Exploring Opportunities in the Canadian Oil Sands

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In our past two blog entries we discussed our long-term views on crude oil. Our first note outlined the reasons that average oil prices are likely to remain elevated well into the future. Our second note listed criteria for evaluating the investment merits of companies that produce oil. Today, we discuss a specific niche of the energy sector, namely the Canadian oil sands.

Alberta, Canada holds one of the largest stores of fossil fuel on earth in the form of very heavy oil deposits known as oil sands. Many energy firms are now exploiting this resource from small Canadian companies to the largest international integrated oil companies. While there are some drawbacks to operating in the oil sands (transforming the raw product into useable fuels is expensive and, like all extractive processes, is disruptive to the environment) we think the enormous size of the resource and its location in a politically stable country make it a uniquely attractive opportunity.

The best positioned firms in the space have access to decades worth of resources to drive future production growth. Therefore, they are not subject to exploration risk or high depletion rates that plague most of the industry. These companies can focus their efforts on lowering costs and improving production methods. In fact, even at current oil prices, many of these firms are already highly profitable.


This post was originally published in the Washington Business Journal’s WBJBizBeat Blog. Read more: Exploring Opportunities in the Canadian Oil Sands | Washington Business Journal

Oil Prices Likely to Remain High

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As we noted in our last entry, crude oil markets are subject to large price swings due to geopolitical events and economic cycles. However, we believe there are underlying secular dynamics in place driven by new demand from emerging markets and constraints on new supply that are likely to keep the average price of oil elevated well into the future. Here is a set of criteria for considering long-term investments in oil producing firms.

First, valuation should be a primary consideration. The high volatility of oil prices has its corollary in highly volatile energy stocks. This can be exploited by the patient investor waiting for attractive entry points. Second, investors should seek firms with large reserves and the ability to grow production steadily over the long-term.

Exploration and production risk is becoming increasingly acute as many firms seek to replace dwindling reserves by drilling in ever more remote, technologically challenging and expensive locations.

Finally, investors should seek out firms with the ability (and desire) to protect the interests of shareholders. The majority of crude oil reserves are held by national oil companies and many private firms operate in countries with weak legal protections and mercurial tax codes.

In our next (and final) note on crude oil we will discuss a subset of the energy industry that we believe is exceptionally well positioned for the long run.


This post was originally published in the Washington Business Journal’s WBJBizBeat Blog. Read more: Oil prices likely to remain high | Washington Business Journal

Federal Estate Tax: Mixed Benefits

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Most have probably heard about the significant increase in the federal estate tax exemption and decrease in the federal estate tax rate enacted at the end of 2010. Over the past decade, the aggregate amount that may pass to people other than a spouse or charity free of federal estate tax has increased from $675,000 to where it is today at $5 million (double these amounts for a married couple). The tax rate that applies to the excess has decreased from 55 percent to the current rate of 35 percent. (Transfers to U.S. citizen spouses and qualified charity remain fully exempt.)

We highlight two potential issues that may offset some of the benefit of the new federal law.

First, for those with wills providing for the exempt amount to pass to children or other beneficiaries with the balance passing to the surviving husband or wife, the new law could have the unintended consequence of keeping a great deal more out of the spouse’s hands than expected. No federal estate tax would be due, but now the first $5 million of the estate (rather than the much lower amount that might have been exempt at the time the will was drafted) would not be available to the surviving spouse.

Second, for those living in states that have “de-coupled” from the federal estate tax law, including D.C. and Maryland, an estate that takes full advantage of the federal exemption could owe a state tax when none was expected. D.C. and Maryland, for example, have only a $1 million exemption from their local estate tax, with rates ranging from approximately 6 percent to 16 percent on any excess that passes other than to a spouse or charity. If $5 million passes into a “bypass trust” for the benefit of the surviving spouse and children, no federal estate tax would be due, but nearly $400,000 could be owed to D.C. or Maryland. (At this time, Virginia has no separate estate tax.)

Your estate planning lawyer can advise you regarding your own exposure to these issues and revisions to your estate plan that may achieve your desired results. Of course, you may have to visit your lawyer again in two years, as the current federal estate tax law is in effect only for 2011 and 2012.


This post was originally published in the Washington Business Journal’s WBJBizBeat Blog. Read more: Federal estate tax: Mixed benefits | Washington Business Journal

Why There Is Investment Potential in Latin America

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A couple of weeks ago, while lamenting the onset of cold weather here in Washington, I discussed the investment potential of Latin America. Since winter does not appear to be ending any time soon, thinking about Latin America still has appeal. While our current local climate in the Washington DC area may not be sunny, the business climate in Latin America is certainly heating up.

One of the more telling economic statistics is the GDP per capita number. The international experience is that once this number hits the $3000 level, countries typically will begin to see the development of a middle class. Once $5000 is achieved, a critical mass develops and middle class growth takes off. The latest World Bank data – using a constant year 2000 US$ – shows that Chile achieved this middle class growth phase in 2002 and Brazil, ending 2009 at $4419, will soon be there. Meanwhile, Colombia with a GDP per capita of $3102 is at the beginning stages of developing a domestic middle class consumer economy and Peru is not far behind at $2913 (as a comparison, the two emerging market headliners of China and India have GDP per capita levels of $2206 and $757, respectively).

With the burgeoning middle class, the region’s domestic economies are beginning to take shape and business confidence is increasing. In an investment world fraught with uncertainty and risk, Latin America, with its growth potential, could contain some unique opportunities for investors


This post was originally published in the Washington Business Journal’s WBJBizBeat Blog. Read more: Why there’s investment potential in Latin America | Washington Business Journal

States Taking First Steps Towards Financial Stability

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There has been widespread concern about state budget deficits. Many wonder if states lack the resolve or political will to make the necessary decisions to get their financial houses in order. This week brought encouraging news. Some debt-challenged states announced significant progress towards improving their books.

Illinois lawmakers passed a 67 percent income-tax increase, the largest in the state’s history, to help close a $13 billion budget deficit. They raised the tax rate to 5 percent from 3 percent and was approved by both chambers in the waning hours of the legislative term. Governor Pat Quinn, a Democrat, has supported an increase. A new Legislature will be sworn in later today. The increase, intended to last through 2014, is aimed at fixing Illinois’s worst fiscal crisis, including a backlog of more than $6 billion in unpaid bills and almost $4 billion in missed payments to underfunded state pensions.

California Governor Jerry Brown proposed a budget that cuts $12.5bn from proposed state spending. The proposal includes 5 years of extending the higher level of current taxes and reducing employee compensation.

Governor Christie in New Jersey delivered his State of the State message. Among the topics discussed, pension reform was prominent. Extending the retirement age, reducing or eliminating COLA’s, and requiring more employee contributions were all highlighted.

These announcements were not unexpected but are welcome. While these are just the first steps down a long road towards improved financial stability, the news is certainly positive. We believe tough decisions must and will continue to be made.


This post was originally published in the Washington Business Journal’s WBJBizBeat Blog. Read more: States Taking First Steps Towards Financial Stability | Washington Business Journal

The Money Has to Come from Somewhere

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A couple of weeks ago we wrote about “numbers” in the municipal bond markets. On the pessimistic end, we showed trillions of dollars in unfunded state pension liabilities while on the optimistic end we showed a .03% historical default rate on investment grade municipals.

Many states face significant budget stress. While states have already reduced budget gaps by $84 billion, many still face daunting challenges.

So, what options are available?

One solution is simple. States can cut spending and raise revenue. Yes, that means higher taxes and fewer services. States can also borrow at near historically low interest rates. There is a saying in the municipal market “doctors bury their mistakes, municipalities refinance them.”

Delaying payments and using fancy bookkeeping can be helpful. In 2009, California deferred payments to creditors and Illinois delayed payments on some of its obligations. Many states shift costs between fiscal years, borrow from lottery programs and grab funds initially segregated for other uses. These are not solutions. They are methods to paint a rosier picture during difficult times.

Perhaps the biggest long term challenges are unmanageable pension and health care obligations. Given the political implications, many states have been unwilling to restructure these obligations. Perhaps Congress will require states to more accurately project the size of pension liabilities or risk their ability to issue tax-free bonds. The concept of a “defined benefit” plan for state employees may be a thing of the past. Many states are moving toward “defined contribution” plans, similar to private industry.

Will financial stresses lead to defaults by states? Anything is possible. But we believe pandemic defaults are extremely unlikely. If a state were to default, the ability to access the capital markets would be compromised for years to come. In many states, bondholders stand in the front of the creditor line and default would be difficult.

A comprehensive solution will most likely take time and a combination of efforts.


This post was originally published in the Washington Business Journal’s WBJBizBeat Blog. Read more: The Money Has To Come From Somewhere | Washington Business Journal

Holiday Cheer and Municipal Markets

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It seems that you cannot pick up a paper or turn on the news without encountering a story about the financial struggles of many state and local governments. These are clearly challenging times for municipalities as tax bases and revenues shrink.

We are fascinated by the significant “numbers” tossed about in these stories. Often some of the numbers are given more attention than others. We thought a summary of some of these indicators might be helpful. So, this year at your holiday cocktail party, why not get the conversation started with some fascinating municipal credit market “numbers”.

  • $3 trillion: size of outstanding debt in the municipal bond market
  • $3 trillion: possible size of future unfunded public-pension liabilities
  • $1.4 trillion: US Government deficit in 2009
  • $457 billion: amount of unfunded public-pension liabilities in the U.S. in 2010
  • $83.9 billion: projected US states total budget deficit for fy2011
  • 1.5 million: approx. number of bankruptcy filings by corporations and individuals for year ending 3/31/09
  • 60,000: approx. number of state and local governments, districts, authorities and other issuers in the municipal market
  • 500: approx. number of Chapter 9 (municipal bankruptcy) filings since 1934
  • .3%: default rate on all municipal bonds in 2008 and 2009
  • .2%: the percent of municipal bonds currently in default based on $ value
  • .03%: default rate on investment-grade municipal debt over the past 40 years
  • 0: default rate from 1970-2000 among general-obligation and essential-service revenue municipal bonds

(All figures are approximate)

What always fascinates us is how differences in interpreting facts creates a diversity in constructing opinions. Two respected analysts or investment managers can look at the same numbers and walk away with completely different opinions. Is the large size of municipal debt more important or the low historical default rate?

These differences are what makes the world go round and why there is typically a buyer for every seller. Opposing views may not present much of an issue if you are choosing a new dishwasher, but can represent a significant challenge when making investment decisions.

There is certainly not enough space here to advocate for or against investments in the municipal bond sector. With over $1.1 billion in managed municipal assets, we have a significant interest in these markets. We believe the municipal bond market presents investment opportunities where quality research, security selection and risk mitigation can produce attractive after-tax returns.

Cheers and happy holiday conversations.


This post was originally published in the Washington Business Journal’s WBJBizBeat Blog. Read more: Holiday Cheer and Municipal Markets | Washington Business Journal

Gifts for 2010: Make Someone Happy!

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With the gift-giving season upon us, it is a good time to review the current tax rules related to gifts, and to highlight a particular opportunity in 2010. The basics:

  • Gifts between US citizen husbands and wives are exempt from federal gift tax.
  • Each person may give up to $13,000 per year to any number of other people, free of federal gift tax. For spouses, this is a $26,000 exemption.
  • A $1 million lifetime exemption offsets aggregate gifts that exceed the $13,000 annual exclusion gifts.
  • Federal gift tax is due when the $1 million lifetime exemption has been exhausted.

For 2010 only:

We are in the final weeks of the year and Congress has not yet addressed the federal estate and gift tax situation that exists this year, including the absence of a federal estate tax and a gift tax rate of only 35% (as compared to the maximum 45% rate that applied in 2009 and the 55% maximum rate that is scheduled to apply in 2011). Most experts agree it is unlikely there will be retroactive legislation that will affect 2010 gifts and estates, providing a window of opportunity to make gifts at an historically low tax cost.

There are several benefits to making taxable gifts in addition to the rate spread between 35% and either the 45 or 55% rate that is likely to apply in 2011 and later years:

  • Gift tax is “tax exclusive,” meaning that a donor pays tax only on the gift that remains in the recipient’s hands, while the estate tax is “tax inclusive” in that tax is owed on all assets in the estate, including the tax dollars themselves. (Note there is an exception to gift tax exclusivity if the donor dies within three years of making the gift; in that case, the gift tax dollars are subject to estate tax.)
  • DC and Maryland do not have a gift tax, but both have an estate tax that is in addition to the federal estate tax. Thus, DC and Maryland residents could save their heirs taxes by giving them assets during lifetime rather than at death.
  • After a gift, the future appreciation and income from the assets given away will escape estate tax on the donor’s death.

Of course, there is still some risk that legislation will be enacted to change the 2010 estate and gift tax laws retroactively. Moreover, the exemption from estate tax may increase in the future beyond the $1 million level that is now on the books for 2011, either to the $3.5 million level that was in effect in 2009 or possibly to a higher level.

An in-depth discussion of gifting and generation-skipping techniques is beyond the scope of this post. Our intention is to bring the 2010 planning opportunities to our readers’ attention, and, thus, any taxable gift should be made only after obtaining legal, tax and possibly financial planning advice from qualified professionals.


This post was originally published in the Washington Business Journal’s WBJBizBeat Blog. Read more: Gifts for 2010: Make Someone Happy! | Washington Business Journal