Published by Raymond James & Associates Jeffrey D. Saut, Chief Investment Strategist, (727) 567-2644, Jeffrey.Saut@RaymondJames.com February 9, 2015 "From Russia with Love?" The big news late last week was German Chancellor Angela Merkel s and French President Francois Hollande s emergency trip to Russia for peace talks with President Putin. Obviously, the situation in the Ukraine is heating up again or such Herculean efforts would not be undertaken. This latest escalation was likely caused by a story in the New York Times (NYT) suggesting the United States is about to send a large shipment of lethal weapons to Ukraine to help the beleaguered Ukrainian forces fight the pro-russian rebels. In past missives I have theorized this was going to happen ever since Ukraine voted to become a non-aligned state. Before that vote Ukraine had been aligned with Russia; and while the non-aligned vote was not a vote to join NATO, it was certainly a step in that direction. To a cornered Vladimir Putin, a NATO-aligned Ukraine is unacceptable for a multiplicity of reasons. In an attempt to gain some insight into the situation, I emailed my friend Bob Hardy, the lynx-eyed captain of the must-have Geostrat organization. My query read something like this, Hey Bob, if memory serves me, I don t recall that anything good has ever come about when leaders of the Western world brave Russia s notoriously severe winter and journey to Moscow. Any thoughts? Here is Bob s response: One thing to note is the U.S. was not included. I hear Putin offered Merkel and Hollande a deal in a phone call last Tuesday. Apparently the French and the Germans are willing to accept a ceasefire and a demarcation line between the two side s forces that accepts the current situation on the ground. Merkel would never have traveled to Moscow unless she thought a real deal was possible. Last Sunday's NYT report that the U.S. was considering supplying lethal weapons to the Ukraine and the report on Monday proposing $3 billion in American equipment be sent to the Ukraine, sharpened Merkel and Hollande's minds. They know Moscow would invade Ukraine if this happens and the conflict would intensify and widen. Getting into an arms race with Russia in the Ukraine is stupid and dangerous. Kiev is #$@!&, but I think it agreed after the EU promised to send it some money. Notice that Kiev stopped exchanging its currency for dollars and euros. It is broke and faces disaster on the battlefield. We will have to see what develops, but where there is smoke there is fire. See what develops indeed because Russian President Putin is being battered on many fronts. Consider this, Russia needs an end to the destabilizing sanctions imposed for its Ukraine misadventures. As the economic environment in Russia worsens, and the Russian solder death toll continues to rise, more and more Russian citizens will start to realize, as The Wall Street Journal (WSJ) notes: [The longer the Ukraine crisis goes on] many Russians may come to see that the Ukrainian model of a peaceful and spontaneous rebellion against a corrupt regime can have relevance for them. It was because of the potential power of the Ukrainian example for Russia that Mr. Putin began the war in Ukraine in the first place. Plainly, corruption is rampant in Russia with 110 people controlling 35% of the country s wealth, while 50% of adults have household wealth of $871 or lower (WSJ). Boy, talk about The 1%! No wonder Russian capital flight is epic. Moreover, in 2014 food prices surged 15.4% while crude oil prices plunged. Crude oil exports from Russia account for roughly 50% of Russia s GDP, and the breakeven price for a barrel of oil to balance Russia s budget is notionally $100. Further, Russian crude oil, for the most part, is priced in U.S. dollars, which is why much of Russia s debt is also priced in U.S. dollars. Given the dollar s strength vis-a-vis the ruble, that debt is becoming increasingly difficult to service. For example, if a Russian energy company borrowed $1 million dollars at the beginning of last year when $1 equaled ~33 rubles (33 million rubles), the size of that loan is now 67 million rubles since the exchange rate currently is $1 to ~67 rubles. Accordingly, our hypothetical Russian energy company s debt has effectively doubled, while its revenues have been cut in half due to the crash in oil prices. To be sure, Ya got trouble. I say trouble right here in River City. Trouble with a capital T and that rhymes with P and that stands for Putin! No wonder Frau Merkel donned her galoshes and trudged off to Moscow. Speaking to crude oil, I thought the most interesting thing about Friday s market action was the fact that the U.S. Dollar Index rose (+1.2%) and so did the price of oil (+2.4%). For a very long time oil has gone down as the dollar s value has increased. What happened on Friday was a change in that relationship and only further bolsters my belief that crude oil has bottomed. Recall, it was three weeks ago today on CNBC I stated, I think the price of crude oil bottomed last week. I still feel that way and would tilt portfolios that way. In the conference call I did with Troy Shaver, CEO/Senior Portfolio Manager (PM) of Please read domestic and foreign disclosure/risk information beginning on page 3 and Analyst Certification on page 3. International Headquarters: The Raymond James Financial Center 880 Carillon Parkway St. Petersburg, Florida 33716 800-248-8863
Dividend Asset Capital and outside PM of the Goldman Sachs Rising Dividend Growth Fund (GSRAX/$21.45), we discussed various energy themes and stocks. Three of the energy stocks Troy currently likes, and that are favorably rated by our fundamental energy analysts, include: Enterprise Products Partners (EPD/$35.29/Strong Buy), EOG Resources (EOG/$95.79/ Outperform) and Plains All American Pipeline (PAA/$51.69/Outperform). Speaking to the equity markets, as stated in Friday s verbal strategy comments, What a difference a week makes for it was a mere week ago last Friday when the S&P 500 (SPX/2055.47) was trading at 1990 and threatening to break below a spread triple-bottom. As noted at the time, there was/is a huge amount of internal energy built up on my proprietary indicators making me think that energy was going to be released on the downside. Silly me, for the news backdrop changed and the SPX surged from last Monday s intraday low of ~1981 to last Friday s intraday high of ~2072 before a late fade left it at 2055.47. The call for this week: I am off to San Francisco to see institutional accounts and speak at various events. Despite last week s hurrah, all we have done is once again rally from the SPX s support level (1990 2000 to 2060 2080). Nevertheless, the last line of Friday s Morning Tack read, While I am still not sure about the upside from here, I am pretty certain crude oil has bottomed. Hereto, I continue to feel that way. Over the weekend, Greece said it would run out of cash in the next few weeks, which is probably why S&P downgraded Greece s debt. S&P also warned that Greece s cash crunch could force it out of the euro and the EU. As of this writing (5:00 a.m. Monday), there has been little news from the Moscow meeting other than Merkel saying she thinks the Minsk deal will provide a dividing line between the Ukrainian troops and pro-russia separatists redrawn to take account of recent separatist gains. There was supposed to be a four-way phone call late Sunday between those leaders, but all that has come from that is another meeting in Belarus slated for Wednesday. Combine that with a defiant Greek Prime Minister on a bailout, and sketchy economic news from China, and you have the preopening S&P futures off some 9 points as I wing my way westward... International Headquarters: The Raymond James Financial Center 880 Carillon Parkway St. Petersburg, Florida 33716 800-248-8863 2
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High Risk (HR) Companies with less predictable earnings (or losses), rapidly changing market dynamics, financial and competitive issues, higher price volatility (beta), and risk of principal. Venture Risk (VR) Companies with a short or unprofitable operating history, limited or less predictable revenues, very high risk associated with success, and a substantial risk of principal. Raymond James Relationship Disclosures Raymond James expects to receive or intends to seek compensation for investment banking services from the subject companies in the next three months. Company Name Enterprise Products Partners L.P. EOG Resources, Inc. Plains All American Pipeline L.P. Disclosure Limited Partnerships may generate Unrelated Business Taxable Income (UBTI), which can create a tax liability that must be paid from a retirement account. You should receive a Schedule K-1 from the partnership annually that would include UBTI and other financial information. Please consult with your tax advisor to determine whether you must file and pay tax from your account. Raymond James & Associates has acted within the past 12 months or may be acting as an agent in an at-the-market offering of EPD shares. Raymond James & Associates received non-securities-related compensation from EPD within the past 12 months. Raymond James & Associates makes a market in shares of EOG. Limited Partnerships may generate Unrelated Business Taxable Income (UBTI), which can create a tax liability that must be paid from a retirement account. You should receive a Schedule K-1 from the partnership annually that would include UBTI and other financial information. Please consult with your tax advisor to determine whether you must file and pay tax from your account. Raymond James & Associates has acted within the past 12 months or may be acting as an agent in an at-the-market offering of PAA shares. Raymond James & Associates received non-investment banking securities-related compensation from PAA within the past 12 months. Raymond James & Associates received non-securities-related compensation from PAA within the past 12 months. Stock Charts, Target Prices, and Valuation Methodologies Valuation Methodology: The Raymond James methodology for assigning ratings and target prices includes a number of qualitative and quantitative factors including an assessment of industry size, structure, business trends and overall attractiveness; management effectiveness; competition; visibility; financial condition, and expected total return, among other factors. These factors are subject to change depending on overall economic conditions or industry- or company-specific occurrences. Only stocks rated Strong Buy (SB1) or Outperform (MO2) have target prices and thus valuation methodologies. Target Prices: The information below indicates target price and rating changes for the subject companies included in this research. International Headquarters: The Raymond James Financial Center 880 Carillon Parkway St. Petersburg, Florida 33716 800-248-8863 5
Raymond James Valuation Methodology: For EOG Resources, Inc., our valuation methodology focuses primarily on enterprise value to prior-year proved reserves, enterprise value to forward EBITDAX multiple, and price to proved net asset value per share. We also consider these valuation metrics in relation to the company's peer group. We believe these valuation metrics are useful when considered in conjunction with the company's debt to book capitalization ratio, reserves to production ratio (i.e., reserve life), and our assessments of the company's risk profile, drilling inventory depth, production growth profile, and forward-looking production growth per debt-adjusted share. Our analysis often requires us to estimate the company's capital structure at certain future dates. We calculate the 12-month target price based on an enterprise value to forward EBITDAX multiple. Valuation Methodology: Our valuation methodology is based on a blended valuation comprised of 1) a 10-Yr Three Stage Distribution/Dividend Discount Model (DDM), 2) a forward Price-to-Distributable Cash Flow (P/DCF) multiples relative to comparable industry peers, and 3) a target yield valuation. Our DDM assumes 1) cash distributions based on our forward-looking assumptions of the asset base, 2) a general cost of equity/discount rate/required rate of return for LP unitholders utilizing either the Capital Asset Pricing Model (CAPM), the Dividend Discount Model (Forward Yield + Growth), or the Bond Yield + Equity Risk Premium Approach, and 3) a perpetual growth rate/terminal growth rate based on the growth profile of the Partnership. International Headquarters: The Raymond James Financial Center 880 Carillon Parkway St. Petersburg, Florida 33716 800-248-8863 6
Valuation Methodology: Our valuation methodology is based on a blended valuation comprising a dividend discount model, DCF multiple analysis, and yield spread valuation analysis. Risk Factors General Risk Factors: Following are some general risk factors that pertain to the projected target prices included on Raymond James research: (1) Industry fundamentals with respect to customer demand or product / service pricing could change and adversely impact expected revenues and earnings; (2) Issues relating to major competitors or market shares or new product expectations could change investor attitudes toward the sector or this stock; (3) Unforeseen developments with respect to the management, financial condition or accounting policies or practices could alter the prospective valuation; or (4) External factors that affect the U.S. economy, interest rates, the U.S. dollar or major segments of the economy could alter investor confidence and investment prospects. International investments involve additional risks such as currency fluctuations, differing financial accounting standards, and possible political and economic instability. Specific Investment Risks Related to the Industry or Issuer Company-Specific Risks for Enterprise Products Partners L.P. Distributions Are Not Guaranteed The actual amount of cash distributed to unitholders may fluctuate and will depend on Enterprise Products' future operating performance. Cash distributions are dependent primarily on margins and throughput volumes. Should Enterprise Products experience significantly lower margins or throughput volumes, cash distributions could be decreased or terminated. Volumes Could Decline Gathering and transmission pipelines generally do not carry commodity price risk but are exposed to supply risk. If supplies decrease and the related throughput in the pipeline decreases, then Enterprise Products Partners' revenues will decrease accordingly. Supply decreases result from normal declines in production, a failure to secure new supply agreements, and competition from other pipelines. Interest Rates Could Rise Interest rate movements can affect yield-based investments, such as MLPs. Increasing interest rates could have an adverse effect on Enterprise Products' unit price as alternative yield investments, such as U.S. Treasuries, become more attractive. Additionally, increased debt service costs and interest expense might negatively affect the partnership's distributable cash flow. Commodity Price Risk Although limited, Enterprise Products' operations or margins could be exposed to volatility in commodity prices. While an MLP's revenues are typically generated primarily by tolling fees, margin-based businesses, such as Natural Gas Processing, can be directly and/or indirectly impacted by increases or decreases in commodity prices. International Headquarters: The Raymond James Financial Center 880 Carillon Parkway St. Petersburg, Florida 33716 800-248-8863 7
Acquisition Risk The risk of a dilutive or unsuccessful acquisition by Enterprise Products Partners exists. There are inherent risks involved (integration risk, limited operating history, competition, etc.) when making acquisitions that could impair a partnership's ability to make cash distributions. Management teams typically attempt to minimize these risks by doing extensive due diligence work. Company-Specific Risks for EOG Resources, Inc. Oil and Natural Gas Price Volatility Prices for oil and natural gas fluctuate widely, and EOG's revenues, profitability, and future growth depend substantially on prevailing prices for oil and gas. Also, lower oil and gas prices can influence the company's cash flow and capital available to reinvest in drilling projects, which could impact EOG's ability to grow its operations. To manage commodity price volatility, in the normal course of its business, EOG typically enters into hedging transactions on a portion of its expected production. Potential Increases in Service Costs Future increases in drilling and other service costs could affect EOG's profitability. As industry participants begin to accelerate drilling activity in response to higher commodity prices, costs will likely rise. However, attractive rates of return may continue to be achievable, depending on the level of future commodity prices and EOG's hedging program. International Exposure A significant portion of the company's operations are outside of the U.S., and as a result, EOG Resources is exposed to various risks inherent in foreign operations. These risks may include, among other things, loss of revenue, property, and equipment as a result of hazards such as expropriation, war, insurrection, and other political risks, increases in taxes and governmental royalties, renegotiation of contracts with governmental entities, changes in laws and policies governing operations of foreign-based companies, currency restrictions and exchange rate fluctuations, and other uncertainties arising out of foreign government sovereignty over the company's international operations. The company's international operations may also be adversely affected by laws and policies of the United States affecting foreign trade and taxation. Company-Specific Risk for Plains All American Pipeline L.P. Inability to Remove the General Partner Consistent with the MLP structure, common unitholders are not entitled to elect the general partner or its board of directors. Given this level of control, removing the general partner or the individuals in management is not likely. As a result, unitholders will have a very limited voice in corporate governance. Distributions Are Not Guaranteed The actual amount of cash distributed to unit holders may fluctuate and will depend on Plains future operating performance. Cash distributions are dependent primarily on margins, storage utilization, and pipeline throughput volumes from the asset base. Should the partnership experience significantly lower margins or throughput volumes, cash distributions could be decreased or terminated. Dependence on Capital Markets MLPs pay out a significant portion of available cash in the form of distributions to unitholders. When growth projects/acquisitions become available, partnerships typically tap the capital markets for the necessary financing. Market conditions may or may not be attractive for Plains at the time it needs external funding, which may hamper distribution growth. Commodity Price Risk Petroleum product prices may be in contango (future prices higher than current prices) or backward-dated (future prices lower than current prices) depending on market expectations for future supply and demand. In an increasing price environment, when a premium is placed on storage, Plains can profit from its storage assets by buying in the current market and selling at a higher price in the future, though its margins on lease gathering volumes may shrink. Alternately, in a backwardated market, when a premium is placed on prompt delivery, Plains may benefit from lease gathering margins, but may not have an incentive to store the physical capacity. Acquisition Risk The risk of an unsuccessful acquisition exists, including integration risk, overpayment risk, environmental or other unknown liability assumption risk, and the risk of asset underperformance once it is acquired. These risks could impair Plains All American Pipeline L.P. s ability to make cash distributions; however, management attempts to minimize these risks by performing extensive due diligence work. Volumes Could Decline Transportation volumes are exposed to supply/demand risk. Supply decreases could result from normal declines in production, failure to secure new supplies or supply agreements, and competition from other parties. Demand could be impacted by higher prices, which could impact system throughput. FERC Regulation The partnership s interstate natural gas transportation and some of its natural gas storage operations are subject to FERC ratemaking policies that could have an adverse impact on its ability to establish rates that would allow it to recover the full cost of operating its pipelines. If a negative ruling is entered, it could impact Plains cash flows and its ability to pay distributions. International Headquarters: The Raymond James Financial Center 880 Carillon Parkway St. Petersburg, Florida 33716 800-248-8863 8
releasable research is RJA client Raymond James Interest Rate Risk Increasing interest rates could increase Plains' financing costs and negatively impact its distributable cash flow. Additional Risk and Disclosure information, as well as more information on the Raymond James rating system and suitability categories, is available at rjcapitalmarkets.com/disclosures/index. Copies of research or Raymond James summary policies relating to research analyst independence can be obtained by contacting any Raymond James & Associates or Raymond James Financial Services office (please see raymondjames.com for office locations) or by calling 727-567-1000, toll free 800-237-5643 or sending a written request to the Equity Research Library, Raymond James & Associates, Inc., Tower 3, 6 th Floor, 880 Carillon Parkway, St. Petersburg, FL 33716. 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