Energy is still at or near the bottom of a pretty rough market cycle, and the sector is acting accordingly.
In this week's Energy Industry Focus, Sean O'Reilly, Tyler Crowe, and Taylor Muckerman go over this week's energy news -- how much the deal between OPEC's two heaviest hitters is going to kick up the price of oil, what it means that yet another mining company is showing signs of significant distress, and what Warren Buffett's Kinder Morgan (NYSE:KMI) buyout means for the company going forward.
A full transcript follows the video.
This podcast was recorded on Feb. 18, 2016.
Sean O'Reilly: Buffett dives into energy, on this energy edition of Industry Focus.
Greetings, Fools! Sean O'Reilly here at Fool headquarters in Alexandria, Virginia. It is Thursday, Feb. 18, 2016, and joining me to talk all things energy and materials are the irreplaceable Tyler Crowe and Taylor Muckerman. What is up, guys?
Tyler Crowe: He's only saying that because we weren't here last week.
Taylor Muckerman: Yeah, because they replaced us.
O'Reilly: If you want to think that...
Muckerman: They replaced us!
O'Reilly: I was trying to be nice. We actually had a pretty good time here on the show last week... yeah, you guys can leave. [laughs]
Muckerman: That's fine; see you later.
O'Reilly: I'm kidding, no --
Muckerman: Turning my mic off...
O'Reilly: You're both irreplaceable, because --
Muckerman: I'm turning my mic off right now.
O'Reilly: -- we're actually talking about energy today.
O'Reilly: Did you guys listen to last week's show with Vince?
Muckerman: Not yet.
Crowe: Not yet.
O'Reilly: Yeah, we talked driverless cars. We did more of an industrials kind of thing.
O'Reilly: Anyway. First up, really quick, before we dive in to talking Buffett and stuff, the other day, this seems like a half-hearted thing that they're doing, but everyone was like, OK, OPEC needs to cut production in order to get oil prices up, dadadadada, and I didn't think this was an option, but apparently it is. So Saudi Arabia called up Russia, and they agreed to a production freeze at elevated production levels or something. Can somebody explain that to me? [laughs]
Crowe: Yeah, that's basically it. Saudi Arabia and Russia, the two largest oil producers in the world --
O'Reilly: They're both at just over 10 million barrels or something like that.
Crowe: Yeah, somewhere right around there. They've said they're willing to freeze their current output at their levels in order to help spur along the recovery. However, it's also contingent that everybody else plays along. So they're saying, "Hey, we'll do it as long as Iran and Iraq and everybody else gets on board with it."
O'Reilly: Which seems unlikely to me.
Crowe: Yeah, seems like most of them are saying, "Hey, we love the idea of you guys freezing output!"
O'Reilly: "Why don't you do it?"
Crowe: "But you know what? We still want to bring on more production because we want more money." So it always just seems like kind of a non-starter, at least from a long-term investor's perspective. These are just kind of those things that, when they happen, we have a 5% jump in oil prices immediately following --
Crowe: -- because everybody got excited. "Oh, oil's back, baby!" Well, guess what? Next day, it happens, and it doesn't happen because people want to keep producing.
O'Reilly: Really quick, before we move on, it just seems weird that they were willing to freeze production at current levels. If memory serves, Saudi Arabia is over 10 million barrels per day, like 10.1 or 10.2. And even in summer 2014, before all this happened, they were at like 9.6.
Muckerman: Well, that's the thing. Why care about freezing when you're producing at record levels? Russia produced an all-time high in 2015. So, they're like, "Sure, we'll freeze, because we probably can't produce that much more anyway."
O'Reilly: "We can't go much higher." Like... [laughs]
Muckerman: Right. Their currency is down over 30% just over the year; the government is strapped for cash. So these companies have no backing right now.
O'Reilly: It's kind of absurd.
Muckerman: And they raised debt in 2015 just to stay afloat and keep producing oil. So Russia, I think, instituted this freeze out of... because there's nothing else they can do.
Muckerman: It's like, "Hey, maybe if we say we're going to freeze it, prices will jump, because we're freezing it anyway out of necessity, not out of desire."
O'Reilly: So Iran came out and said they liked this idea, like Tyler was mentioning, but they were basically like, "Yeah, we're not going to freeze production." But don't they kind of have a point? Because they're trying desperately this year to get to 500,000 barrels a day. But before, in 2011 or 2012 or whatever, before all the embargo stuff and those niceties, they were at 3 or 4 million barrels a day or something.
Crowe: Yeah, they're a little ways off from where they used to be.
O'Reilly: Yeah. And that's their goal, and they kind of... I'm not saying I like them or anything, but don't they kind of have a point there?
Crowe: They might, but at the same time, do you really want to ramp up and spend a whole lot of money when oil's at $30 a barrel?
O'Reilly: They need tens of billions of dollars to ramp up production again! I mean, they need a lot of investment. So, cool.
So, moving on to our next story, out of oil and into mining, it looks like the big guns in the mining space are basically feeling the pinch right now. Report just came out yesterday, Anglo American is going to stop all iron ore and coal operations. What else do they do?
Crowe: Well, Anglo, that's not their big thing. Anglo American is more of a diversified miner.
Crowe: They have a lot in platinum and copper, a couple other precious... well, not precious, but more precious than iron ore and coal.
O'Reilly: Right, which is apparently everywhere or something. [laughs]
Crowe: And they're not a huge, huge contributor to the iron ore market, but they are one of the five largest mining companies in the world. And to see them...
O'Reilly: Throw in the towel on two big commodities, yeah.
Crowe: And what was it, just a few months ago, we watched Glencore almost look like they were going to go through the kind of death throes of the debt spiral. So it's really, as we see these bigger and bigger companies starting to get into these debt issues and asset sales and to stop production and a lot of things, it's really telling as to what's going on. I mean, Rio Tinto (NYSE:RIO) just also mentioned that they're cutting their dividend.
O'Reilly: Who were the two --
Muckerman: And they were one of the strongest balance sheets in the business.
Muckerman: So that's a surprise.
Crowe: Yeah, and BHP Billiton (NYSE:BHP), who has the strongest balance sheet in the business, actually had their credit rating downgraded.
Crowe: So when you have the largest companies, the most profitable companies, seeing that, then you really know that we're... somewhere, we have to be close to some sort of market turn on this, right?
O'Reilly: Who's going to buy these assets at this point? You're talking about the biggest players, and Anglo apparently said they're going to shed their coal and iron ore assets. It's like, who's going to buy this? Like, Cleveland-Cliffs [now Cliffs Natural Resources] was even trying to sell stuff, and it's like, you're not getting any takers.
Muckerman: Well, you could look at a BHP or a Rio Tinto. I mean, if they do want to increase production or have access to greater production for when prices do turn, I think buying something is a much better option than trying to build out a mine --
O'Reilly: Your current production, yeah.
Muckerman: -- or start a brand new mine, because it's a lot less risky. Might cost the same up front, but you're not going to have the setbacks that you generally do see when developing or expanding current mines. So I could see M&A being the way that people try to increase production in this market. You already see dividends being cut across the board. Not necessarily evaporating, but a lot of people are cutting them in half, trimming them. Anglo did cut their dividend completely for the second half of 2015, I think this year, too. So.
O'Reilly: So, Tyler, you said, given that the biggest players are facing some desperation at this point... you're talking about, hopefully, a market turn, are we at the bottom, if it's this bad... do any of these names look good to you guys?
Crowe: The one I own personally, BHP Billiton, as a miner --
O'Reilly: And you said they're very strong.
Crowe: Best balance sheet in the business, and that's why I've been attracted to them. At the same time, I'm still not huge on the buying opportunity right now. You can, as somebody, maybe, just be buying in intervals. I'm not adding a little bit extra like, "Yeah, this is looking pretty good right now." I'm still just kind of adding slowly, just at the current pace I've been at right now. Not really changing my outlook or thesis on anything.
Muckerman: If you look at prices, I've got this from Canaccord Genuity, they've got the last 12 months for copper, down 21%. Lead down only 2%. Gold down 2.5%. Iron ore down 26%. Coke and coal down 27%. Nickel down 43%. But then, if you go back six months, three months, one month, one week, you start to see a noticeable increase -- one-week changes, most of the commodities are positive. One-month changes, double digits for zinc, gold, iron ore, lead. So maybe things are starting to bottom out, price-wise --
O'Reilly: Couldn't get much worse, right? [laughs]
Muckerman: -- but I think companies are still going to have a tough time, because these increases in price are off such a low base that they're still not really making a bunch of money.
Crowe: And it kind of adds to the appeal of a Rio, or a BHP, who are diversified miners, who have assets across several mining spaces --
O'Reilly: They mine palladium, or... yeah.
Crowe: -- versus, like, a Vale or somebody like that, who's much more of a pure iron ore and coke and coal kind of player. If you're spread out among some of these ones that we're starting to see a little recovery in, eh, you get a little bit of help.
O'Reilly: Got it. Cool. All right, well, before we move on to talking Buffett, I wanted to point our listeners to focus.fool.com, where you can take advantage of a discount on the Motley Fool's Stock Advisor newsletter that works out to $129 for a full two-year subscription. Once again, that is focus.fool.com.
And the big story of the week. Kind of. Sort of. I don't know. Warren Buffett steps up and buys Kinder Morgan. He bought, what, 26.5 million shares or something?
Crowe: Yeah, somewhere just shy of a $400 million stake.
O'Reilly: So, not big for him, but...
Crowe: No, no.
O'Reilly: It's nice to see.
Crowe: Yeah. Any time a company gets the stamp of approval from Warren Buffett, it's normally a pretty good sign. When you're looking at a $300-$400 million acquisition, it probably means that it might not have been Buffett himself; it may have been one of his --
O'Reilly: This has a Todd Combs feel to it, because it's only $400 million.
Crowe: Exactly. So it may not actually be Buffett himself, but certainly within the --
O'Reilly: What's the name of that other lieutenant he has? Todd Combs and... ugh, anyway.
Crowe: Not ringing a bell right now. But, if you look at Kinder Morgan, you go from a company that, a few months ago, everyone was questioning, "Is this dividend sustainable?"
O'Reilly: Then it got cut, yeah.
Crowe: "They're going to run into some credit ratings," then they immediately cut, and now, I've got to assume that it wasn't just back in December, when it happened, Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) and the people there said, "Oh! Time to really start looking at these guys!" Then they pull the trigger on it within months. Actually, if you think about it, the purchase that they made on the 13F would have come in the fourth quarter. So this was actually probably happening then. But I've got to imagine that the months and quarters and maybe even a year or so before that, this was something that was on the radar. I can't imagine that they made such a quick decision on that without really looking at the business long term.
O'Reilly: Got it. And actually --
Muckerman: Ted Weschler.
O'Reilly: There you go!
Muckerman: Todd Combs and Ted Weschler.
O'Reilly: There. And actually, I think Ted, he lives here in Virginia, in Charlottesville.
Muckerman: Yeah, I think you're right.
O'Reilly: Anyway. So, as an addendum, we have that loyal listener that wrote in a couple of times before, Leland Paine down there in Texas, he actually wrote in about this. He said, "Sean, today we learned that Berkshire Hathaway acquired millions of KMI shares, and the stock price closed up 11%," although the jump in oil probably helped, too. He had a couple of questions -- first up was, "Did Buffett get a special look at the books?" What do you think about that, Taylor?
Muckerman: Um, I don't know what other... maybe, just a more microscopic look. But I mean, everyone gets access to balance sheets --
O'Reilly: From what I know about Buffett, he just reads annual reports; he doesn't do anything special.
Muckerman: Yeah. If he does, he keeps that to himself. But I wouldn't imagine that... a company like Kinder Morgan, like, whatever.
O'Reilly: Yeah. I have to imagine he's hung out with Richard Kinder or something, though. Like, he knows all these guys.
Muckerman: If they didn't disclose as much as they do disclose, like...
Muckerman: If there was a company, a small cap, that only released the bare bones of their financial statements, maybe he gets in there and chats with the CFO. But I think everything there is to know about Kinder Morgan is out there; it's just whether or not you can understand it.
Crowe: So when we were down in Houston, actually, and I got to sit down with Clay Williams over at National Oilwell Varco, he was actually talking about the process of Buffett and Berkshire Hathaway buying a company --
Crowe: -- with us. Like, some of the things that they did looking at it as an investment.
O'Reilly: Because they sell him pipelines, or, what did they do?
Crowe: No, it was --
O'Reilly: Just in general, yeah.
Crowe: Because Berkshire did have a stake in National Oilwell Varco a while ago, and he said it was really surprising, because, typically, when an analyst or researcher is coming in, they're asking a whole bunch of these microscopic sort of questions on, like, margin compression or expansion and very short-term things. And when Berkshire came in, there wasn't that huge focus of looking at the books. It was questions like, "Who are your big customers? Who are your big suppliers? What kind of relationship do you have with them?" And then, they would go from there, and actually go speak with the customers and the suppliers. The idea was not just looking at the company itself, but then looking at all of the people that affected --
O'Reilly: He was assessing how durable their business is.
Crowe: Right. So, I've got to imagine that when he was taking that special look, it wasn't necessarily at the books themselves, but probably more likely looking at the space like, some of the major --
O'Reilly: That is a really good insight.
Crowe: -- suppliers and customers that Kinder Morgan serves, and trying to get a gauge of how they may have some pricing strength, contract strength, things like that, rather than the, "Are you able to expand your margin 0.5% next quarter?"
O'Reilly: Right. So Leland was also curious, Kinder obviously got overextended and then they cut the dividend in order to focus on expanding and everything. So, he just asked, "Has the balance sheet been substantially deleveraged at this point?" I have to think the answer is no, it's a little early, right?
Crowe: No, it hasn't.
O'Reilly: Yeah. [laughs]
Crowe: I mean, when you have leverage on your balance sheet, it is... there's a couple ways you can think about it, but I think the most common way is net debt to EBITDA. And a couple months ago is when we started to see them focus on deleveraging the balance sheet. And really the only way you can do that is cut debt or increase EBITDA.
O'Reilly: There's no way that's happened in two months.
Crowe: In the market, you're certainly not seeing an increase in EBITDA from bringing on any new projects or anything like that. And they don't have that huge cash pile to pay down debt. So if neither of those things have really moved yet, then they're not really deleveraging. However, if you look at the way they've made their dividend policy, they're on the path to do it.
O'Reilly: Got it. So, this gets a little bit more into, maybe, for our listeners who maybe don't know a ton about Kinder Morgan... His next question is, "Are all their contracts to transport oil and gas rock-solid, so they'll meet or beat their 2016 revenue and cash flow numbers?"
Muckerman: I don't have the --
O'Reilly: So, what does Kinder do, and then what do you think about his question?
Muckerman: Well, I don't have the breakdown, but I would imagine that over 50% of their pipelines are filled with oil from some of the integrateds. I know, like, Enbridge is about two-thirds supplied by integrated. When you're dealing with the amount of pipeline you're dealing with with Kinder Morgan, I mean...
O'Reilly: It's hard not to do, with ExxonMobil. [laughs]
Muckerman: Yeah. My guess would have to be that Exxon, Chevron, all these guys, are filling the pipes for the most part. So you're looking at a pretty safe customer base. Like I said, I don't have that mix, I don't --
O'Reilly: Well, you don't get as big as Kinder Morgan by just dealing with the small players.
Muckerman: Right, exactly. I think, you know, EOG might be one of the smallest companies that they work with --
Muckerman: -- because, other than that, who's going to move the needle for the kind of capacity that they're looking for? Then they have oil and gas production, assets, not ultra-meaningful in comparison. And then you have the fleet of ships that they bought last year, or 2014, where they have oil transportation ships. So they have smaller bits and pieces, but the bulk is the oil and natural gas transportation and terminaling, and you have to deal with integrateds to be as big as Kinder is.
Crowe: And, I think, maybe just the one weak spot where it might not have that rock-solid coverage is, like you said, in the production side. In that, they've got their CO2, carbon dioxide business, where they're supplying carbon dioxide to producers who are looking to use that for enhanced oil production, and as we've seen, over the past year or so, that has been the declining spot of earnings and where the contracts aren't as robust. And so, yeah, if you're looking from a very, very large component of it, like 85%-90% of it is very strong. That little bit, that 10%, can be kind of a game changer. Certainly, a while ago, when they were paying out so much in terms of dividends, when you have a little bit of weakness, all of a sudden, the dividend payment looks unsustainable. But now that they've got that much more wiggle room, it's not as bad.
O'Reilly: Right. So nobody at this table, to my knowledge, is a billionaire investor. So sometimes, what those guys buy is a little bit different than what we can buy. But Leland is curious, and I'm sure we're all curious -- is the stock a buy for the rest of us mere mortals? [laughs]
Muckerman: I know it's been recommended in the last couple months by a lot of services here at the Fool.
O'Reilly: Yeah, a lot of people here at the Fool like it.
Muckerman: So I would say, for the average investor, it could be a buying opportunity. Yeah, you look at the price increases over the last week or so, and you might get scared thinking you missed it, but then you look at where it used to be --
O'Reilly: It's so low still.
Muckerman: And it's like, wow, there's still 50%-60% upside to where we have to get to.
O'Reilly: Cool. Tyler, you've been liking them, too, haven't you?
Crowe: I'm more attracted to them now than I was a while ago. I'm still --
O'Reilly: You liked the dividend cut, didn't you?
Crowe: I did. I think it puts them in a better place. But at the same time, I'm still actually a bigger fan, if I'm going to go out and buy a major pipeline company, I'm going to go buy Enterprise Products Partners (NYSE:EPD) right now.
O'Reilly: You and Enterprise, man. [laughs]
Crowe: They were in a position where they captured themselves, maintained during the high times.
O'Reilly: They were not aggressive.
Crowe: Not as aggressive, and now they're reaping the benefits of that. And if you look at the dividend difference, Enterprise is trading at well over 7% dividend yield right now --
O'Reilly: For something that's rock solid.
Crowe: Still getting rock-solid coverage on that dividend payment. And 5% quarterly increases, almost like clockwork. They've been doing it for 19 years now.
O'Reilly: Awesome. All right. Well, that is it for us. If you are a loyal listener and have questions or comments, we would love to hear from you. Just email us --
Crowe: Be like Leland!
O'Reilly: Yeah, be like Leland!
Crowe: Submit questions!
O'Reilly: Email us at IndustryFocus@Fool.com. And thank you, Leland, once again! As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against those stocks, so don't buy or sell anything based solely on what you hear on this program. For Tyler Crowe and Taylor Muckerman, I am Sean O'Reilly. Thanks for listening, and Fool on!