|The Global Investor Newsletter: March 2012|
Welcome to the March 2012 edition of Euro Pacific Capital's The Global Investor Newsletter. Our investment professionals are standing by to answer any questions you have. Call (800) 727-7922 today!
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No Easy Fix for Gas Prices
By: Peter Schiff, CEO and Chief Global Strategist
BRIIC is a Better BRIC
By: Russell E. Hoss, CFA, Portfolio Manager of EuroPac Asia Small Companies Fund (EPASX)
China Shops While American Investors Drop
By: Neeraj Chaudhary, Investment Consultant
The Egg Man Cometh
By: Andrew Schiff, Director of Communications & Marketing
Supply Issues and Energy Prices
By: Euro Pacific Capital Research
Sector Watch: Latin American Rail
By: Mark Suarez, CFA, Senior Research Analyst
No Easy Fix for Gas Prices
By: Peter Schiff, CEO and Chief Global Strategist
This month, as unleaded gasoline prices increased for 17 consecutive days (to a national average of $3.647 per gallon - up 11% thus far this year) and West Texas Intermediate crude joined Brent crude in breaking through a $100 per barrel level, energy prices emerged as a full blown political issue. While President Obama conveniently claimed that rising prices were the consequence of an improving economy (they're not, and it isn't) Republican fingers began to point sanctimoniously at current drilling policies. And while none of the accusers had any idea why prices were actually going up, the award for the most dangerous 'solution' must go to Bill O'Reilly at Fox News. The master of the "No Spin Zone" announced that high pump prices could be permanently brought down by a presidential order to restrict exports of refined gasoline. Not only does Mr. O'Reilly's idea demonstrate contempt for the U.S. Constitution but it also displays a thorough lack of economic understanding.
Oil and gas prices are high now for a very simple reason: the U.S. Federal Reserve has gone on an unapologetic campaign to push up inflation and push down the value of the U.S. dollar. Just last week on CNBC James Bullard, the President of the Federal Reserve Bank of St. Louis, stated this unequivocally. What is somewhat overlooked is the degree to which an inflationary policy at home creates inflation abroad. Many countries who peg their currencies to the U.S. dollar need to follow suit with the Fed. As China, for example, prints yuan to keep it from appreciating against the dollar, prices rise in China. This is especially true for commodities like crude oil.
Many critics, such as Mr. O'Reilly, have relied on a limited understanding of the supply/demand dynamic to question why gas prices are currently so high at home. With domestic gasoline production at a multi-year high and domestic demand at a multi-year low, he logically expects low prices. But he fails to grasp the fact that the price of gasoline is set internationally and that U.S. factors are only a component.
O'Reilly's loudly proclaimed solution is to limit the ability of U.S. refiners (and drillers) to export production abroad. If the energy stays at home, he argues, the increased supply would push down prices. Although O'Reilly professes to be a believer in free markets he argues that oil (and gasoline by extension) is really a natural resource that doesn't belong to the energy companies, but to the "folks" on Main Street. What good would "drill baby drill" do for us, he argues, if all the production is simply shipped to China?
First off, the U.S. government has no authority whatsoever to determine to whom a company may or may not sell. This concept should be absolutely clear to anyone with at least a casual allegiance to free markets. In particular, the U.S. Constitution makes it explicit that export duties are prohibited. Furthermore, energy extracted from the ground, and produced by a private enterprise, is no more a public good than a chest of drawers that has been manufactured from a tree that grows on U.S soil. Frankly, this point from Mr. O'Reilly comes straight out of the Marxist handbook and in many ways mirrors the sentiments that have been championed by the Occupy Wall Street movement. When such ideas come from the supposed "right," we should be very concerned.
But apart from the Constitutional and ideological concerns, the idea simply makes no economic sense.
In 2011 the United States ran a trade deficit of $558 billion. For now at least America has been able to reap huge benefits from the willingness of foreign producers to export to the U.S. without equal amounts of imports. China supplies us with low priced consumer goods and Saudi Arabia sells us vast quantities of oil. In return they take U.S. IOUs. Without their largesse, domestic prices for consumers would be much higher. How long they will continue to extend credit is anybody's guess, but shutting off the spigots of one of our most valuable exports won't help.
In recent years petroleum has become an increasingly large component of U.S. exports, partially filling the void left by our manufacturing output. According to the IMF, the U.S. exported $10.3 billion of oil products in 2001. By 2011, this figure had jumped nearly seven fold to more than $70 billion. How would our trading partners respond if we decided to deny them our gasoline?
Keeping more gasoline at home could hold down prices temporarily, but how much better off would the "folks" be if all the prices of Chinese made goods at Wal-Mart suddenly went up, or if such products completely disappeared from our shelves because the Chinese government decided to ban exports that they declared "belonged to the Chinese people?" What would happen to the price of energy here if Saudi Arabia made a similar decision with respect to their oil?
But most importantly, limiting the ability of U.S. energy companies to export abroad will do absolutely nothing to improve the American economy. As a result of our diminished purchasing power, American demand for oil has declined in relation to the growing demand abroad. Consequently, we are buying a continually lower percentage of the world's energy output. Consumers in emerging markets can now afford to buy some of the production that used to be snapped up by Americans. If U.S. suppliers were limited to domestic customers, then prices could drop temporarily. But what would happen then?
With the U.S. adopting a protectionist stance, and with gasoline prices in the U.S. lower than in other parts of the world, less overseas crude would be sent to American refineries. At the same time lower prices at home would constrict profits for domestic suppliers who would then scale back production (and lay off workers). The resulting decrease in supply would send prices right back up, potentially higher than before. The only change would be that we would have hamstrung one of our few viable industrial sectors. (For more about how diminishing supplies could exert upward pressures on a variety of energy products, please see the article in the latest edition of my Global Investor newsletter ).
Mr. O'Reilly can spin this any way he wants it, but he is dead wrong on this point. It is surprising to me that such comments have not sparked greater outrage from the usual mainstream defenders of the free market. To an extent that very few appreciate, America derives a great deal of benefits from the current globalization of trade. Sparking a trade war now would severely reduce our already falling living standards. And given our weak position with respect to our trading partners, such a provocation may be the ultimate example of bringing a knife to a gun fight.
Rather than bashing oil companies, O'Reilly, as well as other frustrated American motorists, should direct their anger at Washington. That is because higher gasoline prices are really a Federal tax in disguise. The government's enormous deficit is financed largely by bonds that are sold to the Federal Reserve, which pays for them with newly printed money. Those excess dollars are sent abroad where they help to bid oil prices higher.
For years, mainstream economists argued that as long as unemployment remained high, the Fed could print as much money as it wanted without worrying about inflation. The argument was that the reduction in demand that results from unemployment would limit the ability of business to raise prices. However, what those economists overlooked was the simultaneous reduction in domestic supply that results from a weaker dollar (the consequence of printing money).
I have long argued that neither recession nor high unemployment would protect us from inflation. If demand falls, but supply falls faster, prices will rise. That is exactly what is happening with gas. The same dynamic is already evident in the airline industry. Fewer people are flying, but prices keep rising because airlines have responded to declining demand by reducing capacity. Since seats are disappearing faster than passengers, airlines can raise prices. At some point Americans will be complaining about soaring food prices as much more of what American farmers produce ends up on Chinese dinner tables. Because the Fed is likely to continue monetizing huge budget deficits, Americans are going to be consuming a lot less of everything, and paying a lot more for those few things they can still afford.
Back in 2001 when tech weary investors first started noticing the allure of the emerging markets, Goldman Sachs analyst Jim O'Neill coined the acronym "BRIC" to collectively refer to Brazil, Russia, India and China, then considered the top tier of the emerging economies. The BRIC countries became a symbol of the shift in economic power from the G7 countries to the developing world. For much of the first decade of the 21st Century, the BRICs lived up to their billing. They largely led the world in GDP growth and delivered rock solid returns to those wise enough to invest early.
Over the years, with investors continuously seeking the next wave in emerging markets, other clever acronyms came and went, but none caught on quite like the BRIC. In the investment world nothing is static, and at Euro Pacific Capital we feel it's time for a change. But the BRICs don't need to be abandoned, just expanded. In particular, it needs another "I" as in Indonesia. In other words, we think the "BRIC" bloc should now be the "BRIIC" bloc. For a variety of reasons, Indonesia has earned the right to be considered as a premiere destination for emerging market investment.
Most investors don't realize that Indonesia is the 4th most populous country in the world, with more people than Brazil or Russia, two other charter nations in the BRIC club. They also may be unfamiliar with Indonesia's enormous under developed natural resources, including oil/gas, coal, tin, gold, wood and rubber. Indonesia's economy is well-balanced, with a large consumption component and limited reliance on exports to the developed world. Impressively, retail sales in Indonesia doubled from 2009 to 2012 (yes, doubled in three years) which we attribute to an improving labor market, favorable demographics, strong growth in wages and high consumer confidence. Meanwhile, developed markets struggle with high unemployment, an aging workforce, stagnant wages, and low consumer confidence. It's no wonder retail sales in the US and Europe, struggling to grow 1% per year, create a stark contrast to Indonesia.
While Indonesia's economy is still small relative to the other BRICs (roughly half the size of Brazil and Russia), it does have an economic growth rate that puts it well into the mix. According to the IMF, for the 17 year period between 1990 and 2007, Indonesia grew at an annual rate of 7.54%. While this is less than China (13.3%) and India (7.6%), it is more than Brazil (6.1%) or Russia (4.92%). The country is the largest economy in Southeast Asia and is a member of the G-20 group of the world's major economies.
In the past two months, while the rating agencies were busy downgrading most European countries and financial institutions, Fitch and Moody's actually upgraded Indonesia's sovereign debt ratings to investment grade, the first time Indonesia has achieved such a rating since the 1997 Asian Financial Crisis.
The upgrades demonstrate the strength of the underlying economic fundamentals in Indonesia, which we believe will support asset prices. With debt to GDP at 27%, GDP growth forecast of approximately +6% and inflation running at the lower end of the central bank target of +4-6%, Indonesia's economy is one of the strongest in the world. Indonesia also has large foreign exchange reserves (US$110b), a strong banking system, government bond yields near all time lows, consumer confidence near all time highs, and retail sales/industrial production at 20-year highs.
The contrast with the United States and Europe could not be more pronounced.
Investment grade sovereign debt ratings should result in lower cost of capital, which supports growth in the public and private sectors. After under spending on infrastructure for much of the past 15 years, Indonesia needs significant development. We expect such spending to accelerate and broaden, as the government recognizes the positive correlation between proper infrastructure and economic growth. Additionally, we anticipate that a strong corporate bond market will partially offset the likely slowdown in credit availability from European banks.
Indonesia still has many risks, including corporate governance, a complex political environment (it is a country comprised of more than 17,000 islands around 300 distinct native ethnicities), inefficient subsidies and sluggish policy responses to economic developments. However, we consider the Fitch and Moody's sovereign debt upgrades indicative of Indonesia's progress since the Asian Financial Crisis of 1997 and its emergence as an important global economy.
While the G7 countries celebrate 1-2% GDP growth (partially reflective of massive quantitative easing), the Indonesian economy appears well positioned to continue its impressive fundamental growth with little fanfare. At some point, global investors will begin to focus on the many opportunities emerging from one of the strongest economies in the world. We think it's high time to add another "I" in the BRICs. As we all know, better bricks make better houses.
Russell Hoss, CFA is Portfolio Manager of EuroPac Asia Small Companies Fund (EPASX). Opinions expressed are those of the writer and may or may not reflect those held by Euro Pacific Capital, or its CEO, Peter Schiff. Russell Hoss is not affiliated with Euro Pacific Capital.
Carefully consider the risks and special considerations associated with investing in the fund. You may lose money by investing in the fund. Foreign investments also present risks due to currency fluctuations, economic and political factors, lower liquidity, government regulations, differences in securities regulations and accounting standards, possible changes in taxation, limited public information and other factors. The risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies. In considering this investment, please also keep in mind that, due to the limited focus of this fund, the fund is more susceptible to market volatility because smaller companies may not have the management experience, financial resources, product diversification and competitive strengths of larger companies. Additionally, smaller company stocks tend to be sold less often and in smaller amounts than larger company stocks. More information about these risks and others can be found in the fund's prospectus.
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Precious metals are volatile, speculative, and high-risk investments. Physical ownership will not yield income. As with all investments, an investor should carefully consider his investment objectives and risk tolerance as well as any fees and/or expenses associated with such an investment before investing. The value of the investment will fall and rise. Investing in precious metals may not be suitable for all investors.
China Shops While American Investors Drop
By: Neeraj Chaudhary, Investment Consultant
Unquestionably there has been a significant change in investor sentiment since the crash of 2008. The 50% decline in stock prices in 2008-2009 combined with the financial sector bailouts, the "Flash Crash" of 2010, and the continued demonization of our leading financial institutions, has helped shatter the public's faith in Wall Street. With U.S. stock markets essentially flat over the past 13 years (despite occasional heart-stopping volatility), many investors may have decided that long term equity investments are just no longer worth the risk.
It is important to realize however that this sentiment is not universal. On the other side of the world, the Chinese are showing no such hesitancy. There is mounting evidence to suggest that the Chinese government is in the midst of a voracious buying spree in which they are actively snapping up productive assets around the world. What do they know that we don't?
Data shows that in recent years U.S. investors have pulled money out of stock focused mutual funds and have instead piled into assets that at least appear to be less risky, such as bonds and money markets. When one considers the large unresolved problems that currently overhang the market, such as the Greek debt negotiations, the U.S. elections, and the perennial problems in the Middle East, one can understand the concerns that are keeping them on the sidelines.
Although these investors may be somewhat insulated from market volatility the protection comes at a very high price. With near 0% interest rates, bond investors are consistently losing to inflation. The world's central bankers - led by the Fed - have created a landscape where the shaky ground of the markets is surrounded by the quicksand of deteriorating cash. Investors have seemingly nowhere to run. But China seems undeterred.
A scant 10 years ago, China joined the WTO and began her rise to prominence on the world economic stage. Though today China possesses over $3 trillion in foreign exchange reserves, in 2001 Chinese reserves were estimated at a relatively paltry $200 billion. China has accumulated these funds by keeping her currency cheap, and socking away trade surpluses to the tune of hundreds of billions of dollars per year. And although the stash is growing, the Chinese are not simply sitting on this pile. They have been one of the leading global investors, strategically buying international assets that fit its growth plans. There is every reason to suspect that these trends will continue and accelerate.
For the first few years after her accession to the WTO, China was content to simply pile up foreign exchange reserves, accumulating both US Treasury bonds and agency (Fannie and Freddie) securities. Being risk-averse, and considering them the safest assets in the world, the Chinese were content to earn the lower interest income that these investments offer.
But in the past few years, China began to recognize that their savings were losing value in real terms. Beginning in 2007, they made the strategic decision to protect themselves from inflation by diversifying out of US dollar-denominated financial assets, and into the hard assets she required to grow her economy.
The volume of deals has been breathtaking, and the tempo is accelerating. According to the Heritage Foundation - which publishes the only publicly available, comprehensive dataset of large Chinese investments and contracts worldwide beyond Treasury bonds - Chinese foreign investment has gone off the charts:
All told, the Chinese have spent $443 billion in nearly 400 separate ventures in every continent around the world. And yet, a simple analysis of these investments reveals a highly concentrated portfolio of holdings; if actions speak louder than words, then Chinese priorities are glaringly obvious. Over the past few years, they have deployed fully 80% of their cash into just four sectors: Energy (the lion's share at $172B or 39% of the total), Metals ($85B or 19%), Transportation ($60B, nearly 14%), and Power ($38B, just under 9%).
By geography, the Chinese first went shopping in Asia, picking up $115B worth of assets in their backyard. Then, choosing to ignore the niceties of international sanctions, the Chinese turned their attention to Africa and the Middle East, where they have plunked down at least $111B of capital. After that, they came to our front door in the Western Hemisphere, to the tune of $88B. Europe is home to $52B of Chinese capital. Australia is the largest single country investment, representing 10% of investment at $43B.
And they're not done yet. According to recent media reports, the Chinese are currently planning to deploy another $300 billion into "aggressive" investments. The trend is crystal clear. While some investors hold out, trying to time the market, China is buying up everything they can get their hands on.
But perhaps even more interesting than what is going on in the glare of the public spotlight is what is being done in private. In addition to its massive disclosed investments, China has begun to execute a parallel strategy in secret. With respect to gold, China kept a large scale purchase program under wraps for a full five years until 2009 when China's State Administration of Foreign Exchange (SAFE) announced it had spent the previous five years buying gold in small lots. Then, in April of that year, they publicly announced that they had acquired 500 tons of gold, and transferred it to the People's Bank of China. At current market prices, this single transaction is valued at nearly $28 billion.
One of the biggest questions that investors should ask themselves now is where the Chinese might decide to spend its considerable sums that continue to languish in debt instruments. There are reasons to expect that large scale purchases by the Chinese could support asset prices in whatever sector they decide to target.
If the trend of publicly disclosed and secret Chinese transactions continues, and if other developing markets holding piles of like valued U.S. treasury debt follow suit, the world could soon wake up to an even more intense kind of shaking, one where prices for agriculture, energy, and precious metals are continually increasing, and investors seeking apparent safety in dollars have instead lost wealth in real terms.
So as U.S. investors drift away from equity and commodity based assets in hopes of finding safety, they should in fact pay more attention to activities of those countries that will likely drive global markets for years to come. China is gearing up for what they hope will be a long period of economic expansion. American investors would be wise to take notice.
Neeraj Chaudhary is an Investment Consultant with Euro Pacific Capital. Opinions expressed are those of the writer and may or may not reflect those held by Euro Pacific Capital, or its CEO, Peter Schiff.
The Egg Man Cometh
By: Andrew Schiff, Director of Communications & Marketing
The Federal Reserve recently announced that it returned more than $76.9 billion in profit to the United States Treasury, representing the second consecutive year that the Fed apparently made money for U.S. taxpayers. Many media reports have suggested that the profits confirmed that investing in American debt was a wise proposition, and that there may be more strength in the economy than pessimists believe. We disagree and caution private investors who may try to replicate these results.
Most of the Fed's profits came from its $2.6 trillion portfolio of Treasury debt and mortgage backed securities. The nearly $77 billion in profit means that Bernanke & Co. "earned" 3% on this enormous book of assets. Some of this came from the interest paid to the Fed by the U.S. Treasury. As these "earnings" are simply passed from the Treasury to the Fed, and then back to Treasury, many may rightly question how they could possibly qualify as gains to taxpayers. The remainder comes from the Fed's buying and selling of debt securities on the open market. Although these trade-based earnings are a more legitimate source of profit than recycled interest payments they do not necessarily result from the Fed's sharp-eyed investment acumen or the underlying strength of the assets. The more likely driver is simply the market that the Fed is creating for itself. Looked at from a more pragmatic angle, the announcement illustrates how the Fed has manufactured a bubble and that its meager current profits will be paid for with crippling future losses. To understand why, let's recap the Fed's role in the debt market since the financial crash of 2008.
Before 2008, the Fed held a $488 billion dollar portfolio comprised almost exclusively (97.5%) of low-risk Treasury securities. In 2008, the Fed's first Quantitative Easing program (QE1) tried to unclog the frozen credit market by buying in the murkier waters of mortgage backed securities (the kind of instruments that private investors wouldn't touch with a 10 foot pole). When the dust settled, the Fed became the proud owner of more than $1.05 trillion of these assets, as well as $150 billion of Federal agency debt (such as FHA loans). These purchases made the Federal Reserve by far the biggest holder of those types of securities. When QE2 came around in November 2010 Federal debt issuance was hitting record levels. Not surprisingly the buying spree this time around was focused on Treasury securities. As a result of this program, and earlier efforts in 2009, the Fed increased its Treasury note and bond holdings (from pre-crash levels) by a stunning 249 percent to $1.66 trillion.
There can be no question that Fed buying helped push up bond prices, and push down yields (in fact that is the whole purpose of the program). The moves have made a dramatic impact on the broad economy. Qualifying home buyers can now get financing for 30 year fixed home loans for less than 4 percent. The interest rate on 10-year Treasury notes has declined nearly 24% since November 2010 to its current 2% level. This massive intervention in the market has lulled private and foreign government investors into thinking there is a genuine bull market in Treasury debt. Everyone may be making money - for now.
It's important to note that interest rates and bond prices work inversely. If you buy a bond at, say, 3% interest, and then the prevailing rate drops to 2%, your bond gains value. That's because it pays more than currently issued bonds. Conversely, when current rates rise, prices of existing bonds fall. With the Fed adding huge amounts of buying pressure to the market, it is no surprise that they have been making a few percentage points of profits as bond prices rise generally.
But all this may simply point to what is called in finance, the greater fool theory - and it tends to work until you run out of willing buyers. Just ask your local realtor. If the other buyers lose faith, the big guy gets stuck with heavy inventory.
It reminds me of the old Wall Street story of the Egg Man, which goes like this:
A big investor calls his broker and asks, "What's the price of eggs today?"
The broker responds, "$1 a dozen."
"That's great," the investor says, "Buy me a million."
The next day the big investor asks again.
"The price of eggs are now $1.25 a dozen," says the broker.
"Great. This time buy two million!"
By the next day price of eggs rises to $1.50 a dozen and the investor calls again. Encouraged by the surging market, he puts in an order for 10 million!
At the end of the week, eggs have risen to $2 per dozen. The investor, happy with his profit, calls the broker to sell.
"To who?" the broker responds. "You're the egg man..."
This is what the Fed is doing in the Treasury market. It's bidding up the price and then claiming to have made real profits. But if the Fed actually tried to unload a fraction of its toxic portfolio, prices would fall, perhaps even substantially. Declining bond prices will not only expose the Fed to real losses, but as our former economist Michael Pento pointed out in a June 2011 commentary they will severely degrade the Fed's ability to adequately fight inflation.
The Fed is essentially out of ammunition to stimulate further. It has already more-than-doubled the money supply since the 2008 crisis. Nominal interest rates are nearly zero - and real interest rates very much negative - but there are still no signs of real recovery. While the Fed is actively hiding growing inflation using fuzzy accounting, the problem of rising prices may soon be too painful to ignore. Eventually the Fed will have to allow interest rates to rise to stop surging inflation - like Paul Volcker did in the early '80s.
Will the Fed issue a press release when interest rates rise and the value of its $2.6 trillion portfolio falls? Look for such an announcement to be buried as deeply as possible in Fed communications. Losses to the Fed mean little, as it doesn't operate on the same profit-and-loss motives as the rest of us. It can magically create hundreds of billions to buy bonds. If it experiences losses, it can just print the difference, and pass the pain onto other holders of debased dollars. Unfortunately, private investors who take their cues from the Fed may not be so lucky. The money they play with is real and they can't pass off the losses indiscriminately.
For recent investors in US government debt, the potential downside is plain to see. The 10-year Treasury note that you might want to buy today at 2% has only so far it can gain in value. The downside risk is much greater. If you were to buy a $10,000 note today, and prevailing rates were to rise to, say, the average 2006 level of 4.79%, the price of your bond could fall to about $7,787 (the point where it would yield 4.79% to a new buyer). If interest rates returned to the 40-year average of 7.11%, your bond could fall to $6,350.
The Fed's loudly issued profit announcement is sending a misleading message to naïve investors that US government debt is a safe asset to hold. The short-term profit announcement is simply a PR stunt to reinforce that perception. In the near future, today's profit announcement will look as laughable as Chairman Bernanke's 2005-6 claims that the housing market would likely have limited effects from troubles in sub-prime mortgages.The Fed has created this market, but they won't suffer the losses. Still, the bulk of investors seem blinded by the prospect for easy profits and the supposed certainty of endlessly low rates. They cannot see the grave downside risks that now accompany what were traditionally conservative assets. This is the Bernanke Put - and it could be even more disastrous for the US economy than his predecessor's.
Andrew Schiff is Director of Communications & Marketing with Euro Pacific Capital. Opinions expressed are those of the writer and may or may not reflect those held by Euro Pacific Capital, or its CEO, Peter Schiff.
Supply Issues and Energy Prices
By: Euro Pacific Capital Research
In recent years the energy markets have shown an uncanny aversion to stability. Over the past decade, monetary policy, the waxing and waning of the U.S. dollar and wild fluctuation in demand have all made large impacts on price charts of oil, coal and natural gas. In recent months it appears as if supply concerns will be another increasingly important driver in the months and years ahead.
Currently, the energy market is moving in different directions. Geopolitical risks in the Middle East and financial uncertainty in Europe have lit a fire under the price of oil, with Brent Crude peaking in February at more than $125 per barrel. Consequently, oil producers have largely held their own through the choppy markets of 2011. Meanwhile, advances in production technology have pushed natural gas inventories up 32.8% above their 5-year average. The tradeoff for gas producers has come in drastically lower prices and share values. Coal miners have had a similarly rough go of it. Having already seen prices driven down by reduced European demand and competition from natural gas, coal miners also have had to contend with higher operating costs and a web of new environmental regulations.
But there may be good news on the horizon in the energy sector. There is ample evidence to suggest that further reductions in supply in all three industries may occur in the near to medium term. These reductions, which have, in fact, already begun, should help put a floor under energy prices thereby creating a better environment for investors.
Take oil. Late last month, Saudi Arabia's oil minister joined with OPEC in voicing their aspirations that the price of oil remains above $100 a barrel. For many OPEC countries, $100 has become their break-even price, thanks to increased social costs following the Arab Spring. In its announcement OPEC conveniently released its determinations that $100 oil did not make any meaningful downward impact on global growth. Well that's a relief. Although it can't dictate prices, OPEC seeks control through production management, and indications suggest that they will keep a lid on things for as long as they can afford it.
More recently events in Iran, which threaten to choke off oil exports from the Straits of Hormuz, have exerted upward pressure on oil prices. In a worst case scenario, Iran will either close the Straits - which some have estimated could potentially lift the price of oil by 50% within days - or collapse from international sanctions or an international attack. Last April, the war in Libya - only the 18th biggest oil supplier - sent prices above $113 a barrel. Iran has the world's 4th largest oil reserves and could exert a far larger effect on price.
There can be little doubt that 2011 was a horrific year for natural gas prices. Over the course of the year, prices fell more than 30% in North America and ended the year at a 27 month low. Recently however, it appears as if there has been a bottoming out, with prices up about 10% percent thus far in 2012 from its January low. But current prices are still far below the average of $5.75 per million BTU that have been the benchmark over recent years. The current low price is primarily a result of massive new inventories brought online by hydraulic fracturing, with the mild winter in North America adding to the pressure by slackening demand.
There is, however, reason to believe that the current rebound will continue. First off, the Energy Information Agency has reported that one major Pennsylvania gas field has less gas than estimated. More importantly, major gas producers have recently cut production. In January, a major U.S. energy provider announced planned cuts of hundreds of millions of cubic feet of production per day. Other major producers seem to be going in the same direction, indicating that they will reduce supply until prices rise to an acceptable level.
Coal has also been negatively impacted by low natural gas prices, an effect that is compounded by uncertainty and weakening demand in Europe. Although many major coal producers have reported strong 4th quarter performances, the 2012 outlook for the industry is uncertain. Several companies have already started scaling back production, and reducing shifts at various mines.
Perhaps more importantly, producers face major costs over the next two years due to environmental regulations. Plants in the U.S. will be required to reduce sulfur dioxide emissions by as much as 50% over the next few years. To achieve this goal, many power plants will be required to install costly Flue Gas Desulferization (FGD) scrubbers. This cost of this technology will be difficult to bear for many marginally profitable suppliers. To get around this problem, some are simply closing coal plants. In the short term, lower demand from US plants may cause mines to further decrease production. However many suppliers try to take up the slack by tapping into the export market where Asian demand remains strong. But this will restrict supply at home.
If current trends continue, it seems possible that the world will see a reduction in the supply of coal, natural gas and oil.
Sector Watch: Latin American Rail
By: Mark Suarez, CFA, Senior Research Analyst
In the past Latin America had been synonymous with dysfunctional governments and stagnant economies. But in recent years, some countries in the region have seemed to turn themselves around and have bid farewell, at least for now, to the debt defaults and currency devaluations that used to define them. As a result of the resurgence in countries like Brazil and Chile, real GDP in the region managed to grow by 6.6% in 2010 and 4.9% in 2011 according to the IMF. This came at a time when much of the developed world was mired in recession or very slow growth.
With above average economic performance relative to the United States and the EU, and with several important secular trends driving growth, there are indeed worthy investment opportunities in Latin America for those who know where to look, and for those who can bear the risk. We believe that the rail sector in particular shows a good deal of promise in Latin America.
Unlike in the United States or Canada where rail is an established means of transportation, in Latin America rail is still only in its early stages of development. To put this into perspective; while rail transportation accounts for almost half of total freight market revenue in the US and Canada, it accounts for only around 25% and 16% in Brazil and Argentina, respectively.
The increasing participation of Latin America in global trade of agricultural and hard commodities over recent years has driven demand for rail traffic throughout the region. The agricultural segment in particular lends itself naturally to rail transportation given the heavy volume and long-haul nature involved in shipping these commodities to marine terminals for export.
Though many Latin American transportation companies have acute exposure to the ups and downs of their respective domestic economies, rail transportation typically shows a greater degree of insulation. This is because agricultural products (which compose a significant portion of rail transportation revenue) have generally exhibited a lower correlation to GDP than other hard commodities. In Latin America grain represents over half of total rail volumes, making it by far the largest component of rail transportation. In contrast, agriculture accounts for only 8% of total rail volumes carried by Class I rails in North America.
This bodes well, then, for those companies that are heavily weighted towards agriculture. For one company in particular that we are bullish on, agriculture accounts for 63% of their total revenues. Investors who are suitable for such investments should ask their Euro Pacific representatives for more information.
Secular trends impacting the industry
There are several key trends impacting the rail industry and these must be understood outside of cyclical factors that typically drive a national economy.
First, there is the phenomenon of expanding rail network capacity. Throughout the 1990s, a number of Latin American countries embarked upon a campaign to sell off state-owned rail systems. This was a welcome development as rail transportation had languished under government ownership. Poor track conditions were responsible for significant operational disruptions along the supply chain: cycle times were long, and average commercial train speed was low. But this all changed under privatization. The introduction of superior technologies such as better signal and brake systems, new and more efficient diesel locomotives, the transition from single-stacked trailers to double-stacked containers, and longer train lengths, have all served to create and sustain productivity gains. In addition, the capacity and efficiency of rail networks themselves have been boosted by investments in siding extensions, tunnel restorations, and track, signal and break technology (which has decreased the frequency of accidents and track closures).
Although there has been much progress here, there is still ample room for continued improvements to bring network efficiency more into line with North America. Looking forward, we expect rail capacity to grow as network expansion closes the growing demand gap for rail transportation services.
In North America, rails compete with truck-based transportation for roughly 30% of freight transport. But in Latin America a much greater percentage of freight moves over the road rather than rail. Even in the long-haul movement of agricultural commodities, which should be the natural province of rail transport, trucking takes a very large percentage of the Latin American market. Rail, however, enjoys a roughly 10% cost advantage relative to transportation by truck and, on a fuel efficiency per-km basis, rail is now roughly two times more efficient than trucks. With petroleum prices continuing to move higher, with the pressure to divert freight from increasingly congested highways, and with the service level and reliability of rail continuing to improve, we believe that the sector is well-positioned over the coming 10-20 years to gain long-term market share away from trucks.
Though all these developments are positive, it should be pointed out that there are risks of escalating regulation for the rail industry. Based on conversations with industry sources, however, we believe the chances are somewhat low that the most detrimental proposals will pass into law in their current form.
With demand having outpaced capacity for many years now, and with positive growth prospects thanks to continued strong commodity demand from Asia and an expanding middle class in Latin America itself, this may be one sector of the world economy that deserves a closer look.
Mark Suarez, CFA is Senior Research Analyst with Euro Pacific Capital. Opinions expressed are those of the writer and may or may not reflect those held by Euro Pacific Capital, or its CEO, Peter Schiff.
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