Getting Back to the Basics of Oil and Gas

The Chinese yuan has been devalued, and that could lead to higher profits for the commodities markets in the manufacturing sector.

While some investors might view this as a time to scurry and relocate shares, our top analysts give their outlook on the effects that this devaluation might have on the market. They also help break down what stocks to buy as a new investor and answer a listener question about dividend despair on today's Industry Focus.

A full transcript follows the video.

Michael Douglass: China's falling currency and what it means for this sector; this is Industry Focus.

Hi, Fools. Michael Douglass here today for this Thursday energy edition of Industry Focus. I'm here with longtime Fool contributor Tyler Crowe. Tyler, how are you doing?

Tyler Crowe: Doing pretty good, man. Good to see you actually in here with energy. Sean's been doing it for a long time. He's out on vacation, but we'll bring in someone else.

Douglass: You have to pull in the B-string from time to time.

Crowe: Sometimes you've got to bring somebody up from AAA -- you've got to develop a pipeline a little bit. What happens if Sean goes down on the DL? We've got to bring somebody up.

Douglass: You're very kind. Let's hop right in. Commodities markets seem to care a great deal about... First off, let me say: China currency moves have been a big story in the stock market this week.

Crowe: You can't go anywhere. You go to Yahoo! Finance, you go to Bloomberg; everybody wants to talk about China's devaluing currency. It's a big deal.

Douglass: Apparently. Certainly in the commodities markets as well. Why do the commodities markets care so much about China's currency?

Crowe: Obviously, people think of China right now as the manufacturer of the world. They import a lot of material, they export a lot of refined, finished goods, and one of the biggest reasons that people see... Currency exchange movements in general -- we'll start there, then we'll move specifically to China.

What has happened is the Chinese central bank has made a couple moves to deflate its currency in relation to the global market, but most specifically what we're concerned about here is the U.S. dollar. For many years, the Chinese yuan was actually pegged to the U.S. dollar, but a couple of years ago, they let it free-float in the market.

What they're doing now is saying that because the U.S. dollar is so strong, we're going to devalue our currency a bit more to be more competitive on the global market in reference to Europe and a lot of its other markets it sells to. They don't just sell to us. When you look at that, when a country like China decides to devalue its currency, it's basically trying to make the products that it exports to the world less expensive.

On the flip side, when you look at something like commodities, it makes everything they import more expensive. If you're looking at oil, natural gas, coal, anything that it needs to import.

Douglass: On that note, China imports a lot of all this.

Crowe: China imports a lot. For every mining raw material in the world -- lead, copper, iron ore, nickel, aluminum -- they import or consume more than 40%. It's somewhere between 40% and 50% for every single commodity on the planet. That is a lot.

Douglass: Yikes.

Crowe: What happens is when that currency devalues, all these commodities I mentioned are priced in U.S. dollars. It's more expensive for them to buy them when they are imported. If you think in common supply and demand [terms], the more expensive commodities means lower demand, which is going to hit the bottom line for commodities companies' long term.

When you look at that in that sense, it's this idea that if China devalues its currency, it's going to lower the overall demand for commodities, more so than other sectors. Healthcare or retail aren't going to be as affected as something like a commodities market.

Douglass: That makes sense. We all know there are plenty of investors that think about forex and that sort of thing -- a lot of them are day traders; really not the Foolish way. How should a long-term investor think about this devaluation and what it means for the commodities market?

Crowe: They could stick their hands over their ears and go, "La, la, la, la, la." In many ways, for a long-term perspective, it doesn't have a lot of things. We need to really keep this in perspective here. It's devalued its currency 3% the past couple of days. That's not a huge move in the grand scheme of things, and if you look over the past four or five years, the Chinese yuan has actually strengthened in relation to the dollar over that long-term trend.

This 3% over the longer term is well within the margin of error. From a long-term perspective, it's not that big of a deal in that sense. Anyone who is looking at their portfolio today based on this and is making any move based on the Chinese yuan... it's probably not a great move. If you're looking long term at commodities, we're still going to have demand.

Not just in China, mind you. There are markets that are growing much faster than China. Not only from a GDP base but a population base. These other countries are going to be major centers of demand in coming years.

I think it's 40 of the top 50 fastest-growing GDPs in the world right now are in Africa, Middle East, and Central Asia. These areas are going to require the resources, and it's going to reduce that total consumption percentage of China and it's going to broaden that scope and make demand for commodities a huge thing for the next 25 to 30 years.

Douglass: The takeaway here is probably: Keep calm and carry on. Turning from that, let's step over into beginning energy investing.

Crowe: Listen, this is actually a segment we came up with especially for Michael Douglass.

Douglass: Those of you who listen to all the shows -- by the way, if you don't listen to every day of Industry Focus, you totally should because they're all awesome. Know that I pop into financials and I pop into healthcare. I don't really pop into energy very often. This is a nice chance for someone like me who's not a specialist in energy to learn a bit about energy, and hopefully you all can, too.

Thinking about approaching energy from another sector. A lot of people are retail investors, and they're investing in consumer goods and tech companies.

Crowe: Stuff they know.

Douglass: Right, obeying the Lynch Principle. What are some metrics and measures that you can take from some of these other sectors and apply to energy?

Crowe: One of the things you have to do first is change the mind frame of your investing. A lot of investing in terms of retail or consumer goods and things like that is very much based on brand. You're buying a certain brand of toothpaste and brand brings pricing power and can command margins.

When we're talking about energy -- especially oil and gas -- it's a commodity. You're not going to an ExxonMobil gas station and spending more than the mom-and-pop station that's across the street. You're not going to look and go, "Oh, because it's ExxonMobil gas station, I need to get that one." There's no premium there, whatsoever.

One of the things you have to think about is the competitive advantages in sectors such as energy can be different.

Douglass: You're looking for low-cost producers, for example.

Crowe: Yeah. Who are the low-cost producers? Are there any geographic advantages that a company has? For example, a company that is producing oil in Texas today is going to get a higher price per barrel for their oil than somebody that's producing in North Dakota because the transportation costs to get it to a refinery are greater.

There are things like that. There are geographic advantages you want to think about, you want to think about production costs, and those are some of the elements you have to think about rather than getting the highest price. It's more of "How can I reduce my costs?" That's the mentality you have to bring to it, much more so than retail or consumer goods.

Douglass: How does scale play into that? Certainly, in other sectors, you can get that G&A leverage, spreading out your initial costs over more units of revenue, especially in pharma and insurance; that happens a lot. How does that play in here?

Crowe: If you look across the industry, scale is an absolutely huge thing. One of the biggest reasons scale is so big is in some ways due to cost, but more importantly for the energy sector is access to capital. Cheap capital, more importantly. If we start down at those mom-and-pop shale producers that we have in the United States today, these go, go, go ones that will go out and produce really quickly and two or three years ago when oil was $100 per barrel, that looked like a great idea.

We can get debt financing at junk bond rates, but for some reason they're still at 6% or 7%, which is pretty low cost to capital and they can go out and grow. When you have a cyclical commodity like oil dropping as far as it has all of a sudden, their access to the financial markets is much more constrained.

Compare that with an ExxonMobil, or a Chevron, or someone like that who have investment-grade ratings that are better than the United States Treasury.

Douglass: Kind of hard to argue with.

Crowe: Yeah. So you're getting better than Treasury rates on your debt and you have this much easier access to capital, which allows you to fund these major development projects over the long term. Having that ability, that scale, really helps. At the same time, energy has this value chain. You start with the production, you move through the transportation, the refining, the actual retail of it, and having assets in all of those can really help because it helps balance out that commodities' swing.

Low prices mean better refining margins. High prices mean better cost on production.

Douglass: Makes sense. We are an investing show. In your mind, in your opinion, what's a fantastic stock for a newbie energy investor today?

Crowe: Some of the things that people can get very nervous about in energy investing is the fact that it's extremely volatile. If you want to dip your toes in and look for something a little less volatile, one thing I would recommend is looking at midstream pipeline companies. They're very stable businesses, they have a model similar to a tollbooth, have a geographic advantage of "we're the only pipeline in an area," and a couple companies that are really high on my list in that regard are Enterprise Product Partners (EPD 1.41%) and Magellan Midstream Partners (MMP).

These two companies are very stable businesses, they have long-term, cash-generating abilities that allow them to pay a good, strong dividend, and you're not going to see the volatile price swings that you see with something like an oil and gas producer.

Douglass: OK. Makes sense. Actually, this transitions very nicely into a reader question we got. By the way, folks, we love to get questions.

Crowe: From all five of our listeners.

Douglass: Well, we have a few more than that -- 10 or 11 once you include my mother. We just love getting questions. Shoot them at us: [email protected]. Again, that's [email protected]. We don't get to air every question on the show, but we certainly read them all and we love getting them. Please let us know. We're here to help the world invest better. That's a learning process we can all do together, so please send along questions.

We got a note from Aaron, and Aaron had some very nice things to say. Thank you, Aaron. It's a two part question, which boils down to two points. I'm just going to summarize it because we're a little pressed for time. It's essentially: Can you comment on how to use tax-loss harvesting as part of your overall investment strategy in light of the recent stock price declines in oil and energy companies?

The second part is: I'm not sure whether ConocoPhillips (COP 1.23%) can sustain its dividend.

Let me talk about the tax-loss harvesting side a bit, and then we'll go to ConocoPhillips. Aaron, when it comes to that, we can't give individual investment advice. Certainly, tax-loss harvesting is something people will do, but we can't tell you whether it's a good idea or not in this situation.

Crowe: We're also not the best at it. I look at it and go, "I'm better at analyzing a company or looking at something." The individual portfolio? I'm still working on that.

Douglass: What I would highly recommend is talking to a tax professional or someone who could really help you through the plusses and minuses of that. Then there are also lots of free resources about that, including on Fool.com. Feel free to follow up with us, and good luck on that part.

Let's talk about ConocoPhillips' dividend real quick.

Crowe: He was asking about the tax losses because he's a shareholder in ConocoPhillips and was thinking, "Do I want to hang on to this or take a little bit of a loss and move on to someone like ExxonMobil or Kinder Morgan who has a little more of a stable outlook right now?" The question is: Is the dividend sustainable?

I guess you could look at it as, there are a couple things working in its favor and a couple things that are working against it. In its favor, it has one of the lowest-cost supplies for an independent oil and gas producer. Its breakeven point for U.S. unconventional shale drilling is between $45 and $50 per barrel, which is very low and quite promising.

A lot of its big capital requirement spending is actually starting to come off the books. They have two major projects that are coming online this year, which means it's going to reduce its capital spending by about $2.5 billion, at least between this year and next, which is going to help on that end. It's expected to be budget neutral, which means it can cover its operational capital expenditures and its dividend with cash generated within the company by 2017.

It hasn't cut its dividend in 25 years. That's a pretty good thing.

Douglass: It's a little tough to argue with that.

Crowe: Companies take that very seriously. There doesn't appear to be any balance sheet weaknesses right now. It has some flexibility to take on a little more debt to bridge the gap. There aren't a lot of issues there.

The things working there are, as an exploration production company solely -- without all those refining, or transportation businesses -- it's completely tethered to oil and gas prices. There is going to be that volatility that we were just talking about. If oil and gas prices were to remain very low for a long time it could definitely happen.

The other thing that's working against it, some of its major capital projects that it's just brought online like oil sands up in Canada and some of its liquefied natural gas projects; they aren't going to generate as high returns as they had expected. They're going to be in the range of 15% internal rate of return.

Summing all that up, I don't see any real issues with ConocoPhillips' dividend not being sustainable within the next two or three years. Cash is a little tight, but it's manageable until those major capital spending projects start to wind down. Even with oil in that $50 to $60 range, ConocoPhillips won't suffer immensely. There are a lot of companies that will and will probably get knocked out because of it. Eventually, that leads to higher price because of less production.

Aaron, I'm not completely worried about the ConocoPhillips dividend. If you are worried about hanging on to those shares for the long term for that reason, I don't see it as a huge issue today.

Douglass: Sounds good. Tyler, as always, thanks for your two cents and for having me on as a guest host for the show.

Crowe: We'll bring you in every once in a while. We've got to keep you fresh. Keep that extra reserve in place.

Douglass: The B-string has to get practice from time to time.

Crowe: Exactly.

Douglass: You're very kind. Folks, thanks much for listening to today's Industry Focus; stay tuned for tomorrow's. I'm certainly very excited for it. Check back to Fool.com for all of your investing needs and Fool on!

As always, people in this show, and, of course, The Motley Fool may own shares of companies that we discuss in this show, and The Motley Fool may have recommendations for or against stocks that are mentioned in this show. So, as always, please do not buy or sell or do anything with a stock based just on what you hear. Always do your own due diligence and do your own research. It's the Foolish way, it's the right way to invest, and it is the right thing to do.

Thanks!