Current Prices and Future Outlook

Median home prices dropped by up to 40% in select markets in the country in 2008 according to Kiplinger.com. 2008 saw the peak of interest rate resets for the subprime mortgages. However, resets for many other adjustable rate mortgages will continue until 2011. According to Mark Zandi of Moody’s economy.com potentially 12 million houses could go into foreclosure. As such the pressure on housing prices is likely to continue.

According to Kiplinger.com, Fiserv Lending Solutions forecasts that the median home price nationally will fall another 9% in 2009, bottoming out in the last half of ’09, and increase nearly 7% in 2010. However Kiplinger expects the market to fall another 10% in 2010 before regaining its footing in 2011.

Figure 1 below shows the change in home prices from 2000 to 2008 based on the Case-Shiller 20-City Home Price Index.

Fig. 1 Year-Over-Year Percent Change in the Home Price Index, 2000 to 2008

The December 22, 2008 issue of Fortune magazine has an article about the 2009 housing outlook for the top 100 markets in the country. According to its analysis, only two out of the hundred markets is going to show gains in 2009. However, 47 markets are expected to swing to gains in 2010. Here is a webpage showing the 10 worst performers in 2009 from the same data. Eight of these ten markets are in good old California. The top ten worst markets include Los Angeles, Stockton, Riverside, Miami-Miami Beach (Florida), Sacramento, Santa Ana-Anaheim, Fresno, San Diego, Bakersfield, and Washington, DC in order from the worst to the tenth worst.

Mortgage Rates

Thanks to the rate cuts by the Fed, mortgage interest rates are expected to stay low. The 10-year Treasury note yields are at historically low levels. But increased perception of risk by lenders is keeping the spread between the note yields and the 30-year fixed mortgage rates high, preventing the mortgage rates from reaching the target of 4.5%. Figure 2 below shows a forecast of thirty-year mortgage interest rates from Forecasts.org.

Fig. 2 Thirty-Year Conventional Mortgage Interest Rate—Past Trend and Projection, 2006 to 2009

Crisis and Opportunity

Every crisis also presents an opportunity. My heart goes out to those who got caught up in the frenzied go-go years of cheap and easy no-questions-asked mortgages and rising home prices, and are now faced with potential foreclosures and financial hardship.  But for many buyers, lower house prices make purchasing a house possible, affordable, and profitable as an investment. Is this, then, a good time to buy a house?

But first, we should consider the merits of the idea of buying a house. Buying a house at the right time and for a sufficiently long time can have many advantages over renting one. It can give you better control over your living quarters, stability, tax deductions of mortgage interest payments, and a chance to build equity. Historically, over a long period of time, say greater than 10 years, house prices generally appreciate by more than inflation when compared with the original purchase price.

Even if the house prices go down after the purchase in a downturn like today’s, the loss in house value is only an unrealized paper loss. The loss is realized only if you have to sell the house during the downturn because of a move or a loss of income. It is always a better idea to get a 30-year or 15-year fixed mortgage rather than an adjustable rate mortgage or any of the newfangled exotic mortgages. That way the mortgage payments stay predictable and affordable.

If you already own a house and have to move because of a job or you have been waiting to upgrade from your starter house to a bigger house or a house nearer to the job, it could be a good time to purchase that new house compared to when the prices are high. In an up market or a down market the prices on the old house (the one you are living in) and the new house (the bigger or the better located one) will move in tandem. So, if the new house price is going to be higher, so would be the old house price, and vice versa. However, the price differential between the houses will be smaller in a down market, making your new mortgage a smaller one.

Purchasing an additional house for investment depends on a number of factors including the price, investment time horizon, mortgage rates, and rental income from the new house. You can do a quick analysis to see if you have positive cash flow. In other words you can compare your annual payments for mortgage, upkeep, and taxes with the annual rental income. If you expect more income than expenses, then you are cash flow positive and you would not have to keep sinking additional funds into the house after the first purchase. If not, then the additional money you would have to spend every year will take away from the total returns from the house when you sell it later at an appreciated price. You can roughly calculate what would be the break even sale price given your purchase price and annual expenses. You can then compare that with expected sale price to see if you are getting a reasonable return on investment.

If you are considering buying a house for investment, all indications are that you could wait for some more time, say at least up to six months for house prices to fall some more.

What do you think?

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The demand for oil has gone down in tandem with the worldwide economic meltdown, and oil inventories have risen.

According to World Energy Outlook (WEO) 2008, primary demand for oil (excluding biofuels) rises by 1 per cent per year on an average.  It is estimated to go from 85 million barrels per day in 2007 to 106 million barrels a day in 2030.  Responding to the high gas prices at the pump and the slowing economy Americans cut oil consumption drastically in 2008.  According to the Federal Highway Administration, Americans drove more than 100 billion fewer miles (160 billion fewer kilometers) between November 2007 and October 2008 than the same period a year earlier, making it the largest continuous decline in American driving in history.  Data released Wednesday by the U.S. Energy Department’s Energy Information Administration, show demand for gasoline fell 3.3 percent in 2008, although it was down just 2.2 percent in the past four weeks.

Meanwhile, U.S. stockpiles have risen at the key storage facility in Cushing, Oklahoma.  The U.S. government reported rise in crude stockpiles again last week despite expectations for a steep drop, suggesting demand continues to be weak. For the week ending December 26, crude inventories rose by 500,000 barrels.  Analysts had expected a drawdown of 1.75 million barrels.

Where ultimately will oil end up in 2009 and beyond is anybody’s guess, but we have estimates from a number of analysts.  Merrill Lynch forecasts oil prices to average $50 a barrel in 2009.  Deutsche Bank cut its earlier forecast for average oil prices from $60 to $47.50.  Jim Ritterbusch, president of Ritterbusch and Associates says oil prices may have further to fall, however, before rebounding to an average of around $60 next year.  Citibank has optimistically estimated future oil price at US$70 for 2009 and US$75 for both 2010 and 2011.

There have been a flurry of reports about distribution/dividend cuts by the Canroys.

Citibank analyst Richard Roy forecasted a general 20% distribution cut by the Canroys.  Enerplus Resources Fund (ERF), Penn West’s peer, has already cut its monthly distribution from Canadian $0.47 to $0.38 in November, and to $0.25 in January.  Of course, its distribution had spiked to $0.47 for just two months in September and October benefiting from high oil prices.  It had ranged between $0.40 and $0.43 before then.  A distribution cut from $0.43 to $0.25 is about 40%, which is pretty drastic.  Enerplus says that their capital spending and distribution levels for 2009 are based on the current forward commodity prices of US$52.83 per barrel.

PWE has not come out with a formal announcement about distribution cut or the level of its distribution cut.  It plans to substantially reduce capital spending in the first six months of 2009 compared to the $525 million spent in the first six months of 2008.  It also plans to sell properties currently producing approximately 3,400 barrels of oil equivalent per day for approximately Canadian $147 million, and to use the proceeds to reduce bank debt.  Its goal is to enhance its financial flexibility for potential strategic acquisitions in 2009.

The other concern with PWE and other Canroys has been the impact of Canadian SIFT tax on the Canroys starting in 2011.  It appears that PWE is well-positioned for the least possible impact till 2013.  It says it is likely to retain trust structure till 2013, and is unlikely to pay any cash taxes till then.  It is likely to pay 8% to 12% cash taxes starting in 2013 after the end of tax-free conversion to corporate structure in 2011 and 2012.

Summing up, I believe Penn West would be declaring a distribution cut in the range of 20% to 35%.  That will bring down its monthly dividend per unit to about Canadian $0.27 to $0.22 from $0.34.  Assuming the current exchange ratio to hold, it would amount to about US $0.22 to $0.18 per month.  At the current stock price of about $11, it is still a healthy yield.  However, the yield is okay but not as attractive at the original purchase price of $17.  As of now, there is a loss of principal in the Penn West stock purchase for me.  However, I believe with economic pick up the price of oil will go up.  It would be prudent for me to hold the stock for now rather than sell and realize a loss.  What do you think?

I wish you a very happy, joyous, and prosperous new year 2009.

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I expected lower dividends in line with falling oil prices.  The Canroys have generally maintained their distributions till October.  Enerplus Resources Fund (ERF) is the first to reduce monthly cash distribution level from $0.47/unit to $0.38/unit effective with the November distribution payment.  That is about a 20% reduction in dividends.

I am anxious to see what Penn West comes out with.  A similar reduction would not be too drastic.  The stock price seems to account for that already.

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These Canadian oil and gas royalty trusts or Canroys, as they have come to be called, have historically offered attractive dividends with annual yields in the range of ten to fifteen percent. They pay out dividends monthly instead of quarterly allowing for better compounding of dividend income. And unlike their US income trust counterparts, they can make new asset acquisitions to extend their lives.

Recently these Canroys have taken a big hit in the stock market. The first systemic concern has to do with their tax status. The Canroys were able to give out big dividends because under Canadian law their distributions to unit holders were not taxed. However, Canadian federal legislation enacted on June 22, 2007, implements a new tax (the SIFT Tax) on certain publicly traded income trusts and limited partnerships, referred to as Specified Investment Flow-Through (SIFT) entities. Under the new law, starting in 2011 these income trusts will not be able to deduct a portion of their distributions to unit holders from income for assessing corporate taxes. As such, Canroys investors run the risk of substantially lower dividend distributions starting 2011. Penn West Management believes that they will be able to avoid prematurely triggering the SIFT Tax, i.e. before 2011.

The second more recent issue has been the substantial drop in the price of oil. It has been widely feared that the demand and consequently the prices for oil will stay low in tune with the expected word wide recession in the short to medium term. As oil and energy stocks have taken a beating on the stock exchange, so have the Canroys.

At the current stock price, Penn West Energy Trust appears to be an attractive investment in the short to medium term. Its current dividend is about $3.60 assuming current monthly dividend to hold constant over the next twelve months for a current yield of more than 20%. The question is whether the actual dividend over the next 12 months would be that much.

Rough Calculations

It is hard to guess exactly what the average price of oil would be for the next 12 months. Using financial data from Penn West’s second quarter 2008 report and conservatively assuming an average price of $50/boe for the next 12 months, no risk management (hedging) price gain, and an average daily production of 200,000 boe/day, the gross revenues should be approximately $3.65 billion over the next 12 months. Using funds flow/gross revenue ratios from the first two quarters of 2008 and 2007, the funds flow is computed to be $1.97 billion or about $5.24 per unit. Assuming a very conservative distribution at 50% of funds flow, the annual distribution computes to about $2.62 per unit. At the current stock price, that is still a very healthy yield.

Ignoring the upside potential of higher than assumed oil prices, the downside risk of gains from dividend payout being offset by a drop in stock price in the next year appears low for an investor, because eventually the world economic engine, and the demand and price of oil should pick up. However, as the corporate tax liability and dividend payout could change structurally in 2011, the stock needs careful ongoing monitoring to keep up with management’s policies and decisions in light of the expected and/or unexpected changes.

P.S. — Today is Diwali, also known as Deepavali, the festival of lights. Here is wishing happiness and joy to all on the occasion, and a very happy celebration to those who would be celebrating in some way.

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