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My Thinking on Energy Stocks March 2, 2014

Posted by shaferfinancial in Finance, Uncategorized.
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Buffett in his letter to investors March 1, 2014.

“What the economy, interest rates, or the stock market might do in the years immediately following [two personal investments he made in 1987 & 1994] was of no importance to me in making those investments. I can’t remember what the headlines or pundits were saying at the time. Whatever the chatter, corn would keep growing in Nebraska and students would flock to NYU.”

Does anyone think that the global use of oil products is going down in the future? So my analysis starts with that premise, backed up by data of increasing demand [even with China economically in a lull], that oil will continue to be in demand.

Again Buffett: “Focus on the future productivity of the asset you are considering.”

Now some people have asked me why I invested in deep sea drilling companies instead of land based oil & gas drilling companies? My analysis was pretty simple here. Even a cursory look at what is happening would draw into question the “future productivity” of land based shale oil plays. That is, the wells drop in productivity by as much as 60%-70% in the first year and are played out in a few short years. This forces companies to continually drill wells incurring expenses not yet accounted for.

Now SDRL, AWILCO and SFL all have future productivity that under the premise of growing long-term world demand for oil, are assured barring major management miscues.

Buffett: “If you instead focus on the prospective price change of a contemplated purchase, you are speculating. There is nothing improper about that. I know, however, that I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so.”

Hence, I look at the dividend payments schedule for these companies. Consider shale oil drillers Chesapeake Energy at a dividend yield of 1.35% or Encana Co. at 1.48%. I note that these independent drillers spend $1.50 for $1 worth of profits. Continental Resources reported increase production of 35%, yet net income decreased 39% from the last quarter due to increase expenses and derivative losses. Expenses increased 69% over last year! They pay no dividend. Their issue is the rising cost of getting that oil against the supply/demand equation. The more oil they produce, the greater chance the price of oil decreases meaning they will lose even more money. Sitting out there is OPEC which could increase its production decreasing the price of oil. That’s why we are seeing major energy companies selling their land [Shell, Hess, BP]. They simply don’t like the economics of the shell oil play. They need to drill and produce more oil to make a profit, and yet if they do that the price of oil could drop below their cost of drilling.

Current yield for the three energy companies I purchased are 10.7%, 8.5%, and 21.2%. All those companies have billions of dollars in order backlogs securing their current dividends. [I will discuss specifics of this in a later post]. All have increased their dividends over the last year.

So looking at future productivity and current yield leads me to the place of investing in drillship owning companies with huge backlogs of leases. And if the price of oil goes down they can simply lower their dividends temporarily.

Now a long term decrease in the use of oil products is the major risk here. I am comfortable assuming that risk while my dividends are reinvested causing my dividend income to increase exponentially over the long term.

Finally, Buffett: “It should be an enormous advantage for investors in stocks to have those wildly fluctuating valuations placed on their holdings-and for some investors, it is. After all, if a moody fellow with a farm bordering my property yelled out a price every day to me at which he would either buy my farm or sell me his-and those prices varied widely over short periods of time depending on this mental state- how in the world could I be other than benefited by his erratic behavior?”

I picked up some more SDRL last week when the market pushed it down into the $35 range. I was happy to buy it at $41, and more than happy to buy some for less than $36. I sold some Berkshire and will increase my AWILCO after I get my dividend. All part of the plan to develop dividends enough to live off of in retirement.

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