Tuesday, November 23, 2010

Deflation or Inflation: Energy is the key


The price of energy is the key to what the future holds for inflation or as some writers want to say disinflation. The charts above show what has happened to the price of crude oil and natural gas since their peaks of 2008. As you can see the recovery in crude oil has been much better than the recovery or lack there of in natural gas. The latest report from the Department of Energy shows that we are now importing 63% of all the crude oil used in the United States. Because we do not produce enough we have to buy from countries that may or may not be our friend.  The price of crude is a function of supply and demand; we demand it and other nations supply it at their price.

As you can see from the chart above, the high in the price of crude oil in the Spring of 2008 when it was about $157 a barrel. As of this blog it was around $81 which is up from the low of $46 in February of 2009.  We are up about 100% from the bottom and still down about 50% from the top.

Natural gas is a different story. The most recent high in natural gas futures was during the summer of 2008 at around $56 and hit its low on November 2, 2010 at $3.83 and currently is around $4.13. Why has the price of natural gas not kept up with the recovery in crude oil? The answer is simple, supply and demand. We have a vast supply of natural gas and we are finding more every day. The inventory is growing faster than we are using natural gas.

I believe there is a significant long-term investment opportunity in natural gas both in the ground and in the transportation of it. There is an energy efficiency factor that tells how much natural gas is necessary to produce the same amount of energy as a barrel of crude oil. Right now, based on the current price of natural gas, you would have to spend $22 on natural gas to produce the same amount of energy as an $81 barrel of crude oil. Using natural gas in the production of electricity is cheaper than coal, or nuclear power.

Could legislation before the lame duck session of Congress change the demand side of the equation? According to T. Boon Pickens a bill is before Congress that would provide tax incentives to switch to natural gas for trucks and transportation equipment and encourage natural gas as a replacement for crude oil. In many big cities in America you will see signs on buses that say, “running on clean burning natural gas fuel.” You may have read that GE will be purchasing 1,200 Chevy Volts as company cars. Peterbuilt, the big truck building company says they are ready to make the changeover to natural gas powered trucks. In fact, they have an order for 120 alternative energy trucks.

If natural gas is going to become an important source of clean energy in the future, in turn increasing demand for natural gas, how do we make money?

My clients already own natural gas in the ground through the investment in natural gas royalty trusts. We own the reserves and as the price of natural gas increases our income will increase. The second way to participate is through natural gas pipeline companies. Again, my clients already have positions in some of the pipeline companies that are master limited partnerships. In both cases, the natural gas in the ground or the pipelines, we are earning dividends in the 6% to 7% range and as the price of natural gas increases our income will increase. I will be adding to these positions as I see opportunities in the market.  

I do not know if the low in natural gas prices in early November was the bottom or not, I do know that 6% to 7% yield at these levels is very attractive and there is not a lot of downside risk. If you do not have Master Limited Partnerships or Royalty Trusts in your portfolio you need to take a closer look at them.

I want to wish you and your families a Happy Thanksgiving and to make time for family.
Dan Perkins      

Wednesday, November 3, 2010

History doesn’t make mistakes; people do by not remembering the past.

In the Saturday, October 30, 2010 edition of the New York Times there was an article titled, “US Hears Echo of Japan’s Woes,” by  Martin Fackler and Steve Lohr. The subtitle for the article was “The Great Deflation, Studying Past Blunders." The initial focus in the article was Hiroshi Kato who now is the President of Kaetsu University in Tokyo. In 1997 he was head of the government advisory committee that blundered in deciding that his country's economy had recovered enough that it could withstand an increase in taxes and continue to grow. He and his committee recommended an increase in the national consumption tax from 3% to 5%. This hike in taxes lead to an unprecedented period of no growth and deflation that still is affecting Japan today, thirteen years later.

In the article Mr. Kato says, “Our sins are large.” He goes on to say, “I hope the rest of the world can learn from this mistake.” Many times over the last few years I have been telling my clients and readers that I felt that the recovery in the United States when it came would look like the recovery in Japan. The Japanese central bank has had interest rates close to zero for almost 10 years. We have seen interest rates near zero for 2 years in the United States what if we have 8 more years at near zero interest rates and an under performing economy, with very high unemployment?

I don’t know what will happen in the lame duck session of Congress, but I hope they take seriously the words of the man who is credited with leading the biggest economic blunder in Japanese history about raising taxes. The mid-term election is only part of the history making process that our leaders will be facing over the next 6 to 12 months. The lines have been drawn over more government, more debt and higher taxes vs. the concept of smaller government, lower taxes and debt reduction.

The concern I have at both the federal and state levels is how you say to people we will have to cut your health care, your retirement benefits and reduce services in order to bring spending under control. The private sector has had to make these same decisions which affected millions of people. Will our government leaders have the courage to truly think about our children and grand children?
Dan Perkins