The New U.S. Energy Scene: How To Play It From Here

by: Peter F. Way, CFA

In a SA article, we made a case for recognizing that the energy scene in the US had made a (largely unrecognized) highly significant change in the past couple of years. Lately, but not because of our note, more and more recognition of the change is coming to light. The increased exposure is largely due to the magnitude of its importance to this country's future well being.

Assertions of national energy independence possibilities have become part of the political, upcoming election scene.

Exxon Mobil (NYSE:XOM) has made further deals to ensure its major position in NatGas production, and has made public its plans to begin exporting US-sourced NatGas to markets abroad, where substantially higher market prices may be obtained.

Discussions of CNG-fueled passenger car developments are starting to be observed.

Confirmation of the stream values and prospective extent of "wet gas" (accompanied by associated liquid petroleum forms, including crude) reserves are becoming more available. Less valuable "dry gas" activity is shrinking, with drill rigs formerly devoted to these fields being withdrawn to serve on the more remunerative fields under development.

Additional rail transportation resources are being made available to move product from areas like North Dakota that formerly had no such need.

Further evaluations of shale fields continue to add substantially to recoverable reserves estimates. Utica joins the adjacent Marcellus (OH, PA, NY) and joins Haynesville (LA), Bakken (ND) and Eagle Ford (TX) fields as major developing areas

Expansion of highway fueling stations for CNG-fueled truck transportation is progressing, with financial support of major NatGas producers.

Is this all just another "gas bubble" that the energy industry has seen many times before? Will the present enthusiasm intensify a NatGas oversupply that has pushed prices down to the low of $2 a mcf from its multi-year average of $7, and keep market prices in the $3-$5 range for the next few years until the quick, cheap resources are extracted and committed?

We believe that the answers are all contained in the question above, concealed by a presumption that the "excess supply" will be lacking new markets. That condition would remove the motivation for producers to look for more cheap resources that would sustain the oversupply. It is a wrong presumption.

What has become evident is that advances in extraction technology - horizontal drilling and hydraulic fracturing (fracking) - have so altered the cost economics as to make geological formations that are known to be widespread in the US, not only viable "technically recoverable" resources, but highly profitable ones.

What has been discovered is that the volumes of available hydrocarbons are far more extensive than originally expected, and along with the "dry gas" there are large proportions of liquids (NGLs and Crude) that substantially up the pay content of the wells' flowstreams. The strong motivation is there, both from the reserves abundance and the cost-payoff balance to pursue and intensify this kind of production.

All energy sources and uses are integrated by a common denominator, the delivered cost of an employable BTU (British Thermal Unit - a measure of heat content). The nation's largest coal producer, Peabody Energy (BTU), uses BTU as its stock ticker symbol.

Many applications of BTUs can be engineered to use a variety of fuel sources (i.e. electrical utility generation) while some (aircraft propulsion) are far less likely. Fuel source substitution is the order of the day in the energy business, driven by the utilized cost of the delivered BTU.

The calculations can get pretty intricate where demand has predictable variations in a continuing need. Electric utilities, where circumstances permit, have used off-peak (fueled) generating capacity to pump water to reservoirs at elevation so that hydroelectric turbines in peak demand periods can provide needed capacity. In other situations, off-peak (interruptible) power is sold at cheaper (but still profitable) prices to industrial heavy users of electrical energy (i.e. aluminum producers) as an alternative to their higher-cost alternatives.

An important part of that cost calculation in nearly every case, is the delivery cost. Coal mined at lowest production costs, but far from its ultimate usage finds rail transport to be the practical answer, but to cover its cost there must be a reduction in what price miners can get from Utilities at the generating station. Crude pipelined to refiners has a similar cost offset. Now, new production from the Bakken Shale fields in North Dakota where there is no available pipeline capacity, is turning to rail tank cars to deliver liquids.

That may be a temporary situation. Pipeline economics are very advantageous, once the transport facility is in place. But the installation cost is enormous. That makes it essential that there be an assurance of continuing demand to keep the transportation unit operating at a high level of capacity, or the pipeline will never be built. That consideration has kept limited the construction of gas pipelines to electrical utilities, limited by supply assurances, rather than demand factors.

Past occurrences of NatGas "bubbles" have emphasized, in the thinking of using industries, the irregularity of cheap prices and periodic excess product availability. Now the energy industry confronts the virtual certainty that huge quantities of NatGas will be abundantly available at probable delivered costs (assuming available pipeline capacity) that alternative fuels (rail-delivered coal) may rarely be able to meet. Expect to see new bond issues financing the new pipelines.

Pipeline builders include TransCanada Corp. (NYSE:TRP), Enbridge (NYSE:ENB), and ONEOK (NYSE:OKE), with producers Hess Oil (NYSE:HES), Enbridge Energy Partners (NYSE:EEP), Statoil (NYSE:STO), and Continental Resources (NYSE:CLR) often contributing financial assurances through deals. As always, current market prices and knowledgeable future price expectations should dominate investment actions.

A parallel to the Electric Utility market expansion exists in the highway truck transportation market. The low-hanging fruit of local delivery-and-use operations like FedEx (NYSE:FDX), UPS (NYSE:UPS), and recently, the State of Virginia's own internal government-transit needs, are already being met or are in the process of being provided for. But the longer-distance haulers need refueling capabilities. These are being developed initially by Clean Energy (NASDAQ:CLNE), a Boone Pickens company, which is building a network of hundreds of coast-to-coast CNG refueling stations. Others apparently are following their lead, which will expand and hasten the truck hauler fuel conversion actions.

In the private consumer transport opportunity area (not yet a market) there is already an in-stock CNG-fuel automobile, the Honda (NYSE:HMC) Civic CNG model being offered at $26-27,000 with MPGs of 27 city, 38 highway and none of the distance limitations and huge battery costs of electric cars. The present highlighted pitch is on emission absence, rather than fuel price economy. When that changes and this gets to be a significant market, the abilities of the existing, pervasive gasoline service station network will undoubtedly become quickly expanded to vend CNG, at minimal installation costs relative to the potential demand and profits.

Given that conversion kits for conventional cars are readily available and in use in several foreign markets, as fueling economies become evident here, there will undoubtedly be tragedies from incompetent installations, followed by legislative fights over inhibiting regulations, ultimately followed by the growth of an industry presently populated by installers of sound systems and other automotive embellishments. But there also is likely to be major auto-industry expansion to new-car CNG models.

How quickly that all happens depends a lot on how the energy industry is able to influence the marketplace for prices of the competing fuels. What? Say it ain't so! For shame, in a "free-market" democracy, where the consumer is King? How could that happen?

It seems that in ages past, things just like that have caused problems -- the Standard Oil Trust, and others. Philosophically, the creator of comic strip character, Pogo, perhaps had the insightful notion as he described a lesser annoyance: "Albert, you gotta expect 'skeeters to skeeter, skeeterin's their business."

We'll have to see how well those "noble" guardians of the public's "well being," from their enclave in the "beltway," will be able to provide any constructive refereeing in the matter. Please remember, they're from you-know-what, and are "professionals here to help you."

Right now, prices for crude at $90 a barrel are 22-25 times the $3.50-$4 price for NatGas. Some say coal can get competitive if NG goes much above $4. But Crude's heat content in BTUs is only 6 times that of NG, while its price ratio is nearly 4 times that 6-to-1 relationship. If coal holds NG to $4, and current retail gasoline prices are at $4 a gallon, perhaps CNG could be provided approaching as low as $1, certainly by no more than $2.

Reflecting on the simpler mid-stream processing of CNG, compared to crude's required cat-cracking-refineries, does gasoline at a competitive pump price of $2 suggest a crude price perhaps as low as $45 a barrel?

It all is going to take time and a lot of brutal negotiating before economic sense gets returned to the competitive scene. But it looks like new investments in purely-crude-based ventures may have a tough slog. Particularly when they may be a mile or more under an already mile-deep seabed.

The broadening number of independent US hydrocarbon producers makes it much more difficult to prevent prices from seeking rational economic relationships. That's encouraging for consumers.

For now, we have a current fix on what the market pros at the block trade desks of the major market-making financial institutions think their big-fund clients are likely to do to and with the prices of many energy industry firms between now and the presidential inauguration day early next year. We also know how well prior examples of those current forecasts have worked out in the past.

We tend to emphasize those issues where current investments seem to have much better than average odds of attractive payoff results. But we also report on the more lackluster potential candidates, to give some sense of what might be in store, for comparison purposes.

Our analysis stems from a common evaluation process of self-protective market hedging actions based on rational, forward-looking judgments. The results are expressed by us in terms intended to make investment prospects as comparable and understandable as possible.

But in as complex a game as this, with so many movable parts and players, don't expect any guarantees. We try to be as helpful as possible so you will come back next time to check on how things may have changed for the next outlook period. Here's how things appear at this point in time and prices for some of the more promising E&P players.

The current buy candidates are EV Energy Partners (NASDAQ:EVEP), EXCO Resources (NYSE:XCO), Energy XXI (EXXI), and Rosetta Resources (NASDAQ:ROSE). Earlier examples are Continental Resources (CLR), Range Resources (NYSE:RRC) and Carrizo Oil & Gas (NASDAQ:CRZO).

The first five lines of the table are examples of earlier actual buy recommendations from our letter on, with the histories of prior forecasts like those being made at the time of the recommendations. The actual results are in the three right-hand columns.

A comparison of those forecast histories with the present ones suggests the likelihood of less robust results, but still quite competitive rates of return in comparison with many alternatives.

Our citation of past return experiences are not promises of future behavior, but are offered as a guide to what may be possible, for your convenience in choosing between investment alternatives.

Our intent continues to be to provide productive and profitable indications of what the future may be, as an alternative to simple conventional descriptions of the past and present usually found in many newsletters.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.