Thursday, December 18, 2014

Linn Energy: A Shale Play Challenged at $55 Oil

Linn Energy (LINE) (LNCO) traded closed below $10 a unit on December 15, 2014, marking both a 52 week low, and lows not experienced since the December 2008 financial crisis.  During the 2008 crisis, oil reached a bottom in the $35 range, whereas currently we are just reaching the $55 per barrel range.  Why is the panic so much more acute today than the time period politically labeled as the “Greatest Recession since the Great Depression?”  Are we entering an even bigger Depression?  That question I may have an opinion, but will not attempt to answer in this article.  What I will provide readers is a clear nuts and bolts view of why there is a run on the Linn Energy units, and why as the market approaches $55 oil per barrel on the front-end of the curve, the investor sentiment is warranted. 
The big issue facing common unit holders of Linn Energy is the over-extended financial structure of the business, i.e. financial leverage.  While Linn Energy is well hedged with favorable $90 oil derivative contracts for the next several years of production, the reassessment of the value of its proven reserves is expected to severely stress its financing capacity in the very near future.  In addition, even with the hedge program, the drop in oil price will still place a burden on cash flow to pay distributions while continuing to maintain a steady capital expansion program.  If drilling is constrained for any period of time at Linn Energy, the current high oil production rate will decline rapidly given the characteristics of the proven undeveloped reserves that Linn Energy owns (light oil, high concentration of NGL and Natural Gas).  The cost structure of the company makes the oil production “cliff” a particularly onerous problem.  Based on an assessment of the financial position of the company contained in this article, investors should expect a radical down-sizing, or even complete elimination of the $.24 monthly distribution level which is currently a 28.76% yield.

Wednesday, November 5, 2014

SandRidge Permian Trust – Struck by the $80 Oil Lightning Bolt

On October 30th SandRidge Permian Trust (PER) announced its quarterly distribution for production during the time period of June through August 2014.  During the summer the energy market showed high oil prices throughout that benefited the Permian Trust which has 86% its production in crude oil.  The spread between WTI and WTS crude oil widened during the quarter causing a slight decline in price level realized by the Trust.

The distribution announcement was greeted with a rally in the market as the units traded up from $9.50 to $9.93 per unit on the day after the press release.  However, the information released may not have been the primary factor in share price movement during the day.  On Halloween the entire market experienced what is being reported by experts as a massive global shortcovering rally because of the announced changes in Japan monetary policy and pension fund allocation.  The unit price movement in Permian Trust units in the five day period leading up to the announcement was probably more indicative of the change in short-term sentiment about the Trust units, rising from $9.00 to the most recent $9.93 closing price on October 31st.

Thursday, October 30, 2014

Stocks Post QE3 - Pay Attention to this Data

For years the Fed Funds rate has been the sacred measure that investors followed to determine if the Federal Reserve was promoting and accommodative or restrictive policy.  Fed rate hikes were a signal that the market was a little too juiced on the punch, and margin calls or a reduction in lending in the market was considered prudent.

What about today?  The Fed Funds rate has been at 0% since December 2008 yielding the rate meaningless in understanding just how Fed policy is influencing the financial markets, much less the economy as a whole.  I separate the stock market from the economy because increasingly, and particularly since the new Fed policy of using excessive amounts of QE as a tool in its policy, the two have diverged in correlation.  In fact, from a pure numbers standpoint, it can be argued that over the last 6 years, Fed policy has been an outstanding success in pumping up the stock market.  Stocks have risen from the depths of 666 on the S&P500 to over 2000.  Economic growth, however, has struggled to exceed 2% in real terms, and 3%-4% nominally.

The Fed has announced that it will now end for the foreseeable future, its bond buying program known as QE3 in the market (the program followed QE1 in early 2009 and QE2 in early 2011).  Stocks went progressively higher with QE as a backstop.  With the QE program ending for the time being, will the stock market suffer from the change?  Logically given the correlation one might suspect trouble; but what indicators should an investor monitor?

The answer to these questions is completely up to what happens to the bubble the Fed has created on its balance sheet, and correspondingly the high level of excess liquidity that it has created within the U.S. banking system.  One such indicator that is likely to become useful in the post QE3 distorted financial market is the level of excess reserves in the U.S. banking system. (Excess Reserves of Depository Institutions)

Tuesday, September 30, 2014

Investors Beware, U.S. Fiscal Spending Shift Coming

As we approach the 2014 mid-term elections, U.S. fiscal policy is an economic headwind without any apparent current political movement to change.  The relatively tight policy as measured by rate of growth is a counter inflationary force foremost, but also potentially slows down economic growth.  You can see the evidence that the present fiscal policy is currently tight by reviewing the August 2014 year over year fiscal expenditure growth rate compared to previous years when the stock market peaked.

This data is surprising to many investors because they are so accustomed to hearing how Washington is out of control from a spending standpoint.  The data, however, is actually pointing in a different direction presently.

Monday, September 22, 2014

Lending Activity Heats Up – Should Stock Investors Worry?

One aspect of the recent U.S. economic growth not widely recognized is that it is being fueled by renewed high levels of debt being taken on by consumers, businesses and investors.  Unsustainable debt levels are notorious for derailing GDP growth.  This phenomenon was evident prior to the last two stock market peaks, and the risk has returned to the U.S. market once again.

If you review the statistics shown in the table below, you will see that just like 2000 and 2007, debt levels in 2014 have risen to warning zone levels relative to the size of the U.S economy (red = historically high, yellow = approaching historical high levels).

Monday, September 15, 2014

Stocks Expensive, Force Building to Knock Bull Down

Many articles have been released in the media in recent weeks concerning whether the stock market is over-valued or “very expensive” and may be approaching a peak.  One highly regarded researcher is Robert Schiller, who in August of 2014 was interviewed by many media outlets concerning the high level of the CAPE Ratio (cyclically adjusted P/E) to give his views.  Using this analytical approach he notes, “The United States stock market looks very expensive right now.”

I take a slightly different approach to look at the relative value of stocks compared to historical norms, but reach the same conclusion as Dr. Schiller.  The analysis, as summarized in the graph below, simply looks at the ratio of the traded value of the DOW relative to the nominal GDP (stated in billions) during the same time period.  Most recently the U.S. nominal GDP was just over $17.3 Trillion, and the DOW was trading at 17,098 at the end of August giving a ratio of .98.

The ratio is functionally useful in highlighting periods when the market is in outlier territory.  Presently, the stock market indices (DIA) (SPY) (QQQ) by relative measure are expensive.  However, history has demonstrated stocks can trade at these levels for extended periods before a steep correction occurs.  Since the 1990s, expensive in relative terms is a necessary but not sufficient reason for a major decline.  Saying stocks are expensive is different from trying to assess whether they are at a peak, and a portfolio adjustment toward higher liquidity and lower risk is a good play.

What is the likelihood that the S&P500 at 2000 is a peak?

Tuesday, September 9, 2014

Trend in U.S. Treasury Ownership Highlights Precarious Fed Rate Policy

Fed policy continues to be aggressively accommodative going into year-end 2014, even as it is projecting a wind down of the massive $1.54T QE program begun in January of 2013.

The easiest way to see the market rate impact of the Fed’s QE program and ZIRP (zero interest rate) policy is to review the current Treasury yield curve.  As the above graph shows, the current yield curve is

Thursday, June 5, 2014

Watch Out for the Stock Buy-Back Taper

Back in the year 2000 I got a call from a broker wanting me to take a look at particular large cap financial stock.  The pitch was “the company has lagged its peer group, but it has announced a major share re-purchase program.”  I asked what the company plans were for growth.  Awkward silence was evident on the other end of the line.  I then said, “So you are asking me to buy-out certain shareholders who don’t want to own the company anymore because the management team is struggling to find ways to invest?”  Needless to say, I did not invest in the company.  But I did follow it.  Sure enough it did rise in the following months, only to be cut in half within the next 2 years.

I tell this story because I have always been wary of common stock buy-back plans.  Not because they are all bad.  Many companies have a disciplined approach of returning capital through this process rather than paying dividends.  However, when the buy-backs are not backed up by fundamental growth in the company, they turn into little more than the company entering the debt market to finance dividends, or worse, robbing from needed capital investment to maintain future cash flow.