The 11% fall in the price of crude oil in the past month on panic selling in the energy futures pits of New York, London and Singapore has unnerved the world’s leading oil and gas exporters. Saudi Arabia will both extend last November’s OPEC output deal beyond and 2017 and even coordinate fresh output cuts with Russia, Iraq, Iran and Algeria. The Kremlin and even the Chinese Premier have voiced support for ‘stability’ in the oil market, code for the $50–60 Brent range Saudi Arabia is doing its best to engineer. The kingdom, with vast fiscal and national security spending, needs a $50–60 range to assure the success of the planned Saudi Aramco IPO. Putin cannot afford another oil price crash at a time when the Russian economy is still in recession and anti-regime protests have broken out in Moscow and Petrograd. China has even agreed to buy Russian crude oil for its own Strategic Petroleum Reserve. A Saudi-Russian-Chinese tacit pact on oil prices means we could have seen a short term bottom once again in the $48 Brent crude level. In the run-up to the May 25th OPEC meeting in Vienna, the balance of risks finally once again favours the wounded oil bulls. This is Saudi Arabia’s ‘whatever it takes’ moment.
True, US shale output will grow by at least 600,000 barrels a year and the US is producing 9.2 million barrels even now. Global inventories, while high, will decline since Chinese, Indian and Japanese demand growth will accelerate while the US economy exhibits zero recession risk.
My favourite integrated oil major pick in the US is Occidental Petroleum, which owns fabulous acreage in the Permian Basin, offers a 5.10% dividend at $60 and has serious potential to increase its cash flow yield. Oxy could even divest its chemicals or GCC businesses and thus raise its current modest valuation to a pure play low cost, long life reserves Permian Basin operator ranges near 12-13 times earnings. Oxy is the most crude oil price sensitive stock in Big Oil. Its 6–8% output growth plus a 5% dividend yield make it a no brainer since even at $50 Brent the net asset value is at least $64.
Pioneer National Resources (PXD) is America’s most exciting shale oil exploration and production firm, with the potential to grow output by at least 20% a year. Pioneer has the acreage and financing to increase output to 1 million oil equivalent barrels per day in the next five years. Even if oil prices average at $50 a barrel and natural gas $3.00, Pioneer can achieve 15–18% cash flow growth. I was not around in this world when Sir Henry Deterding built Shell in the 1920s or when Dr Armand Hammer built Oxy in the 1950s but I plan to be around for the ride as an epic wildcatting management team builds the world’s next shale BP in the Midland Basin. If Pioneer falls to 150, I view it as the energy growth star of the year.
I had recommended French oil major Total SA as my favourite Seven Sister global oil major at 42 euros with a target at 48–50, which was achieved. The latest crash in Brent has led to a correction in Total despite the 7% rise in the French stock market on hopes of a Macron win. Total has slashed its cost structure and capex budget, leading to a surge in free cash flow that enabled management to raise its cash dividend to 2.45 euros and the dividend yield is now a stellar 5.3%. Incredibly Total, once the Quai d’Orsay’s oil and gas play on the fabled Françafrique (plus Angola, a former Portuguese, Soviet and Cuban colony!), has reduced its break even Brent price to $40. Total has also used the oil price crash to accumulate valuable LNG concessions and new oilfields/gas fields in Brazil, the Ivory Coast and Uganda.
Chevron has better output growth prospects than its archrival Exxon Mobil but its rise in upstream EPS growth will be offset by margin compression in the refining/marketing downstream market. Chevron’s low balance sheet leverage and 20% net debt to market cap makes total sense at a time of Fed rate hikes. Chevron offers a 4.2% dividend yield at my preferred entry level of 104. Chevron shares would become even more compelling below 96–98 even though I doubt this will happen if Saudi Arabia/Russia seal another OPEC and non OPEC pact on May 25th in Vienna.
Macro Ideas – The South Korean election and Asian equities
The election of South Korea’s new President Moon Jae-in will not derail the stellar bullish momentum on the KOSPI in 2017, up 4% in last week alone. South Korea will improve relations with China, a potential ballast for tourism and auto stocks. President Moon has also promised to negotiate the anti Thaad missile defense system with the US, defuse geopolitical tensions with Pyongyang and reform the nation’s powerful but corruption riddled chaebol conglomerates. After the impeachment trauma, South Korea finally offers global investors the political visibility and reform agenda they crave. Awful corporate governance, notoriously low dividend payout ratios, an opaque boardroom culture and North Korea’s risk premium has ensured that South Korea trades at the cheapest valuations of any major Asian stock exchange. Will this change under President Moon? No.
I have heard bombast about chaebol reform all my adult life. In any case, South Korea has to contend with Washington’s protectionist policies, China’s liquidity squeeze and the nuclear armed Supreme Leader in North Korea. A center-left government in Seoul will be bullish for South Korean banks, among the cheapest in Asia, notably KB Financial and Woori. If Beijing ends the boycott of South Korean cars, Kia Motors and Hyundai Motors will surge at least 20%. While I think the won is a tad toppy at 1132, the Hermit Kingdom will remain a money making theme in 2017, with Moon in the Blue House. O blue moon!
The Asia ex-Japan index gave us its most profitable four months since 1991, when the regional stock exchanges skyrocketed after the liberation of Kuwait and the swift US victory over Saddam Hussein in the Gulf War. EPS growth can be at least 14–15% in 2017 and valuations are not excessive on the Asia ex-Japan index at 13 times forward earnings and 1.45 times forward price to book value at a time when crude oil has slumped below $50 once again. The positioning data also suggests that global fund managers are still one sigma or 400 basis point underweight emerging Asia while they are maximum overweight Dalal Street.
Summer is usually a somnolent period for Asian equities and I believe the easy money in the index has now been made, especially since China has once again begun to emit a deflation SOS. Note that Dalian iron ore is down 30% and Shanghai copper (Dr Copper is as misleading an indicator of economic cycles in the Middle Kingdom as it is on Wall Street!) has slid down, as have Chinese A shares and Shenzhen shares. The MSCI Emerging Market Asia index fund (symbol EEMA) is up an incredible 28% since I began to go gaga over Asian equities in my column last April and May. The Pakistani and Indian midcap banks I recommended in 2016 are now up 40–50%.
As the macro chill rises in both Washington and Beijing, I believe it is now time to book profits and wait for the political and financial storm clouds to pass. Emerging Asian equities cannot rise to new highs while the commodities complex gets skinned alive, US nuclear submarines prowl the coast of North Korea and the US President fires FBI Director Comey in the midst of a critical investigation. The moment the Volatility Index (VIX) dips below 10, I believe it is prudent to buy dirt cheap insurance to book profits in emerging Asia. No guts, no glory – no puts, no story! In any case, I doubt if the wild bull market in emerging Asia will survive the at least seven Fed rate hikes I expect in 2017 and 2018. China is at least 25% of the emerging markets constellation, as the world learnt the hard way in August 2015 and January 2016.
From a strategy perspective, it is now evident that India’s Nifty index is the mother of all stock market bubbles at 9300 or almost 20 times earnings. Almost nine out of ten midcap shares are above their 200 day moving averages and even the gloriously named Motilal Oswal (Yoda) Next Trillion Dollar Fund has stopped accepting new money. I expect the Nifty index to easily fall to 8500 as Mr Marketji’s pendulum swings once again from greed to fear. Risk is a four letter word. So is ruin.
Australian Treasurer Scott Morrison’s levy on the big banks on the eve of a housing peak also gives me a green light to short Aussie bank center stocks. Drake and Skull’s restructuring? Skull and bones now. I do not seek to understand, change or explain the world, only to make money from its madness!
Stock Pick – The value case for Japanese stock market
The Japanese stock market and the yen exhibit a high correlation coefficient, as is only natural since the Empire of the Rising Sun is Asia’s export colossus. So the election of the LDP Prime Minister Shinzo Abe in November 2012 was a game changer for both the Nikkei Dow/TOPIX stock market indices and the yen. Abe handpicked Haruhiko Kuroda, the chief executive of the Asian Development Bank in Manila, to be the governor of the Bank of Japan. The Bank of Japan, in turn, engineered one of the most aggressive quantitative easing programs in the history of world finance, the fabled ‘second arrow of Abenomics’. The Japanese yen fell from 78 against the dollar on the eve of Abe’s election to 113.6 now. Even though Kuroda-san did not achieve his target for a 2% inflation rate, the Bank of Japan’s epic depreciation of the yen has enabled the Nikkei Dow index to more than double since Abe’s election to a recent high of 19800.
2017 has not been kind to Japanese equities. A safe haven bid in the Japanese yen saw it rise from 118 to as high as 108, making it impossible for the Nikkei Dow bulls to propel the index significantly higher. Toshiba’s fall from grace, the Takata scandal, geopolitical tensions with North Korea and Trump’s veto of the Trans-Pacific Partnership are all bearish data points for Japanese equities. However, on any 1000 point Nikkei Dow correction caused by a spasm of risk aversion. I believe the Japanese stock market is a value buy in the constellation of the developed markets. Why?
One, Japanese economic growth is accelerating. The Japanese GDP growth rate could well be 2% in 2017. The Tankan survey is the strongest in the past decade. Exports have risen at double digit rates despite the stronger yen and a protectionist Trump. Japan has finally emerged from ‘two lost decades’ of dismal growth and mild debt deflation.
Two, Shinzo Abe’s government has boosted fiscal stimulus, mainly road construction and infrastructure spending, as a prelude to the 2020 Tokyo Olympics. This is another factor that will anchor Japan’s 2% economic growth rate.
Three, Japan’s trillion dollar Government Pension Investment Fund (GPIF) continues to increase its allocations to domestic equities while reducing its holdings in the Japanese government bond (JGB) market, which is almost comically overpriced, thanks to Kuroda-san and the Bank of Japan’s asset buying spree. Life insurers, trust banks and Asian fund managers are also using any pause in the Nikkei Dow bull run to add to their positions in Japanese equities.
Four, Japanese equities could well offer 15% earnings growth in 2017-18, higher than on Wall Street or even Europe. Earnings momentum revision has now begun to accelerate. This is hugely positive for Japanese equities and makes a TOPIX target of 1800 by mid-2018 credible.
Five, the Federal Reserve will raise its policy borrowing rate at least twice more in 2017 while the Bank of Japan will do nothing to end its ‘zero yield’ yen money market policy. This means the Japanese yen could well fall to 122 against the US dollar by end 2017, a bullish omen for Japanese equities.
Six, labour markets have begun to tighten in Japan. This is a bullish omen for consumer inflation. The unemployment rate is now 2.8%, the lowest since 1995. Average hourly earnings have begun to rise, a key Bank of Japan policy objective. Inflation is a steroid shot for Japanese equities. As consumer inflation rises but the Bank of Japan continues its debt buying program. This will reduce the real (inflation adjusted) yields in the money markets, accelerate the depreciation of the yen and thus boost Nikkei Dow/TOPIX indices.
Seven, I have a rule of thumb. When the equity risk premium in Japan rises to 7%, I must go long Japan – yen hedged, of course! The equity risk premium in Japanese equities is now 7.8%. Japanese equities now trade at a 12.8 times forward earnings at a time when EPS growth rates, operating margins and returns on equity will rise. Relative to the American stock market, Japan is a steal. I expect the valuation case for Japan will strengthen once the fallout from the Toshiba debacle ends as better corporate governance norms, higher profits and the paradigm of shareholder value reshapes Marunouchi. As the spring cherry blossoms fall on Mount Fuji, it is time to buy (yen hedged) Japan!
This article was originally published by the Khaleej Times.
