Go Overweight E&P and Underweight Consumer Discretionary, Part I

by: George Fisher

It is an interesting time in the energy patch these days. It seems like a real tug of war between traditional energy sources and competing alternatives to these traditional sources. Stuck in the middle is the US consumer and investors.

In the US, conventional oil, natural gas, and coal have been the historic cost-effective energy sources of choice. Alternatives, such as solar, wind, and geo-thermal, have been at a distinct cost disadvantage that has prevented widespread adoption of their use.

However, it appears our elected officials in federal and state governments have decided that higher cost energy is the best path for our country. The most effective method to overcome the competitive disadvantages of alternatives is to raise the price and reduce the availability of traditional energy to diminish this disparity.

In addition, there are large taxpayer-funded subsidies and direct payments, along with requirements for utilities to purchase higher cost energy, which will be ultimately paid for through higher taxes and higher consumer energy costs.

There are several important long-term supply related issues that desperately need to be decided by the government, and these decisions will impact the price and availability of traditional energy sources. In the short-term, uncertainty and decision delays will reduce production growth and, in the long-term, specific restriction on exploration and development will increase production costs and further limit supply.

The long-term issues of revamping the business culture for the Gulf of Mexico (GOM) needs to be completed quickly, judicially, and effectively. Uncertainty concerning new rules and regulation, from SIDs to liability caps to permitting processes and timeframes, will prevent any serious expansion of production.

Assets are being redeployed to opportunities that are less uncertain, creating a potential shortage of future GOM infrastructure. Even under more stringent operating rules, if half the drilling rigs currently in the GOM are contracted elsewhere and are unavailable, production growth would be in jeopardy.

New drilling equipment requirements will create extended lead times to acquire the upgrades, with product orders going out possibly a year. This will delay the start of any new drilling projects even after new regulations are developed.

The longer the cloud of uncertainty lasts, the lower the medium-term production growth potential from the GOM. Without at least depletion replacement drilling, output from the GOM will decline.

Shale gas has several advantages, the first of which is its abundance. Shale assets operate at an elevated depletion rate and, although initial production levels are higher, drilling activity must be maintained to offset the deletion. However, there are environmental concerns about the technique of shale fracking that the gov’t has decided to investigate. It is estimated that this investigatory process could take upwards of two years to complete. New York has a moratorium on fracking until new state regulations are developed.

There could be potentially new restrictive shale drilling requirements that could negatively impact shale gas supply and this creates uncertainty for the long-term direction of shale gas until these issues are resolved.

One of the largest sources of future oil production in North America is the Oil Sands in Canada. While the process of retrieving the oil is in itself natural gas intensive, the economics of this source is improving with higher oil prices. There currently exists a pipeline for oil sand production from Alberta to Chicago for refining.

There is a request to build another pipeline from Alberta to New Orleans that has been presented to the US State Dept for approval. Rep. Henry Waxman, Chair of House Energy Committee, has voiced strong opposition to the proposed pipeline and to importing more oil from Canada. If the pipeline is rejected, the Canadians have the option of building a pipeline to their west coast and offer the supply to another willing buyer – the Chinese.

The uncertainties and delays in decision-making outlined above and the potential for a reduction in traditional energy production growth will increase the price of oil and natural gas. A return to $100 oil is probable with a pick of economic activity, either here or abroad. Throw in the potential for a weaker US dollar over time, and the price of oil-related energy should increase by at least 30%.

Investors should be overweight in the energy E&P sector to take advantage of this shift to higher traditional energy market prices.

Investors have the options of owning geographically diversified oil and natural gas companies or area-specific companies. Most large multi-national energy companies should benefit from a rising oil market, while smaller firms are usually more leveraged to rising prices.

Geographically, diversity offers less risk to specific resource locations and is usually factor in choosing larger capitalization companies.

A conservative selection with good geographic diversification could include Apache (NYSE:APA), a well run and opportunistic oil and gas exploration firm. While it recently purchased $5 billion in assets in GOM that will take longer and cost more to develop, APA offers worldwide diversification of oil and gas.

ConocoPhillips (NYSE:COP) is a major integrated oil and gas company that also should benefit from higher oil prices and is worth researching.

Natural gas royalty companies, like Dorchester Mineral (NASDAQ:DMLP) with diversified locations, should experience higher revenues and unitholder distributions as the price of natural gas increases.

Area-specific companies allow investors to selectively choose opportunity and risk. Smaller companies are usually highly leveraged and struggle to be operating cash flow to cap ex positive. For these companies, higher debt and share offerings usually bridge the shortfall. Investment selections in area-specific companies usually carry increase risks, but potential rewards are highly leveraged to success.

Selections could include controversial ATP Oil and Gas (ATPG), one of the most leveraged and GOM dependent oil plays in the Gulf, with an intriguing risk to reward potential. APTG offers GOM optimists a current stock price valuation where planned and funded production increases, and its accompanying cash flow, are greater than its current share price.

Also controversial is Suncor (NYSE:SU), the Canadian oil sands firm. More diversified than many other oil sands companies, SU will benefit from both higher production volumes and higher prices.

GMX Resources (GMXR) is a small-cap Haynesville shale gas company with a large inventory of undrilled locations. It may take another year or two, along with higher gas prices, for GMRX to be cash flow to cap ex positive.

There are several other excellent quality oil and natural gas companies in all market capitalization categories that will benefit from higher market prices. Evaluate your current energy holdings and determine where Exploration & Production firms might fit. As a sector, oil and natural gas E&P firms should do well as this tide will lift all boats.

Consumer Discretionary as Offset

Offsetting this, investors should underweight Consumer Discretionary exposure. Someone has to pay for these higher costs, and it will ultimately be the consumer.

According to the law of unintended consequences of higher traditional energy prices, investors should expect a tepid consumer sector. Over the next few years, consumers will experience higher local, state and federal taxes as a direct result of higher government subsidies and direct payments for alternative energy programs, overall spending increases, and deficit reduction programs.

Consumers will also experience higher energy costs and the inflationary ripple effect it has throughout the economy. Oil-related transportation and electrical power generation will experience the highest inflationary pressures. Combined, these will reduce disposable income and spending, and the re-emergence of robust consumerism will be delayed.

It’s too early in the tug of war to determine the exact winners for the growth of alternative energy. I prefer to seek out the potential beneficiaries of a fundamental shift to much higher traditional energy prices.

As always, investors should conduct their own due diligence, should develop their own understanding of these potential opportunities, and should determine how it may fit their current financial situation.

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Disclosure: Author is long APA, DMLP, ATPG, SU and GMXR