The outlook for energy stocks in 2011 appears promising considering U.S. Federal Reserve efforts to keep interest rates low to encourage inflation and promote economic growth. Fundamentally, rising oil demand is close to supply limits. The opposite appears to be the case for natural gas where abundant supply may attract a bigger share of global energy. Six-year futures are holding above $5 a million btu ahead of a potential advance in 2011. A leading stock in 2010 such as ConocoPhillips (COP) in the U.S. Integrated group has further potential. Some lagging stocks in 2010 might be winners in 2011 such as Total (TOT) in the European, and Canadian Oil Sands Trust (OTC:COSWF) in the Canadian group.
Oil and Gas Stocks Respond to Free Money
In the past oil and gas stocks have responded positively to free money, which occurs when the rate of interest is below the rate of inflation. Most recently the stocks advanced strongly to a peak in 2008 following free money in 2002-2006. We expect a positive response in 2011 to the restoration of free money in 2010.
While weak economic growth prompts free money in the U.S., strong economic growth in China and emerging markets has contributed to higher inflation. We are optimistic China can counter those pressures with the lifting of price controls on oil and gas and allowing its currency to appreciate. Chinese energy demand would likely remain strong as lifting local price limits would be offset by a lower price for imports in Chinese currency terms.
Oil Demand Stronger than Supply
People love the freedom of personal transportation everywhere in the world. Transportation is booming in less developed economies and oil has little competition as a fuel for mobility. Supply limits were reached in 2008 and little new capacity has been added. High taxes, price controls and environmental overreaction further tend to restrict supply growth. Nearly all new sources of oil supply are expensive. We judge the base case price outlook as moderate appreciation with the likelihood of sharper increases greater than the likelihood of decline.
Natural Gas Supply Gift
The biggest surprise in the global energy picture is the booming production of natural gas with the success of horizontal drilling with multi-stage fracturing, especially in shale formations. Despite a low price at one-third the heating equivalent of oil, natural gas volume reached a record 75 billion cubic feet daily (bcfd) in September 2010, reported on November 29. Natural gas has about a 25% share of total U.S. primary energy production of about 300 bcfd equivalent. Considering that oil is limited by supply, coal is environmentally less desirable and that alternative fuels need increasingly unaffordable government subsidies, natural gas looks like a long-term winner for investors and the economy. The average of futures prices for the next six-years for natural gas may have found a floor above $5 a million btu.
Income and Small Cap Show the Way
After recovering in 2009, stock returns have been mostly less than 10% in 2010 for large cap oil and gas recommendations. In a free money environment, income and small cap can show the way to appreciation for large cap. Large caps have the financial strength to take advantage of free money to buy small caps or to do partial purchases through joint ventures. At the same time, appreciation in purer play small caps highlights resource values also present in large caps. In short, higher McDep Ratios for small caps may point the way to higher McDep Ratios for large caps.
Invest at Home and Abroad
European stocks may be better performers in 2011 from their current position as the group with the lowest median McDep Ratio after lagging in 2010. Much of the deviation in performance appears to reflect currency fluctuations which appear to be surprisingly volatile and unpredictable. Oil and gas companies depend fundamentally on global trends that should be relatively independent of currency trends. Canadian large caps look good to us for 2011 after a quiet 2010 stock market performance. The attractiveness of Canada for resource investment by giant companies in our coverage from the U.S., Europe, and China reinforces investment in the stocks of publicly-traded Canadian companies.
McDep Ratios suggest appreciation in most of the remaining stocks in the U.S. Integrated, Emerging Market, and U.S. Independent groups.
Originally published on November 30, 2010.