September 16, 2005No one could have anticipated the tremendous devastation brought on by Hurricane Katrina. Lost homes, lost lives, a lost way of life -- the impact of Hurricane Katrina is more than anyone could have ever imagined. When the floodwaters recede and people start to rebuild, we will have a better understanding what to expect in the near term. Below is what we believe the impact to public companies will be based on information available today.
Financials
With an estimated $60 billion in insured damages, property & casualty insurance companies will face the greatest impact. Fortunately, there is a great deal of excess capital on the books of insurance companies to buffer the impact, so the effects on this industry may not be as great as feared. In the meantime, however, Standard & Poor’s has placed two insurance companies on watch for a ratings downgrade. Additionally, in the near term, the storm will most likely hinder the earnings of banks operating in the affected areas. Lower fee revenue and reduced net interest income, resulting from lost business, coupled with higher expenses and increased loan charge-offs, will affect earnings of financial institutions in the area. Over the long-term, however, companies may actually benefit from higher deposits as a result of insurance proceeds and government stimulus flowing into the region and from increased construction lending as the rebuilding begins.
As for our portfolios, we currently do not have any exposure to property & casualty insurance companies, and we hold relatively little exposure to banks with operations in the affected areas. We do not anticipate any additional surprises to the financial sector as the waters recede.
Energy
Of all industries that have been impacted, Energy has been the most widely discussed. Katrina had a significant impact on the U.S.’s energy infrastructure, especially production capabilities. Oil companies would be most directly affected, but those companies have more than enough cash flow to rebuild any damaged facilities and are very well diversified geographically, so any storm effect is small relative to the operations of the companies. Immediately following the storm, lower crude and natural gas production led crude oil to rise to record levels above $70/barrel while natural gas climbed above $11/mcf. As normal production levels have begun to return to the Gulf of Mexico, crude prices have fallen back to the mid-$60s. In fact, critical pipelines, as well as 9 refineries affected by Katrina, are operating again, with some companies now running at 70-100% of capacity. This ability to bounce back quickly implies that the impact on the oil industry will be less than initially believed.
However, in the natural gas sector, Katrina may have damaged several key natural gas processing facilities on the Gulf Coast, which could delay a recovery in natural gas supplies. Given the lack of a meaningful global market for natural gas, the hurricane’s impact on this commodity, which fuels power plants and is used to heat much of the U.S. in the winter, may be more sustained than its impact on crude oil.
The impact on energy companies held in Westwood portfolios will likely be negligible, as any decrease in production is likely to be largely offset by higher commodity prices. Furthermore, the need for additional offshore rigs, which were in short supply before the hurricane hit, may benefit oil field service companies held in our portfolios.
Transportation
Many roads into and out of the areas were flooded, but it appears that the overall impact to the trucking industry will be small since most are able to revise their routes to accommodate the changes in road availability. Most railroads have little direct exposure to the area, as well. Additionally, with decreased oil refining and production capacity in the Gulf of Mexico, crude oil and crude product imports into the U.S. are likely to increase, leading to higher tanker charter rates. The industry has already seen rates begin to rise on this expectation for an increase in demand, so tanker companies held in our portfolios may actually benefit from the effects of the hurricane.
Industrials
Treatment of water will become a high priority as the region works to recover from the effects of toxins contained in the floodwaters. Companies who specialize in water treatment will see long-term benefits in the form of new business as municipalities in the region and around the country work to rebuild and upgrade their infrastructure. However, the companies we own that participate in water treatment will see little direct impact due to their large size and highly diversified business portfolios.
Health Care
Several hospitals in New Orleans and along the affected Gulf Coast sustained damage, and some were even evacuated. Most hospitals, however, are insured for property damage as well as for interruption of business, which should offset any financial liability incurred by these companies. As power comes back online and these facilities are able to re-open their doors, we should see them work to resume normal operations in the area.
Materials
Approximately 200,000-400,000 people lost their homes in this disaster in addition to substantial damage to commercial buildings. As the region rebuilds, building materials, including electrical equipment, lumber and steel, will see prices rise on increased demand over the next few years. In the near term, the increase in the price of steel and other building materials will contribute positively to the performance of various manufacturers and hinder the performance of those who buy these commodities. Our portfolios are currently more heavily leveraged to the suppliers of these commodities than to the users of them.
Utilities
Electric utilities with exposure to the region will be hurt financially. Although power has been restored to some areas, the initial loss of power to over 1 million customers will hurt companies from the perspective of lost power sales and the threat of permanent customer migration. However, the costs to repair damaged transmission and generation assets will be deferred and recovery requests will be filed with local regulators. For some unregulated power generators, such as those focused on coal and nuclear power generation, which have excess power to sell to the market, the spike in natural gas prices is beneficial. Unfortunately, for the regulated power producers, higher natural gas prices generally means higher bad debt expense, as fuel costs get passed through to the consumer. Additionally, as a result of the higher gas prices, we will face higher heating bills when the weather gets cooler. For those in Texas, however, the impact will be less than initially thought. The major public utilities players in the state will use gas prices before Katrina hit, which were high but not $11, and will not contemplate raising power prices until October 3rd, since the Texas Public Utilities Commission does not want electric companies to profit from such a tragic event.
The hurricane is actually a positive for the coal sector as this represents more evidence that coal is the most dependable source of fuel for power generation. Underground mine flooding will require watching but will only have a short-term impact.
Other
Certain REITs, particularly those owning office buildings or apartment complexes in the Southwestern U.S., may benefit from increased demand arising from displaced New Orleans families and businesses. Already, cities such as Houston and Dallas have seen marked increases in demand for office space. In addition, due to port closures in the Gulf region, the agriculture industry may be affected due to the inability to efficiently ship product out of the U.S. Our portfolios have no holdings in the agricultural industry likely to be materially affected while we do have some exposure to REITs that may benefit from increased demand.
All in all, the majority of the negative impact from Hurricane Katrina will occur over the next two quarters. Supply disruptions, a pull back in consumer spending, a decrease in consumer confidence, and job losses are all possibilities. Should natural gas, crude oil, and refinery supply interruptions last longer than anticipated, we will be spending a great deal more on our heating bills this winter, which could have significant negative implications on overall consumer spending. When coupled with an increased price at the pump, Americans will have far less discretionary income to put back into the economy, particularly around the holidays. These price pressures, brought on by the energy supply shock, could also lead to inflation. However, the massive amount of resources that have been and will be devoted to the crisis will result in a significant source of economic stimulus over the long-term. As we have seen since 9/11, the U.S. economy has shown an amazing ability to withstand and recover from economic shocks. We no doubt believe that the U.S. is resilient and will recover from this tragedy, as well.
We sincerely hope that you and your loved ones are safe, and we will do our best to guide your portfolios during this difficult time.
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This information is provided for clients and prospective clients of Westwood Management and Westwood Trust, hereinafter "Westwood" and their employees. It is not an offer or solicitation to sell securities. The information provided here is copyrighted by Westwood and may not be used without its permission.
