Looking Up for Energy and Resource Stocks

Swiss investor, Marc Faber, still hates America, but he has a good track record for market prediction. So, I paid attention when I read this in Barrons today, in the Investor Roundtable Part 3:

Faber: When volatility diminishes (in the next few months), you want to be in cyclical industries. Among the most cyclical stocks are resource producers. They were driven up by incremental demand from China, and then collapsed. In the next six months they could have significant upside. I like Rio Tinto, BHP Billiton and CVRD [Companhia Vale do Rio Doce].

The financial crisis and collapse in commodities will keep supplies out of the market. Nobody is exploring now. There is no money, and projects are being postponed. Whenever the recovery comes, in five or 10 years, resources stocks will go ballistic from today's low levels. If you're optimistic about the next six months, too, when the news may be slightly better than today, you should own them. Freeport McMoRan Copper & Gold fell from 127 to 15 and is now 26. Xstrata, in Switzerland, is another one. A lot of these stocks are more attractive than gold, because gold is at a 20-year high relative to industrial commodities.

Scott Black: Rio Tinto's balance sheet isn't in good shape. They have a refinancing issue.

Faber: Worst-case, the Chinese government could buy them out. China has taken a big stake in the company. Meryl recommended Kaiser Aluminum [KALU] earlier today. I would add Alcoa.

Felix Zulauf: You're not saying this is the beginning of a big bull market, but of a base-building process from low levels.

Faber: Correct, but when stocks decline by the magnitude seen in resources shares, or the Nasdaq after 2000, a base-building period follows that can extend for several years. When you print money, you can get an artificial bull market (in cyclical and resource stocks) that exceeds everyone's expectations.


And this is a quote from Scott Black, another on the Barrons Roundtable of great investors (and a disciple of Benjamin Graham and value investing). He makes the case for XTO. But the arguments and metrics can be applied just as well to the Canroys (though it appears XTO did a much better job of hedging than PWE or PGH):


BLACK : My next pick is an old favorite, XTO Energy, in Fort Worth. The stock is 37.58, there are 577 million fully diluted shares, and the market cap is $21.6 billion. The company did a smart thing by hedging approximately 77% of its natural-gas production in 2009. They have locked in 1.6 Bcf [billion cubic feet] of gas at $8.94 per Mcf [thousand cubic feet], and 62,500 barrels a day at $118.85 per barrel. Production has been growing dramatically, and should average about 2.67 Bcf per day in 2009, up 18% year over year. About half the increase is from drill-bit growth, the rest from acquisitions. XTO bought Hunt Petroleum last year for $4.2 billion, figuring it could triple reserves, which are now 80% gas, 20% oil. It has 12 Tcfe [trillion cubic feet-equivalent] of gas and 500 million barrels of oil.

BARRONS: What are you pricing reserves at?

Black: I value the gas reserves at $3 per Mcf and the oil at $8 per barrel. Breakup value is about $44 a share, so the stock is selling at 85% of breakup value. My 2009 revenue estimate is $9.86 billion -- slightly higher than the Street's -- which converts to $4.50 a share in earnings. Return on equity is 15.5%, return on total capital 10.3%. Free cash flow is $2.28 billion. XTO has cut its capital-spending budget this year, to $3.8 billion from more than $5.3 billion. They are wed to the notion of knocking $1 billion to $2 billion of debt off the balance sheet.

Their finding and development costs were $1.45 to $1.50 per Mcfe in 2007, and $1.65 in 2008. This year they could fall to $1.50. XTO is one of the few energy companies with rising earnings, because of hedging. They will earn about $3.75 to $3.80 a share for 2008, and $4.50 for '09. The stock sells for 8.3 times earnings and 3.6 times discretionary cash flow. It is extremely cheap. You've got asset and earnings protection. And they are in every major field in the U.S. -- the Barnett Shale, Fayetteville and so forth. Energy is a controversial investment today, but XTO is the cream of the crop.

Schafer: If they hedged this year, does that mean next year's earnings will be down?

Black: No, because they hedged 2010, too.

Gartman calls for end to Commodity Boom

Continuing from where I left off yesterday, I have had some some additional thoughts overnite about the natural resource / energy stocks. My thinking was reinforced this morning (Wednesday, August 6) by comments from Dennis Gartman on CNBC. He came on and unequivocally said the bull market in commodities is over. Now, he is a trader, and he did not frame that comment with a period of time. Later he suggested that it was over for the near term (which might be 6 months to two years for all I know). During the show, Gartman suggested that oil would not top $145 a barrel anytime soon. This is not so different from my thinking. I have been watching the commodity charts and they all look the same, and it is not good for commodities. BHP does a nice job of representing the general natural resource trend, as it has a little of everything, including coal, gold, copper and iron.

Notice that the stock price broke below the Moving Average about July 1. About the same time, red flags occurred on the MACD and Stochastic trends. Investools analysis suggests that three red flags are a strong sell signal. Other technical analysis suggests that when previous support (the moving average) becomes resistance, it is a further indication the trend has changed (see the bounces off the MA on July 14 and again on about July 21). Because all the commodity charts show this pattern, it may indeed be over, as intuitively we may feel that way (notice gas prices have dropped the past 2 weeks).

The second MA test is interesting for its timing. It was on July 23 that the financials broke out to the upside after Fannie and Freddie were rescued by the Feds. We have also looked in the recent past at how Commodities and Financials are countertrend of each other right now. So, the breakdown in commodities in July has supported the surge in Financials and the broader stock market (aided by Fed support for the banks, of course). No suprise here, because commodities are a surrogate for a weak dollar, and anything that helps the dollar hurts commodity prices denominated in US dollars.

How long will this last? Yesterday I suggested that the Chinese Olympics may be the signal of the top for the near / intermediate term for natural resource stocks (for the next several months). So much talk has been about the huge infrastructure buildout in China, and how China was rushing to get ready for the Olympics. As the Olympics begin, everyone will take a collective breath and know that the big buildout is done. Traders will respond accordingly using this as a signal.

Probably more important than this symbolism is the fact that the European and Asian economies are cooling off, most likely in response to decreased consumer demand in North America. Because much of consumer demand has been financed by loose credit in our banking system, it may not reignite until housing and banks have bottomed. Again, it is likely that won't happen before mid-2009.

What is a reasonable strategy until that time? I would suggest it is similar to the strategy followed until now, which is to invest in high dividend stocks and funds. This play has hurt me some the past year, as Value stocks really were out of favor. Some of that was due to the focus on international and commodity stocks, which don't issue dividends. The rest was the fact that much of the high dividend stock world comes from out-of-favor sectors, like banks, insurance, REITs and consumer products.

But, eventually this high dividend strategy will prove correct. All dogs have their day. So, it is best to stick with the strategy knowing it will eventually pay off. As long as we stay diversified with our high dividend investments, we won't be hurt by individual company failures (ala Bear Stearns). DHG is my favorite high dividend stock fund right now. Not because of recent performance, but because it has a solid strategy and continues to make its dividend payments without reduction. DHG has become much more of a commodity / natural resource play the past 6 months. When it first was introduced, there was quite a bit of financial exposure for the high dividend bank stocks. But the management team moved away from financials late last year and avoided most of the carnage early this year. To demonstrate the degree to which DHG now reflects the trend in commodities, see the attached chart comparing DHG (red line) to BHP (blue line) over the past 6 months. So, if commodities do bounce back, DHG will go with that trend. But if commodities continue to lag the market, DHG will be able to offer high dividends to offset the decline in commodity stocks.

Why Invest in Gold and Precious Metals?

Brian, Your thoughts on Gold/Precious Metals.
I recently bought some Freeport Gold & Copper FCX and it is up 15% in one week. The price of gold is $745+-. Many analysts are saying that Gold will double in 2 years. Should I buy more? What percentage do you have in Gold/Precious Metals?

Jake, Even though I really like FCX and have owned it in the past (going back to 1999 when it was Freeport-McMoran C&G), it is not a gold pure play. It is as much copper as gold (and other minerals), but it is a very good China play since most of its mines are in Indonesia and an “anti-dollar” which is the key value of gold right now, as the dollar dives. Another good stock very similar to FCX is BHP.

I have been using funds to create a core position in precious metals and then dabbling around the edges with option contracts on the miners. My favorite gold fund is VGPMX, but it may be closed right now. It has done great the past three years I have owned it (41% annualized return over 3 years). I started buying another fund, GGN, early this year when VGPMX was closed. GGN is a “natural resource” fund and so has a lot of energy stocks as well as gold and basic materials. It also has a very good yield at 6%. There are other good precious metals funds that can be found on Morningstar or other websites.

Once I have my core position, I trade around the edges when the stocks are moving up. Precious metals and basic material stocks are very volatile, so they create good trading and option opportunities. I have been playing with AU, GG and AUY. The latter is a small cap and so very volatile. It is also a darling of the day trading crowd, so really moves fast. I just closed out my positions on AU that I have held off and on for four years. I will get back into AU when it approaches $40 again. I will probably sell put options to get in. Same is true for GG which I closed out in June when it was around $27. Now it is over $30, so probably got out too early. I just got back into AUY this week as it is well below its 52 week high. I sold (20) October 12.50 put contracts for 0.65 each on Friday (worth $1300 on Oct. 19 if AUY finishes above $12.50). That price is still good and will be on Monday (with the price of AUY at $13). I am looking for $15 or $16 in the next 6 weeks if gold stays at these levels.

Selling put options, you may end up with the stock if the price drops. That has happened to me with all the gold stocks along the way. If it happens, I just hold the stock knowing that the price is volatile and I will have a chance to get out at a profit. This is what I just did with the AU (Anglogold) and GG and AUY in the past.

Other conservative gold plays include the bullion ETF (GLD). You could also look at the silver ETF (SLV). Large cap miner possibilities are Newmont (NEM) and Barrick (ABX).

I think gold might double in 2-3 years from this level. It depends on the Fed and tax / spending policy. As long as we run fiscal deficits and also cut interest rates / create excess money, we will continue to see a devaluing dollar which encourages the price of gold to rise. If Congress and the Fed decide to protect the dollar, by raising interest rates and taxes and/or cutting Federal spending, then gold will decline in value. But I am not betting on that in the short term (during an election year).