Welcome to the eighth piece in Seeking Alpha's Positioning for 2015 series. Earlier pieces have covered currencies to biotech, and today, we are pleased to address the energy sector with Jennifer Warren.
After Monday's trading, there's no need to recap what is afoot in the energy markets as we launch into the new year. Oil has dipped below $50, and as the market tries to determine what that means, now is the perfect time to speak to one of our site's leading voices on the sector.
Jennifer's areas of expertise include energy trends - their economic and geopolitical implications - and resource sustainability issues. Other interests include shale oil and natural gas, climate change, green and efficient infrastructure, China, India, and the energy-water nexus.
Her work has been published in various academic, policy and business publications such as Far Eastern Economic Review, Economist Intelligence Unit's Executive Briefing, Journal of Structured Finance, Lloyd's List, D CEO, Energy Trends Insider, Financial Sense, and many others. Currently, she is principal of Concept Elemental, a strategic communications consultancy focusing on knowledge work, and includes over fifteen years of financial services industry work.
Last week, SA's George Moriarty conducted an email interview with Jennifer discussing the year ahead. The discussion is thought provoking and insightful. Enjoy.
George Moriarty (GBM): Let's start with the simple stuff first. Oil is around $50 as I type this question. What does that mean for you as an energy investor, broadly?
Jennifer Warren (JW): With oil prices nearing the $50 mark, as an investor with an oil-weighted concentration in my portfolio, it means that patience is in order. I will be observing how firms within the oil and gas space are adjusting or not adjusting plans in light of changes to the pricing environment, managing their balance sheets, and revealing any adapted strategies as supply and demand re-balance.
It also means that opportunities are present to add to the portfolio, which I began in the third and fourth quarters, though I wish I had waited a week or two in some instances. But overall, I made decisions that should prove out positively over the longer term because I believe that the U.S. oil and gas industry is in a positive position given the ability to extract from the numerous shale plays in an increasingly more efficient manner.
GBM: Depending on their perspectives, many commentators are citing geopolitics as driving this recent action. Today alone I've read that the Saudis are punishing the Russians, the Saudis are punishing the Iranians, the Saudis are punishing the U.S. shale operators, and the U.S. administration is punishing everyone. Point being, oil and politics are inextricably linked, but how do you keep the politics in perspective?
JW: I think it is very easy to look at an action, such as the Saudi (and OPEC) move to refrain from production cuts, and infer and build numerous cases and narratives. But oil is a vitally-important, globally-traded commodity that suffuses numerous economic and production processes that also propels political consequences. While the action of the largest oil-producing group influences prices and its accompanying political consequences, the OPEC decision was based on sound economic policy for their particular competitive, economic and political environment. And the Gulf states of OPEC have dominated that decision. In my view, they are not expecting protracted low prices like $50-$60, but nearer the $80 mark, in time.
As a result of the price reaction, Russia is suggesting it will cut production by over 2% next year and possibly 10% over the next couple of years. The U.S. oil and gas industry is responding by implying reductions to capital spending. In the last three weeks, oil-directed rigs have declined by 76, of which 37 were in the week ended December 26. Allowing the market to determine prices is the only way OPEC could respond. Cutting production would have kept prices artificially higher and other non-OPEC producers would have gained market share at OPEC's expense.
The dominoes now fall. The knock-on effects of political fallout in oil dependent places like Venezuela, Russia, Iran and other OPEC countries begins. While there are "negative" consequences in the short run, over time these economies may consider other means to diversify away from an over dependence on oil revenue and implement reforms.
GBM: And where then do you place the fundamentals? And what fundamental factors are you looking at heading into 2015?
JW: On the supply side, the evidence is clear that oversupply will likely be reduced as producers cut back in a lower price environment, particularly Russia and to an extent the U.S. Mexico may slow down its pace of energy reforms in a lower price environment, so they will not be making additions to supply of consequence. Frothiness will be skimmed from oilfield services costs, a cost of production, to match the price environment. Geopolitics will continue to play a role in the Middle East as ISIS and other threats to stability weigh on energy producers like Libya, Nigeria, even Yemen. According to the Qataris and other analysts, an approximate 2 million barrels of oil per day is in excess, not what I would consider glut territory.
On the demand side, Europe's malaise, China's slowing of growth and other emerging economies were chief culprits of demand not fulfilling the expected balance in the oil market. With today's lowered oil prices however, the head of the German Bundesbank and European Central Bank (ECB) governor said December 28th, that the ECB should not implement quantitative easing because low oil prices would give new tailwinds to the European economies. Thus Germany expects better growth next year, reports the think tank Stratfor. India, and other main Asian economies continue to grow, in spite of China's growth forecast declining from 7.3% to 7.1%. The U.S. and Britain are posting reasonable growth. Ironically, the global oil price cut may prove to be the remedy that allows various economies around the world to catch a break and move ahead faster than in its absence.
In 2013, increased U.S. production was a source of moderation in oil price volatility, meaning prices were swinging from extremes to a lesser extent. Supply shocks, which were in record amounts, were less likely to rattle the market. In the second half of 2014, the price reactions became more extreme once again for both demand and supply shocks. An awareness that this will take multiples of months to re-balance the market has settled in. Thus price expectations have variations but one has to cut through the noisy whims of the market's psychology. Fundamentals of demand and supply indicate adjustment, and now the new normal for short-term oil prices are in discovery mode. Demand is wagging the tail right now. But in one scenario, expected future supply reductions in combination with demand growth could move prices upward faster than the one-year to eighteen months time horizon that some say the adjustment phase indicates.
GBM: Shifting a bit, when oil is at highs, people are always looking at alternative energies, now, there's less talk of alternatives in the mainstream media at least. What does this recent slide in oil mean for various alternative energies, broadly?
JW: I see the oil price drop as it relates to alternatives in a more nuanced way. Economic theory as it relates to alternatives would imply that as oil prices rise then it becomes more economically feasible to introduce and develop alternative energy sources. This we clearly witnessed in the first half of the 2000s, with oil rising to a $140 level, the interest and investment rationale increased for alternatives. Across that time to today however, both solar and wind power have become more cost competitive with other sources of power generation, that is, in relation to coal and natural gas. (Though these two fossil fuels still have cost advantages.) The other cost however is that of carbon emissions and/or pollution. There are societal, health and environmental costs not factored into total energy costs. When and if policy and economics can account for these factors in the marketplace, then we will see investment choices become different.
The other divergence is that oil competes less with commonly known alternatives head-to-head in transportation; it is in power generation that alternatives play a larger role to date. So my view of the energy landscape as an investor accommodates the many opportunities for success in both the oil and gas and alternatives camps. I see the energy system as a whole from an investment perspective and a decoupled point of view rather than the market's apparent synchronicity.
GBM: Now let's focus in on some specific companies. Among oil-related companies, what companies are you looking at for 2015? And which ones are you avoiding?
JW: As an experiment, I began looking at how a number of exploration and production (E&P) stocks behaved within the context of the shale ramp-up. Of course this was predictable. Then I began diversifying my selections. In the middle of 2014, my portfolio was adjusted from growth E&Ps only to dividend and growth potential because of long-term potential in shale oil and gas, and the players I identified as landing on the forward growth curve of the various shale plays.
I built a portfolio that featured strategies and management styles that were solid, alongside an array of assets in Canada, Middle East/North Africa (MENA) and the U.S. I also like having a couple of the larger more diversified E&Ps that in fact have MENA exposure I am comfortable with. This acts as a hedge against the very thing which has happened. In the summer of 2013 when interviewing a veteran geologist for a large E&P, he said that a glut would form similar to that which happened with U.S. natural gas because the industry will become too good at producing it (meaning their expertise in producing from the shales would increase in volumes and efficiency, and this has happened).
My selections are Occidental Petroleum (NYSE:OXY), added in the latter half of 2014; Apache (NYSE:APA) added in 2Q 2014; and RSP Permian (NYSE:RSPP), added back in late 2014, after I questioned my growth players in mid-2014. RSPP is back on its own merit. There are a number of MLPs that are good prospects in any energy portfolio, especially with the U.S.'s role as an energy producer. I like the Energy Transfer family with ETE, ETP and RGP. For my own purposes of simplicity, I have the MLP ETF AMZA in my portfolio. In time, I may decide to select individual MLPs but a spectrum of MLPs actively managed by a smart team makes sense. I also added Encana (NYSE:ECA) in mid-October, given their asset diversification, Permian acreage additions, strategies, balance sheet health, and a modest dividend.
Also related to portfolio stability, I added stocks or related plays that could derive upside from the 'U.S. as oil and gas producer' theme but also provide diversity and hedging against volatility. This was the railroad pick of CSX Corp (NYSE:CSX), though other railroads could be substituted, and the Hennessey gas utility index fund, (MUTF:GASFX).
In 2015, I will continue to see how the balance of oil and gas-weighted firms plays out, but I am likely coasting with the production firm selections locked in the final quarter of 2014, unless course corrections are needed. The midstream MLP space may be quite interesting to watch. Depending on if lower prices endure, some shifts and consolidations may occur there as well. Although oil pricing is a dominant theme driven by demand and expected supply reductions, the LNG and natural gas liquids (NGL) export environment is of high interest. Related to firms, I lean away from repeated poor management decisions and an inability to adapt to the events of the day. In my energy portfolio, individual firms work together to diversify and participate in running secular trends, rather than an approach segmented by energy sector.
GBM: And within the alternative space, what is your direction?
JW: I believe in the approach of investing in the 'sustainable infrastructure' space. Financing the lower carbon future is a primary challenge. Owning the stock of one firm helps me participate in both the financing of and participation in sustainable or lower carbon infrastructure: Hannon Armstrong Sustainable Infrastructure (NYSE:HASI). I also lean toward firms making strides in energy efficiency like General Electric (NYSE:GE) but also within the organization itself, for example Lockheed Martin (NYSE:LMT). Doing more with less is a theme that resonates in my investment choices provided a certain threshold of performance and operating rationale. In that light, particular MLPs also have characteristics that mirror a resource efficiency investment theme.
There is also a great need worldwide in the area of energy and resource efficiency and numerous players are headed in that direction. I do not look at specific energy source types so much as firms innovating and solving the problems of today and tomorrow. The growing area of "green" bonds interests me as well. It is in these areas I hope to further refine ideas and test hypotheses.
Energy demand is increasing around the world; water resources are an issue with development. A holistic approach is needed to accommodate these demands at the least cost with the highest purpose use of resources. To meet the challenges of sustaining an interdependent system of people and planet, U.S. firms are some of the best, but other global players are emerging.