Making Another Bet on a Bounce in Energy

Last week was another down one for stock markets across the world, with the Dow Jones slipping 1.43%, the S&P 500 sliding 0.81% and the NASDAQ dipping 0.59%. In addition, the MCSI Emerging Markets Index fell 2.30%.

Your short position in China through the Direxion Daily CSI 300 China A Share Bear ETF (CHAD) rose 1.17%. You also were stopped out of Dycom Industries (DY) at a loss.

With energy and gas prices not this oversold since it least 2002, calling a bottom in the energy market is tough to predict.

Yet as your Warren Buffett-inspired Bull Market Alert recommendation, Phillips 66 (PSX), suggests, some of the smart-money investors are doing just that. In addition to Buffett, David Tepper, of Appaloosa Management, one of the savviest and most successful traders in the hedge fund business, has placed big bets on energy giant Kinder Morgan, Inc. (KMI).

Here’s why I agree with Tepper and expect that Kinder Morgan will rally sharply during the next three months.

First, despite a continued plunging in energy prices, Kinder Morgan was able to generate $4.7 billion in distributable cash flow in 2015. That comes to $2.14 per share, a 7% increase over 2014. How did it manage such robust results? Kinder Morgan has more than 90% of its cash flow secured by fixed-fee long-term contracts.

Second, Kinder just cut its dividend by 75%. Why is that good news? The cut will generate $3.6 billion in cash flow in excess of its dividend for 2016. This extra cash is more than enough to cover management’s expected $3.3 billion in capital spending. When combined with a new dose of $2 billion in unsecured loans to refinance existing debt, the extra cash ensures that the company won’t need to access additional debt or equity markets beyond 2016.

Finally, from a technical standpoint, Kinder Morgan has shown impressive relative strength. After Friday’s rally, it is slightly up for 2016 — a remarkable feat for an energy stock.

What’s the risk here? Despite its robust business model, a bet on Kinder Morgan is ultimately still on a bet on the oil price. Kinder’s projected $4.7 billion in 2016 distributable cash flow is based on projections that the price of West Texas Intermediate crude and natural gas prices will average $38 per barrel and $2.5 per MMBTU this year. Today, these are trading at $29.44 and $2.13, respectively, after rising sharply last Friday. That means both would have to rise by about 30% for Kinder to meet its targets.

While a 30% rise in oil and gas price in 2016 from current levels may seem like a stretch, remember that the last time oil traded this low, it rebounded 150% within the next 12 months. Extremes simply don’t last that long.

So buy Kinder Morgan (KMI) at market today and place your stop at a wide $9.50 a share. With the stock bouncing more than 7.16% on Friday, I am holding off on recommending any options until the stock settles a bit.

Here’s a word of warning. With volatile energy prices, this is a high-risk bet. If you act on this recommendation, you might want to start with a smaller than usual position and strap yourself in for a volatile ride.

Portfolio Update

Direxion Daily CSI 300 China A Share Bear ETF (CHAD) rose 1.17% last week as the bearishness continued. Not only did last year result in the slowest Chinese economic expansion in several decades, but China’s manufacturing sector also closed 2015 with its strongest contraction in more than three years. Investment bank UBS is also quite reserved on its China stance, declaring, “China’s stock markets will see no gain in 2016.” CHAD is a BUY.

Phillips 66 (PSX) gave back 4.00% last week. Warren Buffett closed yet another week by buying PSX stock worth $37 million. And, Mr. Buffett is not alone in his bullishness on PSX. Eleven analysts have “Buy” ratings on PSX, and one even has a “Strong Buy” rating. The consensus price target is $87.82 for Phillips 66 — a potential 17% gain from last Friday’s close. PSX is a BUY.

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Sincerely,

Nicholas A. Vardy