Stanley Druckenmiller’s interview last week with the Wall Street Journal represented just the kind of unconventional thinking that helped make him so successful. He was discussing what might happen if the Federal government was to “technically default” (i.e. delay a coupon payment for example) during the latter stages of brinkmanship between the Administration and Congress over the debt ceiling.
He argued that if the ultimate outcome was the type of far-reaching fiscal reform (inspired no doubt by the sense of deepening and immediate crisis such a default would cause) then treasury bonds would then be a better investment. At a time when today’s bond yields are almost uniformly believed to be sure to rise, Druckenmiller’s views bear consideration.
The Federal deficit has much in common with global warming. Both problems are described as unlikely to solve themselves without substantive action; require a reduction in consumption today in order to benefit later generations; and exhibit few tangible reasons for urgent action today. The world doesn’t feel any warmer (though in New York it is certainly wetter). Long term interest rates don’t reflect any investor reluctance to keep funding our enormous spending gap.
As a result, it’s likely that solving both global warming and the Federal deficit will require a real crisis that will jolt public opinion and provide support for the unpopular decisions that will be necessary. Nobody should confuse the current focus on fiscal conservatism with popular support for higher taxes and reduced spending. Recent opinion polls reflect the strong ambivalence voters feel about moving from a solving a conceptual problem to making impactful decisions.
A Washington Post/Pew Research centre poll in April found that 81% of surveyed adults believe the federal budget deficit must be addressed now. However, a USA/Gallup poll at approximately the same time found that 62% of respondents felt the Democratic plan to reduce the budget deficit would be an excuse to raise taxes. 66% felt the Republicans would cut Medicare too much. That is the problem.
Everybody wants the deficit cut through others bearing the pain. While Mr. Druckenmiller may be correct in noting that the good from a positive resolution would easily outweigh the potential disruption preceding it, the incompatible opinions reflected in the two opinion polls virtually ensure that a bond crisis will have to precede a solution. We will probably find out whether rising sea levels and rising bond yields both cross their respective tipping points before action is taken. Democracies are ill-suited to take decisions that will benefit later generations at the expense of today’s.
In our Fixed Income strategy we have been cautious on long term bonds for some time. The recent rise in prices, while challenging that view, of course makes bonds even less attractive than a month ago. For some time we have invested in emerging market currencies as a source of yield, preferring to invest where growth, inflation and interest rates are all higher.
The U.S. government is relentlessly driving investors out of domestic fixed income; while the goal is to drive investors into more risky U.S. assets, it doesn’t seem wise to let the government set your asset allocation. Since they’re providing little reason to invest in the US$ we’re looking elsewhere. The WisdomTree Emerging Market Currency Fund (CEW) is a well constructed fund with diversified exposure to emerging market currencies but very little interest rate risk. We have been adding on recent US$ strength.
We also started building exposure to the Canadian $, through FXC. Canada runs its affairs in a wholly more prudent fashion than its southern neighbour. Its banks avoided causing a real estate bubble and its fiscal house is in much better order. Canada’s vast store of oil and natural gas provides long term support and short term interest rates are headed modestly higher as the stimulus is gradually withdrawn.
On Friday the Department of Energy authorised the export of U.S. natural gas, in response to an application from Cheniere Energy Partners, LP. Our Deep Value Equity strategy maintains a substantial investment in several natural gas E&P names that have (i) low debt, (ii) low operating costs, and (iii) a concentration in natural gas (versus crude oil).
The U.S. is starting to exploit this enormous domestic resource as a result of the many shale plays which have led to increased supply and lower prices. Natural gas is cleaner than other fossil fuels, cheaper on a BTU equivalent than crude oil and doesn’t require any imports from parts of the world that are not reliably friendly. While exporting natural gas is still some years away since the compression facilities do not yet exist and further regulatory approvals are needed, this development should provide support for natural gas futures 2015 and beyond, and is long term bullish for stocks in the sector.
We continue to like Range Resources (RRC), Petrohawk (HK), Comstock Resources (CRK) Southwestern Energy (SWN) and Ultra Petroleum (UPL). RRC was an early player in the Marcellus shale in Pennsylvania and has 4.4 TCFE (trillion cubic feet equivalent) in proved reserves with another 35 – 52 TCFE in potential (at 50 TCFE they’d have enough to provide more than two years’ U.S. consumption). We think the stock could double over the next couple of years. If they generated $0.50 per MCF in cashflow on the proved and potential that would represent $19.7-$28.2 BN in value, versus today’s market capitalisation of $8 BN.
Floyd Wilson, CEO of Petrohawk, freely admits that the company is being built to be sold, which is probably why it seems to be bid up on Fridays ahead of a possible Monday morning announcement. HK has 26 TCFE of potential reserves amongst its plays in the Haynesville, Bossier and Eagle Ford shales in Texas, Oklahoma, Arkansas and Louisiana and is currently valued at $8 BN.
These stocks all have low debt, are efficiently run and are trading at a discount to tangible value. Natural gas E&P names are not as out of favour as when we first began investing in them a year ago, but are still well short of fully reflecting value in our opinion.
Disclosure: Author is Long RRC, SWN, HK, CRK, UPL, CEW, FXC