TODAY’S S&P 500 SET-UP – August 2, 2013
As we look at today's setup for the S&P 500, the range is 22 points or 0.99% downside to 1690 and 0.30% upside to 1712.
CREDIT/ECONOMIC MARKET LOOK:
MACRO DATA POINTS (Bloomberg Estimates):
WHAT TO WATCH:
COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)
The Hedgeye Macro Team
This note was originally published at 8am on July 19, 2013 for Hedgeye subscribers.
“Never memorize something that you can look up.”
I used to have something of a photographic memory. Lately, however, a plot of my capacity for short-term recall and a YTD chart of Gold would probably be hard to distinguish.
I’d proffer that my bout with Cognitive Deflation is only transient and simply the byproduct of late nights with infants, serial overconsumption of caffeine, and serial under-consumption of exercise. At least that’s what I tell myself.
Either way, I’ve come to more closely relate to the aphoristic wisdom embedded in Einstein’s quote above.
With some beach time on the August calendar, I’m holding out hope the downtime catalyzes some needed cerebral exfoliation.
Back to the Global Macro Grind….
We have been negative on emerging market debt and equities for most of 2013 with #EmergingOutflows & #AsianContagion headlining our 2Q13 and 3Q13 Macro Investments themes calls, respectively.
The story of emerging market pain is one birthed from emergent strength in the U.S. dollar, acceleration in U.S. growth and the associated reversal in unprecedented Fed policy driving an expedited reversal in Hot Money & Yield Chase Flows out of developing economies.
We’ve presented the principal conclusions of our research and suggested positioning in recent presentations, but it’s probably worthwhile to take an illustrative, didactic tour of capital flows to understand how the cycling of capital into and out of emerging economies can work to propagate negative economic and market impacts in an archetypical scenario.
Capital Flows to Emerging Economies for 3 Principle Reasons:
1. External: “Push” flows occur for reasons external to the capital-importing economy and generally relate to relative investment attractiveness. Perhaps the simplest way to understand it is in the context of U.S. interest rates. If growth slows, policy turns easy and interest rates in the U.S. decline, investment yields available in emerging economies become relatively more attractive and capital flows accordingly. Historically, this has been the largest driver of rich-to-poor capital flows. It’s also generally the most volatile.
2. Internal: “Pull” flows are catalyzed by improving economic fundamentals, sound policy and/or trade & capital market liberalization initiatives. Pull flows provide firmer bedrock for sustained inflows.
3. Financial Globalization: Here we’d highlight the ongoing, global trend towards Financial & Capital market integration and the proliferation of conduit investment vehicles allowing broad institutional and retail access to developing economies. A secular shift in portfolio allocations towards international diversification holds positive longer term opportunity for developing economies. However, in compressed periods in which flows chase performance, it can work to amplify volatility in market prices.
It’s the potential transience of “push” and portfolio (i.e. equity & debt) flows that are of most concern to capital-importing countries, particularly given the reality of hyper-fast capital mobility.
So, what happens when the Hot Money starts to flow?
In a generalized model, the body of empirical evidence points to a number of discrete macroeconomic impacts:
1. Currency Appreciation: Absent Central Bank intervention the demand for foreign currency drives the exchange rate higher.
2. Consumption Growth: The influx of foreign capital provides for a higher level of domestic investment. This higher level of investment is generally accompanied by a decline in the domestic savings rate. Consumption rises as consumerism displaces saving.
3. Rise in the Money Supply & Inflationary Pressure: Stemming from a rise in economic activity along with any attempts by the central bank to quell the currency appreciation.
4. Widening of the Current Account Deficit: Don’t worry if you don’t remember the details about what the Current Account is. Here, it’s sufficient to understand that imports rise relative to exports generally due to an appreciating currency and rising consumption.
It’s not difficult to understand how the confluence of the above dynamics can work to drive recurrent boom and bust cycles for emerging and formerly, capital-rationed, economies. Consider how the interaction of the above factors, which initiates with a large influx of foreign capital, can work to drive a self-reinforcing cycle in both directions:
U.S. growth slows, Bernanke cuts to 0%, institutes financial repression and forces capital to search out yield. Capital flows into the EM economy causing increased investment, falling domestic savings and rising domestic consumption. Incomes rise alongside accelerating growth, driving a further increase in consumption in a positive, reflexive cycle. Further, foreign capital inflows along with diverted domestic savings provide a bid for real (i.e. housing) and speculative financial assets. Net wealth increases alongside inflating asset values. Faster growth, higher incomes, and rising net wealth all serve to increase capacity for credit. Credit expansion then serves to amplify the cycle. Everything is great, until…….
U.S growth starts to inflect to the upside, #StrongDollar starts to sniff out a Fed Policy reversal, and “push” flows begin to reverse.
When portfolio capital starts to exit, asset prices deflate and credit gets tighter, investment and consumption both decline. The currency depreciates, driving local inflation higher at the same time that aggregate demand accelerates to the downside. If demand is local and the debt is denominated in foreign currency, the debt burden on business is amplified. Declining demand in the face of a crashing currency and elevated inflation can leave policy makers handcuffed.
Thus, capital flows, this time the expedited exportation of foreign capital, catalyze a reversal of the boom cycle described above with some version of a self-reinforcing, contractionary cycle playing itself out.
Of course, country specific fundamentals, policy decisions, and monetary systems matter and understanding the prevailing risk for a particular country is more nuanced, but the generalized model described above captures the broader dynamics that tend to drive the cycle.
Further, given the large-scale proliferation of EM related investment vehicles whereby investors indiscriminately bought ‘international diversification’ without a real understanding of the underlying exposures, it’s unlikely they will be overly discriminate in their selling. Historical precedent suggests #StrongDollar driven outflows from emerging markets are protracted.
In short, we don’t think #EmergingOutflows have bottomed yet.
Hopefully the decline in my recollective ability has.
Our immediate-term Risk Ranges are now:
UST 10yr yield 2.49-2.74%
Enjoy the weekend.
Christian B. Drake
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“Think of me like Yoda, but instead of being little and green, I wear suits and I’m awesome. I’m your bro — I’m Broda!”
I’m not going to try to weave that recent #Tweetshow gem from Keith above into some sort of missive theme. It just makes me laugh.
Let’s start somewhere else.
Back in school the bullies used to wait until Picture Day to punch a kid in the face. Risk Management in Central CT starts early.
Yesterday could probably be considered an investor picture day and the market delivered a bevy of black eyes to the perma #EOW contingent.
In related End of World and Recency Bias news, it’s now August and for the better part of the last 5 months, the ‘Sell in May’ mantra has been iteratively thesis drifting towards an un-convicted call to ‘Sell in September’ alongside another crescendo in congressional budgetary and debt ceiling discord.
September, incidentally, also happens to be when the seasonal distortion present in the reported econ data flips from a headwind to a tailwind - serving to (optically) amplify any positive underlying economic trend.
Hearing implied volatility in ‘sell in December & go away’ calls is ripping!
Back to the Global Macro Grind……
For much of 1H13, our pro-domestic growth call was buttressed by some positive redundancy. That is, with our model signaling for the slope of U.S. growth to accelerate out of 4Q12, we had a bullish absolute call for domestic, consumer-centric equities.
With most of Europe Bearish TRADE & TREND, an expectation for slowing EM growth, and upside to troughed out expectations for U.S. growth, we also had a relative call supporting a long bias to domestic exposure.
In essence, even if U.S. growth turned out to be “okay” instead of very good, we were still taking a high probability swing at positive absolute performance.
As it happened, our conviction in the strength of the relative call was tested more acutely as we transitioned out of 1Q. A quick review of the last few months will be helpful in understanding how our view has evolved to where it is today.
As we moved through 2Q, it become apparent that consumption growth, while remaining healthily positive, would not accelerate sequentially. In part, this was not unexpected.
Fiscal policy impacts generally hit on some short lag and the 1Q13 comparison was artificially difficult as consumer spending in 1Q benefited from the special dividend deluge and compensation pull-forward that occurred in December 2012 ahead of impending fiscal cliff related tax law changes.
With the savings rate rising in 2Q and disposable personal income growth largely flat, divining the slope of sequential consumption growth just became simple math.
Further, with federal employment growth running at approx -2% YoY and furloughs for ~700K+ federal employees beginning in July – which, in tandem, equates to ~7% reduction in income for ~2% of the workforce – upside to disposable income growth would likely be constrained in 3Q13 as well.
Would a modest deceleration in consumption matter from a market perspective? – becomes the simple, but nontrivial investment question.
As we highlighted yesterday, when re-evaluating positioning, it’s often helpful to start by detaching yourself from the myopia of trying to contextualize every market tick and, from a broader perspective, remember how this whole reflexive economic thing works. Archetypically,
Rising spending drives income and employment higher which, in turn, drives consumption and confidence higher in a virtuous, self-reinforcing cycle. Credit serves to amplify the cycle with credit expansion following pro-cyclically as loan demand and creditworthiness both increase alongside rising incomes and higher household net wealth.
In short, if the TREND slope of improvement across the balance of key macro drivers (employment, consumption, credit, confidence) remains positive, and if the forward research view and risk management signals are still aligned, the path of least market resistance and the highest probability call is to stick with the TREND - particularly if you don’t have a discrete catalyst for a reversal.
So, how are the aforementioned macro metrics #TRENDing?
Labor market trends remain positive with Initial Claims continuing to register accelerating improvement while employment growth as measured by the BLS’s Establishment and Household Survey’s both remain positive.
Confidence readings across the primary surveys continue to make new 5Y highs and are finally beginning to break out of their post recession channel.
Business and Residential Investment growth has accelerated in each of the last two quarters.
On the credit side, banks are finally beginning to report positive loan growth, Commercial & Residential Real Estate loan demand continues to improve and credit standards across commercial and consumer loan categories continues to ease.
Consumption has shown a discrete acceleration, but faces some well advertised, nearer-term headwinds. If labor market trends remain positive, does the market look past middling consumer spending growth over the next few months with an eye towards a diminishing fiscal drag and easy compares as we annualize the sequestration and the tax law changes in early 2014? That’s an increasingly probable risk for the consensus #EOW bear crowd to manage.
Now, Is Congress a discrete negative catalyst? As our Healthcare Sector Head, Tom Tobin would say; you can never underestimate congress’s ability to create a crisis so they can subsequently save us from it. Congressional risk may rise, on the margin, but this iteration is likely to be mostly noise so long as the fundamental trends remain positive.
Is #RatesRising a catalyst? We have a hundred page slide deck and a 60 min presentation on why we don’t think a return to interest rate normalcy is a threat to growth or market performance. (ping if you’d like a copy)
Is today’s Employment Report a discrete catalyst? Yes, but not really. We don’t have any particular edge on the NFP number, but given the ongoing strength in the jobless claims data it’s more likely than not we print something close to consensus at 185K.
So, now that I’ve peppered you with bullish jabs for the last 800 words, I’ll remind you that we’re not bullish on everything at every price. In fact, we moved to net neutral into yesterday’s close (5 longs, 5 shorts) as almost everything pro-growth, domestic consumption (XLY, XLF, $USD) signaled immediate term overbought.
But we’ll take our long exposure higher again on the signal so long as the TREND slope of improvement in the Macro data remains positive. At present,….
“Your Friend, the Trend Remains” - Broda
Our immediate-term Risk Ranges are now as follows:
UST 10yr 2.60-2.78%
80o and sunny on tap for the weekend. Enjoy.
Christian B. Drake
Answer: Kinder Morgan CO2 Company, L.P. (or at least one of the most over-valued...)
Kinder Morgan CO2 Company, L.P. is a subsidiary of Kinder Morgan Energy Partners, L.P. (KMP) that the Kinder Morgan faithful don’t want to talk much about. But the segment is crucial, as it generates 26% of KMP’s total earnings before DD&A and certain items (and the GP’s take), and nearly all of those cash flows flow to the DCF line due to the fact that KMP considers 97% of the capital expenditures in the segment to be “expansion capital” – which, as MLP investors know, are not deducted from DCF; “sustaining capital” is deducted from DCF.
Between 2010 – 2012, for its CO2 segment, KMP reported $34MM of sustaining capital and $1,230MM of expansion capital, despite no material volume growth in its E&P or CO2 businesses, and aggregate DD&A of $1,329MM. If KMP considered all of the CO2 capital expenditures between 2010 – 2012 to be sustaining capex, which we think is appropriate considering there was no aggregate growth in the segment, then KMP’s total DCF would have been ~26% lower than reported.
We estimate that the CO2 segment currently generates ~1/3 of KMP’s total DCF after the GP's take, despite only representing 7% of total assets.
This may not be lost on seasoned MLP investors. But there seems to be a lot of interest in this contentious topic lately, as we’ve gotten several questions and comments on it over the last few months. The general view out there on it is something like, ‘It makes no sense, but it is what it is. It’s Kinder Morgan. They do what they want.’ Some have even suggested to us that the SEC won’t do anything about LINN Energy’s (LINE, LNCO) blatantly understated “maintenance capex” (and, as a result, its overstated DCF) because ‘they won’t want to make Kinder Morgan mad.’ But in our view, the fact that KMP does this is indefensible and misleading (as it creates a wide gap between DCF and free cash flow, which most retail investors incorrectly assume are synonymous), and it’s worthy of discussion. The KMP CO2 segment's expansion capital is funded primarily via equity and debt financing – but with no volume growth, the return on that incremental invested capital will be zero excluding the impact of price. These capital raises finance the distribution payment, not growth, and KMP’s CO2 segment is running to stand still...though it is a cash cow for the GP!
“We define sustaining capital expenditures as capital expenditures which do not increase the capacity of an asset.” - KMP 10-K, page 73.
That is purposefully cryptic. How is KMP defining “the capacity of an asset?” It clearly has nothing to do with the top line, i.e. volume growth.
KM CO2 is really two businesses – a EOR (enhanced oil recovery) E&P; and CO2 production, transportation, and marketing. The E&P assets generate the majority of the segment's EBITDA.
In 2012 Kinder Morgan was the 5th largest oil producer (gross) in the state of Texas. It’s three oil fields are CO2 floods in the Permian Basin – SACROC, Yates, and Katz/Eastern Shelf. Net to KMP in 2012, production was 39,107 boe/d (90% oil). As of YE12, KMP had 89 MMboe of proved reserves, of which 57 MMboe (64%) were proved developed. The YE12 PV-10 of the E&P assets was $2.7B.
Production and proved developed reserves have been flat-to-down in recent years, with SACROC production flat, Yates in decline, and Katz – where production has disappointed – growing off of a low base to offset some of the aggregate decline. The 2010 – 2012 E&P production CAGR was -3%, and KMP only replaced 92% and 91% of proved developed reserves in 2011 and 2012, respectively. There is no material growth in the E&P segment. KMP has incurred $1,009MM in E&P development costs over the last 3 years, and nearly all of it was considered expansion capital, despite production and reserves declining. Sorry, but, THIS MAKES NO SENSE.
Growth in production from KMP’s natural gas plants (from 4,117 boe/d in 2009 to 5,717 boe/d in 2012, a 12% CAGR) has offset some off the E&P decline, but total oil, NGLs and natural gas production still declined at a -2% CAGR over the last three years. And KMP’s CO2 production has remained flat around 1.2 – 1.3 Bcf/d.
If we want to think of sustaining capital for the E&P assets as the capital required to keep production and reserves flat (the definition most E&P MLPs use and abuse), let’s try and figure out what that might actually cost KMP today. Annual production over the last two years has come in ~14 MMboe. If KMP replaced 100% of those proved developed producing reserves with the drill bit, what would it cost? We think that the best way to do this is to look at KMP’s PUD conversion cost, because that is really the heart of KMP’s EOR operation. How much does it cost KMP to move a PUD barrel into the proved developed category?
Here are the relevant disclosures from the 2010, 2011, and 2012 10-K’s:
“During 2010...we incurred $248.0 million in capital costs which resulted in the development of 10.0 million barrels of crude oil and 1.3 million barrels of natural gas liquids and their transfer from the proved undeveloped category to the proved developed category.”
“For 2011, we incurred $372.8 million in capital costs, and in prior years, we incurred $43.6 million in capital costs related to the Katz field unit. Combined, these capital investments resulted in the development of 7.3 million barrels of crude oil and 0.9 million barrels of natural gas liquids and their transfer from the proved undeveloped category to the proved developed category. We also developed 3.0 million barrels of crude oil and 0.0 million barrels of natural gas liquids reserves with the development of the Katz (Strawn) unit CO2 flood where the produced gas containing natural gas liquids is injected with the CO2.”
“For 2012, we incurred $353 million in capital costs, and this capital investment resulted in the development of 6.0 million barrels of crude oil and 1.8 million barrels of natural gas liquids and their transfer from the proved undeveloped category to the proved developed category.”
• For scope, Denbury Resources' (DNR) PUD Conversion cost in 2012 was $21.60/boe, and it is a higher cost EOR player. KMP's 2012 PUD conversion cost of $45/boe is very poor.
• The trend in capital efficiency is negative, likely due to activations on the fringes of SACROC and Yates, and disappointing results/cost overruns at Katz.
• The 2010 PUD conversion costs are low because of a large positive performance revision at Yates; the 2011 and 2012 combined PUD conversion costs were $45.38/boe and $33.15/boe excluding and including PD performance revisions, respectively.
• $33.15/boe x 14MM boe = $464MM of annual capital required to keep the proved developed reserve base flat.
The non-E&P CO2 segment assets (CO2 production, transportation, and marketing) will have organic growth going forward, as KMP plans to ramp production from ~1.2 Bcf/d currently to 1.7 Bcf/d by 2017. That is the main driver of the 2013 capex increase (+$200MM total before the recent acquisition). But still, this segment should have some sustaining capex allocated to it. DD&A on these assets are ~$50MM/year, in line with the non-E&P capital expenditures in 2010 and 2011, which resulted in no production growth. Thus, ~$50MM/year is, in our view, a fair number for sustaining capex for the CO2-only assets.
Putting the two pieces together, we argue that sustaining capex on the entire segment should be between $400MM - $500MM per year (and growing), versus the 2013 guidance of $17MM. Of course, that’s never going to happen unless a regulator makes it happen, as it would shave off more than a $1.00/unit of annual KMP DCF.
In 1H13, KMP’s CO2 segment generated $691MM of earnings before DD&A and certain items; if we annualize that and allocate the segment $80MM of annual corporate G&A, then it will do ~1.3B of EBITDA in 2013, or 26% of the consensus EBITDA estimate for all of KMP before the GP’s take, $5.0B. But most of that EBITDA is flowing directly to the DCF line because no material sustaining capex is deducted. So with KMP in the 50/50 IDR split, the GP takes ~46% of the total distributions, and, by our estimates, the CO2 segment alone will generate ~$700MM of DCF net to KMP in 2013 (~1/3 of total DCF). With KMP yielding 6.45% 2013e DCF, the market is valuing this asset net to KMP at ~$11B.
Compare this to the YE12 PV-10 of the E&P assets of $2.7B, and the book value of the entire CO2 segment as of 6/30/13 of $2.8B (we estimate that this is $1.4B E&P and $1.4B non-E&P). And, recall, the GP’s take is over 46% of the distributions, so the value net to KMP is roughly half of those figures. If KMP were to sell the segment and distribute the proceeds, we have a hard time believing that it would amount to more than $3 - 4B after the GP's take.
The point is that the CO2 segment inside KMP is massively overvalued, largely due to understated sustaining capex and the failure of the market to recognize that it's a depleting asset (and valuing it with a yield target). But is it a moot point? Well, it has been for years, and Kinder Morgan will never sell or spin the segment. But, if you own KMI/KMP, you should at least know about this; and if your content to just 'play the game,' so be it.
On the recent E&P acquisition...
"In June , KMP acquired the Goldsmith Landreth San Andres Unit in West Texas from Legado Resources for approximately $285 million. Goldsmith includes more the 6,000 acres in Ector County and is in the early stages of a CO2 flood development. The unit currently produces approximately 1,250 bpd of oil and is projected to peak at approximately 10,000 bpd in about 10 years. Also of importance, as part of the transaction KMP obtained a long-term CO2 supply contract with volumes growing to 150 MMcf/d over the next few years." - KMP 2Q13 Press Release
This acquisition is not surprising to us, even the big multiple of $228,000/boe/d. After all, the purchase price and all future capital expenditures are excluded from DCF, financed at the KMP level, and KMI will take ~50% of all future cash flows. A no-brainer for the GP. Really, as long as the market lets KMI/KMP get away with it, KMI supporters should push for as many CO2 segment acquisitions as possible.
There must be a great deal of cognitive dissonance that comes with owning (or shorting!) KMI/KMP...
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