Energy Sector
Overall it appears that 2013 will be another year of attractive market dynamics for companies and investors, with Brent crude oil prices averaging over $100 a barrel and domestic supply continuing to ramp upward:
Oil Demand
Global crude oil consumption will increase 0.9 million barrels per day to 
record levels in 2013 according to the latest International Energy Agency report. Global demand has increased in 13 of the last 15 years, declining only during the Great Recession of 2008. Global demand in 2013 will be 90.5 million barrels per day, with China accounting for roughly one-half of the global demand growth.
China’s oil demand hit the highest level on record in November (the last month data is available) – 10.5 million barrels per day according to Platt’s. Demand is expected to continue to set records in China in 2013. Apparent demand for crude oil in China is expected to grow by 4% to 6% year on year in 2013, versus 3% to 4% in 2012, according to the consensus analyst forecasts.
Oil Supply
Growth in global demand in 2013 will be met by new supply from outside OPEC according to most analysts, with most of the supply gains coming from increased production in the U.S. Hydraulic fracturing should allow producers to ramp up the extraction of shale oil from formations in North Dakota, Oklahoma and Texas. Gains in production could reach 0.5 million barrels per day.
On the flip side, continued sanctions against Iran, difficulties in Yemen and Syria and Libya, and new violence in Iraq should continue to keep production from most of these areas flat at best.
Oil Pricing
Brent crude oil will average 0 per barrel in 2013 according to the consensus forecast of 30 analysts compiled by Bloomberg, the third year in a row it will trade in triple digits.
In a separate forecast the U.S. EIA said that the rise in U.S. output would contribute to a well supplied market next year. The agency said that international Brent crude oil prices would fall slightly in 2013 to around 5 a barrel on average in 2013 from just under 2 last year.
Note that West Texas Intermediate currently sells at a a barrel discount to Brent, so refineries that have access to the cheaper priced crude have a cost advantage. Note the discount in the chart between Louisiana crude (which generally sells based on Brant pricing) and North Dakota crude (generally based on WTI pricing).
Most analysts expect the WTI/Brent spread will narrow to roughly -15 a barrel. The median of analyst forecasts compiled by Bloomberg call for the difference to narrow to .10. Flows will accelerate through the Seaway pipeline which connects Cushing with the Gulf Coast. The Gulf Coast has roughly 50 percent of the nation’s refining capacity.
Transportation
In 2008, fewer than 20,000 barrels a day of crude oil moved on trains in the U.S. By the end of 2012, that number had jumped above 500,000 – a more than 25-fold increase in five years.
Rail shipping has become the method of choice at new production sites because obtaining permits and rights-of-way can slow pipeline construction and make it more costly. But note that an American think tank, the Manhattan Institute, compared incidents on gas and oil lines with transportation by rail and road, and found pipelines were far less likely to leak, kill or injure anyone. In fact, between 2005 and 2009, railways in the U.S. were almost 34 times more likely to record an incident than a pipeline, per billion ton mile.
This claim was vociferously disputed by the Association of American Railroads, who nonetheless conceded railways were 2.6 times more likely to experience an accident than a pipeline.
Bloomberg noted last week that a group of oil and gas pipeline operators led by Plains All American Pipeline LP announced plans to spend about billion on rail depot projects to help move more crude from inland fields to refineries on the coasts. Burlington Northern Santa Fe LLC, the largest U.S. railroad, spent 0 million on terminals in 2012.
For the first time, energy companies that traditionally rented rail capacity are buying the assets because swelling output from Alberta’s oil sands and shale fields in North Dakota’s Bakken region and Eagle Ford in Texas has overwhelmed pipelines. Producers and refiners such as Devon Energy Corp. and Irving Oil Corp. say they’ll turn even more to rail to get domestically pumped crude to the highest-paying refineries.
When domestic crude is priced 20 percent cheaper than imports, the profit potential is obvious.
Mergers & Acquisitions
Current valuations in the small cap energy sector are extremely depressed. The cheapest oil resources are not found in the ground – they are in the publicly traded small cap energy stocks, with proven reserves verified by third party registered professional engineers using rules promulgated by the U.S. Securities and Exchange Commission. Astute management seeking to expand in the sector will look to acquisitions and mergers in the coming year. We expect the small cap energy sector to outperform.
Looking Back at 2012
With this bullish outlook – similar to the environment seen in 2012 - we need to look back at why many energy stocks did not perform well even as companies posted record production and revenue levels. We think the underperformance of energy sector stocks was temporary for the following reasons:
Shares of small capitalization energy producers, as measured by the PowerShares S&P SmallCap Energy Portfolio ETF (PSCE) fell by over 5% in the last year, underperforming the S&P 500 index by more than 15%. The market data indicates that the smaller the capitalization, the worse the 12 month relative performance. The average market capitalization of companies in the PowerShares SmallCap Energy Portfolio was roughly .2 billion.
- Highlighting the weak short term trends in the energy sector crude oil prices, as measured by the United States Oil Fund LP ETF (USO) have declined by roughly 15% over the last 12 months. The S&P 500 increased in value over the last year, so this measure underperformed the index by around 25% over the last 12 months.
A large part of the underperformance can be explained due to the uncertainty regarding the fiscal cliff and governmental policies. Concerns about massive tax increases on energy producers would impact the smallest firms the most – hence the discounted stock price in the market. The smaller the firm, generally the worst the energy company stock performed.
Concerns about a recession, which would lower oil prices, due to fiscal cliff paralysis was also in play. And of course uncertainty on tax rates for capital gains was an issue. Not to say that these issues will not resurface in the political arena, but valuations have reflected the worst possible outcome. We think the risk and uncertainty for investors in the sector will be a bit lower in 2013 – and the production and revenues gains will help support energy stock prices.
Agricultural Sector
Long term trends remain positive in the agricultural sector. U.S. farm incomes, even with the drought, are expected to be near record levels in 2013. Debt levels in the agricultural sector remain restrained compared to asset valuations. The following developments point to a continued long term bullish trend:
- The Creighton University Farm Equipment Sales index bounced to 67.0 from 60.4 in November. "With solid financial footing, farmers remain optimistic about future agriculture economic conditions and are expanding their purchases of farm equipment," said Dr. Ernie Goss, Director of the Creighton survey. A reading above 50 indicates farm equipment sales are increasing versus the year earlier period. The Farmland Price index, also published by Creighton, also indicated continued price increases for U.S. farmland.
- ‘Production shortfalls have tightened grain inventories’ according to the charts presented on the Potash Corporation website. The grain stock-to-use level has fallen well below the 25 year average.
“The stocks-to-use ratio is a key pricing metric, indicating the tightness of supplies, and thereby the competition between buyers to acquire them” according to the International Grains Council. "The tighter outlook will leave markets more vulnerable to price gains, as well as volatility, in the event of poor crops."
- China’s grain imports are expected to skyrocket according to the Financial Times, with China moving into the top 10 grain importers in the world.
“Already the world’s biggest importer of soybeans, China is now adding cereals such as corn, wheat, barley and rice to its shopping list. The shift could have profound implications for global food markets because China’s total demand for grains is vast relative to the size of globally traded markets.”
- Skyrocketing agricultural commodity prices are causing the world to re-enter a period of "agflation", with food prices forecast to reach record highs in 2013 according to the latest report from Rabobank.
The firm estimates that the Food and Agricultural Organization (FAO) Food Price Index will rise by 15% by the end of June 2013. They expect ‘demand rationing’ to take place, which will require agricultural prices to remain high. Rabobank expects global prices – particularly for grains and oilseeds – to remain at elevated levels for at least the next 12 months.
- Agriculture commodities prices, as measured by the Powershares DB Agricultural Fund ETF (DBA), also underperformed the S&P 500 index by roughly 15% over the last year. Due to long term global trends we don’t this underperformance will continue.
- While drought conditions have eased in some areas, roughly 61 percent of the country still suffers from drought, which is still at its worst levels in more than a decade, according to the U.S. Drought Monitor. The drought is blamed for slowing down U.S. GDP in 2012 by 0.5 of a percentage point, according to economists at Morgan Stanley. But that figure is expected to go higher in the first and second quarters of 2013 if drought conditions continue to worsen.
Market Models: API Study & Bernstein Wealth Management
API Study. The Associated Press conducted a study last month tracking trends in investment flows in the U.S. They found as follows:
“Defying decades of investment history, ordinary Americans are selling stocks for a fifth year in a row. The selling has not let up despite unprecedented measures by the Federal Reserve to persuade people to buy and the come-hither allure of a levitating market. . . . It's the first time ordinary folks have sold during a sustained bull market since relevant records were first kept during World War II. . . .
The AP analyzed money flowing into and out of stock funds of all kinds, including relatively new exchange-traded funds, which investors like because of their low fees. Since they started selling in April 2007, eight months before the start of the Great Recession, individual investors have pulled at least 0 billion from U.S. stock funds, a category that includes both mutual funds and exchange-traded funds, according to estimates by the AP. That is the equivalent of all the money they put into the market in the previous five years. . . .”
The Wall Street Journal also published an article last month noting now many investors have reduced their exposure to equities. Around 37.9% of U.S. households’ financial assets are in equities according to the Journal, down from the peak of 50.5% in 2000. The chart of the performance of the S&P 500 and stock ownership levels published with the article illustrates the trend.
Well known analyst Laszlo Birinyi in his 2013 forecast is predicting a reversal of the exodus from equities by investors that has accompanied the S&P 500’s advance. He noted that more than 5 billion was withdrawn from U.S. stock mutual funds over the last four years. Daily volume on American exchanges has averaged 6.4 billion in 2012, the lowest level since at least 2008. He expects investors to make a slow return to equities which should boost prices.
Bernstein Global Wealth Management Model
Bernstein updated their chart of valuation (as measured by the trialing price/earnings ratio of the S&P 500 index) and inflation (as measured by the Consumer Price Index) last month.
The chart contains 48 years of data, and illustrates the general rule that when inflation is low the price/earnings ratio will tend to be above historical norms. The reason for this is because future income and discounted cash flow is more valuable in a low inflation environment.
The Bernstein model indicates that when inflation is at current levels the valuation as measured by the models price/earnings ratio should be much higher than what we now see in the market. This is positive for stocks in general, and confirms other analysts who claim equities are ‘extremely undervalued’ using their valuation metrics.
Bernstein also noted last month that thirty years ago they began to track the information content of Wall Street strategists’ consensus recommended asset allocations. They found that the consensus recommended asset allocation was a very reliable contrary indicator. That is, it paid to be bullish when Wall Street suggested underweighting equities, and vice versa.
The chart below plots the consensus recommended equity allocation for a balanced fund against the typical normal long-term equity weight of 60-65%. Today the average Wall Street strategist is recommending the lowest equity allocation in the thirty year history of the data.
Bernstein notes:
As a fantastic example of bull markets climbing the wall of worry, Wall Street strategists never recommended overweighting equities at any point during the entire bull market of the 1980s and 1990s. They finally recommended overweighting equities subsequent to the Technology bubble. That overweight proved to be just in time for the so-called “lost decade in equities”, during which US stocks produced a negative return over ten years.
The chart “indicates the stock market has performed well during a period of fear” according to Bernstein.
Short v. Long Term: Luck v. Skill
Keep in mind that much of the activities we participate in - sports, business, and investing - generate results that are a function of both luck and skill.
In the investment world luck plays a larger role than skill in the short term according to studies outlined in a new book entitled ‘The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing’ (2012) by Michael J. Mauboussin.
But long term – the one most investors should be concerned about - the studies indicate a coherent investment philosophy and strategy has the largest impact on returns. This is certainty true with all the uncertain variables in play in the energy, agriculture, and investment world. Short term disruptions due to political dysfunction, drought, uprisings, terrorist attacks or the like should be classified as ‘luck’ – good or bad.
Investing in bullish long term global trends in the energy and agriculture sectors on the other hand should serve investors well – and should be classified as ‘skill’.
Summary
For 2013 we think we will continue to see robust crude oil prices, with Brent trading near triple digits. Domestic producers should continue to increase output, and some firms should generate tremendous returns from some of these prospects.
Food prices will continue to climb, raising fears of unrest in the Middle East oil producing areas, but also will generate robust returns for firms in the agricultural sector. Fertilizer, machinery, and seed companies should do well.
Last, some of the taxation and fiscal uncertainty has been removed. At current inflation levels we expect price/earnings ratios to move upward to reflect this economic environment. High growth firms in this environment, especially small ones that are reasonably valued, should perform very well.
