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Summary

History says Buy.

This energy commodity was the first to yack.

The King is dead, long live the new King.

All the bearish news is in the price.

A historically volatile market — watch out.

Last Monday, when all hell was breaking loose in markets around the world and crude oil plunged to the lowest level in over six and a half years at $37.75 per barrel, natural gas really tried to follow. The price got down to $2.641 per mmbtu and no one would have been surprised if it traded below support on the weekly chart at $2.4430, the April 2015 continuous contract lows. Support on the active month NYMEX October futures contract at $2.6380 even held, and the energy commodity stayed within the trading range. By Friday, as oil recovered in violent fashion to close a volatile week almost 20% higher than the lows on Monday, natural gas quietly closed at $2.724 per mmbtu. I have prepared a video on my website Commodix, which augments this article and provides a more in-depth, detailed analysis on the current state of the natural gas market to illustrate and highlight the real value implications and opportunities available. In addition, I am launching my new service on Commodix today, Monday, August 31.

My favorite episodes of “Seinfeld” are the ones with Izzy Mandelbaum, an octogenarian muscle man and trainer. Chants of Mandelbaum, Mandelbaum, Mandelbaum just amuse me. Izzy’s favorite saying, before he throws out his back as he attempts to dazzle Jerry with his athletic abilities is, “It’s go time.” Well, it is the end of August and for natural gas, now is go time.

History Says Buy

The summer of 2015 is ending. It is back to school time, vacations are over. It will not be long before the leaves are falling from the trees and the brisk autumn weather turns to cold and snow across many parts of the United States. When it comes to natural gas, August tends to mark a low point in price. In 12 of the last 15 years, natural gas prices moved higher in September and October than the lows of August, the dog days of summer. The low for the October NYMEX natural gas futures contract this August was $2.641 per mmbtu.

NG 1

The daily chart of the October NYMEX contract highlights the lackluster trading activity over recent months. Prices have remained in tight trading range between $2.641 and under $2.99 since the middle of June, and speculative activity has been on the decline. Open interest, the total number of open long and short positions on NYMEX natural gas futures contracts, has dropped from over 1,050,000 at the end of June to 919,964 last Friday, a decrease of over 12%. With an 80% history of higher prices from August into the fall season, natural gas is now screaming “It’s go time!”

This commodity was the first to yack

The entire world watched and commented as the price of crude oil began its descent from over $107 per barrel in June of 2014. However, another energy commodity, natural gas, beat oil to the punch.

NG2

Four months before oil began its fall, natural gas shook off frigid temperatures during February 2014 and began its descent from highs of almost $6.50 per mmbtu. As the weekly chart illustrates, since then, natural gas has plunged by over 58%. Crude oil is now exactly 58% below its June 2014 highs of $107.73 per barrel. The current technical condition of the natural gas market is neutral, but there are a few factors worth noting. The decline in open interest means fewer players are in the market these days. Natural gas below $3 is historically cheap. Momentum and relative strength are at neutral levels. The thing that sticks out to me like a sore thumb is weekly historical volatility. Natural gas is combustible and so is its price. At under 20% weekly historical vol, this commodity is just too quiet. Over history, natural gas has been known to trade to levels of over 100% volatility, so today’s readings indicate a market that is asleep. Natural gas has spent the summer of 2015 hibernating; history tells us that it is likely to awake from its slumber soon. It’s go time for natural gas.

The King is dead, long live the new King

Coal has been an important energy commodity in the United States throughout history. The production of power, or electricity, long depended on coal fired cogeneration plants. Coal was king, but that is changing. The U.S. administration has put new rules and regulations in place that sign the death warrant for coal as the energy used to produce electricity. The replacement, the new king, will be clean burning natural gas. There is an abundance of natural gas in the U.S. Huge reserves in the Marcellus and Utica shales contain over a quadrillion cubic feet of the energy commodity. However, the number of rig counts has dropped precipitously over the past year and the replacement of coal is a new demand vertical for natural gas. Another new demand area is liquefied gas. Cheniere Energy (NYSEMKT:LNG) will be shipping liquefied natural gas around the world from their terminals in Louisiana, yet another new demand channel for the forlorn commodity. At a price of under $3 for natural gas, fundamentals seem to be saying, it’s go time.

All the bearish news is in the price

Everyone has been bearish on everything that is energy related for a long time now. The big supplies of natural gas in the crust of the earth depend on companies with the financial wherewithal to extract it. Lower energy prices across the board have caused huge strains on energy producers. The drop in oil prices has been the result, in many ways, of huge U.S. production in recent years, and now at current prices, a lot of oil production in the nation is not economic. At under $3 per mmbtu, it is questionable whether natural gas production is a big money maker for energy producers these days.

Lower energy prices weigh heavily on many debt-laden producers who are likely to produce less given economic strains on their balance sheets and the current levels of price. Additionally, rig counts that are far below last year’s levels and one can make a case that although there are big reserves of natural gas, production is uneconomic and the low oil price has stressed many companies that produce both oil and gas. Just look at the share prices of some of the big gas producers. Chesapeake (NYSE:CHK) is trading at $7.39 a share, down from 52-week highs of $27.15, last month they suspended their dividend. Apache (NYSE:APA) is at $44.86 down from 52-week highs at $102. Linn Energy (NASDAQ:LINE) (NASDAQ:LNCO) is at $3.30 down from $31.80. The list of suffering oil and gas companies is long and growing.

All the bearish news for natural gas is currently in the price. It will take very little to ignite volatility in this combustible commodity. The downside is limited and upside explosive. As summer turns to fall, it’s go time for natural gas.

A historically volatile market — watch out

We have not witnessed real volatility in natural gas since the winter of 2014. Since then, the price has done nothing but make lower highs and lower lows. The price hibernation during the summer of 2015 has resulted in a period of consolidation and very cheap prices. All signs tell me that natural gas is going to surprise everyone really soon.

Whether the surprise comes in early or late fall or even in the coming winter, today’s low price creates an unsustainable position for producers who are facing economic challenges. Classic economics teaches that low prices for a sustained period of time leads to cutbacks in production. Low prices also lead to increased demand. With new demand verticals and producers hanging on by a thread in terms of their financial conditions, this market is at a critical point. It’s go time for natural gas.

Every time Izzy Mandelbaum attempted to show his athletic prowess, he injured himself. Many of you perennial bears are likely thinking you will come visit me when I throw out my financial back on natural gas over the coming months as Jerry visited Izzy. My answer to you in the spirit of Izzy is, “You think you’re better than me?” At prices under $3, the downside is limited and I am willing to take the risk. It’s go time — natural gas, natural gas, natural gas…

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Summary

Last week’s piece explained the issue.

Transocean and Seadrill have suspended dividends.

More cuts are on the horizon.

BHP makes a mistake.

Commodity stocks will not make a bottom until the dividends turn to retained earnings.

Dividends in the commodity sector are like a lethal drug that will destroy shareholders in the great bear market for raw material prices. Commodity producers and related companies need to take a Buffettesque approach to managing their business and shareholder dividend policies. I have prepared a video on my website, Commodix, which augments this article and provides a more in-depth, detailed analysis on the future of natural resource-related equities to illustrate and highlight the real value implications and opportunities available. In addition, I am launching my new service on this site today (Monday, August 31).

The volatility in all assets classes last week reached a crescendo as a combination of a slowdown in China and a supply war in crude oil clashed to create a cascade of selling early in the week. Crude oil made new lows at $37.75 per barrel on the active-month NYMEX futures contract. The Dow Jones Industrial Average plunged more than 1000 points last Monday, and copper made new multi-year lows at just over $2.20 per pound. Gold rallied to almost $1170 per ounce on the fear factor. Things looked bleak. Later in the week, the price of silver plummeted below the $14.10 support level and traded at the lowest level since August 2009 at $13.95 per ounce on Wednesday, which was COMEX expiration day for silver options. The Chinese government supported the local equity market on Thursday and cut interest rates once again during the week, lifting prices. As Chinese stocks rose, so did other asset prices around the world. The price of gold could not make it through $1170 and backed off $50. Oil staged an impressive rally on Thursday, closing almost $4 or over 10% higher than the previous session, copper rallied by over 13 cents and silver came back to the $14.50 level.

It was a wild and crazy week, and another testament to the fact that markets do not go up or down in a straight line. Meanwhile, with all eyes on China and the price of oil, volatility will be the norm rather than the exception in the weeks and months ahead. The oil supply situation continues to weigh on price, and China will continue to add volatility, as it is virtually impossible to stimulate growth overnight. These two issues weigh heavily on U.S. equity prices. When China has the economic flu, the rest of the world gets pneumonia.

U.S. stock indices, which are performance benchmarks for many money managers, contain the equities of many oil sector companies. When it comes to the equity prices of those companies involved in the production of commodities, I believe we have not reached a bottom, even though prices have recovered from last Monday’s nightmare. Commodity prices will continue to dictate the price path of these stocks, and a weak China – the demand side of the equation in commodity markets – means that there is more trouble ahead. Only the strong will survive and flourish in the years ahead, and in this market environment, strong means little or no debt and a rich cash position.

Last week’s piece explained the issue

I believe that commodity producers need to change their mindset when it comes to dividends. While these firms must compete with others for capital in the equity markets, it is currently a time for concern about survival. Last week, in a piece for Seeking Alpha, “The Mirage of Dividends and Yields in Commodity Stocks,” I explained my position that these producers (in all commodities, including the oil patch) pay dividends because investors expect them to. I also explained that the real yield considerations stem from the forward curve or term structure for the commodities themselves. Therefore, it is my contention that commodity stocks and indices will not bottom until companies drastically cut or suspend dividends across the board, reflecting the current dire situation for producers. When they do this, the market will hate it and their share prices will move even lower, but those shareholders that remain will benefit in the end. The problem is that a change in the dividend policy for the commodity sector is a move away from the status quo, quarter-to-quarter mentality of yield-based returns. Given the bear market in raw material prices, those who continue to struggle to meet investors’ hunger for dividends are likely to sacrifice future opportunity. In some cases, their debt levels will swallow them, leaving the equity holders they seek to please with nothing but a worthless share certificate. We have already seen some of these companies taking the bitter pill.

Transocean and Seadrill

A perfect example of what a dividend cut can do to a commodity-related company is the effect seen on Seadrill Limited (NYSE:SDRL), which suspended its dividend on December 18, 2014 as oil was moving lower. In the wake of the OPEC meeting in November 2014, when the cartel shocked the oil market by not cutting production, SDRL stopped paying its shareholders dividends. The share price plunged. Oil had fallen dramatically during the period from June 2014 through December, active-month NYMEX crude oil futures moved from over $107 to just below $55 per barrel, and all oil-related stocks plunged along with the commodity.

WB 1

 

SDRL moved from $38.90 per share to $12. After SDRL suspended its dividend, the price of the stock continued to fall to lows of under $7 recently.

 
WB 2

Oil continued to drop, and this past week, it made yet another new low. The market continued to punish SDRL, as it is an oil services company that does not even pay a dividend these days. A funny thing happened on the way to earnings for SDRL last quarter. When earnings came out last Thursday, the company beat analyst expectations, as it reported $0.77 in earnings per share on revenue of $1.15 billion, compared to consensus estimates of $0.63 on $1.17 billion. Most importantly, debt fell by $1 billion and cash increased slightly to $918 million. Whether this company will survive or not is in the hands of the oil gods these days, but all I can say is bravo to the management, which saw that it was time to put the helmets on and try to survive all the way back in December. They resisted the short-term temptation to please shareholders by paying a dividend, and that resulted in a lower debt load and a stronger position for the company. It should serve as an example to others in the commodity-producing or servicing industries that now is not the time to pay out dividends to shareholders; rather, it is a time to strengthen their financial condition and retire debt. After all, lower oil prices (and commodity prices in general) will likely lead to a downgrade by rating agencies, which will increase the cost of servicing mountains of debt. Doesn’t it make sense to pay down as much debt as possible, which will lower debt-servicing costs, rather than to pay dividends? A company operating in a challenging market environment that continues to pay a dividend to satisfy shareholders and bolster the appeal of its shares is like giving a heroin addict another dose of the drug to keep them going. Those dividends amount to a short-term high for shareholders, but the addiction will eventually kill them.

This week, Transocean Ltd. (NYSE:RIG), whose stock has fallen like a stone, realized that it too should suspend its dividend. Last month, Chesapeake Energy Corporation (NYSE:CHK) and Linn Energy, LLC (LINE, LNCO) suspended dividends. I am not advocating buying any of these companies at their current very low prices right now, given bear market action in the oil & gas markets. It may be a case of a little too little too late for many of these companies. These companies may be better candidates for asymmetric plays on their debt. The whole concept of dividends in these businesses has actually hurt the equity holders the companies so desperately try to accommodate and please.

More cuts on the horizon

I guess many of the producers and servicers in the commodity sector believed that prices would remain high, production economic and business activity buoyant enough to make juicy profits forever. The idea of retiring debt and building war chests for the future inevitable downturn never crossed their collective minds. Survival is the name of the game these days for the commodity sector. Low levels of debt and a strong cash position will not only be a path to survival through the nuclear winter of low commodity prices, it opens up all sorts of opportunity. A strong cash position will allow for the purchase of those companies that have not survived, which will increase market share and benefit the shareholders during the inevitable next commodity bull market. An absence of dividends amounts to sending those addicted investors to rehab. The bear market in raw material prices and China’s economic slowdown has been a rude awakening for the industry as a whole; however, some continue to struggle to pay their shareholders a dividend. They are determined to give those addicts their quarterly injection so they will not look for another company, another dividend drug peddler that will.

BHP makes a mistake

This past week, the world’s largest metal and mining concern, BHP Billiton (BBL, BHP) reported a pre-tax profit for the year ending June 30, 2015 of $8.05 billion, which was a huge decline from last year’s $21.73 billion. This year, revenue dropped to $43.45 billion from $55.04 billion last. Given the slump in commodity prices, this came as no surprise; everyone in the industry is hurting. What did come as a shock was the announcement that the mining company chose to increase its dividend by 2 cents per share. After the announcement, shares of BHP rose as analysts lauded the increase, and dividend addicts fell all over themselves to buy shares.

I believe that this is a disservice to shareholders, as many of the commodities that BHP handles are in brutal bear markets. China’s woes are far from over, and the company is making a major bet on 7% growth in the Asian nation. If they are wrong, it could get very ugly, but the attitude of the market is – who cares, as long as we get the dividend next quarter, we are happy. Copper, a major commodity for the company, is around the $2.30 per pound level, down from almost $4.65 cents in 2011. There is a lot more downside potential for this metal if China continues to have difficulties. In 2008, the metal fell to under $1.25 per pound; in 2000, the price was 85 cents.

Rather than pay those dividends out to the shareholders, it would be much better for the owners of BHP if the company took that cash and bought copper and other metal and mineral production at pennies on the dollar if the price gets to those levels once again. Instead, by paying out these quarterly stipends, they may not find themselves in a competitive position to do so, or worse.

Commodity stocks will not make a bottom until dividends turn to retained earnings

The problems in China are real, and they will not disappear overnight. The supply war in crude oil has no clear end. Commodities are in a bear market, and while we may see occasional upticks in price and short covering rallies, the trend of lower highs and lower lows is likely to continue. The dividend policy of many in the commodity industry is antithetical to the interests of the shareholders, who, in many cases, do not know what is good for them. What drug addict does? I believe that commodity stocks, in general, will not make a bottom until they all stop paying dividends. Those companies that wait too long could find themselves in bankruptcy court, as credit downgrades will increase debt loads.

When times are good, I have no problem with paying a special dividend, an unexpected surprise or windfall, to shareholders, but only when the war chest is full and there is nowhere better to deploy the cash. The mistake is to get them addicted to cash flow. It is widely agreed that the greatest investor of our time is Warren Buffett. His company, Berkshire Hathaway (BRK.A, BRK.B), has never paid a dividend. Perhaps management in the commodity sector should ask themselves why.

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