It’s always interesting digging into the details of what’s happening with oil and gas production. Often there’s useful information provided by the companies themselves. Baker Hughes (BHI) for example publishes a global rig count every month. It covers most oil producing regions, and shows that the global rig count (counting those in use) has barely changed from the Summer. The average for 2014 was 3,578 and December’s figure was 3,570. So far, on a global level, rig use is not down much, although in their earnings call this morning  BHI did warn that operating conditions would be challenging this year because of the drop in oil. Incidental, the U.S. and Canada represent a big chunk of the global. Together, they closed the year at 2,257 rigs so 63% of the global total and slightly above the 2014 average but down 4% from November.

What did jump out at us though was the increase in use in some Middle Eastern countries. Saudi Arabia has been increasing all year, from 89 in January 2014 to 115 in December. The UAE similarly went from 28 to 36. So far, these countries don’t look as if they’re cutting back, as indeed the Saudis regularly remind us.

Another small but interesting nugget came from the Halliburton (HAL) call. They noted that the volume of sand used in fracking was +46% in 4Q14 compared with a year ago. This is consistent with comments from U.S. Silica (SLCA), that more mature wells use greater volumes of sand to maximize production. We think SLCA is attractively priced at current levels, and the indications we see are that their business of providing fracking sand is less vulnerable to falling oil prices than some may think. We are not invested in BHI or HAL.

 

The chart below shows the performance of different sectors of the equity market so far this year. Of course, there are always sectors that are outperforming, so nothing much new there. However, if in general as an investor you don’t commit much to health care and you are overweight energy, recent months have likely given you reason to examine comparative performance rather more closely, as we have. If in addition you’ve had a couple of small positions in smaller energy names, you’ve also experienced first hand the relative underperformance of small cap stocks versus the market. Suffice it to say that the results of owning a handful of large health care stocks and being short a smattering of small energy stocks would have been about as perfect a position to hold over the last three months.

The chart tells the story, but to put numbers on it, while the S&P500 is +14% this year, Healthcare (defined as XLV, the sector ETF) has returned almost double at +27% while Energy is -19%. A good portion of the Health Care/Energy relative performance has occurred just in the past three months (28%). Interestingly, the daily returns of MLPs have been most highly correlated with Energy (64%), even though MLPs have outperformed Energy by a whopping 19.5%. In fact, at +11% for the year the performance of MLPs is not far short of the S&P500.  What’s happened is that bigger than typical daily falls in Energy spill over to MLPs even though midstream energy infrastructure (what most MLPs are engaged in) has a very different risk profile from Exploration and Production. So on days when XLE fell 1%, the correlation with MLPs was higher than normal, at 76%. MLPs react to sudden moves, but on the days when Energy is not down 1% or more (84% of the time this year) they react to their own economics.

So what does one conclude? The surprise of the past 2-3 years has been that ACA (The Affordable Care Act, or “Obamacare”) has been very good for the health care sector. I doubt many architects of that legislation expected to create such wealth for health care providers. However, the major news story of 2014 is clearly Oil. Small energy sector servicers have been extremely weak, while the economics for many energy infrastructure businesses have remained sound notwithstanding big drops in some of their customers’ stock prices. Friday was such a day. with the Energy sector -6.3% and MLPs -5.3%. There are substantial crosscurrents beneath the simply headline result of the S&P500.

 

There has been plenty of concern recently that the drop in oil prices would cause many domestic E&P names in the U.S. to curtail their activities at marginal plays. This in turn would have a knock-on effect on oil servicers and the MLPs that manage and build energy infrastructure needed to exploit America’s shale boom. Several MLPs recently commented that they felt current oil prices wouldn’t have much impact on U.S. production. For example, Enterprise Products’ (EPD) CEO Michael Creel said, “Our analysis shows that most if not all of the core drilling area in key oil plays such as the Eagle Ford, Permian and Bakken are profitable at numbers below where we are today and U.S. drilling is certainly not grinding to a hault.”

In fact, the marginal producer of crude oil looks very much like an offshore producer.

Transocean (RIG) is an industry leader in the ownership and operation of offshore drilling rigs. In their quarterly earnings call this morning, CEO Steve Newman said,

“The market pause we began discussing with you more than a year ago has evolved into a cyclical downturn. Although our customers take a decidedly long-term view in making investment decisions, the approximately 27% decline in oil prices observed over the last three months is likely to increase their challenge to improve short-term returns to their shareholders.

In turn, this may temporarily exacerbate the offshore rig supply and balance that has already resulted in dayrate and utilization pressures and an increase in the inter-contract idle time in stacking of rigs and potentially delay the cynical recovery.”

In addition, their just filed 10Q included the following:

Goodwill—Subsequent to September 30, 2014, market conditions have continued to deteriorate, and we identified additional adverse trends, including continued declines of the market value of our stock and that of other industry participants, declines in oil and natural gas prices, the cancellation or suspension of drilling contracts, the permanent retirement of certain drilling units in the industry and increasingly unfavorable changes to actual and anticipated market conditions.  On that basis, in the three months ending December 31, 2014, we expect to reevaluate whether the fair value of our reporting unit has again fallen below its carrying amount, which could result in us recognizing additional, potentially significant, losses on impairment of goodwill.

So while lower oil prices may well hurt providers of services and infrastructure globally, it looks as if the most immediate pain is being felt in areas away from U.S. shale plays.

 

Some market strategists had been warning of a market reversal, and had been telling us that low levels of volatility couldn’t continue. If you keep forecasting a market drop long enough you’ll be right. Even for those of us who don’t focus much attention on market timing and therefore ought not to care, it’s never pleasant watching the investments you like drop like a fridge hurled from a tenth story apartment.

So there’s no insight here on market direction, simply an update on what we’ve been doing; which is mostly re-examining what we own and not selling. The collapse in crude oil resembles what you’d find in a full-blown recession, and markets are evidently pricing in such at least for the Eurozone with slower growth in China and Brazil among others. Lower oil reflects recently revised forecasts of slower demand growth from the EIA as well as increasing U.S. output. MLPs reacted fully like energy stocks this week even though their energy infrastructure businesses have limited direct sensitivity to oil and gas prices and are more driven by volumes and growth prospects, both of which appear good and unchanged.

Nonetheless, the seeming one-way train that has been MLP prices abruptly changed. The sharp correction allowed us to make minor portfolio upgrades in certain strategies.  In recent days for our MLP Strategy we acquired a little more Plains GP Holdings (PAGP) which we like as the GP of Plains All America, and Markwest Energy Partners (MWE) an MLP with no GP to siphon away cashflows. We may add a little more PAGP on further weakness.

In our High Dividend Low Beta Strategy we added modestly to Spectra Energy (SE), a large pipeline operator whose stock price had dropped 15% from its recent high along with many other energy sector names. In our Low Beta Long Short (Best Ideas) for similar reasons, we bought Enbridge, selling Coke (KO) following its recent strength (surprisingly, some stocks have been rising) after Pepsi’s earnings report.

In Deep Value we added a small position in Monsanto (MON).

All of which is to say we are holding about 99% of the same positions we did at the beginning of the month, albeit at lower prices. Friday’s midday bounce in MLPs almost felt like a market recovery even though stocks overall had another poor day. Kinder Morgan (KMI), Berkshire Hathaway (BRK), Williams Companies (WMB), IBM and Hertz (HTZ) remain among our biggest holdings across strategies.

Interest rates remain low and look set to stay that way a good while longer. We have further minor portfolio upgrades in mind if the market continues its correction. Unlike most prognosticators, we won’t try and forecast it, but will simply be prepared.