05/18/12: Playing the Pullback
The pullback that I’ve warned of in recent months is now under way, with the S&P 500 down roughly 8 percent from its April high. In the April 19, 2012, issue of The Energy Strategist, Looking Back and Looking Ahead, I outlined the major drivers of this correction: softening US economic data, intensification of the EU sovereign-debt crisis and concerns about the US government’s tax and spending policies after the upcoming presidential election.
All these issues will continue to weigh on stocks, suggesting that the S&P 500 will, at a minimum, re-test its technical support at about 1,280 before stabilizing. The price of energy commodities have also pulled back amid concerns that global economic growth is slowing and demand will wane. Over the next one to two months, the price of West Texas Intermediate crude could slip to as low as $87.50 per barrel, while Brent crude oil could dip to $102 per barrel.
I regard this pullback in oil prices and the stock market as a correction within a longer-term uptrend–not the beginning of a bear market. Weak US economic data reflect fading seasonal tailwinds related to the warmer-than-normal winter. Recent US economic data points haven’t softened enough to suggest that a recession is imminent. We continue to expect the US economy to grow at a lackluster pace of 2 percent to 3 percent for the balance of 2012.
The supply-demand balance in the global oil market remains tight. Declining demand in the US and Western Europe will be more than offset by gains from emerging markets. Recent data from China support my view that economic growth bottomed in the first quarter and will pick up.
With US oil and retail gasoline prices down from year-ago levels, demand could surprise to the upside during the summer driving season. At the same time, a series of significant oil production delays and disruptions in non-OPEC countries means that supply growth will lag demand, requiring OPEC to dip into spare capacity to meet global demand.
We anticipated the stock market suffering a third consecutive summer swoon and have taken steps to protect against downside risk, emphasizing the importance of taking profits on our big winners in recent issues.
My Best Buys List features two hedges: A short against First Trust ISE Revere Natural Gas (NYSE: FCG) and ProShares Short S&P 500 (NYSE: SH), which now rates a buy under 38.50.
Our Portfolio recommendations haven’t been immune to the recent correction; many have pulled back significantly from the highs hit in March and April 2012. Although investors should be prepared to endure some more short-term pain, this selloff should prove an outstanding buying opportunity.
Among the hardest-hit recommendations in the model Portfolios are our high-yielding oil and gas trusts and master limited partnerships (MLP). Many of these stocks traded above our buy targets during the rally but have declined to prices that represent a solid value. Here’s my outlook for a handful of Portfolio holdings whose market values have tumbled in recent trading sessions.
Units of Chesapeake Granite Wash Trust (NYSE: CHKR) have sold off for two reasons. First, the trust’s sponsor and parent, Chesapeake Energy Corp (NYSE: CHK), has been besieged by a litany of negative headlines over the past few months, including allegations that the CEO Aubrey McClendon hasn’t acted in shareholder’s best interests. These allegations have been accompanied by more pressing concerns about Chesapeake Energy’s ability to fund its planned $12 billion 2012 drilling program.
But investors’ fear about Chesapeake Energy is overblown. Since most of its 2012 capital spending budget is discretionary, the company could delay some projects until it’s able to raise funds through planned asset sales. Any news on these divestments would be a strong upside catalyst for the stock.
If the stock were to trade at a depressed valuation for some time, don’t be surprised if a larger integrated oil company steps in with a takeover bid.
Bottom line: Chesapeake Energy shouldn’t have any trouble funding the wells it’s scheduled to drill on Chesapeake Granite Wash Trust’s behalf over the next few years.
Chesapeake Granite Wash Trust’s recently announced quarterly distribution of $0.6588–about 11 percent below the target–also contributed to the selloff. Lower-than-expected price realizations on natural gas liquids (NGL), which account for about one-third of the trust’s production, were the culprit.
Weaker oil and NGL prices may mean lead to another disappointing distribution in the second quarter, though we expect these commodity prices to recover in the back half of 2012.
I stress-tested my valuation model for Chesapeake Granite Wash Trust by assuming that the quarterly distribution will be 15 percent below the targeted level throughout the trust’s life. I also factored in a 7.5 percent discount rate when calculating the present value of the units.
Even with these conservative assumptions, the model yields a valuation of more than $18 per unit. For more details on my valuation process for oil and gas trusts, consult Trust Exercise from the Feb. 23, 2012, issue. Chesapeake Granite Wash Trust rates a buy under 25.
Although investors should steer clear of Chesapeake Energy’s common stock, Chesapeake Energy Corp 4.5% Preferred D (NYSE: CHK D) yield 7 percent and offer potential upside when the common stock rallies or in the event of a takeover. Buy Chesapeake Energy Corp 4.5% Preferred D under 105.
SandRidge Permian Trust (NYSE: PER) has also sold off because of the pullback in oil prices; crude accounts for more than 80 percent of the trust’s total production. At current oil prices, the trust’s quarterly distributions should be close to targeted levels. The quarterly payout should exceed this threshold if oil prices increase in the back half of the year. Over the next four quarters, SandRidge Permian Trust will likely disburse between $2.40 and $2.75 per unit, equivalent to a yield of between 12.5 and 14 percent.
The recent selloff has been exacerbated by the fact the stock’s average daily trading volume of less than 500,000 units. Buy SandRidge Permian Trust under 26, a price that represents my base case valuation for the trust.
SandRidge Mississippian Trust II (NYSE: SDR) has also sold off because of concerns about commodity prices. In fact, the stock now trades below its initial public offering price.
Oil accounts for about half the trust’s production and almost three-quarters of total revenue. When the trust went public, the targeted distributions assumed that natural gas prices would remain depressed.
The trust’s first distribution of $0.27 per unit exceeded the targeted distribution of $0.26 per quarter, and I expect the trust’s disbursements to approximate or surpass management’s estimates over the next few quarters. SandRidge Mississippian II will likely distribute between $2.25 and $2.50 per unit over the next 12 months, equivalent to a yield of about 12.5 percent at current prices. SandRidge Mississippian II rates a buy under 23.
Linn Energy LLC (NSDQ: LINE) produces oil, NGLs and natural gas, which explains why the stock price sometimes fluctuates with commodity prices. However, Linn Energy has hedged all its natural gas production through 2017 and all its oil production through 2015. The limited liability company has no exposure to near-term changes in commodity prices.
Moreover, a string of recent acquisitions should enable Linn Energy to grow its distribution at an average annual rate of about 10 percent in coming years. Take advantage of the recent selloff and buy Linn Energy LLC under 40.
Shares of US Silica (NYSE: SLCA) tumbled after the firm issued its first quarterly results since going public. Although the firm’s earnings trumped analysts’ consensus estimate, investors sold the stock after management indicated that the selling price of its fracturing sand would decline in the second quarter.
Some of the projected decline in selling prices reflects a higher proportion of contract sales in the second quarter; many of these agreements were signed years ago at lower prices.
We expect drilling activity in shale oil prices to remain robust despite the near-term dip in the price of crude.
Demand for US Silica’s white sand–the kind used in fracturing oil wells–should outstrip supply for the foreseeable future. Buy US Silica under 19.50.