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Market Commentary September 2015

The Federal Reserve meets next week and will debate the need to raise interest rates on short-term instruments.  There seems to be no consensus either way.  The data has weakened since their last meeting and events external to the U.S. economy are also weighing on their decision.  Some developments would be made worse by a rate hike. Currencies in Turkey, South Africa and Malaysia have fallen to the lowest levels ever against the U.S. dollar.  The cost to buy credit default swaps are pointing to defaults in Brazil and South Africa.  The strength of the U.S. dollar is compounding the problems in our domestic economy as well as those of the developing economies.

In the U.S. economy the second revision for 2nd quarter GDP came in stronger than anticipated at 3.7%; however, a large percentage—over one third—of that update was due to inventory builds.  If sales do not increase, this could slow the economy as retailers work back down their inventories.  Time will tell.  The August employment report did little to calm fears.  The U.S. added 177,000 jobs in August, below the consensus of 220,000, but the unemployment rate fell to 5.1%.  However, most of the jobs were in retail, medical or other service jobs; higher paying jobs in manufacturing and mining lost over 15,000 jobs.  That is one of the reasons wages are not growing any faster.  Another facet of the employment picture is job postings soared 8% for the period.  This suggests that some employers are having trouble finding the skilled workers they need.  There appears to be a mismatch between the skills needed in an expanding high-tech market and the skills processed by many of the unemployed.  Now let’s look at several positive signals.

The Conference Board Consumer Confidence Index rose to the highest level since January.  Also, the Purchasing Managers Manufacturing Index came in at 53; lower than the last few months but still in expansion.  Confirming the jobs added in August were mostly in the service sector, the ISM’s Service Index was reported at 59…a very high level.  In addition, the seasonally adjusted sales of light vehicles rose to an annualized rate of 17.8 million, which is the highest rate since August of 2005.  In spite of the strong dollar, India’s economy expanded at a 7% rate in the second quarter, with the largest percentage of the growth coming from consumer spending.  Retail sales in Europe are also expanding.

As we have mentioned before, the strong dollar is part of the reason for the collapse of oil prices.  Oil prices have been very volatile as of late.  The price fell into the high thirties per barrel, bounced back to almost fifty dollars per barrel and is now hovering in the mid-forties per barrel.  There are several reasons that point to a higher price going forward.  Of the 10,000,000 barrels per day produced in the U.S., 1,000,000 come from stripper wells.  These are wells that produce five barrels or less per day.  With prices as low as they are, many of these small wells are uneconomical to operate and are being considered to be shut down. There are over 400,000 of these small producers in the U.S.  In addition, the Canadian oil sands, for the most part, need oil in the $70 to $80 per barrel range to make money.  Many new projects for expansion have been put on hold.  As in the Canadian oil sands, the North Sea fields need a much higher price to be economical.  They are some of the most expensive fields anywhere. Royal Dutch Shell announced they will reduce their position in the North Sea in total and that they will sell $900 Million of their assets there.  As output declines, the gathering platforms, pipelines and shore facilities become more expensive per barrel delivered, thus speeding up the process to reduce production.  Also, oil traders cut their short positions by over 19,000 contracts last week.  We believe this is the beginning of recognition by speculators that oil is oversold. Additionally the United States has approved the sale of oil to Mexico.  This should help the U.S. producers as well as the mid-stream companies by narrowing the gap between WTI pricing and Brent prices for oil.  In addition, China is expected to surpass the U.S. as the largest importer of crude oil this year.  Their net oil imports are up 9.4% so far this year.  However, the largest reason for our belief that oil prices should rise near term is the impact of the drop in output within the United States.  In their revisions to earlier monthly output reports, the EIA announced a 500,000 barrel per day drop thru August and predicted 140,000 barrels per day reduction per month thru the end of the year.  These reductions will reduce output by over 10% by year end.  For these reasons we are accumulating cash to buy select oil and gas companies.  We are adding small additions to our holdings in EOG, Conoco Phillips, Range Resources and Gastar.

In the mid-stream sector of the energy space, applications have been approved for the export of condensate.  This will help the drillers as well as the companies who build and operate the “Upgraders”, which take the condensate and remove other liquids, which enable them to export the fuel.  As Mexico reforms its energy sector, several pipeline companies have been approached to expand capacity to export natural gas to Mexico.  Presently several Mexico businesses have submitted requests to allow for the import of more than 500,000,000 cubic feet per day of natural gas.  In addition to the demand from Mexico, several mid-stream companies we follow are also building capacity to take advantage of the U.S. expansion in production and demand in the NGL space.  Our two favorite names in this mid-stream space are Enterprise Products Partners (EPD) and Kinder Morgan (KMI).  Kinder Morgan is the 600 lb. gorilla in the space and Enterprise Products has continued to expand its presence through acquisition.  These mid-stream companies derive the majority of their income from fee-based services, which do not vary with community prices.  We feel these companies have been sold off in the panic over reduced oil prices.  For this reason we are adding to both KMI and EPD.  In the down-stream sector of the energy space, the refiners are showing improvement. Refiners buy oil as their raw material and produce gasoline, jet fuel and diesel.  With cheaper oil prices, their profit, known as “Crack Spread”, is improving.  The U.S. is exporting over 4,000,000 barrels of refined product per day in addition to the volumes used for domestic consumption.  Our refineries had gross inputs of over 17,000,000 barrels of oil per day over the last few months.  This is a record going back to 1990.  We are adding to our positions in Phillips Petroleum (PSX), Northern Tier Energy (NTI), and Alon USA Partners (ALDW).

In the chemical industry, natural gas is both a fuel and a raw material.  The boom in shale gas and an abundant supply of natural gas liquids has enabled the chemical industry to have a strong competitive advantage over other producers around the world.  The American Chemistry Counsel (ACC) believes this will enable our domestic producers to export product with very good margins.  There are over $149 billion of capital expansion in 249 projects that are underway.  Most of the rest of the world’s chemical plants use naphtha to make there ethaline where, due to our abundance of Ethane, which is a natural gas liquid, our input cost are much less.  The U.S. chemical industry reported a 4% gain in chemical production year over year for 2014.  The ACC is projecting a year-over-year gain of 3.2% in 2015 and 3.0% in 2016.  This is a highly cyclical industry but the ACC sees signs of gradual strengthening as the overall world economy improves.  There is a lot of chemical usage in the automotive and construction industries.  Westlake Chemicals (WLK) and LyondellBasell (LYB) are showing good profit gains on a year-over-year basis.  Their capital expansion projects are beginning to come on line, allowing them to further reduce their unit costs.  LyondellBasell added 800 million pounds of ethylene capacity last year and just recently completed a major ethylene expansion at its Channelview plant and is continuing expansion work at their other plants.  This helped them to report a 13% gain in their second quarter profit compared to prior year.  Westlake Chemical recently increased its dividend and has maintained 44 consecutive quarters of paying a dividend. They also reported a 40% higher profit in the second quarter on a year-over-year basis.

In previous Market Comments, we have mentioned companies, that derive income from overseas, have been hurt by the strong dollar.  However, companies that are domestically orientated have done well.  For this reason we are adding to our positions in several companies that are showing good growth in the consumer sector.  The names we like are Kroger (KR), Walt Disney (DIS) and Home Depot (HD).  These are companies that will benefit as the consumer starts to reaccelerate their spending after having paid down their debt balances.  Two other companies we like are Wells Fargo (WFC) in the financial sector and Eli Lilly (LLY) in the pharmaceutical sector.

We are not adding new money to our industrials positions at this time, but we are not selling out of them either.  These companies are holding up fairly well in spite of the strong dollar.  We will continue to watch the dollar and to listen to their next quarterly reports.  Honeywell (HON), United Technologies (UTX), Emerson Electric (EMR) and Rockwell Automation (ROK) are the ones we like.

We are monitoring the strength of the dollar, employment gains and the ability of Iran to begin exporting more oil.  As the world’s economy grows, we believe the imbalance in oil will reverse and prices will return to more normal levels.  Stay invested in companies with good cash flow, good cash distributions and companies that operate in areas where they have a competitive advantage due to much lower energy costs and raw material input costs.  We prefer companies with price/earnings ratios that are at levels that are attractive compared to the low interest rates on investment grade bonds.  BSG&L and BFA are long-term investors and we believe that if you are patient, build cash and buy good companies on pull backs, your portfolio will have good growth over the long term.  Author: Ben Dickey, CFP/MBA/CHFC, Chairman of the Investment Committee, BSG&L Financial Services LLC.