Pipelines: Influences Of The Oil, Rail, And Pharmaceutical Pipelines And Hedge Fund Investing
We have heard a lot about the Keystone Pipeline. It is a 2,100 mile oil pipeline network from Alberta, Canada to the Texas Gulf coast. It makes the front page of the newspapers because it is a hot political issue: “Should the Keystone Pipeline be built or not?” The truth is, three phases of the operation are already operating. It is the fourth phase that is awaiting government approval, and Phase IV is actually replacing Phase I that was completed four years ago. There is controversy on the number of permanent and temporary jobs created, on whether or not pipelines are safer than rail cars for oil transport, on the environmental impact of the transport of “tar sands” oil, and on the cultural and health impact of indigenous communities. Two facts for certain are 1) the tar sands are mixed with sand and clay and 2) at 52 degrees Fahrenheit in nature, tar sands oil is as hard as a hockey puck. It has been estimated that the amount of energy that must be used 1) to heat and dilute the tar sands so that they can travel through the Keystone pipeline and then 2) to refine tar sands oil will increase green-house gases by about 17% (U.S. State Department and the Congressional Research Service). Whether or not the gasoline and other products refined from tar sands are going to be exported or not is another matter of debate. However, it has been generally agreed upon by experts at the U.S. State Department, Deutsche Bank, and Morningstar that fuel from the proposed Keystone will have little effect on the price of gasoline at the pump because most of the refineries on the Gulf Coast get a different type of crude oil from Venezuela and the Middle East. The November elections will again bring this popular news topic back to the forefront of headline news as we hear from both major political parties whether or not building the Keystone pipeline will affect the price of gas at the pump and hence impact family budgets.
The Keystone debate has stimulated another “pipeline.” According to the publication “RailwayAge”, demand for railcars is increasing moderately, and given the backlog of demand, this railcar growth is expected to last for the next 5 years. According to the Association of American Railroads, U.S. carloads of petroleum products have doubled in the last 3 years (i.e. since the Keystone project was first delayed). However, the number of rail accidents with petroleum products and hazardous materials has also increased significantly in the same time period. According to the McClatchy News Agency, there was more oil spilled from U.S. rail tank cars last year than in all of the previous 40 years on record. Nonetheless, annual railcar assemblies are expanding moderately, and railroads are expecting strong capital spending in 2014 with continued growth in oil, chemicals, manufacturing, steel, grain, light vehicles, and intermodal transportation. “Rail pipelines” are vital to the continued growth of the nation’s economy. Ask Warren Buffet; railroads are one of his best investments. Remember, he bought the nation’s second largest railroad, Burlington Northern Railroad, in 2009.
There are other “pipelines” that significantly impact the economy. These are the “drug pipelines” of pharmaceutical companies. Key to the success of a pharmaceutical company is its drug development pipeline. On average, a drug usually takes an average of 12 years to develop, and its development costs an average of about $5 billion. In the course of its development, a drug goes through three phases of human clinical trials monitored by the Food and Drug Administration (Phase I, Phase II, and Phase III), and only one drug in 5,000 is ever approved for human use. For instance, Eli Lilly and Co. has 8 product candidates in Phase III trials. Some of their promising drugs in their product pipeline are for gastric cancer, type2 Diabetes, lung cancer, and osteoarthritis. There are a number of factors that impact the success of a pharmaceutical pipeline, some of which can be negative, such as the loss of patent protection. Eli Lilly’s profit dropped when its product Cymbalta lost patent protection in 2013. Another pharmaceutical company that has a very good drug pipeline is Merck & Co. Merck has a very substantial Phase III pipeline, and at least two of these drugs having been granted “breakthrough status” by the FDA. Some of these products under Merck’s development use special antibody treatment for advanced melanoma; other pipeline drugs are for insomnia, osteoporosis, hepatitis C, Alzheimer’s, and as many as 30 other types of cancer. The health and pharmaceutical companies make up a major sector of our economy. With pharmaceuticals and medical goods costing more in this country than any other country, the United States spends more per person per year on pharmaceuticals than any other country. It is apparent that these pharmaceutical pipeline products have a major impact on both our physical health and our family budgets.
In addition to the impact of the petroleum pipelines, the rail networks, and the pharmaceutical drug pipelines on both the growth of our economy and portfolio investments, a fourth pipeline, namely the “pipeline of hedge funds” on sovereign debt, has recently had a major impact on the stock market. The possibility of the default of Republic of Argentina contributed to the stock market drop of several hundred points on July 31st. Here is some background.
In 1973, Paul Singer, an attorney in the real estate division of the invest firm of Donaldson, Lufkin, & Jenrette, founded the hedge fund Elliott Management Corporation with $1.3 million from family and friends. This hedge fund now oversees $21 billion in assets under management.
Generally speaking, a hedge fund is professionally managed like a mutual fund but
- It seeks profits by using more flexible investment strategies such as leveraging (borrowing at increased risk).
- Its investments use leveraging (using borrowed capital) and are usually speculative in nature (such as investing in debt, arbitrage situations as in buyouts, or betting on currency moves).
- A hedge fund may not be regulated by the SEC (Securities and Exchange Commission).
- It is not required to provide the same level of disclosure as is required by a mutual fund.
- Its investors must have a net worth of at least $1 million.
Following the 1987 stock market crash and the recession of the 1990’s, Elliott Management was involved in the restructuring of a number of U.S. firms such as WorldCom, Enron, and TWA. In addition, Elliott Management also trades “distressed securities in sovereign debt.” In other words, Elliott Management purchases risky securities or bonds of a foreign government. Distressed debt sells at a very low percentage of its face value, and the riskier the debt, the greater the chance of a profitable reward if a company such as Elliott Management can restructure a company or a country’s sovereign debt. Once a distressed company emerges from bankruptcy and its bonds become viable, the once-distressed debt then sells at a higher price and a profit. In a scenario like this, a hedge fund can make a profit in a relatively short period of time. Elliott did this with the Republic of Congo between 2002 and 2008. Elliott also bought distressed debt of a defaulted Peruvian bank, and after extensive court litigation, Elliott was awarded millions of dollars. This brings us to the subject of Argentine debt and the “pipeline of hedge fund investing” in that country’s sovereign debt.
The issue of Argentine sovereign debt is nothing new. Argentina first defaulted on its sovereign debt in 2002, and it has defaulted 3 times. Elliott Management now owns Argentine bonds with a face value of $630 million and that now have a value of $2.3 billion. Even though Elliott has won judgments in U.S. and U.K. courts, Elliott has refused to accept Argentina’s offer of 30 cents on the dollar. On June 30th, Argentina defied a court order and refused to pay all of its bondholders. When the 30-day grace period ran out at the end of July and Argentina did not pay its creditors, the U.S. stock market fell.
So why does Argentina refuse to pay? Standard & Poors and other organizations say that Argentina is in default; Argentina says that it is not in default. In 2001, when Argentina was $100 billion in debt,
- 90% of its creditors – called the “exchange group” - settled their Argentina debt by accepting new bonds worth 30 cents on the dollar.
- 10% of its creditors – called the “holdouts” (which includes Elliott Management) - did not accept Argentina’s offer of 30 cents on the dollar.
- The “holdouts” - want to be paid the full value of the bonds.
As of July 31, 2014
- Argentina says that it has fulfilled its duty by transferring money to the Bank of New York Mellon for bond payment to the 90% of the creditors (the “exchange group”).
- Argentina says that the Bank of New York Mellon is supposed to route this money to the “exchange group” of creditors.
- However, Argentina defied a U.S. Court of Appeals (New York) to pay all of its creditors, both the “exchange group” and the “holdout group.”
- The “holdouts” want to be paid 100 cents on the dollar.
- The U.S. Court of Appeals says that the “holdouts” must be paid the full value.
- The U.S. Supreme Court has also ruled that the “holdouts” must be paid in full.
- Argentina states that its payment of money to the Bank of New York Mellon (the trustee bank) insulates it from the charge that it does not pay its bills.
Estimates are that Argentina has enough foreign currency ($30 billion) to pay for five months of imports, and it also has billions of dollars of debt coming due in 2015. On the other hand, Elliott management has $28.4 billion in assets under management. Elliott may well wait out Argentina. It has done that with the Peruvian bank (mentioned above) and in several other situations. Hence, there is a standoff.
The oil, rail, pharmaceutical, and hedge fund financial “pipelines” play significant roles in our nation’s economy. A number of factors influence each of these areas, whether it is the politics affecting the transport of oil within our continent, the rate at which rail car manufacture keeping up with economic growth, the speed with which the FDA can approve new pharmaceutical drugs for use, or the use of millions of unregulated hedge fund dollars to purchase the debt of foreign governments. The financial dynamics of all of these interactions affect portfolio investments. A key to successful investing at Heaphy Investments, LLC is doing the research to find 1) good fixed income and 2) good companies for client portfolios that ideally have, among other qualities,
- Good earnings growth over a period of time relative to the market.
- Good Return on Equity that measures how effectively a company invests stockholder money.
- Good revenue growth over time.
- A good PE value (price-to-earnings ratio) relative to the average PE of the stock’s sector.
- A relatively low PEG value (the PE ratio divided by the growth rate of its earnings).
- Low debt.
- Dividend yield.
- Seasoned management.
- Little volatility.
- Other factors relevant to the stock sector.
Finding the balance of these factors and taking into account a client’s needs, concerns, and risk tolerance guide our client relationships at Heaphy Investments, LLC.
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