Short-Term Bearish On Brent Prices, Exciting Long-Term Energy Outlook

Includes: APA, APC, BNO, OIL
by: Shelley Lin, CFA

This article is an update to the one I wrote almost two years ago: "Major Trends Point to Higher Crude Prices: Statoil to Benefit".

In that article, I made a case for higher crude prices and Statoil (NYSE:STO), my stock pick. Here I would compare those forecasts to actual events in the past two years, examining where I was right as well as wrong, and provide new forecasts for the next three years in light of recent headlines in the energy industry.

Since July 2011, Brent spot prices have ranged from $95 to $125 a barrel, hovering over $100 per barrel most of the time (see chart below).

Source: U.S. Energy Information Administration, released May 15, 2013

While oil prices have not trended dramatically higher, tipping the world economy into a recession, as some pundits feared, they have hovered near or slightly above $100 per barrel, a threshold my article suggested. However, I did not anticipate the wide gap between Brent and WTI in the past two years.

I credited my bullish view to a 2011 report from the International Energy Agency (NASDAQ:IEA). Now the same body is turning bearish on oil for the next three years:

"North America has set off a supply shock that is sending ripples throughout the world," said IEA Executive Director Maria van der Hoeven, who launched the report (the Medium Term Oil Market Report) at the Platts Crude Oil Summit in London. "The good news is that this is helping to ease a market that was relatively tight for several years. The technology that unlocked the bonanza in places like North Dakota can and will be applied elsewhere, potentially leading to a broad reassessment of reserves. But as companies rethink their strategies, and as emerging economies become the leading players in the refining and demand sectors, not everyone will be a winner."[1]

The report went on to forecast, for the period 2012-2018, world liquid capacity to grow by 8.4 million barrels per day, significantly faster than demand, which is projected to grow by 6.9 million barrels per day.

Does this mean that average Brent prices for the next three years would finally drop below $100 per barrel, the marginal producers' previous threshold for bringing additional supply, and if so, by how much? I would tackle this question by calculating the Brent prices that would be required in order for two major producers in the U.S., Apache (NYSE:APA) and Anadarko (NYSE:APC), to make a return that is worthwhile for their investors. The focus is on these two cost leaders because of the assumption that the cost per barrel for other U.S. producers would be higher.

Required Average Realized Price

ROE = 12%














I arbitrarily selected a ROE range of 12-15% because given the heavy capital investments, volatile pricing, and environmental risks involved, it is reasonable for equity investors to demand a higher rate of return from oil producers, compared to a more stable industry such as consumer goods.

The required realized price from above is the weighted average price of crude oil, natural gas, and natural gas liquids and the mix would vary from quarter to quarter, from producer to producer, depending on drilling results. For example, crude oil only represented approximately 45% of Apache's total production volume in the first quarter. A portion of crude oil production is also priced at WTI rather than Brent level. Therefore, the required Brent price in order for the U.S. producers to earn a decent return would be significantly higher. Even with reduced unit costs from economy of scale, my guess is that this threshold is in the $90-$100 range. The age of fracking is also still relatively young, and probably not all of the environmental and geological consequences are fully understood. As time goes by, it is reasonable to expect more government regulations, which inevitably increases costs and could even put smaller producers out of the business. Therefore, my view is that average Brent prices would stay above $90 per barrel over the next three years, given the current stable slow-growth global economy; were Brent prices to drop below $90 per barrel for long periods of time, marginal suppliers would start leaving the market and moving the supply curve inwards, pushing the equilibrium price upwards.

Over the long term, in my view, what would be more impactful for energy companies than this proverbial cyclicality of oil prices is two "anomalies" in world energy markets, recently observed by Paolo Scaroni, the insightful CEO of Eni (NYSE:E), the Italian oil and gas group: "Benchmark U.S. gas at Henry Hub in Louisiana is about $4 per million British thermal units, which compares with about $15 per mBTU for liquefied natural gas imported to Asia, and about $16 per mBTU for the energy content of US crude oil. Over time, Mr. Scaroni believes, market forces will narrow both of those gaps."[2]

In other words, he predicted oil prices to trend lower over time while U.S. natural gas prices to trend higher. How would this impact energy companies? To look for answers, one good starting place is to examine the mix of global energy consumption over time. The IEA published a free booklet entitled "Key World Energy Statistics" in 2012.[3] In it, the analysts compared the fuel mix of global energy consumption between 1973 and 2010: oil's share declined from 48.1% to 41.2%, natural gas' share barely budged over the near four decades from 14% to 15.2%, the dirty coal's share decreased a little from 13.7% to 9.8%, while electricity's share increased from 9.4% to 17.7%.

The pie chart implies a shift from oil to electricity.

Another pie chart in the booklet shows the fuel mix for electricity generation between 1973 and 2010: oil's share decreased from 24.7% to 4.6%, natural gas's share increased from 12.1% to 22.2%, nuclear power's share also increased from 3.3% to 12.9%, and the other fuel types showed less significant changes.

My takeaway from these two pie charts is that the mix of fuel types for electricity generation would be a major driver for global energy demand for at least the next decade, if not longer. The global re-pricing of natural gas to whatever index or scheme that would make it economically more or less competitive versus other substitute fuels for electricity generation would set the ground rules for capital investment decisions on power plants all over the world, especially in light of heightened perceived risks of nuclear power after Fukushima.

The other major driver for global energy demand is fuel mix for transportation. This is probably the single biggest source of oil consumption. So far, we have not seen a dramatic technology to shift from oil to natural gas in a large scale for transportation, but rather incremental technology, such as carmakers boosting fuel efficiency.

In summary, it is too early to predict the net effect of all of these variables on energy companies. My view is short-term bearish, but long-term bullish on energy. Even if oil prices trend down over the next three years, we shouldn't forget that in the first pie chart discussed above, which compares global energy consumption between 1973 and 2010, the 1973 chart shows total consumption of 4,672 Mtoe (million tonnes of oil equivalent) while the 2010 chart shows consumption at 8,677 Mtoe, a CAGR of 1.7% over 37 years!

[1] The International Energy Agency, released May 14, 2013

[2] Financial Times, May 19, 2013

[3] IEA website

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.