US Shale Revolution Might Not Apply Globally

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In This Week's Weekly Insights:

– US Shale Revolution Might Not Apply Globally
– Dividends Versus Technical Analysis: 2-0
– The Fed And Unintended Consequences
– Rudi On Twitter: Market Projections And Commodities
– Buy-Backs Rule
– Rudi On TV: The Week Ahead
– Rudi On Tour

US Shale Revolution Might Not Apply Globally

By Rudi Filapek-Vandyck, Editor FNArena

America's shale energy revolution is changing the world. We only have to look up daily oil prices to support that statement while observing the uncomfortable body language that emanates from OPEC leaders when in public nowadays.

It took some forty years in preparation before the fledgling industry in the US rose to prominence, and started changing the international landscape in only a few years' time, and we are yet to see the final chapter in this ongoing development. Given everybody is now firmly focused on cost levels (oil prices are much lower than expert projections) analysts are taking a closer look into the US industry's dynamics, and like what they see.

A recent sector update by Morgan Stanley estimates the US industry has managed to slice off no less than US$30/bbl from its operational cost level since 2009. This means the average production cost has fallen to circa US$65/bbl. While this sounds like good news for global importers and consumers, not the least for manufacturers and consumers on North American soil, it might well turn out not so good news for peers in other countries.

Ever since "fracking" revealed itself as the latest big sensation for the energy sector in the US, companies and entrepreneurs worldwide have jumped on the bandwagon in an attempt to replicate this US-borne technological break-through, but success is by no means guaranteed. In fact, if calculations by experts such as Morgan Stanley are correct and energy prices are now likely to stay lower for longer, this may in fact destroy aspirations, capital and dreams elsewhere, including in Australia.

The key difference between the US and most locations elsewhere is costs. In the US, several factors combine to generate a fertile ground for this new industry, including in-depth knowledge of the geography, easily accessible shale, plenty of engineers and entrepreneurs, cheap funding and abundant infrastructure. Most places elsewhere are doomed to operate at much higher costs, if at all.

This, of course, also applies to Australia where the Cooper Basin in particular, alongside Canning and a handful of other places, have seen a lot of activity from the likes of Beach Energy ((BPT)), AWE Ltd ((AWE)), Buru Energy ((BRU)), Senex Energy ((SXY)), Drillsearch ((DLS)) and even majors Santos ((STO)) and Origin Energy ((ORG)). While global majors including BG, Total, Chevron and Exxon have invested some $1.5bn in Australian shale potential over the past four years, one simple google search also shows some of these players have already started abandoning shale potential in countries such as Poland and Bulgaria.

While significant progress is being made in countries such as Argentina and China, the key challenge for "frackers" outside the US is there for everybody to see on the graphs below, which are taken from the said analysis by Morgan Stanley.

The underlying message here (and Morgan Stanley is not alone in this) is to not get excited about any of this too early and not to pay too high a price for companies that still have a lot of work to do, without having the prospect of a guaranteed positive outcome.

As is standard the case for a young industry such as is shale energy in the US, expert insights and opinions vary a lot. Deutsche Bank's energy specialists released the chart below, suggesting some 40% of the industry in the US is currently under threat at the present pricing. 
 

Analysts at Citi, however, who have been doing a lot of detailed analysis recently, counter the industry will prove a lot more resilient if and when put under pressure.

See also last week's Weekly Insight: A Perfect Storm For Global Oil

Dividends Versus Technical Analysis: 2-0

The Australian share market seems to have found support, as implied forward looking dividend yields from falling bank shares rose to 6%, and beyond, for three of the Big Four sector heavyweights in this country. In addition, yields for resources heavyweights BHP Billiton ((BHP)) and Rio Tinto ((RIO)) -equally important for local indices- rose to 4% and beyond on average weighted AUD/USD values (also forward looking). To top this off, all these dividends are fully franked.

Why do I keep hammering on about this dividends theme? Because yield does provide support as long as the market overall retains a degree of rationality (panic knows no boundaries and no support, and neither does forced selling) and because this brings back a simple and straightforward focus that should assist investors with keeping their heads cool when others are losing theirs. The question about downside risks thus becomes: what are the chances those dividends won't be maintained?

The banks have had their fair share of scaremongering in recent weeks and it won't be long before most of them will spill the beans about their performances in the second half to September, starting on the final day of the month (next week). If preview-indications are anything to go by, analysts are expecting robust performances, with exception of National Australia Bank, and there will be no cuts to dividends. There should be further increases either.

As far as BHP and RIO are concerned, investors have by now given up on prospects for additional capital management, on top of increased dividends, and this may well prove correct come February next year. But I have yet to see the first analyst who predicts either of these two is about to cut dividends by February. Some do think Rio might have to do it in 2015, albeit in moderate fashion. BHP is one of few companies that hasn't cut dividends over the past twelve years, including during the depths of the GFC.

Another reason why I thought I'd remind everyone about BHP's track record in being one of the most reliable and robust dividend payers in the Australian share market is that, on my observation, technical analysts are once again running riot with predictions of a $25 price target for the Big Australian. Surely, with iron ore prices down some 40% from their recent peak and now with crude oil finding a lower price range, on the back of weak copper and coal prices, such target seems all but plausible?

Is it plausible? Maybe if looking at price charts is your only reference. BHP may not be a profit growth story (it is not) but the company continues to generate excessive cash flows, predominantly from its iron ore operations. The company pays out less than half of its profits in dividends, though this is expected to rise above 50% in the years ahead, and this provides an enormous buffer when headwinds prevail, allowing the company to keep on paying those dividends, and continue to lift them to please shareholders.

A fall to $25 implies -all else remaining equal- the forward yield jumps to 5.75% (plus franking on top), which is what the banks are offering at current prices. Last time chartists were predicting $25, in mid-2013, I stuck my neck out and declared: it ain't gonna happen. Dividend support tells me it won't. Do I really need to say the same thing again this time around?

Regarding the banks, I note Deutsche Bank issued a note on the sector on Monday, countering predictions elsewhere the banks will need to raise capital and their returns are about to come under significant pressure. It won't be anywhere near as bad, says Deutsche Bank, and the banks' dividend reinvestment programs can take care of additional capital/reserves requirements. Probably fair to assume this means no dividend cuts then?

The Fed And Unintended Consequences

Sometimes in finance it's OK not to know all the answers and you might find you are better off by knowing what question(s) should be asked. I have been reminding myself of this old piece of market wisdom in recent weeks as the world goes through a growth scare at the same time as the Federal Reserve wants to retreat to the sidelines and normalise US interest rates, which was always going to lift market volatility.

So while markets and media try to understand what's happening by zooming in on falling oil prices, disappointing growth, Ebola, Russia and Islamic State, I am collecting clues and insights about potential unintended consequences from the fact the US Fed will cease adding to global liquidity. Why? Because a retreat in global liquidity has historically always had consequences, such as the Asian currencies crisis in the late nineties, and given we are talking something unprecedented in scale and duration, it seems a little naive to think there won't be any consequences this time around, don't you agree?

The difficulty is that excessive global liquidity has pretty much influenced just about everything in years past and nobody -I repeat: nobody- knows exactly the who, how, what and when about the many dragon heads that have grown on top of central bankers' tsunamis of cheap money. Because we are at the early stage of the process, it's plain impossible to make any sort of accurate forecast. In fact, it's either a brave man or a genius or an idiot who tries to make any prediction about this. But as said: sometimes we are better off by asking the right question, even if we do not know any answers just yet.

One potential market pressure point is the high yield bond market in the US where the emerging shale gas and tight oil industry has found cheap funding for its capital intensive drilling programs. A recent report by Citi analysts points out the energy sector, dispersed over numerous smaller players, now accounts for 17% of the US high yield corporate bond market, by far the largest representation of any sector to this date. This probably already has some alarm bells ringing in some corners of the market, in particular now that crude oil prices are falling and some 40% of producers is believed to become unprofitable when West Texas Intermediate (WTI) drops below US$80/bbl and stays there.

It would appear many shale producers have hedged their oil price exposure, which is why none of them will necessarily leave the sector even if oil prices drop further in the short term (good luck on that one, Saudis) but said Citi analysis also suggests hedging drops significantly in 2015 and it is pretty much non-existent for following years. The message here for investors speculating on a higher oil price outside of seasonal variances is thus pretty much the same as for coal and iron ore markets: those pesky high cost producers tend to stay much longer in the game than anyone expects.

Further out, and assuming we are witnessing a more permanent lower pricing environment for crude oil, it'll be interesting to see whether US capital continues to flock into this sector when prospects for profits are much lower and riskier, also in the light of reduced global liquidity if the Federal Reserve stays its course. Looking at some rough numbers, there seems to be plenty of potential for bad news stories embedded in this sector:

– Total in high yield bonds from the US energy sector has now climbed to US$75bn, from only US$19bn back in 2009
– Only 50% of companies is believed to be generating more cash flows than capital spending (on drilling)
– Apparently, trading liquidity in these bonds has now all but dried up, so investors who want out are locked in for the time being (exit opportunity unknown)
– One popular hedge against these bond exposures is through selling of oil futures, which further pushes down the price of oil (potentially creating a negative spiral)

Daniel Weston, Chief Investment Officer at Aimed Capital posted a succinct assessment about the potential for disaster from this situation last week, which can be accessed through the following link:

http://www.aimedcapital.com/blog/2014/10/16/oil-part-2-and-how-major-global-financial-pressures-are-unfolding

I note recent market turmoil has brought out stories about margin calls flowing thick and fast, forcing hedge funds in the US and in the UK to sell whatever is liquid.

As per always, this will be a slow grinding process, with many layers and unknown developments. As one market expert recently put it: one of the outlandish predictions made by experts is going to be correct in a few year's time. We don't know as yet which prediction it is going to be and who made it. But we are going to find out.

In time.

(Remember that Nouriel Roubini and the characters in Michael Lewis' The Big Short had been preparing for years before the proverbial finally hit the fan regarding US subprime debt markets in 2007).

Here's another expose about why top financial cognoscenti in the US are worried about retreating global liquidity and its potential consequences:

http://www.zerohedge.com/news/2013-08-12/phantom-markets-part-1-why-tbac-suddenly-very-worried-about-market-liquidity

To be continued.

Rudi On Twitter: Market Projections And Commodities

Since a year or two I post snippets, quotes and thoughts on Twitter, which I quite enjoy. If the feedback I receive is anything close to being reliable, then many of my followers genuinely look out for my regular updates and they appreciate the diversity, and the independence, I bring to their news feeds. Being on Twitter also functions as a direct source of feedback and Q&A outside of Editor Direct on the FNArena website.

Two items I posted in the week past proved unexpectedly very popular, and generated quite a number of re-posts and comments. On Sunday I wrote Citi strategists had calculated, post the correction, global equities should return no less than 21% by year-end 2015, suggesting investors should ignore any more noise and weakness and buy into these markets. The observation has generated a lot of disparaging comments, dismissing Citi's reliability since they are, you know, a stockbroker who benefits from clients buying shares. (I do not believe Citi strategists are that simplistic by nature, but hey, I have no intention of feeding a Twitter discussion loop about it).

Last week I posted a chart taken from a report by ANZ Bank showing price comparison between commodity prices in 2014 and 2013. My comment was: it's been test of conviction for the Super Cyclists. For whatever reason, this one proved my most popular post for the year thus far. Accompanying chart is displayed below.

Every Friday FNArena publishes an overview of my weekly Tweets inside a news story on the website, but for those who want to read me directly: @Filapek

Buy-Backs Rule

I've labeled it the Americanisation of the Australian share market. Economic momentum might be patchy, and the Aussie dollar still very much too high. No real help can be expected from Canberra and top line growth is still a demanding target. But none of this stops boards rewarding shareholders, just like their corporate peers have done on Wall Street in years past.

International research suggests a strong causation between companies who buy in their own capital and share price outperformance. At the very least, share buy-backs provide support to the downside in case of a defensive policy.

Here at FNArena, we've put together a list of companies that have announced buy backs:

Ansell ((ANN))
Cape Lambert Resources ((CFE))
CSL ((CSL))
Dexus Property ((DXS))
Donaco International ((DNA))
Helloworld ((HLO))
Hills ((HIL))
Karoon Gas ((KAR))
Logicamms ((LCM))
Telstra ((TLS))

Companies believed to potentially announce buy backs in the not too distant future:

Aurizon ((AZJ))
BHP Billiton ((BHP))
Rio Tinto ((RIO))

If you know of any more companies, do tell us and we'll investigate and add them to the list. Our address, as per usual, is info@fnarena.com

Rudi On TV: The Week Ahead

On request from readers and subscribers, from now onwards this Weekly Insights story will carry my scheduled TV appearances for the seven days ahead:

– Wednesday – Sky Business, Market Moves – 5.30-6pm
– Thursday – Sky Business, Lunch Money – noon-12.45pm

Rudi On Tour

I have accepted an invitation to present to the Sydney chapter of the ATAA, in Sydney, on November 17th.

(This story was written on Monday, 20 October 2014. It was published on the day in the form of an email to paying subscribers at FNArena).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website)

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THE AUD AND THE AUSTRALIAN SHARE MARKET

This eBooklet published in July 2013 forms part of FNArena's bonus package for a paid subscription (excluding one month subscriptions).

My previous eBooklet (see below) is also still included.

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MAKE RISK YOUR FRIEND – ALL-WEATHER PERFORMERS

Things might look a lot different today than they have between 2008-2012, but that doesn't mean there are no lessons and conclusions to be drawn for the years ahead. "Making Risk Your Friend. Finding All-Weather Performers", was published in January last year and identifies three categories of stocks that should be part of every long term portfolio; sustainable yield, All-Weather Performers and Sweetspot Stocks.

This eBooklet is included in FNArena's free bonus package for a paid subscription (excluding one month subscription).

If you haven't received your copy as yet, send an email to info@fnarena.com

For paying subscribers only: we have an excel sheet overview with share price as at the end of September available. Just send an email to the address above if you are interested.

Click to view our Glossary of Financial Terms