April 2007 Issue
By Byron King
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Energy Paradigms and Rotating Machinery
When most people think about the "energy industry," the model inside their head is one of private enterprises and, in many non-U.S. venues, national companies extracting reserves from the geologic column. That is, the current energy paradigm involves big businesses using big machines to recover oil, natural gas, tar, heavy oil, coal and other of what are called "energy minerals" from the crust of the earth. Call it Big Oil, Big Coal or Big Whatever. When most people think about where their energy supplies come from, they think of some sort of big rig drilling or digging a hole in the ground.
The energy substances that fuel the world today were, to all intents and purposes, formed in the geologic past, and reflect what many commentators call "ancient sunshine." Whether it is the plant life that formed Pennsylvanian Age coal, or the marine life that was the source of Jurassic Age oil or even the primordial nuclear fission and fusion that led to uranium, we have ancient sunshine to thank for our current daily energy supply.
But this "extractive model" of energy resources is already undergoing a dramatic alteration. Looking forward, much of the world's energy industry will revolve not around "extracting" ancient energy stored in the geologic column, but instead will focus on "capturing" the current energy that surrounds us all in the form of sunshine and wind and falling and moving water. As many of the readers of Outstanding Investments probably know, two industries with the greatest potential for growth in the coming years include wind power and solar capture.
So this month we are going to take a look at a company that sells precision-engineered products into both ends of the demanding market for energy resource exploitation, extraction of ancient energy sources and capture of current energy supplies. And these markets are - it is not too strong to say - venues for which design or mechanical failure is simply not an option.
To set the stage, let's think about how a drilling rig, whether onshore or offshore, is similar to a windmill farm. "Huh?" you say? "Why are we making comparisons between those massive structures that drill oil and gas wells and those other far more aerodynamic structures that perch atop high towers and capture the energy of blowing wind?" Let us count the ways.
Whether we are talking about drilling rigs or windmills, both tend to be located in distant, relatively inaccessible locales. Both kinds of structures are certainly exposed to the elements, from water and salt (not just offshore; onshore rigs routinely are covered with the salt residue of the brine waters that come up from the depths below), to blazing sun, temperature extremes and oft-high winds up to and including hurricanes and tornadoes. Both drilling rigs and windmills have as their mission the requirement to support rotating machinery for many hours per day, and in fact, if the critical machinery does not rotate, then both drilling rigs and windmills are worse than junk. They are junk that is costing the owner or operator a lot of money.
Think about it. Dayrates for large drilling rigs, certainly the big, offshore behemoths, can be as high as $500,000 and much more for the largest of them. Do the math on that. Figure that the rig lessee is paying more than $20,000 per hour, which translates into more than $330 per minute just to lease the rig. (Drill bits, tubular goods, labor and diesel fuel supplies are all extras.) So if you are the operator that has a very costly drilling rig under agreement, downtime is immensely expensive. And as the operator whose money is paying that costly dayrate, you will simply not accept downtime that is caused by mechanical failure, no matter what the ultimate cause. Your instruction to the rig manager is, "Don't let anything break." Another way of saying it is, "Use the very best equipment. Pay whatever it costs." Hold that thought.
Now let's consider a windmill, perched, often as not, atop a 250-foot tower that is constructed on some remote mountaintop or in some distant prairie, or even offshore, certainly far from the nearest machine shop or high-lift crane. Its massive blades may be spinning thousands of revolutions per hour, 18 or 20 or more hours per day, every day of every week, every week of every year, generating megawatts of electricity flowing into the power grid. But consider the rigors of that elevated environment. The wind may gust up, from a very low speed to powerful blasts, within a matter of seconds, and then the wind may die down, and soon thereafter repeat the process all over again. So the mechanical workings of the windmill have to absorb and transmit immense stresses, with the rotating machinery gearing up and gearing down, again and again, over the very long haul. But the windmill is almost never attended by a human maintenance worker. In fact, maintenance is intended to be intermittent, and visiting the top of a windmill tower is certainly expensive for the owners and dangerous to the workers.
So the windmill system has to be designed and built with these very significant electricity-generating constraints in mind. And the customers for that electricity, the electric utilities, are under legal mandate from numerous regulatory bodies to keep their electric grid powered up. So again, the instruction to the windmill operator is, "We need consistent levels of power from your windmill farm, so don't let anything break." And not uncommonly, someone is also saying, "Use the very best equipment. Pay whatever it costs."
Now, let me introduce you to a company that makes that "very best equipment" for these extreme kinds of applications. This company manufactures products for which people are more than willing to pay, as I mentioned above, "whatever it costs." The name of the company is Kaydon Corp. (KDN: NYSE), of Ann Arbor, Mich.
Kaydon, incorporated in 1983, is a world leader in the design and manufacture of custom-engineered, critical-performance products, to include bearing systems and components, filters and filter housings, as well as custom rings, shaft seals, linear deceleration products, specialty retaining rings, specialty balls, fuel cleansing systems, gas-phase air filtration systems and replacement media, industrial presses and metal alloy products. And this product line is far more than what you might buy down at your local auto parts dealer. These products are used by high-end, mostly high-tech, customers in a wide range of critical machine positioning applications, instrumentation systems, material handling devices, aerospace and defense systems, security applications, high-tolerance construction efforts, electronic and even medical applications.
Kaydon's stock is selling near a one-year high of $45. There are about 28.2 million shares outstanding, giving the company a market capitalization of about $1.2 billion. It pays a dividend of 12 cents per quarter, 48 cents per year. So the dividend yield is about 1.1% at the current stock price. As recently as August 2006, Kaydon was trading at about $34, so it has had a nice rise in the past six months or so. But then again, the stock is rising for a lot of good reasons, and those reasons appear to be continuing into the future.
First, here are some basics. On Feb. 14, 2007, Kaydon reported diluted earnings per share (EPS) from continuing operations for 2006 of $2.17, a 42.8% increase compared with $1.52 for 2005. On a full-year basis, aftertax income from continuing operations increased 49.4%. Fourth quarter (Q4) sales from continuing operations increased 11.7%, to a record $100.1 million. Q4 operating income from continuing operations increased 22.9%, to $24.0 million, equal to 24% of sales. Q4 aftertax income from continuing operations increased 22.6%, and diluted EPS of 55 cents were up 19.6% compared with the Q4 of 2005.
Net cash flow from operating activities for the year increased 118%, to $89.9 million, versus $41.2 million in 2005. And earnings before interest, taxes, depreciation and amortization (EBITDA) increased more than 33%, to $116.1 million, equal to 28.7% of sales, and covered interest expense 12.2 times. Kaydon's cash and cash equivalents equaled $370.8 million at the end of 2006, equivalent to $13.15 per share. Kaydon's stock carries a price-to-earnings ratio (P/E) of just over 20.
In remarks prepared in connection with the recent release of 2006 financial results, Kaydon President and Chief Executive Officer Brian Campbell referred to "the strength of Kaydon's proprietary product positions and disciplined strategic direction. We believe our strong order intake during the year, combined with increased current incoming order rates and customer product availability inquiries, lay the foundation for increased operating performance in the current year."
One of Kaydon's strengths going forward is, as mentioned above, its sales into the wind turbine market, particularly the critical bearings components of windmills. This is because the windmill sector of the market is growing at near-breakneck speed and the company is expanding its capacity and sales efforts in this line of business. In 2006, investment in windmill systems in the U.S. was second only to investment in new coal-fired power plants for the production of electricity. In other parts of the world, from Europe to Iran, from China to Costa Rica, the market for windmills is just going like gangbusters. So Kaydon is positioning itself into the sweet spot of one of the world's fastest-growing energy markets, and we expect to see earnings in the vicinity of $5 per share by the end of 2010.
The key problem in developing windmill systems at the present time is the availability of windmill turbines, and this puts the investment spotlight squarely on one of Kaydon's most profitable new business lines going forward. To illustrate the point for the need for what Kaydon makes and sells, for example, John Hofmeister, president of Shell Oil Co., recently gave a talk in which he discussed Shell's efforts to develop wind farms. Mr. Hofmeister said, "We would love to build more wind farms. We have the real estate and the permits. We certainly have the funds to construct these facilities. But our biggest problem is just the availability of windmills. We are experiencing a two-three-year delay in delivery of windmill systems."
Two-three-year delays? And this from a large, well-capitalized company like Shell, which can pretty much buy what it wants? Sounds to me like a growth story for a small-cap precision maker of a critical product, the kind about which people say things like, "Use the very best equipment. Pay whatever it costs."
ACTION TO TAKE: Buy a position in Kaydon Corp. (KDN: NYSE) up to $50. Use any decline in the stock price to accumulate shares.
by Byron King
Long-term readers of Outstanding Investments will recall that we recommended purchasing shares of Valero Energy Corp. (VLO: NYSE) back in March 2003, when the stock was selling for about $11. Valero is still part of our portfolio, and has enjoyed a long, fairly steady rise over the past four years. For a good many of our subscribers, this has been a very successful investment. Let's take another look at this company.
San Antonio-based Valero is the largest oil refiner in North America, operating 17 refineries that process more than 3.3 million barrels of oil per day. Of these facilities, 16 are located on the North American continent, and one in Aruba. Valero produces gasoline, distillates, petrochemical feedstock, asphalt, lubricants and other refined products. The company also markets branded and unbranded refined products on a wholesale basis. Valero has more than 5,500 retail and wholesale stores selling refined products in the United States, Canada and the Caribbean under various brand names including Valero, Diamond Shamrock, Shamrock, Ultramar and Beacon.
Valero owns over $33 billion in assets and generated more than $90 billion in revenues in 2006. Its stock is now trading near $59, and in both the spring and summer of 2006 was changing hands in trades as high as $70 per share. The pullback in the price of oil in the fall of 2006 brought the share price down as low as $47, but the recent advance in the price of oil is bringing Valero's stock back up. In January 2007, Valero's board of directors announced an increase in the quarterly dividend from 8 to 12 cents per share, or 48 cents per year. Thus, in addition to any appreciation, the company's stock pays out a yield of just under 1%. So if you are a longtime holder of Valero, you should be quite pleased with your investment. Still, for the more recent subscribers, or if you are considering adding to your portfolio, what are the prospects for Valero going forward?
McKee Refinery Fire
What prompts me to write about Valero in this issue is the recent news from Texas of a fire at one of the company's major refineries. On Friday, Feb. 16, an explosion and fire occurred at Valero's 170,000-barrel-per-day refinery at Sunray, Texas. Sunray has a population of about 2,000 and is located about 60 miles north of Amarillo. The Sunray plant is also called the McKee Refinery. At the time of the fire, there were about 400 Valero employees working onsite, and many hundreds of contract employees also inside the gates.
The McKee Refinery is an important hub for Valero's midcontinent operations, and is connected to other Valero facilities throughout the Southcentral U.S. The refinery sends product via pipeline throughout northern Texas into New Mexico, Arizona, Colorado and Oklahoma. The McKee facility relies on a varying blend of domestically produced crude oil for feedstock supplemented with purchases of foreign sweet and light sour crude oil. Valero L.P., a pipeline operator spun off this year from Valero, has shut crude oil pipelines that lead to the refinery from central Texas and Colorado, and has also shut pipelines that carry gasoline and other motor fuels to north and west Texas, New Mexico and Colorado. (About 30% of the gasoline used in Colorado comes from the McKee Refinery.) Within a few days of the Feb. 16 fire, Valero was buying gasoline, diesel and other motor fuels to make up for the supply lost from the refinery.
Over the term of any shutdown lasting more than a few weeks, the loss of output from the McKee Refinery will disrupt fuel supplies and allocations throughout the Rocky Mountain region, particularly as other refiners and marketers begin to build supplies and inventory for the summer driving season. These disruptions might cause other refinery operators to alter their own scheduled maintenance plans, so as to keep production up.
Injuries
Thankfully, and despite the fact that hundreds of workers were at the plant, there were no fatalities due to the explosion and fire. With so many hundreds of workers onsite, the explosion and fire could have been catastrophic. Still, I regret to say that two Valero workers and a contract employee were badly injured and subsequently transported to a Lubbock, Texas, burn center for treatment, and three other workers were admitted to local hospitals. Ten other Valero plant workers were treated and released by hospitals. One of the burned workers remained in critical condition in Lubbock as of last week.
Valero is a big company that employs about 22,000 people, so every day there are the trials and tribulations of life within the company's work force. We do not, of course, watch for every sparrow that falls from the proverbial tree. But when people are injured in a major refinery explosion, we care and take notice. As long-term shareholders in Valero, this is "our" company as much as it belongs to anyone, so we send our prayers and best wishes to the injured personnel, their family members and colleagues. And without getting in the way of people doing their jobs, we want to know what happened and what it means to the company going forward.
Fire and Shutdown
According to a company press release, the McKee plant fire broke out in a propane deasphalting unit. This is a part of the plant that processes residual fuel at very high temperatures, using propane to upgrade the last fractions of gasoline out of the "gunk" of otherwise residual crude oil. Upgrading heavy and residual oil fractions is an engineering specialty of Valero, and one of the key reasons why Valero has been such a successful refiner in recent years. We will address this point again later in this article.
According to the Associated Press, witness accounts suggest that liquid propane ignited to cause the blaze. In general, liquid propane vaporizes quickly in the atmosphere and expands to form a vapor cloud. At the McKee Refinery, a propane vapor cloud apparently ignited a short time after it was released. Also, according to news accounts, some of the contents of three 1-ton chlorine cylinders also may have been released due to exposure to the fire. Chlorine is a toxic gas, but a Valero spokesperson said that tests by the Texas Commission on Environmental Quality showed no impact from chlorine off the plant site. The Texas Department of Public Safety has permitted access to roadways nearby, an indication that air quality is not dangerous.
The McKee Refinery fire was "essentially extinguished" by Saturday morning, according to a company spokesman, but public safety officials stated that the fire was not entirely extinguished until Sunday, when the last embers of combustion went out. High winds complicated the firefighting effort, although at the same time served to disperse explosive vapors.
Valero shut down the McKee Refinery following the fire. It is rare for refiners to completely shut down plants. Normally, a refiner will just shut down one or a few portions of a refinery and perform whatever maintenance or repair work needs to be done. However, in the case of the McKee Refinery, there are four large, propane-filled spheres adjacent to the deasphalting unit, and there were fears that one or more of the spheres might have been damaged and leaking, which could lead to another explosion, and in all likelihood a massive one.
Apparently, Valero also shut down the steam system that energizes the refining operation. This will make a "fast" startup all but impossible because the plant is now "cold iron." At the McKee Refinery, the steam system is located nearby the area that was affected and damaged by the explosion and fire, so there will have to be extensive inspections of the steam lines before it will be safe to power up the refinery.
Federal Investigation
The U.S. Chemical Safety and Hazard Investigation Board (CSB) has initiated a preliminary investigation into the incident, as has the U.S. Occupational Safety and Health Administration (OSHA). Valero is cooperating with the investigation. Federal investigators for OSHA and the CSB will initially focus on the McKee Refinery explosion, but one CSB official stated that investigators could widen their probe to include three other fires this year at Valero refineries in Texas City, Texas, and Delaware City, Del. "We've certainly noticed there have been a number of incidents [at Valero refineries]," said CSB spokesman Daniel Horowitz to Reuters. "But first and foremost, we're going to look into the Sunray incident."
The CSB is an independent federal agency authorized by Congress in 1990. It has a staff of about 50, who attempt to determine root causes for chemical accidents and make remedial recommendations. But the CSB does not assess fines or penalties against companies, as do OSHA and the Environmental Protection Agency (EPA).
Lengthy CSB investigations and injured workers' lawsuits have proved costly for other refiners in recent years. For example, the deadly BP Texas City blast, which killed 15 and injured 170 workers on March 23, 2005, is still being probed by the CSB. Potential for losses from litigation and fines has forced BP to set aside over $1.6 billion, over and above insurance coverage, as a reserve against potential losses from lawsuits. Both internally and externally, BP has been accused of lacking a "culture of safety" in its operations, a charge that has dogged BP management and operations to the current time. Dealing with these kinds of issues (kind of a "When did you stop beating your wife?" sort of situation) requires large amounts of time from management, which detracts from other things that have to get done in order to run the company successfully.
Culture of Safety
It should go without saying, but it has to be said again and again, that a "culture of safety" is critical to the successful operation of something as inherently dangerous as a refining and petroleum-handling operation. One member of the CSB, John Bresland, recently had this to say about BP and its Texas City plant:
"Running a big operation like this is not an easy job. It takes dedication, expertise, hiring the right people and continuing to train them," he said. "You can't just kind of slide along and hope things will work out for the best."
Mr. Bresland is absolutely correct. Wishing upon a star may work at Disneyland, but an oil refinery is not exactly Disneyland. The lawyer for one of the BP workers who died in the Texas City blast was much blunter. According to The Baytown Sun newspaper, Texas attorney Don Coffey, who conducted an independent investigation into the BP explosion, stated, "It's not about a culture of safety. It's about a company [BP] that was deferring maintenance and cutting costs to maximize profits at whatever cost."
As shareholders of Valero, we defer judgment on this last point. That is, we are not prejudging Valero, or ascribing improper motive to Valero management or condemning the company's culture of safety. We just want the CSB to do its job and make an assessment of why the McKee Refinery had an explosion and fire. And we are sure that Valero will take its corporate responsibilities with all seriousness.
Then again, our readers and subscribers at this point have a lot of money invested in a company whose bread-and-butter operation is refining crude oil. Refining is an inherently dangerous business, and has been since Samuel Kier set up his first "
kettledrum" refining operation in Pittsburgh in the 1850s. A refinery is a complex maze of knotted pipes, tanks, furnaces and stacks, full of hot gases and corrosive, poisonous fluids. There is plenty to go wrong, and sometimes things do exactly that. But there is a reason for everything that happens under the sun, and performing a "dangerous" operation does not mean being "unsafe." You can do dangerous things in this world, but you had better do them safely, without deferring maintenance or cutting costs just to goose up your profit line.
The Valero Restart Plan
So where do things go from here? Before the explosion and fire, Valero had announced that it intended to conduct maintenance on a 30,000-barrel-per-day (bpd) "hydro-cracker" at the McKee facility, starting in April and continuing into May 2007. A company spokesperson has amended this announcement to state that Valero will integrate upcoming planned McKee maintenance into the restart plan for the plant.
According to Valero spokeswoman Mary Rose Brown, Valero employees are working to restart plant utilities, and to inspect piping and other refinery systems, to include essential safety flare, fuel gas and steam systems. "The decision has been made to integrate our previously announced planned maintenance work into the current plant recovery and restart effort," Brown said. However, said Brown, "given the complexity of this work, we have yet to establish an exact restart date, but it will be weeks before a partial startup can be anticipated." And there is no estimate yet for the cost of repairs to the damaged McKee Refinery.
A Cautionary Tale
The story from the McKee Refinery is cautionary, but in fairness, it is also just part of the tale of an exceptionally well-managed company. Valero had a great year in 2006, with record earnings of about $5.5 billion. The company paid out $2.2 billion in dividends and share buybacks. It sold its Valero L.P. interest for $880 million net. Valero has $1.6 billion in cash on the books and a high credit rating. Valero is looking forward to continuing strong demand for its fuel products, both consumer and industrial, and a strong and tightening market for its higher-margin diesel fuel blends. Valero specializes in refining the heavier and "sour" blends of oil, which gives it among the best margins in the refining business. (For example, each 25 cent cost advantage for a barrel of heavy or sour oil translates into about $300 million in operating income, or 30 cents per share.)
Valero has a corporate focus on what it calls "capital discipline." This is something of a business school buzz term in recent years (in my uncharitable moments, I label the use of the term as one of the latest in transient managerial fads). And while the term "capital discipline" is a term that is understood by and intended to impress the Wall Street analysts, it should never take on a life of its own and be used as a budgetary excuse to skimp on safety. In fairness, at root, the concept of capital discipline is a shorthand way of referring to the need to evaluate all projects for return on investment, just as John D. Rockefeller did back in the days when he was putting together the original Standard Oil Co. Capital discipline means that Valero does not want to overpay for what it buys, whether raw materials or tangible capital investment or other companies. Valero works to control its costs, particularly its internal energy costs. The company focuses on high-return, low-risk projects at its key locations. And Valero has ambitious plans to grow its earnings. So far, so good.
But going forward, Valero has to keep one eye on the bottom line and the other on the equipment and maintenance logs, as well as on the training syllabus for its workers. Valero management has done a good job of communicating its successful story to the stock analysts, and for that we long-term shareholders are grateful. But management also has to listen to the line workers and engineers who spend their days inspecting the cracking towers and turning the valves down in "pipeline alley." We are in the oil refining, not the hedge fund, business. And in the refining business, management is not just overseeing the deployment of capital. Management must also exercise wise and forward-thinking oversight of its cadre of personnel, understanding human factors and how to utilize its base of corporate knowledge. Without this sort of focus on people, maintenance and safe operations, "capital discipline" is a term that will come back to haunt management, in particular when some smart plaintiff's attorney uses it against the company in his closing summary to the jury.
I do not want to say that something good can ever come out of an explosion and fire, particularly when people are injured. Bad things like that have some ultimate cause, and basically should never occur when the equipment is well maintained and people are well trained.
But we are dealing now with what has happened at the McKee Refinery, and our hope is that Valero management will take the lesson to heart. As long-term shareholders, we are happy with Valero's performance in recent years. But we also expect the company and its managers to avoid what happened with BP, and not to skimp on the and the personnel development, and the critical maintenance and repairs that are essential to keeping the company strong, safe and well respected. Message to management: You have done a great job over the past several years. Don't push your capital discipline so hard that you screw it up.
Action to take: If you own shares, hold Valero (VLO: NYSE). Consider adding more shares of VLO to your portfolio, because we believe oil prices will rise over the long term and the quality of crude oil will decline. Valero's refining margins for heavy and sour crude oil are among the best in the industry. Keep an eye on how aggressively Valero management tackles any maintenance and safety issues.
by Byron King
On Jan. 10, 2007, the integrated oil company ConocoPhillips announced "preliminary proved reserve additions" for 2006 of approximately 300% of the company's barrels-of-oil-equivalent (BOE) production. In a press release, the company stated that when the final figures are calculated for 2006, proved reserve additions, including sales and acquisitions, are expected to be approximately 2.6 billion BOE. Production for 2006 was approximately 880 million BOE, including fuel gas.
At the end of 2006, ConocoPhillips held approximately 11.1 billion BOE of proved reserves (excluding an additional 300 million BOE associated with the company's Canadian Syncrude operations). This is up from 9.5 billion BOE in 2005. Of the 2.6 billion BOE in reserve additions in 2006, approximately 2.5 billion BOE reflect the acquisition of Burlington Resources in a $35.6 billion purchase agreement completed in the spring of 2006 and an increase in the ownership share in the Russian company Lukoil. Thus, only 100 million net BOE were obtained via internal or organic exploration and recovery methods.
About a month later, on Feb. 9, ConocoPhillips announced a quarterly dividend of 41 cents per share, payable March 1 to stockholders of record at the close of business Feb. 20. This represents a 14% increase in the dividend rate for the company's common stock over the previous quarter's rate of 36 cents per share. The company also announced plans to repurchase up to a total of $4 billion of its own common stock in 2007. ConocoPhillips expects first-quarter 2007 purchases to be approximately $1 billion. The shares have traded in a range of $54.90-74.89 in the past year. Shares of stock repurchased under the plans are held as treasury shares.
These ConocoPhillips announcements failed to impress Wall Street analysts, largely because almost all of the BOE reserve gains occurred through acquisitions. At least three major brokerage houses - A.G. Edwards, Deutsche Bank and Citigroup - communicated to customers that they were disappointed with ConocoPhillips' 2006 reserves replacement figures.
In a research note, Citigroup analyst Doug Leggate said, "With a low-profile exploration program that has offered little in the way of exploration success, [ConocoPhillips] has pursued acquisitions to bolster reserve additions that in this environment, we believe, will likely come with a high price tag and [put] further pressure on the balance sheet." Leggate maintained a "hold" rating on ConocoPhillips stock, estimating that the company's organic reserves replacement (i.e., outside of acquisitions) has averaged only 73% in the past five years.
A.G. Edwards' Bruce Lanni was more critical, estimating that ConocoPhillips reserve replacement statistics likely amounted to only 10-15% last year excluding purchases. Furthermore, noted Lanni, 2006 marked the third straight year of reserve replacement below 100%. "In our opinion, this announcement, along with the company's dependence on acquisitions and joint ventures, further suggests that ConocoPhillips' future organic growth opportunities remain somewhat limited," said Lanni, reiterating a "hold" rating on ConocoPhillips shares.
ConocoPhillips has said in previous announcements that its goal is to replace production at rates equal to or exceeding 100% as part of a three-year rolling average. However, many knowledgeable analysts believe that a company's reserves replacement should average around 130% over a three-year period if it expects to grow production. This is becoming more and more difficult in a world where the "easy" oil has been found, and the remaining oil is located in politically unstable or geographically and geologically remote locales.
In our view, ConocoPhillips, currently trading for about $68 per share, has been drilling for oil on Wall Street. But now the company is itself becoming a potential takeover target. If you believe, as we do, that the world marketplace will continue to pay rising prices for oil, then shares of COP are a safe purchase, and currently yield 2.4%, based on the dividend payout.
by Kevin Kerr
In the past, at least for most of my 17-year career, the commodities markets have been a small part of the overall investment picture for most investors. The NYSE pooh-poohed the commodities exchanges as a form of gambling or worse. Average investors had little access to these markets, and those who did often came away feeling confused and disenchanted. Fast-forward to today, and all of that is out the window. The electronic age has made global commodities futures accessible around the clock and much easier for the average investor to understand. Liquidity and volume of trading has increased exponentially and continues to rise. Global ETFs and individual investors have created a whole new market.
In the past, key commodities markets like gold and oil were the only ones you would hear mentioned in the mainstream press. You may have heard about pork bellies or OJ discussed at a cocktail party, but that was about it. Again, all of this has changed, as the commodities markets have evolved. One sector that was mainly reserved for farmers and professional speculators was the grain markets. With the resurgence of ethanol and biofuels, these markets have suddenly become more precious than gold.
Corn, for example, had quite a run in 2006, and continues to climb in 2007. Corn may continue to rise, but other grains that have lagged behind a bit may soon take the lead.
Corn's Not the Only Crop Catching Traders' Eyes
Ethanol, ethanol, ethanol. Corn has absolutely been on an explosive run, and the cash and futures prices are soaring. The main cause is the ethanol plants springing up right and left across the country. It's almost as though you can't turn on the TV or pick up a magazine without hearing or reading about it. The demand for ethanol is real, and even though the science of ethanol is still questionable, the reality is that it's now the primary blending ingredient for gasoline. Ten percent ethanol is pretty much standard now at the gas pump, and in many states, E85 is taking hold. E85 is 85% ethanol.
While the arguments rage on about whether or not ethanol is the answer to our fuel needs, the demand is already here. Until there is a viable alternative or a repeal of the 54-cent sugar tariff in the U.S., corn-based ethanol is here to stay, regardless of whether or not it's actually efficient.
So clearly, corn and sugar are two commodities destined for much higher prices. In the rush for corn and soybeans, one grain that's being overlooked is wheat.
Where's the Wheat?
Wheat is one of those commodities that isn't sexy. It's not gold and it's not oil, so it's not that exciting to talk about at the club - but there is real money to be made in the wheat market right now. Very few people are talking about it - at least for now - and that's good news.
I grew up in Minneapolis, Minn., born and bred. Minneapolis happens to boast the largest cash grain market in the world. There is a small futures exchange and it trades wheat. Chicago also trades wheat and is where I usually suggest you trade. However, wheat is also traded in Kansas, and although the market is a bit thinner, it can sometimes work to your advantage. Some of the best markets to trade are the ones you never hear about in the mainstream. With the grain markets moving so fast even wheat is picking up steam and the trading action is like a tornado.
Dorothy, You Are in Kansas!
Speaking of tornadoes, Kansas City wheat is the second most actively traded wheat contract after Chicago. The reason the KC wheat is special is that it's the hard red winter wheat. This type of wheat accounts for about 45% of total wheat production in the U.S. and is a higher quality wheat that's used to make food products. It's more easily refined and milled.
Last summer, the United States Department of Agriculture said 49% of the spring wheat crop was already harvested and only 32% of it was rated good to excellent. That's down from 67% a year ago. This year may be even worse, and demand is growing.
The situation gets even more grim as the United Nations Food and Agriculture Organization is reporting that nearly two-thirds of the winter wheat crop in western and northern China has been wiped out by a prolonged drought. Some other areas have experienced a 40-50% cut in the winter wheat harvest.
The rumbling in the pits is that red winter wheat, while volatile, is one of those crops that simply will go higher in the long term, due to increased demand and ever-decreasing supply. Sounds like a good time to buy.
The Forgotten Grains Could Bring Big Gains
The grains used to be pretty obscure to most investors, and certainly there were no respectable Wall Street traders who looked at corn charts (or at least admitted it). Now if traders aren't looking at the grain charts, they're considered strange, so times change.
In the last few years, due to the ethanol craze, the grains everyone's heard about are corn and soybeans, and these grains are the most actively traded. However, there are many other smaller grain markets for the more aggressive investors who want to do their research and take a little more risk. Canola, oats and a more mainstream commodity like rice are all more markets to take a look at. Personally, of the three, I would look at the rough rice (market symbol RR). The futures contract is pretty liquid, relatively speaking, and it can be a good-trending market. It certainly doesn't get as much attention as corn or soybeans, but that can be a good thing.
Sure, corn and soybeans will remain the front-runners in the grain race, but the rush for profits and the ethanol hysteria (like the new gold rush) is far from over.
I could list about 50 more reasons to buy grains right now, but the bottom line is that these markets are very strong and this trend is likely to continue. While corn may retreat a bit, I expect wheat, and even soybeans, to climb. The grain charts have risen so fast they will give you a nosebleed if you look at them, but don't let that deter you. Bull markets often have charts like that. As always, use protective stops and a strong defensive trading strategy in these markets, because a correction is always possible.
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