Recovery Indicators: Finding Hope in Energy Trends

Includes: AES, BNI, BRK.A, DUK, SO
by: Roger S. Conrad

You don’t have to be a longtime reader to know that I'm primarily focused on underlying businesses. I’m a lot less interested in whether a company has met a particular earnings projection than I am in how it’s meeting the challenges of competing in its industry or dealing with economic ups and downs.

If a company is measuring up on these counts, odds are I’m going to stick with it through thick and thin. In fact, that’s basically what I did in my advisories over the past year, as markets crashed and took everything but US Treasury bonds down with them. And it’s paid off with the massive recovery we’ve seen since early March, which has wiped out the lion’s share of losses from the worst bear market since at least the 1970s.

Conversely, when a company fails to measure up, I always advise getting rid of it. That’s also a strategy that paid off again and again, when overleveraged and economically exposed entities not only slashed dividends but also went belly-up in unprecedented numbers.

When it comes to the economy, I also focus on underlying businesses. Government statistics and other gauges of the macro picture can give a pretty good indication of what condition the overall economy is in now. But it’s often the anecdotal--the straws in the wind involving individual enterprises--that provide the best indication of where we’re going.

One of the most reliable such gauges is what those with deep pockets are doing. Last week, for example, the Energy Information Administration (EIA) dramatically reduced its projection for oil use going forward, postulating that conservation measures would trump the end of the recession and continue to depress demand.

At the same time, however, a major Chinese oil company announced a huge new oil producing venture in Iraq. That was only the latest of a series of deals in which that country has attempted to lock down new sources of energy and other natural resources to feed its growth.

Maybe if these Chinese managers had read the EIA report they would have concluded they could simply count on oil prices staying cheap and saved themselves the trouble of buying more at today’s prices. On the other hand, maybe China knows its needs better than anyone and is willing to use its considerable resources to plan for them. And because it’s rapidly moving toward becoming the world’s leading consumer of black gold, just maybe China’s moves are worth paying attention to.

China is also making a major move to diversify away from fossil fuels, which it will have to increasingly import. The move this month by sovereign wealth firm China Investment Corp (CIC) to buy a big chunk of US power company AES Corp (NYSE:AES) is certainly ground breaking. And if approved by US regulators as expected, it will mean big money for AES as well as a leap forward for China’s build-out of renewable energy.

So is the recent partnering of major Chinese utilities with big US utilities such as Duke Energy (NYSE:DUK) and Southern Company (NYSE:SO) to produce clean coal solutions. China, like the US, is a major producer of coal, particularly of the dirty variety. Being able to clean its air and use more coal will further reduce dependence on foreign oil. And Chinese sovereign wealth firms are also on record stating their interest in buying US utilities.

All of these moves add up to one thing: a belief by China that it needs to lock down supplies of energy in a world where conventional oil supplies are going to be increasingly constrained, and where imports from the Middle East and Africa will be increasingly endangered.

And that’s a far better indicator of where oil prices are ultimately going than EIA projections, which are notorious for huge revisions, depending on economic forecasts that have proven all too prone to influence from current conditions.

China’s energy moves are but one straw in the wind pointing to a reviving economy ahead. Another was provided recently by the legendary billionaire investor Warren Buffett, whose flagship Berkshire Hathaway (NYSE:BRK.A) purchased major railroad Burlington Northern Santa Fe (BNI).

The railroad carries a great deal of coal and timber from Western states, grain from the Midwest and imports from Mexico and Canada, as well as through California ports. Buffett’s stated attraction: Burlington runs transportation facilities that will be increasingly valuable in a world of increasingly tight fossil fuel supplies. And the price tag of $26 billion to buy the 77.4% of the railroad he doesn’t already own shows how serious he is in his belief.

Buffett, of course, is a patient man. Although he’s rarely wrong on the long trend--evidenced by the huge amount of wealth he’s accumulated--it can take a while for his ideas to play out. Those who follow his bet on energy, however, are facing a very low bar of investor expectations, which means little real long-run risk. And there’s no shortage of low-risk ways to play either, from utility/producers and Super Oils to Canadian income trusts and energy services shares.

It’s also noteworthy that Buffett and Microsoft (NASDAQ:MSFT) billionaire Bill Gates have stated the worst of the financial crisis and recession in general are behind us. That’s an assertion that’s tough to verify if you’re among the 10.2% of the workforce now unemployed, or if you live in a community that’s been foreclosed on.

From an investment point of view, however, it is what’s being borne out in third quarter earnings, from sequential gains by energy producing companies to rising productivity and strengthening balance sheets. Those are ultimately the building blocks behind real, lasting economic recoveries.

Although it may take months or years for one to truly emerge in North America, these developments are certainly a step in that direction. For income investors, that means less credit risk, greater dividend safety and increased potential for capital gains as perceived credit risk vanishes. Eventually, it also means more worries about inflation and a falling dollar, though real risk is probably still a ways off.