Nothing Moves in a Straight Line

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Well we are back after a bit of a 24 hour bug and as always the markets are moving.  A nice 200 point gain in the Dow is probably just a relief rally of sorts before we get more global bad economic news.

The last couple of days it was interesting to watch the talking heads chat about “what is wrong with this market”.  Then we look at Yahoo Finance headlines with titles like “Wall Street Rallys after Huge Selloff” and we damn near laugh out loud.  It becomes more obvious each day that the financial networks on TV and the mainstreet financial writers want to sensationalize everything–a key reason why we limit our reading on Seeking Alpha to just a few choice authors is because all they want is eyeballs–forget some of the crap they use to get them.  The day we we operate an investment portfolio based on what we read instead of thinking for ourselves is the day we need to quit.  Huge sell-offs? 500 Dow points in 5 days.  Obviously they weren’t watching the old Financial News Network (FNN) in 1987 when the Down dropped 30% in one day.

Nothing in markets moves purely in a straightline and today is a day that that MLPs get a reprieve from the drubbing they have taken in recent weeks. The drop has been truely savage.  Today is the day that investors that have invested in ‘hope’ instead of reality can move a bit away from their oil investments. For those holding preferreds of MLPs you best be in the right ones–not that they will have dividends suspended necessarily, but the preferreds will be (and have been) painted with the same brush as the common units.  The common units WILL have distribution cuts next year. Now why do we say this with such firmness?  Believe it or not we read lots and lots of 10q’s and 10k’s and we don’t know a single person who can slice and dice a balance sheet as well as we can (not to brag, but we see so many folks that don’t have a clue to what a balance sheet is and if you want to mess with upstream oil companies in this day and age you had better learn to check them out to a fair degree).  So–it is mostly common sense that tells us they will cut their distributions.  First off no company is fully hedged on their production selling prices–thus they must sell some at spot prices.  2ndly hedges that are in place today will start to ‘run off’–as early as next month and then continuing through the year and with each hedge that runs off they likely will have to put new hedges in place to protect against further price declines–or simply operate without them and take what the market gives them on the spot market.  Additionally virtually all these newer upstream companies are shale drillers and the decline rates on the wells is really, really sharp–up to 90% in the 1st 24 months.  Because of the decline rate of the wells they need to keep drilling to maintain production volumes.  Now here is the big catch–lenders (sometimes you and I) have now been ‘shocked’ into reality and we know better than last year that prices go down as well as up.  Are we willing to loan money to the e&p’s for the same interest rate that we loaned them money 3 months ago?  NO, we are not and neither are the banks and other private lenders.  Now we know that some drillers have lines of credit etc that they can operate on for some amount of time, but many (most) of these loans are made against production and reserves of oil and gas in the ground.  What if the company can no longer borrow at reasonable terms to keep drilling? What if oil in the ground which was economical to find and produce from at $70/barrel is no longer economical at $60/barrel?  Do you know that the SEC requires them to remove barrels from their proven reserves if they are not economical to produce?  If this were to happen to one of the MLP’s they would likely be in default on loan covenants and all hell would break out.

Now we have simply painted a framework above that could play out (but these take time to play out and we will not know many of the answers for about 6 months).  This is why we say we need a move in crude to $80 or $90 relatively soon.  $60 crude in June of 2015 will mean we will have already experienced bankruptcys and certainly substantial consolidation (maybe this is the point where the Exxons of the world swoop in and buy the shale drillers for pennies on the dollar).

Now for everthing there is an appropriate risk/reward.  What is your risk tolerance?  Do you want a current yield of 15%, 20% or more?



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