Market Commentary Fourth Quarter 2013

Fourth Quarter 2013 simulated the first three quarters:  Washington remained dysfunctional and investors remained fretful concerning interest rates, but the stock market rose anyway.  During the quarter, the S&P 500, Dow Jones Industrials and NASDAQ Composite gained 10.5%, 10.2% and 11.1%, respectively, with year-end gains of 32.4%, 29.7% and 40.2%.




During the fourth quarter, Treasury interest rates fluctuated without trend.    Although most private investors find today’s Treasury low yields unattractive, the Federal Reserve and foreign banks continue to buy a substantial majority of Treasury offerings.  Thus, for now, only modest private sector demand keeps the Treasury market in balance.  Currently, the 10-year and 30-year Treasuries are yielding 3.0% and 3.9%, respectively.  These yields are well above 2012’s historical lows but are still abnormally low compared to historical averages.




The federal spending sequester and increased tax revenues are reducing the federal deficit – a positive turn toward fiscal responsibility.  But as explained in our April 2012 market commentary, federal deficit spending is an important contributor to corporate profits and economic growth, and it is diminishing.  A possible “replacement” source of spending is business capital spending, which currently amounts to only 2% of GDP.   This measure is near all-time historical lows and contrasts with a sustained ratio of 10% capital spending to total GDP in the 1950s and 1960s, when CEOs were expanding businesses, employment and incomes.


One possible reason why capital spending remains anemic is the growing propensity of businesses to repurchase their own stock rather than expand their businesses.  According to data from Standard & Poor’s, corporate stock repurchases now exceed a $400 billion per annum pace, compared to only a $150 billion per annum pace as recently as the early 2000s.  By shrinking the amount of common stock outstanding, earnings per share can grow at a faster rate than the company’s gross earnings, and investors tend to focus on earning per share growth.  This strategy can be a boon to shareholders, including executives holding large stock option packages, but it diverts funds away from business expansion.  Funding stock repurchases with money otherwise available for business expansion should remain a damper on economic growth.



Two sectors not hobbled by a lack of capital spending are the rapidly expanding U.S. oil and natural gas industries.  Both are benefiting from a combination of two game-changing technologies that facilitate low-cost oil and gas production from underground shale formations previously deemed worthless.  The two technologies, both in development for decades, are horizontal drilling and hydraulic fracturing (“fracking”).  These two innovations are being combined to produce enormous supplies of oil and gas trapped within shale, an abundant rock that had been deemed worthless due to its low porosity and low permeability.




Experiments fracturing underground rock to increase oil production date back decades, with the injection of liquids first attempted in 1903.  Early fracking experiments also centered on the use of explosives, sand, chemical gels and steam.  The U.S. government even tried to rejuvenate declining oil fields in three experiments during the 1960s and 1970s, using underground nuclear explosions.  The nuclear fracking results were disappointing, and the program was terminated.


A small Texas energy company, Mitchell Energy, made the key breakthrough in hydraulic fracturing during the 1990s by switching from a mix of chemicals to 99% water, injected at high pressure.  Using the water frack, Mitchell began producing the Barnett Shale, a large shale field that sits beneath Ft. Worth, north Texas and, ironically, Exxon’s headquarters.  Today, according to the Department of Energy, 95% of completed oil and gas wells in the U.S. have been stimulated with hydraulic fractures, and those wells produce 43% of our oil and 67% of our natural gas.




Shale formations can be very long but also very thin.  Historically, traditional vertical drillers drilled through thin layers of shale on the way to thicker, more promising rock layers below.  Horizontally drilling the length of shale fields, not their width, is the key to achieving a high volume of production from them.  The technology of directional drilling (drilling at an angle) was developed as early as 1934, when a directional well was drilled to help extinguish an oilfield fire. The key breakthrough for horizontal drilling was the invention of downhole drilling motors in the 1970s, which supplied enough power to turn a drill bit into a horizontal position deep within the shaft.  The technology was first applied to drill for natural gas pockets in coal fields, and the Department of Energy funded a number of early directional wells.  Starting in the late 1980s, another small energy company, Oryx Energy, began a program of drilling horizontally through shale in hopes of producing large volumes of oil and gas.  However, Oryx lacked Mitchell’s fracking know-how, and the wells were disappointments.  In the meantime, the oil majors (Exxon, Chevron, Mobil, etc.) either gave up on shale or ignored it altogether, viewing shale drilling as a waste of resources.



Through persistence and experimentation, Mitchell and a number of other mid-sized energy producers learned how to combine the two technologies to turn mediocre shale wells into big producers.  The result of these efforts on natural gas production has been stunning.  Gas well productivity has shot up 360% since the mid-2000s.  In 2005, it took 1,200 wells to produce a daily supply of 50 billion cubic feet of gas; today, the U.S. is producing 72 billion cubic feet from just 375 wells.  The U.S. could be producing much more gas if the economy could learn how to transport and consume the additional supply.  Gas drilling is a dirty, noisy, and disruptive business, so reducing the number of working wells also benefits the environment.  The U.S. Energy Information Agency (EIA) projects potential gas production as high as 90 billion cubic feet by 2040. Since gas demand has lagged exploding gas supply, gas prices have declined from $13.50 in 2008 to only $3.75 today.  The savings to gas-burning households are substantial.



On the oil side, daily U.S. production has climbed from 5 million barrels in 2008 to 8 billion barrels currently.   That increase has reduced our dependence on oil imports from 60% of daily demand in 2008 to 45% today.  The number of rigs drilling for domestic oil has jumped from less than 200 in early 2009 to 1,397 currently, oil being a much more valuable commodity than gas.  The rapid jump in U.S. oil supply has dampened global prices and forced OPEC producers to reduce their production.


The state most impacted by shale oil production is North Dakota, whose Bakken Field was once estimated to hold just 151 million recoverable barrels of oil but is now believed to hold 3.0-4.3 billion barrels.  The Bakken is already producing 700,000 barrels daily, supplying 10% of our nation’s usage and experts believe it might one day produce 1 million barrels daily, which would make it one of the seven most prolific oil fields in history. The entire U.S. currently holds verified oil reserves of 28 billion barrels, but the Energy Information Agency (EIA) now estimates the U.S.’s “technically recoverable” oil endowment is 163 billion barrels, with shale oil being a large proportion.  For perspective, the U.S. consumes 6.7 billion barrels of oil annually.  Foreign shale fields may hold another 340 billion barrels, but the feasibility of producing those fields will vary widely.



Will exploitation of this natural endowment lead to energy independence as some politicians claim?  The near-certain quick answer:  no.  Complete energy independence would require not only persistently rising production of oil and gas but also much greater conservation and the development of new fuel sources.  (On that topic, The Brookings Institution estimates that the U.S. government has allocated over $150 billion for research on “green” energy sources since 2009.)  Nonetheless, replacing some foreign oil and gas imports with domestic production would increase American incomes, jobs and tax revenues.



Finally, last quarter’s letter included a “not conservative” estimate that the future return on stocks might average approximately 6-8% per annum.  We stated that some other calculations suggested even lower annual returns.  In December, data from Ned Davis Research showed that the average annual 10-year return on stocks, starting from currently high valuation levels, has been 4%.   Equity investors need to prepare for a stock market that will be less prosperous and more volatile than in 2013.  It is not excessively cautious to hold reserves with the hope of being able to buy at lower prices should the stock market decline during the coming year. Another recent study showed that when the ratio of system-wide money market holdings to total stock market valuation has been as low as present, the stock market’s subsequent return, on average, has been negative.  We are not predicting a decline, but we believe the market has entered a period of heightened risk.

We welcome your thoughts and comments.



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