Energy and Natural Resources Market Radar (February 20, 2012)

Monday, February 20th, 2012

Energy and Natural Resources Market Radar (February 20, 2012)

Strengths

• Brent crude oil prices hit a six-month high of $119.28 per barrel this week on reports that Iran might cut crude exports to six European countries.
• The Global Resources Fund’s holdings of pipeline MLP stocks posted solid gains this week as the Alerian MLP Infrastructure Index climbed to record levels.
• Grain prices edged higher this week with soybean futures climbing to the highest level in almost five months after Chinese buyers purchased a record amount of the oilseed from the U.S.

Weaknesses

• The global steel market remains soft as Swedish specialty steel maker SSAB said it is postponing the restart of an idle blast furnace due to weak demand conditions in Europe.
• Rusal, the largest global aluminum producer, said it believes shutdowns in global aluminum capacity will reach 3-4 million tons per year in 2012. The company stated that “as a result of aluminum price decline at the end of 2011, a significant share of the world and European primary aluminum capacity has become unprofitable, resulting in partial or total closing of some smelters . . . a further 6-8 percent of global capacity curtailments are to be expected in the first half of 2012.”
• Preliminary U.S. gasoline consumption statistics for January appear to have diverged from relatively strong macroeconomic statistics.

Opportunities

• Deutsche Bank reported that traders are once again focusing on the Brent-WTI spread within the oil markets. WTI gained almost $2 per barrel to close over $100 per barrel for the first time in February, while Brent remained flat around $117.50 a barrel. With the first phase of the Seaway pipeline reversal due before summer, the differential between Brent and WTI is expected to narrow.
• China’s Ministry of Land and Resources will likely offer more than 20 blocks in its second shale-gas auction, compared to its original plan of more than 10. China is estimated to hold more gas trapped in shale than the U.S.
• Not only did BHP Billiton and Rio Tinto approve a $4.5 billion expansion to their Escondida copper mine in Chile, which is planned to increase the mine’s reserve by 25 percent, but BHP also made plans to reopen its Pinto Valley mine in Arizona, which was closed three years ago.  The substantial capital commitments by both companies demonstrates optimism about longer term demand for the metal; analysts have said that tight global supplies for a metal used for everything from power transmission to plumbing have left them with a positive outlook for the metal and its cost structure as well.

Threats

• Peru’s copper producers face the risk of blackouts next year because of power line delays in the southern Andes. Spain’s Abengoa and Colombia’s Interconexion Electrica may cancel new transmission projects unless the government clarifies a law that has delayed three lines by at least a year. Delayed power lines will set back projects including Xstrata’s $5.67 billion investment in the Las Bambas and Antapaccay copper mines and Luz del Sur’s $160 million Santa Teresa hydroelectric plant.
• Low demand and higher costs are expected to further erode profits in the Chinese steel sector in 2012. Also, many big steel enterprises suffered losses in the second half of the year, and the situation was unlikely to improve in 2012.

Tags: Alerian Mlp, Aluminum Price, Aluminum Producer, Blast Furnace, Brent Crude Oil, Brent Crude Oil Prices, Company Stated That, Consumption Statistics, Crude Exports, Crude Oil Prices, Gasoline Consumption, Global Capacity, Global Steel Market, Macroeconomic Statistics, Market Radar, Price Decline, Rusal, Seaway Pipeline, Soybean Futures, Steel Maker
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Energy and Natural Resources Market Radar (January 23, 2012)

Sunday, January 22nd, 2012

Energy and Natural Resources Market Radar (January 23, 2012)

Strengths

• The Global Resources Fund performance over the last week has bested its benchmark largely through stock selection in the energy sector and specifically in the oil services and equipment area.
• Barclay’s capital highlighted that base metals have started the year with a “bang;” prices are up on average 11 percent since the start of the year making it the best-performing sector so far. Copper gained approximately 10 percent for the week.
• One of the key leading indicators of U.S. non-residential construction, the American Institute of Architects Billings Index, remained above 50 in December, representing an increase in the month.
• Consultancy Steel and Metal Market Research said this week global crude stainless steel production hit a new record high of 35.5 million tons in 2011, but the pace of growth was slower than the previous year.
• Freeport McMoRan has resumed copper concentrate shipments from its Grasberg copper-gold mine in Indonesia, which had recently only resumed work from a three-month strike ending in December. Freeport is the world’s second-largest copper mine and supplied the global market with nearly 2.5 percent of the global demand.

Weaknesses

• After another soft reading of the weekly storage withdrawal, natural gas prices tumbled further this week as warmer than normal weather curbs demand. Natural gas futures fell 12 percent this week to close at $2.35 per mmbtu.
• Total steel shipments rose just 5 percent year-over-year for their smallest increase in nearly two years. Shipments fell 14.7 percent month-over-month on a days-adjusted basis, while total steel inventories rose 3.1 percent month-over-month and 8.3 percent year-over-year.
• According to Deutsche Bank, Norsk Hydro, the world’s fifth-largest primary aluminum producer with market share of nearly 4 percent, has confirmed that it will close one of the three potlines at its 180,000 tons per annum Kurri Kurri smelter in Australia in response to the price weakness of recent months. Rio Tinto and Alcoa, the world’s second- and third-largest producers, have also announced plans to close some capacity.
• ArcelorMittal will extend the closure of it Sestao plant in Spain as it does not expect southern European steel demand to improve in the near future, it said. The company had announced last October that it would halt steel production at the Sestao plant in November and December. “ArcelorMittal Sestao will restart operation as soon as market conditions turn around,” a spokesperson said in an e-mailed statement.

Opportunities

• Deutsche Bank highlighted that the International Energy Agency (IEA) said that China’s oil-product consumption is expected to rise 400,000 barrels per day to 9.9 million barrels per day in 2012, almost 40 percent of the increase in global consumption. According to its forecast, global crude oil consumption is expected to increase 1.1 million barrels per day to 90 million barrels per day.
• BP Plc said that China will drive the world’s growth in oil demand in the next 20 years and in 2027 will overtake the United States as the world’s top oil consumer.
• Deutsche Bank reported that Japan’s largest copper smelter suspended its Saganoseki smelter operation, with an annual capacity of 200 000 tons, due to fire damage. On top of this, Philippine’s PASAR copper smelter is also facing production problems. On the back of production disruptions, London Metal Exchange (LME) copper cancelled warrants increased significantly from New Orleans, where more free copper units exist globally.
• Freeport McMoRan reported that downstream demand in the U.S. is positive and project a tight and encouraging copper market in 2012, with the auto sector strong and signs of improvement in construction.
• U.S. service center steel inventories rose 3 percent month-over-month for December and were still 18.7 percent below average historical levels. December inventories were 52.8 percent below peak levels and 42.5 percent above trough levels. Inventory restocking likely has helped boost steel prices in recent months.

Threats

• Nigeria’s government ordered a fresh audit of its entire oil and gas sector covering the last three years. This move follows the opening of an investigation into the sector by the corruption watchdog and a separate Senate investigation into fuel subsidies – all announced this week. In response to a reduction in fuel subsidies, the country has witnessed a country-wide strike threatening the gas and oil sector.
• Crude oil is the most vulnerable to near-term supply disruption from geopolitical tensions. The sustainability of commodity supply is being challenged by rising state political interference and local self-interests that is delaying and constraining the resource development needed to meet emerging demand growth.

Tags: Aluminum Producer, American Institute Of Architects, Base Metals, Copper Gold, Copper Mine, Freeport Mcmoran, Fund Performance, Global Demand, Gold Mine, Institute Of Architects, Leading Indicators, Market Radar, Natural Gas Futures, Natural Gas Prices, Norsk Hydro, Oil Services, Resources Fund, Stainless Steel Production, Steel Shipments, Stock Selection
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Energy and Natural Resources Market Radar (January 9, 2012)

Sunday, January 8th, 2012

Energy and Natural Resources Market Radar (January 9, 2012)

Strengths

• First Quantum Minerals Ltd. resolved a long-running dispute with Eurasian Natural Resources Corporation Pls (ENRC) for $1.2 billion over mines in the Democratic Republic of the Congo (DRC). The controversial dispute over ownership of the Kolwezi project will be settled with ENRC paying $750 million plus a deferred consideration of $500 million as part of the settlement with First Quantum, the former owner of the project until its license was revoked by the DRC in 2009.
• Crude oil futures (WTI) moved higher by nearly 3 percent this week to close at $101.56 per barrel as geopolitical tensions surrounding Iran continued to escalate.
• Barclay’s highlighted that China raw coal production in November rose 4.4 percent year-over-year to reach 321 million tonnes while total output in the first 11 months of the year rose 11.6 percent to 3.46 billion tonnes.

Weaknesses

• Weekly data released by the U.S. Department of Energy indicates that 4-week trailing total demand for oil and oil products is down 7.2 percent year-over-year and gasoline demand is down 4.9 percent year-over-year.
• Alcoa Inc., the biggest U.S. aluminum producer, will close 12 percent of its global smelting capacity after the price of the lightweight metal slumped amid a global surplus.
• Indonesia, the world’s largest exporter of power-station coal, cut the benchmark price for sales in January by 3 percent to the lowest in 13 months. The Directorate General of Coal and Minerals at the ministry said on its website today in Jakarta that the cost of coal with a gross energy value of 6,322 kilo calories per kilogram was set at $109.29 a ton on free-on-board basis at vessel compared with $112.67 a ton in December.

Opportunities

• This week on the front page of the Financial Times, it was reported that a cut in Saudi posted prices to Asia is seen as a signal that Asian buyers are looking for new sources to reduce their dependence on Iran as U.S. pressure builds over sanctions. However, RBC Capital highlighted that Saudi looks to be the most willing to offer incentives, as International Oil Daily reports that the United Arab Emirates has increased February prices, albeit only by a nominal 2 cents per barrel.
• The Chairman of the China Iron and Steel Association said this week that China’s total apparent crude steel consumption is expected to rise about 4 percent to 700 million tonnes this year.
• Tudor Pickering reported that preliminary estimates show global oil production rebounded significantly quarter-over-quarter following third quarter maintenance. Biggest estimated additions quarter-over-quarter are Libya with 418,000, United Kingdom with 111,000, and Brazil with 109,000 barrels per day.
• BofA Merrill Lynch global investment strategist raised energy and gold commodities to overweight in its tactical asset allocation model for the first quarter of 2012. In their view, energy is well supported by easy monetary policy and the risk of a spike due to geopolitical events. Their model continues to overweight gold due to high risk of a sovereign default in Europe and low/negative real interest rates around the globe.

Threats

• A potential short-term rise in pricing for Colombian coal may force European buyers to seek other sources. Heavy rains have led to a two week delay in coal transport from the mine site to the ports for Colombia’s two largest producers – Drummond & Prodeco. The rains have also resulted in reduced coal production at the mines for the two companies.
• Deutsche Bank highlighted that India’s gold imports, the largest consumer, is expected to drop by 48 percent in the first quarter as a decline in the currency boosts prices and high interest rates cool investment demand, according to the Bombay Bullion Association.
• Zhu Jimin, head of Shougang Group, one of China’s biggest steelmakers, addressed members at CISA’s annual meeting, saying that prospects for the steel sector remained gloomy, with the entire sector facing falling profits in 2012. “Enterprises are facing increasing operating risks, under pressure from a variety of factors such as rising costs, falling demand and difficult and expensive financing,” he said. Zhu said a series of policies introduced last year to control the real estate sector had reduced demand for steel, and if the policies were not adjusted the situation could worsen in 2012. Slowing growth in domestic manufacturing, railway, shipbuilding and auto sectors could also take its toll, he added.
• Resource Daily reported that Nigerian unions are calling for indefinite strike action on January 9 to shut down both the up and down stream oil sector. The strike is in reaction to the recent government decision to remove fuel subsidies which has seen gasoline prices double. In 2010 Nigerian production accounted for 13 percent of Shell volumes and 12 percent for Total, 10 percent for Eni and 2 percent for Statoil.

Tags: Alcoa Inc, Aluminum Producer, Asian Buyers, Benchmark Price, Board Basis, Coal Production, Congo Drc, Crude Oil Futures, Democratic Republic Of The Congo, Energy Value, Financial Times, Global Surplus, Gross Energy, Kilo Calories, Largest Exporter, Lightweight Metal, Market Radar, Natural Resources Corporation, Raw Coal, Republic Of The Congo
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Three Profit Metrics to Avoid Earnings Season Myopia (Hester)

Sunday, April 10th, 2011

by Bill Hester, Hussman Funds

Alcoa, the aluminum producer, announces its earnings on Monday. So begins the reporting season of first-quarter company results. During this period in particular, it may be easy to become enamored with past corporate performance and miss potential forward-looking risks. To counterbalance the deluge of earnings reports to be delivered over the next few weeks, here are a few intermediate-term indicators and trends that investors may want to watch to gauge earnings conditions.

Watch Sales Growth for Clues to the Direction in Profit Margins

The current profit margin of the S&P 500 Index is sky high. During the past 40 years it was only higher during 2006-2007, fueled substantially at the time by record margins and earnings of financial companies that would eventually disappear into the ether. The current profit margin is 50 percent above its long-term average.

One of the primary drivers of profit margins is sales growth. But the important role that sales growth plays is often left out of the discussion. Year-over-year changes in revenue have a strong correlation with changes in profit margins historically. This makes sense, because a large part of company expenses are fixed for a period of time, especially contractual ones like those for labor and supplies. So over the short-term, revenue growth often falls straight to the bottom line. So when sales growth comes in faster than recent trends, those new sales help deliver higher profit margins.

Recent data show a divergence in sales growth, which is moderating, and margins, which continue to expand. This is likely the result of corporate executives who continue to be uncertain of the durability of the economic recovery. Even though sales growth has been strong during the last few quarters, corporate cost structures haven’t changed materially, which has boosted margins. The graph below compares the year-over-year change in sales in the S&P 500 with the Index’s profit margin.

It’s important to highlight the recent rate of growth in sales, which is moderating. Even if corporate executives continue to move slowly in hiring and raising wages, if sales growth continues to moderate, margins are likely to be dragged lower over the next few quarters. Even now, profit margins look extended based on their relationship with sales growth. Typically, high profit margins follow strong sales growth. As sale growth moderates, margins decline. This helps explain why there is also a strong inverse correlation between profit margins and subsequent profit growth, as John Hussman has frequently noted.

There has also historically been a negative correlation between profit margins and subsequent stock market returns. The current trailing 5-year return – which began with profit margins close to current levels – is a bit less than 3 percent annually (with intense volatility and drawdown). Based on historical correlations, current profit margins suggest similarly low returns over the next few years.

Valuation Differences Across Sectors

The first graph above shows that S&P 500 profit margins are near peak levels. And we know that by looking at valuation models that normalize fundamentals, the level of valuation of the Index is also extended. Are the sectors within the Index equally overextended on both a profit margin and valuation basis?

The graphs below attempt to provide some insight. The data for these graphs is provided by Ned Davis Research . NDR’s analysts have calculated sales and income totals for the main sectors of the S&P 500 going back to the early 1970′s, which I’ve used to calculate profit margins. They have also calculated a set of historical median valuation ratios for each sector. To separate the level of valuations from the impact of peak profit margins, I’ve used the median sales yield (sales/price) in the calculations below.

As an example, the first graph presents the data for the Consumer Discretionary Sector. The top half of the graph shows profit margins for the sector – which are at record levels. The bottom half of the graph shows sales yields – which are at record low levels (implying high levels of valuation).

The graph below extends this concept by comparing each sector’s current profit margin and sales yield to its historical range (as a percentage). For example, sectors in the lower right quadrant have profit margins and levels of valuation that are higher than average for those sectors. The lower and further right you go on the graph, the more extended the current profit margins and valuations are. Keep in mind that by using sales yield we are focusing on how expensive sectors are, relative to a fundamental that isn’t influenced by year-to-year fluctuations in the sector’s profit margins.

The S&P 500 itself is in the lower right-hand corner. You can see how extended the Index is based on both the level of profit margin and valuation, compared with historical norms. The Consumer Discretionary sector (COND) is even more extended on both measures. Also interesting are the cyclical components of the S&P Index. The Materials, Energy, and Industrial sectors are all at peak levels of valuation (independent of margins) and have near-record profit margins as well. Consumer Staples and Financial sectors are less overvalued relative to their history (keep in mind how highly valued financials were in 2007 prior to their declines, which likely distorts their current level of relative valuation). The Healthcare sector appears least extended on these measures.

It’s clear from the graph that any argument that the market and the majority of its sectors are fairly valued relies strongly on the assumption that profit margins will remain near their all-time peak levels. Valuation metrics that aren’t influenced by year-to-year fluctuations in profit margins are showing record levels of overvaluation. Near-record profit margins with near-record levels of valuation for most industries suggest potential for risk to the stock market in the event earnings disappoint investors over the next couple of quarters.

Investors May Be Running Out of Surprises

One of the worst-kept secrets in the financial markets is that earnings surprises are not true surprises. Company executives have learned over time that if they provide modest earnings guidance, then beat that guidance, even marginally, their management and company performance look better. Stock prices often react favorably to those ‘surprises’. You can see the development of this sort of “pact” between executives and analysts by looking at the upward drift of earnings surprise rates – which measure the percentage of companies that beat estimates. Surprise rate have generally moved higher from the mid-1990′s when a little less than half of companies typically beat estimates, to the recent high where more than 80 percent of companies beat estimates.

This doesn’t mean that tracking the earnings surprise rate is without merit, as long as you’re mindful of its upward drift. Because of the upward trend in the data, the most useful signals are based not on the level of surprises, but on noticeable reversals of that trend. Bloomberg keeps an index of these earnings surprises, which I’ve mentioned before as a tool for monitoring potential risks. The graph below shows the index on a monthly basis, with a 12 and 24-month moving average that track its smoothed performance.

It’s a relatively short data series that begins in the early 1990′s. But over that time, when the 12-month moving average of the index has fallen below its 24-month moving average, especially from a noticeable peak, poor returns have generally followed. For example, the shorter-term moving average dipped below the longer-term average in early 2001, following a noticeable peak in 2000. The two crossed again in 2007, prior to the profit surprise rate collapsing from 70 percent to almost 50 percent in 2009. During both periods the 12-month moving average stayed below the 24-month moving average until a substantial amount of the decline in stock markets that followed had already occurred. There were less effective signals given in 1996 and 2005. The indicator is plotted against the performance of the S&P 500 Index below.

The 12-month moving average of the surprise line fell below the 24-month moving average last week, which is noted on the graph. Again, it’s a data series with limited history so the signal alone shouldn’t be used for investment decisions. But the deterioration in the positive surprise index will clearly be worth watching as the coming earnings season unfolds.

Earnings reporting season always brings an intense scrutiny of profit metrics, but not always the most helpful ones. During these periods it’s easy to lose focus on intermediate term indicators that can provide useful information. The metrics that track some of these trends – the level of profit margins in relation to sales growth, sector valuation, and a downward drifting earnings surprise rate – are currently highlighting potential intermediate-term risks on the earnings front.

Copyright © Hussman Funds

Tags: Alcoa, Aluminum Producer, Company Expenses, Corporate Executives, Corporate Performance, Deluge, Divergence, Earnings Reports, Earnings Season, Economic Recovery, Enamored, Hester, Hussman Funds, Metrics, Myopia, Profit Margin, Profit Margins, Reporting Season, Term Indicators, Watch Sales
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