consider buying the Energy Select Sector SPDR ETF (NYSEARCA: XLE ), which contains the larger players in the energy sector, to capitalize on this potential for higher oil prices in the future. Investors should avoid buying the SPDR S&P Oil and Gas Exploration and Production ETF (NYSEARCA: XOP ); however, as many of these producers are smaller and may not be able to ride out the storm. Investors should also avoid the United States Oil ETF (NYSEARCA: USO ), as contango will eat away at profits over time. Cash Operating Costs of the Marginal Shale Producer Below is a chart of the estimated cash operating cost of oil production for oil producers globally. “Cash cost” is the variable operating cost of pulling oil out of the ground. These figures are roughly a year old, but are probably still relevant. Note that Canadian oil sands, U.K. producers, and U.S. producers are on the upper end, within a $25-40 barrel cash cost range. As oil prices dip into these levels, independent producers will begin to shut-in production as it stops making economic sense to continue producing. This, in theory, should create a floor on the price of oil, as the price-determining marginal supply from these producers diminishes. Note that as the price dips as low as $30, almost 30% of producers are operating at levels that don’t make sense to continue. (click to enlarge) Source: Morgan Stanley and Business Insider Falling North American Rig Count Rig counts have fallen dramatically since last year as oil has collapsed and oil producers have cut back CAPEX in the face of a deteriorating credit market in the oil and gas sector. New rigs that would be too expensive to operate at low oil prices are not coming online, and old rigs being phased out are not getting replaced. Per Baker Hughes, North American rig counts have collapsed from a high of 2,300 rigs to 883 today, or a decline of 61% in one year. North American Rig Count through Time (click to enlarge) Source: Baker Hughes and Bloomberg Given that many producers have cash costs of oil in the $30-40 range, rig count is likely to decline further with oil breaching $35 a barrel, in my opinion. As rig count falls, the industry as a whole sets itself up for stronger oil in the future. The effect is twofold; supply of oil falls initially, stabilizing prices, but then the ensuing underinvestment in oil infrastructure creates a situation where oil prices could increase dramatically as underinvested producers are less able to quickly increase production in response to higher oil. We could see a repeat of the underinvestment of the late 1990s that led to the boom in oil prices in the mid-2000s. Buy XLE, Avoid XOP and USO Investors should consider XLE, as it contains very large producers such as Exxon Mobil (NYSE: XOM ), Chevron (NYSE: CVX ), and Schlumberger (NYSE: SLB ) that have the ability to weather the storm of lower oil prices for a long time. Investors should avoid XOP, as it contains a higher concentration of smaller capitalization companies that may not be able to survive mid-30s oil for a long time. I could imagine a situation where oil remains in the mid-30s, and XOP continues to tank, as smaller producers come under increasing financial pressure. See below for the breakdown of top holdings of XLE and XOP; note that some of the largest concentrations in XOP are in stocks with market caps of less than 4BN: Source: Bloomberg Investors should also avoid USO, as it is long oil futures contracts, and is therefore subject to the negative roll yields associated with contango. Oil contracts trade for future delivery at specified points in time. Currently, the market is in contango, meaning that contracts further into the future are more expensive than contracts expiring closer to the present. Contango in WTI Crude (click to enlarge) Source: Bloomberg USO owns short-dated contracts, and as those contracts expire, it sells them and buys contracts further into the future. With today’s prices, for example, USO would sell the Jan. 16 expiries at 37.11 and buy the Feb. 16 expiries at 38.27, creating a 37.11/38.27-1= -3.03% yield in just one month. A rough annualization of that yield means that USO is currently losing 36.4% annually! It is better to own the producers themselves who sell their production forward in the futures market than to own a fund exposed to the cost of maintaining a long position in futures, as the price performance between XLE and USO over the past five years has shown. Shorting $1 of USO and buying $1 of XLE, price performance over past five years, excluding dividends: Source: Bloomberg Conclusion Oil in the mid-30s is approaching the cash operating costs of many North American oil producers. As oil falls, they will shut in production, theoretically creating a floor in the price of oil in this range. Underinvestment in oil production in the future due to low oil prices today may also one day contribute to strong future oil prices. Investors looking to take advantage of this potential floor should look to buy XLE, as it contains some of the largest oil-producing companies in the world, and should be able to weather the supply glut in oil, and avoid XOP, as it has smaller producers that may not be able to survive lower oil. Investors should avoid USO as it is subject to negative roll yields associated with contango in WTI futures markets.

Can Airlines Funds Take Off On Profit Outlook, Low Fuel Cost?

The Airline sector is witnessing improving trends right now, and the momentum is much needed to ensure profits for investors in this space. While much of the encouragement comes from fundamentals within the airline space, another key catalyst for the sector’s growth is the slumping oil price. Airline stocks will likely continue their bull run into 2016 as recently reinforced by the encouraging outlook provided by the International Air Transport Association (IATA). Separately, weakness in oil prices, which has lasted for well over a year now, is nothing short of a godsend for the airline space. Airline profits depend largely on fuel prices, which form nearly 30% of operating expenses and are also the major variable component in the industry. Operating expenses of airline companies have gone down considerably as fuel accounts for one of the major input costs for air carriers. Thus, it is time to focus on funds that have investments in the airline space. Please note that there is hardly any fund that focuses solely on airline stocks. However, the sector attracts heavy investments from many mutual funds that focus on the transportation sector. The funds we discuss may not carry a favorable Zacks Mutual Fund Rank at the moment, but an improving trend in the airline space demands attention on them. Airliners Fly High as Crude Hits Ground Stocks in the airline space soared following the Dec 4 decision by the Organization of the Petroleum Exporting Countries (OPEC) – the international cartel of oil producers – to not curb output of crude. A blip came thereafter as Southwest Airlines (NYSE: LUV ) revealed a disappointing outlook with respect to its operating revenue per available seat miles (RASM) for the fourth quarter of 2015. Nonetheless, the low oil price environment makes airline stocks attractive. The drop in oil prices has reduced airline companies’ operating expenses significantly, thereby boosting the bottom line. OPEC’s decision not to curb output despite the slump in prices means that the oversupply will continue to haunt the energy space. This implies good times ahead for airline carriers. Weak oil prices have resulted in tremendous savings and improved bottom lines for carriers in the past quarters. The massive savings have certainly supported the financial health of carriers and prompted them to launch share buyback programs, hike dividend payments and significantly reduce their debt levels. Buoyed by their sound financial health, several carriers intend to invest heavily in upgrading overall facilities for better customer satisfaction. This is likely to result in greater travel demand, improved goodwill and eventually, a higher top line. Although it is true that most carriers struggled to post meaningful revenue growth in the third quarter of 2015 courtesy of a strong US dollar, their bottom lines benefited owing to low fuel costs. IATA’s Outlook Buoys Airliners Further The International Air Transport Association now expects profits in the aviation industry to touch $36.3 billion in 2016 with a net profit margin of 5.1%. IATA also projects profits of around $33 billion in 2015 with net profit margin of 4.6%, marking an improvement from the previous guidance of $29.3 billion, which was released in June 2015. Christmas holidays and summer vacations will contribute to traffic. IATA projects 6.7% and 6.9% growth in air traffic in 2015 and 2016, respectively, with load factor or percentage of seats filled by passengers pegged at 80.7%. IATA also believes that 3.8 billion passengers will travel in 2016. Moreover, increased fleet restructuring programs, retiring older and less efficient aircraft and new aircraft orders are anticipated to enhance the performance level of the company by trimming fuel and operating costs, and rendering a comfortable flying experience. Moreover, most carriers are focused on augmenting ancillary revenues by launching value-added services at affordable rates. Funds In Need of a Turnaround Although there is no airline-specific mutual fund category, the space represents a substantial portion of the transportation sector. Mutual funds from the transportation sector with significant focus on airliners are the ones to watch out for. Not all of them may be carrying a favorable rank right now, but the positives are much needed to turn the tide for them. Fidelity Select Transportation (MUTF: FSRFX ) seeks growth of capital. FSRFX invests the majority of its assets in common stocks of firms mostly involved in providing transportation services or ones that design, manufacture and sell transportation equipment. FSRFX is the only fund that carries a Zacks Mutual Fund Rank #2 (Buy). FSRFX has not been able to stay in the green in recent times, as its year to date and 1-year returns are -16.7% and -13.7%, respectively. The 3- and 5-year annualized returns are, however, respectively 19.2% and 11.8%. Annual expense ratio of 0.81% is lower than the category average of 1.14%. FSRFX carries no sales load. Among the top 10 holdings, FSRFX holds airline companies such as Southwest Airlines, American Airlines Group Inc (NASDAQ: AAL ) and Delta Air Lines Inc. (NYSE: DAL ). Rydex Transportation Fund Investor (MUTF: RYPIX ) invests a large chunk of its assets in domestically traded companies from the transportation sector and in other securities including futures contracts and options. RYPIX may allocate a notable portion of its assets in companies having market capitalization within the range of small to medium size. RYPIX may also invest in ADRs in order to gain exposure to non-US companies and may also invest in US government securities. RYPIX currently carries a Zacks Mutual Fund Rank #4 (Sell). The year to date and 1-year losses of RYPIX are 12.4% and 8.6%, respectively. The 3- and 5-year annualized gains are 19.4% and 11%, respectively. Annual expense ratio of 1.35% is higher than the category average of 1.14%. RYPIX carries no sales load. Among the top 10 holdings, RYPIX holds airline companies such as Delta Air Lines, Southwest Airlines and American Airlines Group. Fidelity Select Air Transportation Portfolio (MUTF: FSAIX ) seeks long-term capital growth. FSAIX invests the major portion of its assets in companies primarily engaged in providing air transport services all over the world. FSAIX focuses on acquiring common stocks of companies depending on factors such as financial strength and economic condition. FSAIX currently carries a Zacks Mutual Fund Rank #4 (Sell). The year to date and 1-year losses of FSAIX are 6.5% and 3.2%, respectively. The 3- and 5-year annualized gains are 23.1% and 15%, respectively. Annual expense ratio of 0.83% is lower than the category average of 1.14%. FSAIX carries no sales load. Among the top 10 holdings, FSAIX has airline companies such as Southwest Airlines, American Airlines Group, Delta Air Lines and Spirit AeroSystems Holdings (NYSE: SPR ), which is one of the largest independent suppliers of commercial airplane assemblies and components. Original Post

Even After Recent Drop, PGP Is A Sell

PGP trades at a large premium, putting it at risk for a steep decline. When rates rise, high premium and highly leveraged funds will suffer. Friday’s drop is a sign of how risky the fund truly is. The purpose of this article is to evaluate PIMCO Global StocksPLUS & Income Fund (NYSE: PGP ) as an investment option. To do so, I will evaluate the fund’s characteristics, recent performance, and trends within the industry as a whole to attempt to determine if PGP will be a profitable investment going in to 2016. First, a little about PGP. PGP’s stated objective is to seek a total return comprised of current income, current gains, and long-term capital appreciation. The fund attempts to achieve this objective by building a global equity and debt portfolio and investing at least 80% of the fund’s net assets in a combination of securities and instruments that provide exposure to stocks and/or produce income and by utilizing call and put options to generate gains from options premiums and protect against swift market declines. Currently, the fund is trading at $16.91/share, after Friday’s decline of 8.62%. The fund pays a monthly dividend of $.18/share, which translates to an annual yield of 12.77%. While the fund has come under pressure over the past few trading sessions, performance in the past few months has been strong, with the fund up almost 15% in the past three months, excluding dividend payments. Given that performance, and its high yield in this low rate environment, PGP may seem like a sound investment. However, there are a few reasons, which I will outline below, why I would avoid PGP going forward. First, and probably most important, PGP trades at an enormous premium to Net Asset Value (NYSE: NAV ), currently at 56.24%. This in and of itself is a red flag for any fund, as it indicates investors are paying well above the fair market rate for future performance. PGP has been able to maintain this high premium because it has a history of reliability for its dividend payout, which is high, and investors have flocked to PGP and other similar funds to earn this yield while interest rates have remained at record lows. While this strategy may have paid off during that environment, once rates start to rise, investors will shift out of riskier funds and in to safer asset classes that will begin to pay more. Funds that demand a high premium, such as PGP, will be most at risk. This was evident during Friday’s drop, as credit markets were rattled over Third Avenue’s decision to suspend redemptions on one of its credit mutual funds. This decision hit many Pimco funds hard on Friday, but funds that trade at large premiums were hit the hardest. For example, PHK, which also trades at a premium (albeit at only 10%) dropped over 7%, which was similar to PGP’s drop. Meanwhile , PCN, which trades at a 7.62% discount to NAV, dropped only 2.44% and PCI, which trades at an almost 16% discount to NAV , dropped only 1.18%. While this is just a snapshot of one trading day, it demonstrates how funds with high premiums are more sensitive to market swings and are riskier for the initial principle investment. Second, interest rates are likely to increase this week, as 92% of economists surveyed by the Wall Street Journal are predicting a December rate hike to be announced during the Fed’s meeting this week. If Yellen announces a hike, and lays out the groundwork for future hikes in 2016, investors may begin to exit riskier funds like PGP, as yield on safer investments, such as Treasury bills, will begin to be higher. Again, due to its large premium, PGP will probably suffer more than most and the drop could be steep. In the past month, as expectations for the first rate increase became more pronounced, PGP has suffered, down about 5% (excluding dividends). With the rate hike becoming more evident, I expect this decline to continue. Third, while PGP has traded at an ultra-high premium for quite some time, historically the fund has traded at NAV, or at a discount. It wasn’t until the depths of the of the financial crisis and the near zero interest rates in 2009 that PGP began to sell at a premium. Investors have irrationally bid up this fund to the point where owning it now sets up the investor for a very quick, steep drop in principle. When rates rise, I expect PGP to return to pre-recession valuations, which would mean a dramatic decrease in share price from where it stands today. Of course, avoiding PGP has risks of its own. The fund has traded at a premium successfully for years, and its high yield, along with capital appreciation, has rewarded investors handsomely. If Yellen announces that the Fed will yet again delay raising rates, or lays out a dovish stance for future increases in 2016, funds like PGP could rally, as that could indicate the low rate environment will be around for longer than anticipated. Additionally, PGP’s yield of almost 13% could be enough to entice investors to stay the course throughout 2016, even with rising rates. While rates rising seems to be an almost certainty, those rates will most likely still be at historically low levels. Investors may decide that the high yield and below investment grade credit sectors that compose PGP could be worth the risk. However, I expect the Fed to follow through with the December rate hike, and lay a groundwork for a few rate hikes in 2016. This albeit slow rate of increases will gradually steer investors out of high-yielding closed-end funds, and PGP should fall quicker than others. Bottom-line: PGP has paid a reliable, high-yield during a period of ultra-low interest rates, rewarding investors with high income during a time when such income was hard to come by. The fund has also performed strongly from its 2009 lows, more than doubling in share price. However, this performance has priced PGP well above NAV, and has shown itself prone to dramatic losses when the market gets rattled, such as on Friday. With volatility expected in the credit markets in the coming months as interest rates are set to rise, the risk-reward of PGP is just not there. While the yield is high, and PGP has proven to pay it reliably, there are other Pimco funds available with similar yields, that won’t expose investors to such a large potential loss in principle. Heading in to the new year, I would caution investors away from PGP at this time.