We often write about companies involved in drilling for shale gas in the U.S. Their drilling success has depressed natural gas prices with little near term prospect of a bounce, and consequently we’ve focused on companies with low debt and cheap operating costs. Range Resources (RRC) Southwestern Energy (SWN), Devon Energy (DVN) and Comstock Resources (CRK) are all holdings of ours in this sector.

In the years ahead it seems clear that the growing use of natural gas will require significant investment in infrastructure to transport, refine and distribute what the E&P names above and others extract from the ground. Master Limited Partnerships (MLPs) offer an interesting opportunity to invest in this growth. A great deal of the midstream energy infrastructure currently employed is owned through MLPs. Since they are structured as pass-through entities they are not subject to corporate income tax. The public unitholders are partners owning a proportional share of the assets, and therefore receive K-1s rather than 1099s. This additional tax reporting complexity dissuades many investors from owning MLPs, but their cheaper cost of capital (since they don’t pay corporate income tax) and the tax-deferred nature of most of their distributions make them compelling for most U.S. taxable high net worth investors.

Building the additional infrastructure to process growing volumes of natural gas will over the next ten years result in a bigger MLP industry. JPMorgan recently forecast (using estimates from the  Interstate Natural Gas Association of America, INGAA) that today’s $250BN market cap MLP sector will require an additional $130BN in new capital to fund new natural gas and oil transmission lines, gathering lines and storage facilities.

Plains All American (PAA) is one of the larger MLPs with a market valuation of $12BN and a well regarded management team. In their 2011 10K PAA outlines the growth they expect to see in U.S. oil business and their position as a major owner of energy infrastructure places them in a good spot for natural gas as well. Cheap ethane, often used as a feedstock in the petrochemical industry, is expected to continue attracting investment in the U.S. Some analysts expect Natural Gas Liquids (NGL) supply (including ethane) to increase by as much as 40% by 2016. PAA’s ownership of assets is significant, including storage capacity for 71 million barrels of crude oil and refined products (equivalent to almost 4 days total U.S. demand for crude oil), 9 million barrels of NGL/LPG storage capacity and 90BCF (Billion Cubic Feet) of natural gas storage working capacity and base capacity (around two days’ total U.S. consumption).

The companies that will be able to raise the capital to build additional energy infrastructure will be the ones that have shown they’re capable of managing existing assets efficiently. PAA is likely to be one of those. Sell-side coverage of MLPs is increasing as banks anticipate the fees they can earn from helping raise capital. As an investor, owning shares (or LP units in the case of MLPs) in a company doing a secondary isn’t as exciting as it is for the underwriter, and prices often fall somewhat when the announcement is made. However, MLPs’ capex plans are subject to the discipline of the market, in that new money raised must be deployed at an IRR above the marginal cost of capital. Since MLPs can’t retain much of their earnings they have to make their case to investors every time they wish to finance a new project, and as such the better-run firms invest new money in ways that are ultimately accretive to unitholders.

MLPs have been strong performers of late, but PAA still offers a distribution yield of 5.2% and is expected to grow its Distributable Cash Flow at over 7% this year. PAA is a holding in our MLP Strategy.

Last week Ford (F)  announced plans to shift their pension fund even more heavily towards bonds. At a time when interest rates are ruinously low and equities should appear attractively priced to a long-term investor such as a pension fund this represents quite a radical move. As recently as 2006 the company had targeted an equity allocation of 70%. Generally pension obligations are long-lived and one would expect pension funds to be more tolerant of equity market volatility in their quest for higher long-term returns. However, Ford’s stance probably reflects an acknowledgment of the inherent cyclicality in their own business; if they had a higher equity allocation in their pension fund, it would likely be most under-funded during a weak equity market which would coincide with a tough automobile market, perhaps stretching Ford’s  ability to inject additional cash to meet a projected shortfall. It’s part of a plan to reduce the risk of their overall balance sheet. Nonetheless, the reaching the 7.5% return target (reduced from 8%) on their pension assets appears challenging with 80% of their assets in fixed income, and the company is currently facing a $15.4BN shortfall on such obligations.  Today’s yield curve is a long way short of delivering adequate returns, even with the other 20% of their pension assets invested in “growth assets (primarily alternative investments, which include hedge funds, real estate, private equity, and public equity)”. Naturally I should point out that hedge funds may wind up underperforming even their fixed income allocation if past history is any guide.

But it does illustrate an alternative to the concept of overweighting equites to meet pension obligations. Ford is in effect relying on strong operating results to generate additional cash contributions (which will surely be needed). The decisions they’ve taken are consistent with an analysis showing that their business prospects will generally be tied to those of the overall economy and therefore public equities. So rather than invest directly in diversified equities that will (they assume) correlate with Ford’s own results, they are relying on their own equity-like business prospects to generate needed future cashflows. It’s quite a clever strategy. They reduce their balance sheet risk and the volatility of their pension obligations. The worst scenario is one where Ford’s results are dismal while the economy is doing well, perhaps driving up their ultimate obligations at a time when they’re ill-equipped to contribute more needed cash. But they may have calculated that retiring Ford workers will earn pension tied to their pre-retirement earnings, again mitigating their risk.

Ford’s approach represents an intriguing approach to the pension shortfall common to many S&P500 companies.

Two articles concerning shale gas have caught my attention this morning. “The Death of Coal” reflects the view of some that under current EPA policies coal will continue to lose ground to natural gas as the fuel of choice for electricity generation. Cheap and relatively clean natural gas is eating into the demand for coal and EPA regulations on some of the more harmful pollutants released by burning coal are adding fuel to the fire. Abundant and cheap natural gas has certainly pressured the stock prices of some E&P names recently, but low prices will create their own demand.

Another piece from UBS makes the case that as the U.S. reaches energy independence this will increasingly provide support for the US$. The U.S. has been an importer of crude oil for as long as any of us can remember (currently estimated at $300BN), but that is changing as new domestic discoveries are reducing the need for imports. The revolution in shale gas as well as new discoveries of oil (North Dakota now produces more oil than OPEC member Ecuador). This will eventually reduce the drag on our trade deficit of being an energy importer, and could well be supportive for the US$. Over time it will reduce U.S. reliance on the Middle East, and by reducing global trade imbalances could slow the growth of sovereign wealth funds.

Devon Energy (DVN) is squarely in the middle of this (and incidentally just reported strong earnings this morning). We also continue to like being long US$ versus the Euro. Short the Euro is a nice form of tail risk insurance. While a Greek default is still unlikely, some European finance ministers are reportedly more sanguine at that prospect should Athens fail to sign up to the latest austerity plan. Neither outcome makes the Euro attractive.

Disclosure: Author is Long DVN, EUO

As I’ve watched the ongoing saga in Europe, the discussions of sustainable Debt:GDP and other elements of the “Maastrict Criteria” I’ve often been puzzled at why these figures were so important. The U.S. represents a large single currency union, and although different states have incurred different levels of indebtedness there is no Federal law dictating what those equivalent ratios must be. Most states are required to run balanced budgets, but those laws are passed by the states themselves.

So although many commentators repeat the mantra that too much borrowing by a few profligate countries is endangering the entire Euro-zone, and this sounds as if it makes sense, I’ve never fully comprehended the precise linkage. Why shouldn’t countries in a common currency (or even cities for that matter) be allowed to borrow whatever they wish at prevailing market rates? Municipalities do go bankrupt in the U.S. (though far less frequently than Meredith Whitney once forecast). Orange County defaulted in the 1994 because of speculative interest rate bets gone awry, and nobody questioned the viability of the US$.  In 1975 the Federal government was willing to let New York City go bankrupt (although President Ford did not tell NY to “drop dead“, as is popularly believed). But at no time was there any question about the viability of the US$ or the single currency area.

So I’ve been somewhat uncomfortable with the accepted wisdom that a fiscal union is necessary for a currency union to work. Fiscal transfers do take place in the U.S. on a far greater scale than in Europe, but not in response to local deficits but to growth shocks.

Then I came across an academic paper called “Target Loans, Current Account Balances and Capital Flows: The ECB’s Rescue Facility“. It’s quite technical and I can’t claim to fully grasp its many nuances. However, the main insight is in the following example: an Italian buying a BMW car from Germany writes a check in Euros drawn on an Italian bank. This results in a series of transactions from the Italian bank to the Bank of Italy, ECB, Bundesbank, German bank and BMW. The Italian buyer obtains his car. The Bank of Italy has a liability with the ECB, and the Bundesbank has an asset. The key point is that these balances, while they offset at the ECB, never have to be settled. Italy has been running a growing trade deficit (hence the discussion of improving southern European competitiveness) while Germany has been running a surplus (because it is already an exporting powerhouse).

Germany, through its Bundesbank, has an “asset” or claim with the ECB of 450BN Euros (as of September 2011). All the Eurozone members net out, but the imbalances have soared since the 2008 debt crisis. They are called “Target” balances, and according to the paper are obscurely reported by the ECB, only disclosed in footnotes. Germany’s loan to the ECB is guaranteed by the other Eurozone countries, but if one was to leave (say, Greece) they may default on their pro-rata share. In this way, Germany is already on the hook to its Eurozone partners for 450BN Euros (and presumably growing).

These imbalances are caused by the fiscal deficits southern European countries have been running, which is why the Maastricht Treaty imposed a 3% deficit:GDP limit and a 60% debt:GDP limit. The architects of the Eurozone payments system understood this. But the debt owed Germany by the ECB is substantial, not widely reported, and fundamental to the crisis.

In the U.S., a Texan buying a Caterpillar earth mover from a California factory would trigger the analogous payments sequence through his regional Federal Reserve bank. However, the Dallas Fed would have to settle its deficit with the San Francisco Fed within a year by transferring government securities. This critical “true-up” doesn’t exist in the Eurozone.

It’s a complex topic, but I found  Target Loans, Current Account Balances and Capital Flows: The ECB’s Rescue Facility helpful. It helps show why Germany doesn’t necessarily want Greece to leave the Euro, and how its break-up could uncover some substantial debts. So the risk of a Euro disaster is extremely low, since it’s not in anyone’s interests. But the growth outlook is correspondingly extremely poor, which should cause the Euro to depreciate. We continue to own EUO so as to be short the Euro in combination with being long risky assets such as equities (SPY).

We continue to like using a short Euro position in combination with risky assets. In our Fixed Income Strategy we’re invested in senior loans through closed end funds such as BlackRock Defined Opportunity Credit Trust (BHL) and ING Prime Rate (PPR). They’re both at a modest discount to NAV of around 5%, and yield over 6%. Their portfolios of leveraged loans to non-investment grade borrowers will no doubt go down if equities sell off, but holding this position in combination with a short Euro (we’re long EUO) protects against the tail risk associated with Euro sovereign debt problems or Middle East conflict (such as an Israeli attack on Iran). The US has a 3% GDP differential over the Eurozone so over time this should favor the US$ anyway. Short Euro is akin to owning put options on the market – you just need to own something in addition that will generate a return.

There were a couple of interesting articles about energy over the past 24 hours. The WSJ noted that natural gas is eating into demand for coal. Over the past three years natural gas has gone from producing 21.4% of U.S. electricity to 24.4% (coal has dropped from 48.2% to 42.8%). It’s a slow process and don’t expect near month natural gas to trade at $4 anytime soon. But it does illustrate market forces at work. In another article, Bloomberg notes that the U.S. is on its way to achieving energy independence . By way of illustration, they report that Methanex, the world’s biggest producer of methanol, is dismantling a factory in Chile and moving it to Louisiana to take advantage of cheap natural gas. We continue to own Comstock Resources (CRK), which reported earnings yesterday and expects production to be 20% oil by the end of 2012. They have minimal debt, low operating costs and while today’s low natural gas prices don’t help the company does control its own destiny and trades at a healthy discount to book value (even after taking a reserve writedown in 4Q11).

Finally, Bill Gross wrote an interesting piece on the problem with low interest rates in yesterday’s FT. He suggests that QE2 and Operation Twist are keeping long term rates so low that banks don’t see much upside in lending there. This slows down the recapitalization of the banking system that a steeper yield curve would provide. Whether he’s right that this is slowing growth or not, he’s certainly right that long term rates provide little incentive to lend. Long term high grade and government bonds are a safe way to lose purchasing power. An obscure but interesting trade can be found in the eurodollar futures curve. The spread between Sept 2013 and Sept 2014 is 35 or so basis points. The market is pricing for an increase in three month Libor of only 35 bps between 2013 (when a majority of FOMC members expect short term rates to be unchanged) and 2014 (when a majority expects them to be rising). This spread is unlikely to narrow much beyond 25-30 under those circumstances, and an upside surprise in GDP growth (perhaps led by housing?) could cause a substantial steepening in this part of the curve, straddling as it does the point at which the Fed has indicated it will start raising rates. We think it’s an interesting trade, there’s probably no need to rush into it though.

Disclosure: Author is Long PPR, BHL, CRK, EUO

This looks on the surface to be good news across the board. Private payrolls up almost 100K greater than consensus; increased hourly workweek, and a drop in the Unemployment rate in spite of an increase in the labor force. Not a 4% GDP type of number, but good enough to reassure that the 2-2.5% type GDP growth trajectory we’re on is sustainable.

It supports the case for equities over bonds. The Equity Risk Premium is wide but this type of data will cause it to narrow somewhat, as stocks rise and bonds fall. In addition, the utility of holding a short Euro position in combination with long stocks is highlighted. The U.S. economy is likely to grow 3% faster than the Eurozone this year. The $ can draw support just from the relatively better prospects here, as well as providing tail risk insurance against an economic or geopolitical surprise. Leon Panetta probably isn’t using the Washington Post to communicate policy, but the article draws attention to the closing window Israel has to set Iran’s nuclear plans back several years. While the more likely outcome is that EU-led sanctions will be allowed more time to play out, an Israeli attack on Iran is just the type of event that could derail the recovery. The US$ would undoubtedly offer some protection in that type of environment.

We continue to like Microsoft (MSFT) which has quietly broken above $30 following a solid earnings report in January. Corrections Corp (CXW) is also attractively priced – California’s state budget included no cuts in funding for private prisons which has helped the stock price of the largest private prison operator. We’ve added to a couple of natural gas E&P names lately – most notably Comstock Resources (CRK) which has $1.5BN in reserves based on its PV-10 (albeit using early 2011 natural gas prices), net debt of $700MM and is valued at $560BN. They recently announced reduced 2012 capex and expect revenues will be 20% oil by year-end. We expect them to be acquired if valuation doesn’t improve soon.

Discclosure: Author is Long SPY, MSFT, CXW, CRK, EUO

The Euro has been a good hedge on a portfolio of long stock recently. Equities are attractively valued for a long-term investment; the equity risk premium remains high. But who can think about investing in stocks for the long run and shunning bonds when the Euro sovereign debt crisis rolls on. For us, the solution was to short the Euro as a hedge against long equity positions. The correlation between the two rose during 4Q11, not surprisingly since Europe was driving short-term market moves.

But the ECB’s Long Term Repo Operation committed them to support the banks and, by extension the Euro sovereign governments (barring possibly Greece, which is heading down its own path). Since Europe’s banks are the biggest holders of European sovereign debt, the ECB has in effect become a lender of last resort to its governments. The removal of the Sword of Damocles hanging over markets has been replaced with a more plausible path to a lower Euro. Europe is in recession, the GDP differential between it and the U.S. is likely to exceed 3% this year, and the next move in rates from the ECB is likely down. Meanwhile, the U.S. economy continues to produce steady if unspectacular growth.

It’s still worth holding a short Euro with a long equities position. The tail risk, an unforeseen crisis in Europe, still makes it a worthwhile hedge even while the day-to-day relationship has become slightly more subdued. But they could just both be good investments in their own right. Equities are attractively priced and the threat of a European crisis is receding. The Euro area is in for a period of no-growth while banks recapitalize and governments impose austerity. Long equities and short Euro is not the pairs trade it was, but both look like attractive investments.

Disclosure: Author is Long SPY and Short FXE

Those of us who traded Foreign Exchange in the early 90s will have noticed something familiar today. A country is attempting to fend of a speculative attack on its currency by raising interest rates. Hungary, on the edge of the Euro-zone and its current recession, is expecting barely positive GDP growth this year of 0.5% and has policy rates at 7% with expectations that they will have to rise. The risk is that GDP will be lower than expected, and that the central bank will raise rates higher. Inflation is currently running at 4%, but that is not the main problem facing the country.

Hungarian homeowners took out mortgages in Swiss Francs because interest rates there were lower than domestic ones. Unfortunately, the Swiss Franc has appreciated against the Euro beyond all expectations as investors have fled the Euro (a currency and region with whom Hungary’s shares an almost umbilical attachment). So the debt owed by many Hungarians has soared in their own currency, since the Forint has also weakened against the Swiss Franc.

Back in the 90s when European countries were attempting to maintain stable FX rates as they proceeded towards eventual monetary union, occasionally they would raise short-term rates when their currency was weakening. It rarely worked; Hungary could double its short term rates and that would scarcely deter an investor seeking to exit the currency – indeed, it might strengthen his resolve given the risk to domestic growth.

So it’s deja vu all over again (as Yogi Berra memorably said). There doesn’t appear to be a Forint ETF to be short, but being short the Euro works nearly as well.

Disclosure: Author is Short FXE

That the world’s a risky place has not escaped the recent attention of investors. The potential demise of the European single currency and perhaps with it European banks and the European project itself looms large over every investment decision, and has for many months. Economic slowdown in China, the uncertain consequences of the Arab Spring and more recently Iran’s nuclear ambitions all add to the global uncertainty. Within the U.S. a highly partisan Congress has led to legislative gridlock and no certainty about long term fiscal policy. It makes you wonder how investors get out of bed in the morning. And when they do, they are confronted with a choice of risky assets (such as equities) which may lose value immediately, or less risky assets (such as bonds) which will lose real value with certainty. That investors are choosing the certainty of lost purchasing power over the available alternatives reflects the seemingly poor choices on offer. Thus is the equity risk premium, the difference between the earnings yield (inverse of the P/E ratio) on the S&P500 and the ten year U.S. treasury yield, at its widest since 1974, a year that closed with the Dow Jones Industrial Average having dropped 45% from its peak only eighteen months earlier, and inflation at 12.3%.

Start with bonds. Today’s ten year treasury yield of around 2% assures even the tax-exempt hold-to-maturity investor of a loss in purchasing power if inflation over ten years exceeds 2%. The taxable investor of course will fare even worse. Even a portfolio of blue chip corporate bonds yielding around 4% will struggle to overcome the twin headwinds of taxes and inflation. But bonds have a big thing going for them, which is momentum. For those who draw comfort from investing with a tailwind, bonds are a warm and cozy place. The Dow Jones Corporate Bond Index has returned 10% per annum for the past three years including 8.5% in the most recent one.  Who’s to say that this won’t continue? And of course it may, although such forecasts will struggle mightily to overcome the Math; for bonds to return more than their current yield, their yields need to fall causing prices to rise. Corporate bond yields could drop from 4% to 3%, although such would presumably require a similar drop in treasury yields, to 1%. The world in which 1% ten year treasuries draws buyers is unlikely to be a friendly one for corporate credit, and at such a time credit spreads might be substantially wider, depressing the prices of corporate bonds. So, much as bonds investors might draw comfort from looking backwards, their best plausible outcome is that they’ll earn the current yield and suffer a steady depreciation in the real value of their assets.

In fact, relative pricing between stocks and bonds is such that $20 invested in the S&P500 yielding 2% will, assuming 4% dividend growth (and the 50 year average is 5%) generate the same increase in after-tax wealth as $100 in ten year treasuries. This assumes the $80 not invested in stocks earns 0% by sitting in cash, although holding cash provides the option to do something with it that might well earn a return later on. The Math works for corporate bonds as well (just change the $20 in stocks to $40).

So bonds have been good, but past performance is highly unlikely to be repeated. In fact, we believe there’s a strong case to be made for all investors to reduce their asset allocation to fixed income. Government policy is to maintain ruinously low interest rates while debtors rebuild their balance sheets. The Federal government is effecting a transfer of real wealth from investors to borrowers. This policy is likely to continue for quite a long time, not least because it’s popular (with those voters who contemplate such things). There are many more debtors than creditors, and regardless of how independent you think the Federal Reserve is, monetary policy is unambiguously populist, designed for the masses. The appropriate response is to allow the government’s voracious appetite free rein. If Chairman Bernanke likes bonds that much he can have the lot.

As a result, identifying alternatives sources of investment income is a task that consumes much energy on a daily basis at SL Advisors.

The stock market offers a risk to suit every taste. For those who like to wake without first worrying whether their holdings are solvent, many reasonably priced large cap companies with low levels of debt and a history of steady earnings growth are available. Kraft (KFT), Microsoft (MSFT) and Berkshire Hathaway (BRK-A) are all examples in our Deep Value Equity Strategy, along with less well-known names such as Corrections Corp (CXW) and Republic Services Group (RSG). Domestic energy exposure adds volatility and return potential through Devon Energy (DVN) and Comstock Resources (CRK). The former bond investor can allocate his new funds to a combination of stocks and cash (depending on risk appetite), or to other income generating strategies.

There are even examples of stocks whose dividend yield exceeds that on their own bonds – not because their fortunes have suffered and a high dividend yield reflects expectations of a cut, but because price-insensitive bond investors have driven bond yields low in their flight from equities. Johnson and Johnson (JNJ) is one such example. Our Dividend Capture Strategy consists of a diversified portfolio of such names combined with a hedge to eliminate most of the daily market moves. The result is a portfolio exposed to dividend paying stocks and dividend growth that is hedged against excessive moves in stocks.

Master Limited Partnerships (MLPs) are another attractive asset class for taxable investors tolerant of K-1s. I won’t repeat here the well-worn arguments that are familiar to regular readers, except to note that the sector’s unique structure renders it worth having in many income-seeking portfolios. MLPs offer tax-deferred distribution yields of 5-6% combined with growth expectations of 4-6% (suggesting a total return potential of 9-12% with no change in earnings multiples).

Disclosure: Author is Long KFT, MSFT, BRK-B, CXW, RSG, DVN, CRK, JNJ

Euroland euphoria has broken out – so say Ambrose Evans-Pritchard and Louise Armitstead of the Daily Telegraph. Mario Draghi rode to the rescue with Long Term Repo Operations (LTRO), and it’s now reported that Eurozone banks borrowed 489 billion Euros from the ECB for three years. If they are so moved they can engage in the carry trade, buying southern European sovereigns and steadily recapitalizing themselves. The symbiotic relationship between Euro area governments and their banks assures that they can only survive together.

It illustrates the multiple tools available to the ECB and the Eurozone to avoid catastrophe. And betting on a Eurozone collapse is to place your chips on one specific number at the roulette table, with a commensurate low likelihood of success but a big payout. But choosing red pays much better than 2:1, where red is defined as long U.S. equities hedged with a short Euro position. It’s analogous to borrowing money in Euros to buy risky assets. There is already so much excess debt issued by European governments that you can be reasonably assured they’ll do everything they can to stop the cost of funding it going up anytime soon. It’s clearly in their interests to keep borrowing costs low, and the ECB has few measures with which to combat a depreciating Euro. Ultimately the Eurozone needs real GDP growth, and so the current procyclical policies being followed (fiscal austerity during a recession) are likely to make it a long road back to better economic times.

The correlation between the Euro and the S&P500 (SPY) has been increasing in recent months, not surprisingly since Europe’s issues are the major risk visible to investors. But the attraction of combining long equities with short Euros, with a hedge ratio of around 0.4, is that the Euro is unlikely to rally strongly without an equivalent reaction in stocks, whereas a European disaster will see the Euro leading stocks down. The GDP 2.5%+ differential between the U.S. and Eurozone in 2012 provides a steady US$ bias.

MLPs have had another strong year, delivering 12% so handily outpacing high-grade bonds and far better than stocks. We own a diversified portfolio of midstream names including Kinder Morgan (KMP), Plains All America (PAA) and Williams Partners (WPZ). Identifying sources of income is every investor’s challenge given today’s punitively low interest rates. MLPs can be part of the solution.

Disclosure: Author is Long EUO, KMP, PAA, WPZ