Stand or Fall – How Much Longer?

By Russ Koesterich, CFA | 

In an economy with few bright spots, the corporate sector has remained remarkably resilient and unusually profitable. US corporations are generally flush with cash and have managed to maintain historically high margins despite anemic growth and a lack of consumer confidence.

The Upside of Lethargy: What’s Behind the High MarginsBased on one metric – economic growth – it is surprising that earnings have rebounded as strongly as they have. Corporate profitability is largely driven by growth, as faster economic growth leads to stronger top-line growth. In the past, the level of GDP has driven approximately half of the variation in corporate earnings growth.

How Margins Could Shrink: The Goldilocks Scenario of Too Hot or Too ColdWhile corporations have benefited from the unusual nature of the recovery – as well as very tight management of expenses and capital spending, to their credit – this happy confluence of events will not last forever. Two scenarios could upset this equilibrium: either a sharp deceleration in growth or a meaningful pickup in economic activity, and with it rising wages and interest rates.

Conclusion 
Some say the world will end in fire, Some say in ice.

 

But how long can this continue? An unusual combination of low inflation, low interest rates, and just enough growth can probably sustain margins over the near term. The principal risks to corporate profitability are likely to come from either too little growth – the global economy slips back toward recession – or, ironically, a surge in growth that leads to higher interest rates, higher input prices, and higher wages. To the extent the global economy continues to muddle along, this may actually extend this unusual period of high corporate profitability.

Eventually, however, this benevolent combination will come to an end. When that occurs, how should investors position their portfolios? The answer depends on why margins are shrinking:

• If margins compress due to a stalling economy, investors should do well to follow their instincts and get defensive. Historically, classic defensive sectors such as consumer staples, healthcare, and utilities have been the most resilient to margin compression due to a weak economy.
• If the economy continues to rebound and ultimately inflation rather than growth is the culprit, investors may want to adopt a different approach, favoring natural resource companies that can benefit from rising prices.

In either case, investors may want to remain cautious on financials. While the sector appears cheap, unless one expects a return to a Goldilocks economy – strong growth and falling interest rates – this sector is vulnerable to both a stalling economy and rising rates.

Corporate America: Last Man Standing 

The 13^th annual Global Automotive Executive Survey, conducted by KPMG and released on January 5, indicated that US auto brands should continue to increase market share over the next five years. The report went on to conclude, “Global executives see the American resurgence spurred by product innovation, continued improvement in product quality and restructuring activities.” This is a remarkable statement about an industry that less than four years ago faced an existential crisis, necessitating a federal bailout. It is also illustrative of a broader point: the US economy continues to struggle with an anemic recovery and long-term structural ills, but the corporate sector has rarely been healthier or more profitable.

US households are still trying to get out from under the prior decade’s debt binge, a process complicated by lackluster nominal wage growth. Meanwhile, the public sector is going in the opposite direction: expanding its balance sheet – both from a fiscal and monetary perspective – in an attempt to cushion the deleveraging of the household sector. While this may be necessary in the near term, it is unsustainable over the long term. The fiscal situation is further complicated by the noticeable lack of clarity or consensus on either entitlement or tax reform.

Source Bloomberg 12/31/2011

However, despite all of these considerable headwinds, US corporate profits recently eclipsed their 2006 peak (see Chart 1). This resurgence in profits is obviously not purely a function of stellar top-line growth, which would be a difficult trick in a weak recovery. Instead, much of the resurgence in earnings has rested in a rebound in corporate margins, which were decimated during the financial crisis.

During the last recession, margins troughed in fourth quarter 2008 at around 4.5% of GDP, an all-time low. Since then, profit margins have more than doubled, and at slightly more than 10% are right below their 2006 peak (see Chart 2).

Source Bloomberg 12/31/2011

Given the historical tendency of margins to revert to the mean – the long-term average is roughly 8.20% – and the weak nature of the recovery, many investors are wondering how long this virtuous state of affairs can continue.

Germany Set to Invest $260 Billion in a Renewable Revolution

By Dr. Kent Moors, Global Energy Strategist, Money Morning

The moment Germany announced its highly publicized decision to phase out nuclear energy in the wake of the Japanese triple disaster; observers began to ask one very important question.

Just what energy source would replace such a huge swath of power in Europe's dominant economy?

The short-term solution had to be natural gas.

But this would make Germany more dependent upon imported energy, especially from Russia.

In that sense, the nuclear phase-out made the Nord Stream pipeline - from Russia, under the Baltic Sea, to northern Germany - absolutely essential.

Today, the first line of the twin pipeline is already in operation. The second should be on line at the end of next year (if not sooner).

Then there is the other Russian project - South Stream. This one intends to move Russian and Central Asian gas into Southern and Central Europe.

Much of that will also reach Germany.

In addition, several pipeline projects are vying for the excess production from the second phase of the Azerbaijani Shah Deniz offshore development in the Caspian Sea.

Included among these is Nabucco, a venture to bypass Russia and transport gas into the Baumgarten hub in Austria for ongoing distribution.

Nabucco has long been the European Union favorite, but it has been unable to attract sufficient supplies. Three other pipeline proposals also are attempting to secure the Caspian gas for transit to Europe.

But there is a problem for Germany in all of this.

It does not want to form an increasing dependence upon imported gas to power its economy.

And this sentiment is driving one of the biggest alternative energy revolutions in recent memory.

The German Push Toward Wind and Solar Power

The 17 currently operating nuclear reactors in the country provide about 20% of the national electricity needs. Any replacement of those plants (where capital expenses are already sunk) will add significantly to the end costs of energy.

That means a political decision following the Fukushima Daiichi disaster one year ago ends up costing the average German citizen even more to secure what is already among the most expensive electricity in the world.

Germany does have shale gas.

But the furor over nuclear power is paralleled with a similar environmental concern regarding the dangers of fracking, a process of pumping water and chemicals under high-pressure to break open the rock and free the gas.

There are now four U.S. examples of seismic anomalies resulting from the combination of fracking and deep horizontal drilling.

And they have not instilled much confidence for the markets.

Instead, what the Germans are deciding to do is already being called the biggest restructuring of the national energy landscape since the end of World War II.

The government will initiate a campaign valued at more than $260 billion to harness wind and solar power.

The price tag is staggering. It is already pegged at more than 8% of the nation's entire gross domestic product (GDP). And it could move even higher.

This will involve huge wind farm areas in the Baltic and massive new high-power transit lines nationwide. The goal is to have at least 35% of the nation's power needs generated from renewable sources by 2020.

All Eyes on Germany

Germany has become the first nation to really tackle the rising energy crisis. To succeed, the country will need new technologies and fresh approaches, some not even yet on the drawing board.

The most important European market will transform into a massive energy laboratory. But success is hardly certain.

Either way, all eyes will focus on this huge German experiment.

It will cost German consumers even more than they pay now - some analysts say as much as 60% more. It holds captive the survival of a government, political careers, industrial prospects, and continental-wide financial policy.

As the Eurozone wrestles with debt contagion and questions the strength of cross-border banking, the main lynchpin of that zone - Germany - is embarking on a very ambitious and risky path.

For those accustomed to seeing renewable energy sources such as solar, wind, geothermal, and even biofuels dependent upon heavy government subsidies, the German experiment will be a significant change.

The large public sector injections of tax revenues and credits will still be there.

Germany will have to increase taxes to pull off this grand departure. That could make it the most expensive government debacle in recent memory.

What changes is this.

A Solid Market for Alternative Energy

For the first time, a huge, guaranteed market will be opening up for alternative energy.

It will require new developments, infrastructure, improvements, and breakthroughs to make it work.

In short, there will be a new playing field for well-focused, forward-looking, entrepreneurially driven energy firms.

Unlike any other alternative energy push in memory, this one will have both government support and an assured, expanding need.

In the months ahead, wind power pioneered in Denmark and major advances in solar from China, along with a number of other ingredients introduced geographically in between, will converge on Germany.

That will translate into some huge profits over the next decade, both from new applications in Germany and the export potential to other countries.

A brave new world is underway for retail investment's next big return sector.

Wall Street Doesn't Like First Solar

First Solar now faces warranty claims that could bankrupt it… And unknown to Wall Street, I believe the company will also be the subject of a Justice Department investigation for foreign bribes.

This is as clear as I can be: Solar power will simply never work as a source of energy for the power grid. And by "work," I mean it will never be remotely economic. The reason has nothing to do with technical hurdles or innovations that have yet to be made. Solar power will never work because of the laws of nature – in particular, the Second Law of Thermodynamics…

Major investments are being made, driven by demands and financing from governments, to use photovoltaic semiconductor (PV) technology to convert sunlight into electricity for the power grid. I believe this is a tremendous waste of capital. It would NOT occur without the intervention of governments – which are notoriously bad at allocating capital – because it is horrendously inefficient. PV processes use photonic energy in sunlight (not heat) to "lift" electrons and create electricity. The thermodynamic limitations of this approach mean that many of the electrons fall back into the hole from whence they were lifted. That makes the panels very inefficient…

The catch is… in the real world, the materials needed to improve their efficiency are very rare and expensive. The other, even more important, catch is that the main impediment to PV efficiency is… heat. Yes, that's right. As PV solar cells are exposed to ambient temperatures above room temperature, their efficiency plummets. And seeing as how most of the places best-suited for solar power panels (like the roofs of buildings in warm climates) also have high ambient temperatures, I believe it's unlikely that this approach will ever prove worthwhile. I'm convinced that PV solar panels will never be economic.

The basic reason PV solar cells can't power the grid is simple: They do not generate heat. Without heat, there's no useful energy. That's a law of nature, not an engineering impediment. The hurdle manifests itself curiously… by changing the behavior of the electrons, rendering the PV solar cells almost totally inefficient above room temperatures.

A writer at TheStreet.com explained it this way yesterday: "Imagine a company that has predicated its future on building out large-scale projects in desert conditions. Now imagine the technology the company uses doesn't have a long-term track record of performing under intense heat. You don't have to imagine the company. It's First Solar…"

As a result of this problem, First Solar isn't going to commission its Mesa Arizona PV manufacturing plant. It's ceasing production at a plant in Germany, and it's no longer going to build a plant in Vietnam.

What will it do instead? Pay a lot of money in refunds.

So far, First Solar has spent a total of $125 million on warranty claims. It says future claims are likely to be "only" $44 million. I'd bet future warranty claims are closer to 10 times that amount.

The big problem for First Solar is that the company guarantees power efficiency – for solar panels that rapidly degrade under heat. These problems have already cost the company millions of dollars from panels made in 2008 and 2009. And the company says future losses from these problems will be limited. But the truth is, the company doesn't actually know – and can't know – how much it faces in future losses. The following is an excerpt from First Solar's 10-k…

Although our power output warranty extends for 25 years, our oldest solar modules manufactured during the qualification of our pilot production line have only been in use since 200 1. Because of the limited operating history of our solar modules, we have been required to make assumptions regarding the durability and reliability of our solar modules. Our assumptions could prove to be materially different from the actual performance of our solar modules, causing us to incur substantial expense to repair or replace defective solar modules in the future.

So… despite the fact that First Solar doesn't actually know how its panels will perform in the real world and that everyone with any knowledge of PV physics knows the panels won't work in hot environments… the company has made huge, long-tail promises to buyers. First Solar's 10-K continues…

We also warrant to our owners that solar modules installed in accordance with agreed-upon specifications will produce at least 90% of their power output rating during the first 10 years following their installation and at least 80% of their power output rating during the following 15 years. As a result, we bear the risk of extensive warranty claims long after we have sold our solar modules and recognized net sales.

I think all of us are familiar with what happens to companies that pay out royalties and stock options for net sales booked today, when the real costs of fulfilling those sales evolve over decades. Think Enron.

Despite all these obvious problems, some people on Wall Street still don't get the sham. Jeff Osborn, analyst with the financial services firm Stifel Financial, says, "We see the disclosed heat-driven degradation issue as lowering the economics of expanding into new markets and potentially posing a product acceptance risk."

A "product acceptance risk"? Ah… the product doesn't work. It never has. And First Solar sold it mostly to governments, which were too stupid to care… or were they?

I've been wondering for a long time why anyone – even a government – would buy these things. Well… maybe there's an obvious reason: They were bribed. First Solar all but admits it bribes local government officials in many of the places where it operates…

We currently operate in, and pursuant to our Long Term Strategic Plan intend to further expand into, many parts of the world that have experienced governmental corruption to some degree and, in certain circumstances, strict compliance with anti-bribery laws may conflict with local customs and practices.

In addition, due to the level of regulation in our industry, our entry into new jurisdictions, including India, China, and the Middle East, requires substantial government contact where norms can differ from U.S. standards… our employees, subcontractors and agents may take actions in violation of our policies and anti-bribery laws. Any such violation, even if prohibited by our policies, could subject us to criminal or civil penalties or other sanctions, which could have a material adverse effect on our business, financial condition, cash flows and reputation.

While nothing in life is certain… I am more and more convinced that First Solar will actually go to zero.

One last thing to keep your eye on… Last December, Warren Buffett, through MidAmerican Energy, spent $2 billion to finance a First Solar power plant (the Topaz plant in California). The plant is scheduled to be completed by 2015. The deal was heralded as a triumph for solar energy, as the plant failed to get a Department of Energy loan and was the first large, privately financed plant to be built… except it wasn't really…

It turns out, 30% of the construction cost was covered by a Treasury Department cash grant. Furthermore, the plant was built because California's PG&E power utility promised to buy power from the plant (at absurdly high prices) for the next 25 years. As a government-regulated monopoly, PG&E will pass these costs on to its customers, whether they like it or not.

Buffett, meanwhile, will collect hundreds of millions of dollars from making the loan and pose for all of the accompanying goodwill. But what will happen when the plant doesn't work… and the bribes become public… and the whole thing blows up? I'm sure Buffett will walk away saying he knew nothing about it…

America Is Proving "Peak Oilers" Are Utterly Mistaken

By Matt Badiali, editor, S&A Resource Report

If you think we're running out of oil, you're wrong…

I just got back from this year's giant North American Petroleum Expo (NAPE) in Houston, where all the talk was new oil production coming online.

Some commentators won't buy it. But there's an oil boom going on right here in the U.S.

The boom is coming from new drilling in shale rock. Shale is made up of flat layers, like pages of a book. The good ones are full of organic material that becomes oil and gas.

A decade ago, no one believed you could economically extract energy resources from shale rock. But new technologies (like horizontal drilling and hydraulic fracturing) have allowed us to tap vast new resources. Back in 2000, it was all about natural gas shales. Today, it's all about oil.

The great thing about these new oil wells is how low-risk they are. These are rocks that are all well-known. We've been drilling through them for decades. They're right here in the U.S. This isn't like drilling miles below the ocean. And it's not like exploring in some unstable African dictatorship. That means there's no political or exploration risk.

Take the Bakken shale for example. The Bakken is huge. It underlies about 200,000 square miles of North Dakota, Montana, and Saskatchewan. It holds about 400 billion barrels of oil. We know where the oil is… Until recently, it just refused to come out.

However, engineers cracked the code, and now we're pumping over 114 million barrels per year out. Oil production in the Bakken is up 310% in just six years. Bakken oil makes up nearly 8% of U.S. oil production today.

The Bakken and its cousins are creating a renaissance in U.S. oil production. Here's a chart of U.S. oil production over the last 20 years. As you can see, after years of decline, the trend is heading UP. That's due to shale production like we're seeing in the Bakken.


We saw something just like this in the early 2000s with natural gas shales… And early investors in natural gas shale producers made a fortune. Companies like Ultra Petroleum, Range Resources, and Pioneer Natural Resources soared thousands of percent from 2000 to today.

I think the same could happen with companies drilling for shale oil. I'm looking at oil producers with big land positions in "oily" shales like the Utica shale (in the northeastern U.S.), the Granite Wash (in Texas), and the Tuscaloosa Marine shale (in Louisiana and Mississippi). These include companies like Chesapeake Energy (CHK), Carrizo (CRZO), and Linn Energy (LINE).

If you're betting on peak oil, you're losing. If you're betting on more oil production in the U.S., I expect you'll make a lot of money over the next few years.