What’s Hurting

Oil prices of $130-plus per barrel are an unprecedented windfall for producers. Moreover, with global supplies tightening and demand still surging—particularly in rapidly developing Asia—they’re likely to go higher still in the months ahead.

Consumers are starting to change at least some of their behavior. Driving in the US is apparently well below last year’s levels. And many are swapping their gas guzzlers for hybrids or public transportation.

Oil producing companies, meanwhile, are moving rapidly to find new supplies and bring new output on stream to take advantage of today’s prices. And there’s a lot of oil in the world that’s very economic to get out of the ground at $130 or even $100 a barrel.

On the other hand, inventories continue to disappoint for their sparseness. The price point needed to maintain current production continues to rise, with the chairman of French giant Total stating recently that $80 was the new level needed. The CEO of ConocoPhillips has set the bar even higher at $100.

In other words, if oil fell below that level, much of today’s output wouldn’t be economic. Production would drop, supplies would tighten, and prices would inevitably ratchet higher again.

There’s still the possibility of a sharp economic slowdown in Asia, which would push down global demand. Alternative energies to fossil fuels like nuclear power, solar and wind continue to catch hold around the world, displacing oil and gas use as they did in the 1970s and ’80s. And as long as prices are high, consumers will continue to adjust their behavior to burn less crude in their daily lives.

Ultimately, these are the forces that always bring down commodity bull markets. It’s just that it takes years and years of hard work and investment to make the turn, and that means economic pain. It took years to get us into this mess. No one is going to wave a magic wand and get us out of it.

Winners and Losers

For the past several years, I’ve strongly advocated buying and holding a portfolio of high-quality energy producers and related companies. And readers of my newsletter advisories Utility Forecaster (http://www.utilityforecaster.com) and Canadian Edge (http://www.canadian edge.com) have enjoyed the benefits.

Remarkably, thus far in the cycle, the energy patch has been able to prosper without the rest of the economy being crippled. Some obvious industries have gotten hit hard—for example, airlines nailed by rising jet fuel costs. For the most part, however, the economy has operated on an even keel, and companies in most sectors have reported solid results.

Unfortunately, those days of peaceful coexistence may be rapidly coming to an end, as higher energy prices take a greater toll. That makes it ever-more critical to get a grip on what could be vulnerable beyond the usual suspects.

Area one of concern is the economy. Starting in summer 2003 and continuing every year until 2007, interest rates—led by the benchmark 10-year Treasury note yield—spiked higher, as investors became convinced economic growth was about to blast off. Each time, however, the spike was followed a month or two later by an equally steep plunge in rates, as growth expectations cooled.

Summer 2007 took the game to a new level. The spike in rates was quickly followed by mounting evidence the crisis in the mortgage market over subprime loans was going critical. Meanwhile, the US housing market went into full reverse as the debt mountain it was built on came crashing down. And the 10-year T-note yield went to its lowest level in a generation.

Virtually unnoticed in all of this is oil’s considerable role. Higher oil prices are contractionary to economic growth. Paying more at the pump for gasoline, in winter for heating and/or for electricity sucks away money that could have been spent on other things or invested. In other words, it has the opposite impact of an accommodative Federal Reserve pumping money into the system by cutting interest rates.

Earlier in the decade, after a nearly 20-year bear market, energy was a much smaller portion of the overall economy. Consequently, jumps in its price, however seemingly severe at the time, had far less overall impact than they do now after several years of ratcheting ever-higher. They did have a contractionary impact, however, helping to bring down growth expectations and, thereafter, interest rates.

Oil at $130-plus a barrel, however, is a much more important force to be reckoned with. And coupled with the collapse in the housing market, it’s starting to impact a wide range of industries, not just the obvious major consumers of the fuel.

Financial stocks, for example, aren’t commonly thought of as sensitive to higher energy prices. In this environment, however, a higher price for gasoline at the pump takes money away from consumers at a time when mortgage loans are getting more difficult to service. Defaults and delinquencies on consumer debt are also rising for the same reason.

Normally, when the US economy has cycled out of trouble, financial stocks have been the best group to own. Higher oil prices’ contractionary impact on overall growth, however, is going to make that more difficult this time. And the situation will be made even more difficult if inflation emerges as a greater problem.

Thankfully, today’s number for “core” inflation was relatively benign at 0.2 percent. That was above last month’s tally but right on estimates. On the other hand, inflation including food and energy soared 0.6 percent—an annual rate of 7.2 percent. That was well above last month’s 0.2 percent, as well as forecasts of 0.5 percent.

A rising inflation rate in an environment of slowing growth is classic stagflation. Few industries do worse in such times than financial stocks. And with different elements of the debt market starting to get hit, including higher-quality loans, the blowups could literally happen anywhere.

Although financials and energy stocks are opposites, other sectors are less clear cut, with some companies in them better able to handle tough times than others. One of the more encouraging signs recently has been the resilience of the wireless phone industry in the US, which is on the brink of explosive growth in demand for data services. Both AT&T and Verizon Communications stated this week they were seeing basically no impact on sales from the slowing economy.

On the other hand, the longer the economy remains in a sluggish mode, the more cracks are going to appear in the market. That’s why we have to keep reading the numbers for the stocks we own and of others in their sectors. And when there’s weakness, we need to have the fortitude to take whatever losses (or, hopefully, gains) we have off the table and wait to play another day.

Dollar Daze

A second major impact of higher oil prices is on the US dollar. Oil is still priced in world markets in US dollars, one of the main reasons gasoline is only $10 a gallon in heavily taxed countries such as Norway.

To date, virtually all the commentary I’ve heard about the dollar and oil concerns how a falling dollar has propped up oil prices. So the argument goes, if the US dollar were stronger, the price of oil would be a lot lower. Consequently, if the US government would just start supporting a stronger dollar, the price of oil would crater and the global economy would revive.

Because this is such a widely held view, we’ve actually seen this relationship play out on certain trading days. For example, tough talk by the Federal Reserve on inflation this week triggered a boost in the US dollar, which continued on Friday, with oil stocks selling off a bit in response.

Unfortunately, history shows it really isn’t that simple. Rather, the real relationship to concentrate on is how rising oil imports to the US are affecting the US dollar.

Take a look back to the ’70s, the last real commodity/energy bull market. By the peak of that market, the US dollar had fallen to parity against the Canadian dollar and was at a similarly low level relative to the Australian dollar and British pound. The reason: All three of these countries are major energy exporters, with the US the biggest import market. US dollars went out of this country to pay for the oil and into those countries.

By the early ’80s, global demand for energy had fallen sharply because of massive conservation, a switch to alternatives such as nuclear power and a crippling recession, particularly in the developing world outside China. At the same time, higher prices had encouraged new development of reserves, particularly in the North Sea. By the time Saudi Arabia abandoned its role as “swing producer” propping up prices in 1985, the world was awash in oil. Prices plummeted, hitting a nadir of less than $10 a barrel in the late ’90s.

Not surprising, the US dollar was extremely strong in the late ’90s, hitting a high of 80 cents to the euro in mid-2001. And it was particularly strong relative to the currencies of oil producing nations. The Canadian dollar, for example, basically bottomed out earlier this decade in the 60 cents US range after sinking versus the greenback for most of the previous decade and a half.

Today, the loonie is back to parity with the US dollar, after a brief run well past that level late last year. And the Canadian government has been actively working to keep the lid on in order to protect nonenergy industries in the eastern region of the country that have been devastated by the weak US dollar and slumping US economic growth.

The bottom line is that it’s not the US dollar’s weakness that’s driven up the price of oil. Rather, it’s a rising price of oil—which means more US dollars coming out of the US to pay for it—that’s pushing down the greenback. Government action to prop up the buck may for a time influence the markets, including the oil market. But it’s not going to have any lasting impact on either the dollar or oil prices. Only supply and demand can do that.

As one of my former colleagues used to say, currencies are like aircraft carriers. Once they get going in one direction, it takes a long time and a lot of effort to turn them around. The US dollar has had numerous ups and downs since I’ve been in the business. And it always will as long as it’s “free floating” and not pegged to the price of gold as in the past. And the trend now is for further weakness.

Ironically, this is a good thing for many US businesses. Multinationals such as General Electric, for example, are enjoying record profits abroad on strong infrastructure growth. And they can bring those profits home in the form of a much greater quantity of American dollars, given the greenback’s lower exchange rate.

Exporting companies are also in good shape, particularly in reviving industries such as steel. For example, Carolinas-based Nucor—now the largest US steel producer with its fleet of mini-mills—is now extremely competitive versus steel makers in higher-currency economies. The company also enjoys a relatively cheap, stable supply of electricity in the US southeast, a huge advantage over Asian steel companies that must buy increasingly expensive stores of metallurgical coal.

What’s not likely to fare as well is any company dependent on exports to the US or even resellers of items produced abroad. The longer the US dollar is weak, the more expensive their wares will be, and that could be a tipping point in an economy where the consumer is being stretched ever-more thin by rising oil prices and weakening property values.

By the Numbers

Finally, lofty energy prices are presenting a growing challenge for a wide range of other industries by pushing up costs. Sectors like airlines, of course, felt the bite very early on and are in ever-more precarious position for it, as jet fuel costs continue to soar and companies are unable to push the cost along to the consumer.

Trucking and transport have also felt some pain. Most are set up to pass along energy costs to the consumer—in this case businesses in need of shipping large loads. But there’s a limit to how much can be passed along, as it becomes progressively less economic to do so. For example, businesses may still have to ship. But they’ll ship less, and that eats into profits.

Most electric and gas utilities in the US are able to pass changes in their energy costs directly into customer rates. For example, if the price of coal to run plants rises, that will go directly into rates.

Many natural gas and electric utilities are even further removed from energy price swings. Before deregulation, for example, most gas utes bought gas from suppliers and then sold it to customers. Today, however, companies such as AGL Resources in Georgia merely provide transmission service. The job of selling the commodity is instead left to marketers who manage their price risk by hedging.

Many electric utilities in the Northeast are also purely transmission and distribution outfits, making their money in fees for use of their networks. Again, all the commodity risk is left to the consumer and the marketers who vie for their business.

There are elements of the business, however, that remain very vulnerable to energy price swings. One of these is energy trading and marketing. This business has been recovering its stride since the Enron fiasco earlier this decade, and a number of very profitable players have emerged, gaining business and providing price stability to the market with successful risk management.

There’s nothing like a big-time price movement in energy, however, to really expose vulnerability in this industry. We saw it in the late ’90s, as dozens of power marketers went out of business in the blink of an eye on supply shocks and surging prices. We saw it again with the post-Enron fallout of 2002, as power prices plunged across the board and a mountain of debt came crashing down.

Now we’re seeing it again in an environment of hot weather that’s put a strain on electricity supplies around the country against a backdrop of lofty oil and natural gas prices. Several power marketers have gone belly up in Texas over the past few weeks after miscalculating supply, demand and hedging strategy, and more are likely as prices continue to spike.

Last month, PNM Resources announced it was exiting energy trading as a business after suffering a $30 million writedown. The company’s credit rating has been cut to junk by Standard & Poor’s, and only an emergency rate hike in late May headed off a serious cash crunch.

This isn’t to say that energy trading can’t be a great business, and it has been for some companies. But given what’s happened to the financial services industry this year—supposedly the sector with the most advanced risk management in the world—it’s no surprise that stress tests are again showing some scary cracks.

And generally, I like my utilities to stick to what they do best. That’s running infrastructure like power plants, transmission wires and other hard asset, scale-based businesses. It’s not dealing with a bewildering array of derivatives, the value of which can change radically minute to minute.

Another industry to be wary of is propane, particularly heating oil. This business has definite utility-like characteristics, including steady, largely captive customer bases, reliable cash flows and strong benefits to scale. And it’s not a regulated business, which allows the companies a lot of flexibility.

On the other hand, spiking natural gas and oil prices mean higher costs for propane and heating oil. That induces consumers to conserve. If the weather turns off mild, that translates into a double whammy on revenue and lower cash flows.

The biggest positive in this industry in recent years has been its rapid consolidation. Larger companies have demonstrated time and again their greater ability to handle volatile costs and to continue to maintain distributions.

Even this year, the likes of AmeriGas Propane and Energy Transfer Partners—which is further stabilized by its pipeline business—posted strong cash flows that covered distributions handily. Smaller outfits, however, have a much tougher time. Again, this is another industry to keep watching the numbers on, and any consolidation will be a major plus for the acquirer.

The list of industries where costs are rising or potentially will rise this year goes on and on. But one other group is worth commenting on now: Natural resources, particularly mining companies.

Contrary to popular belief, mining isn’t carried on with ropes and pulleys by ill-fed miners operating with picks and shovels. Rather, it’s become an incredibly energy-intensive business, with electricity playing a critical role in extraction as well as processing.

As a result, rising electricity prices push up mining costs. And anytime there’s an actual stoppage of power, output plunges, as it did in South Africa earlier this year when coal was in shortage.

At this point, increases in the prices of everything from copper and nickel to iron ore have more than offset rising costs. But with companies going further and deeper than ever before to replenish reserves, the cost factor is becoming increasingly important to separating the real winners from the also-rans.

As my coeditor Yiannis Mostrous and I have discussed in our service Vital Resource Investor (http://www.vitalresourceinvestor.com), cost pressures are a major reason for the merger mania now heating up in this sector. And even the world’s largest mining companies, such as Rio Tinto, are on the block.

Mining mergers benefit investors two ways. First, for the target, there’s always a steep premium to the pre-deal market price, which translates into a windfall profit. Second, for the acquirer, deals make them bigger and better able to control costs and, therefore, more profitable.

In short, mergers are another reason why the vital resource industry remains attractive for buying. And that’s even after scoring strong gains over the past several years and despite the slowdown in the US economy.

Speaking Engagements

“The coldest winter I ever spent was a summer in San Francisco,” a saying that’s almost a San Francisco cliche, turns out to be an invention of unknown origin, the coolest thing Mark Twain never said.

The natural setting is, however, among the most exciting in the US. Venture west for the San Francisco Money Show Aug. 7-10, 2008, and conduct your own field study.

Neil George, Elliott Gue and I will discuss infrastructure, partnerships, utilities, resources and energy, and tell you what to buy and what to sell in 2008.

Click here or call 800-970-4355 and refer to priority code 011362 to attend as our guest.