Energy Sector Outlook: Intermediate And Long Term

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Includes: BNO, BOIL, DBO, DCNG, DGAZ, DNO, DTO, DWTI, GAZ, KOLD, OIL, OLEM, OLO, SCO, SZO, UCO, UGAZ, UNG, UNL, USL, USO, UWTI
by: Mark Bern, CFA

Summary

History review of oil prices for some perspective on where we are today.

History of natural gas prices for additional perspective.

We have been here before but this time it really is different.

Summary and introduction to Parts 2 & 3 about where we are today and where I expect prices to trend over the intermediate and long term.

Introduction

This commentary represents the first of a series of three parts discussing the overall outlook of the Energy Sector. Once I have presented my expectations for pricing and the primary influencing factors, I will convey my expectations for what the future will bring. Following this series, I intend to write about each of the industries I consider worth following within the energy sector: petroleum producing, integrated oil, natural gas diversified, pipeline MLPs, oilfield equipment and services, oil and gas distribution (or midstream), and royalty trusts. In each of those articles, I plan to provide an assessment of each of the leading companies that have a history of above average dividends. Finally, I will provide my favorite one or two picks from each industry with an assessment of fair value and future total return expectations.

My Investment Strategy

I take a conservative approach to investing, usually buying for the very long term. I am also of retirement age, so I focus on creating a rising stream of income with appreciation relegated to secondary status. That said, I try my best to avoid companies that seem likely to provide below industry average total returns over the long haul. I provide this explanation of my investment thesis for readers to discern if my picks will be logical for consideration by each individual reader.

Overview of Historical Oil Prices

The U.S. is once again a major energy producer of consequence on the global stage. We have been here before. For those too young to remember, high oil prices in the early 1980s (spiking to over $100/bbl) made exploration in new areas profitable and led to rising supplies later in that decade. Oil prices eventually bottomed, due to oversupply relative to demand, below $12 per barrel.

At that time, Saudi Arabia was the "swing" producer and had substantial sway over global oil prices from its leadership position within the Oil of the Producing Exporting Countries [OPEC]. When other members of OPEC called for lower production by all members, at first Saudi Arabia complied. But when those same OPEC members did not lower production (cheated) to meet agreed upon quotas, Saudi Arabia changed its game, it raised production to flood the world with cheap oil.

Saudi Arabia has the envious position of owning some of the lowest cost of production reserves in the world at less than $10 per barrel. Other members of OPEC have low lifting costs, too, but those countries generally spend all monies obtained from exports nearly as quickly as it comes in. Thus, those countries do not have adequate currency reserves to get through the tough times associated with low oil prices.

Oil prices hit a high of over $115 per barrel back in April of 1980, falling to about $25 by July 1986, then spiking back up to as high as $64 in October 1990 during Desert Storm. The ultimate low near $16 per barrel came around December 1998. By September 2000, oil prices had recovered once again to nearly $47 per barrel, then dropped again to near $26 by December 2001, after the World Trade Center bombing and predicated on the falling demand that resulted. The recession in the U.S. following the dot com bust also contributed to slowing demand for oil at that time. Since then, oil has been trending mostly upward with two major exceptions: the financial crisis of 2008-09 and the recent glut caused, in part by a dramatic rise in production by the U.S. and partly by the decision of OPEC (primarily Saudi Arabia) to keep pumping at record levels to maintain market share.

In short, oil prices have been and will most likely continue to be for the foreseeable future a roller coaster ride of very high highs and very low lows. Take a look at the chart at this link for a better visual representation. The latest boom in oil production here in the U.S. attracted both established companies and newly formed wildcatters, all hoping to cash in on the bonanza promised by the tight oil and gas contained in vast shale formations. There was also a national desire to become energy independent that was supporting the investment (or should I say mal-investment as some of it, at least, has turned out).

The problem is that in the rush to become energy independent and for outrageous profits was more fantasy than reality. We should have been able to see the glut and the accompanying drop in prices coming. We should have been able to look to history for a glimpse of what would come, but we didn't.

Of course, supply is only one half of the equation that determines price. The other half is demand. Global economic growth has slowed thereby reducing the rate of growth in demand for oil. In addition to slowing growth, there is the rise in adoption of alternative sources of energy. Countering that somewhat is a movement away from nuclear power as a result of the catastrophic outcome from the earthquake offshore from northern Japan and the resulting disaster from the tsunami thus created. These are the ebbs and flows of demand that will continue into the future. But, overall, demand for fossil fuels will continue to rise for the foreseeable future, as the cost remains lower than cleaner alternatives, especially for faster growing emerging economies where cost is of paramount concern.

Recently, the net U.S. imports of oil and refined products from outside of North America had dwindled to a trickle. Total U.S. crude imports were over 12.5 million barrels of oil per day in 2005; current imports are down to just over 5 million barrels per day in 2014. Of that total, 2.5 million came from Canada and nearly .3 million barrels per day came from Mexico. Persian Gulf exports contributed an average of 1.85 million barrels per day and the total from all OPEC countries was nearly 3 million per day. That adds up to more than 5.0 million, right? The majority of the difference comes from U.S. exports of refined products, a little more than 2 million barrels per day! If you want a break down by country for net U.S. import of crude and refined products since 2009, this link will take you to the website of the Energy Information Agency (eia.gov) of the U.S. government.

Now for a little more history going back to the last time the U.S. reduced its imports from Saudi Arabia. In June of 1985, the U.S. imported an average of only 26,000 barrels of crude per day from the Saudis, down from a high of 1.6 million barrels per day in February 1979. Notice that the low came in 1985. Now recall from above that oil prices fell from $115 in 1980 to $25 in 1986. It would appear that to every action there is a reaction. 1.6 million imported in 1979 and a high price of $115 in 1980 led to adjustments to demand in the U.S. and increased global oil exploration and production which, in turn, led to lower imports and prices evidenced in 1985 and 1986, respectively. Of course, the Saudis had been instrumental in creating the high prices, but they also learned a valuable lesson: high prices lead to increased exploration; increased exploration leads to increased production and competition for market share. As more and more oil production entered the global marketplace, the Saudis determined that lower prices would be a good solution to waning demand AND competition. Click here for a chart showing the history of oil imports from Saudi Arabia from eia.gov.

With its low lifting costs, Saudi Arabia can remain profitable while most of the rest of the world is wallowing in losses until bankruptcy or other means of reduced production reduce supply. At the same time, dramatically lower prices for energy, especially for gasoline and other refined products, had another effect: people felt less compelled to conserve energy and began to use more energy (NYSEARCA:OIL). We bought bigger cars, minivans, SUVs and trucks. We stopped turning off electrical appliances and lights. The Internet was launched in the public domain during this era of low energy prices and usage soared. We bought computers by the millions and left them on all day long. For the baby boomer generation those may have been the good ole days!

But then incessantly increasing demand caused the oh so predictable outcome: higher prices for energy. And it all happened during a period of reduced exploration and waning production. Then came the siren call of "Peak Oil!" Another imaginary (at least for the next few decades) stimulus to drive prices ever higher, along with a temporary scare named Katrina, a devastating hurricane that shut down offshore production of oil and natural gas in the Gulf of Mexico temporarily. That brought about the peak of the price of oil at $147 per barrel. And the high prices that were expected to be around forever due to peak oil spurred technological advances in drilling and made all sorts of heretofore unprofitable oil locked up in deep water, oil sands, frozen areas of the arctic, and trapped in shale formations suddenly economically feasible.

The result? We have too much oil again! Prices had to drop. Each time oil prices rise to levels that encourage massive capital expenditure to explore, drill, and expand infrastructure the Saudis have two options: reduce production to prop up prices (leading to probable losses of market share) or maintain production levels and let prices fall (an attempt to maintain or expand market share). Being the low cost producer with the largest reserves naturally places them in this enviable position. The Saudis made the choice once before to let prices fall back in the 1980s and 1990s. Why would we think it would be any different this time?

History of Natural Gas Prices

Petroleum has maintained the top dog position in global energy production primarily because it is so plentiful and can easily be transported via special tankers to ports around the globe. This creates a global market for crude oil. Natural Gas Liquids [NGLs] can also be transported with relative ease but supplies are much more limited compared to crude. Natural Gas (considered "dry" because it is not in liquid form when it comes out of the ground) is also plentiful, but more limited in terms of its capacity for ease of transport and by restrictive laws regarding export from the U.S. Sizeable investments must be made, not only in specialized tankers, but also in export and import terminals to accommodate expanded trade of natural gas on a global scale similar to oil. Thus, prices for natural gas remain more localized, especially in the U.S. because of the limited volume available to global markets.

Most natural gas is transported via pipelines which limits its availability to connected land masses. That situation is going to change dramatically in the next few years as I will explain in more detail later in this series.

The price of natural gas is driven by local supply and demand, which, in turn, is influenced primarily by weather conditions, conservation efforts, and technological advances that decrease the cost of production. Everyone probably understands how extreme cold will increase the demand for more heat. Natural gas is used to heat a lot of houses and commercial buildings. Electric heating is prevalent in the southern and western areas of the US. Thus, when extreme heat or cold hits those regions electricity usage climbs. Many coal fired plants are being replaced with natural gas powered electric utility generation. So, when electricity usage rises so does demand for natural gas.

Another way that weather has influenced natural gas prices is by suppressing supply. When Katrina hit the gulf coast of the US many natural gas wells had to be shut down for safety reasons. After the storm had passed, it left many of the production rigs in the gulf area damaged and needing repairs. This extended the supply disruption (the same thing happened to oil production in the same region). Hurricane Katrina made landfall in late August 2005. By October of that year, natural gas prices at the wellhead had risen to over $10 per thousand cubic feet [mcf] from about $5.80 per mcf in January 2005. You can see the spikes in natural gas prices in this chart from the Department of Energy, Energy Information Agency [eia.gov]. Notice that most price spikes happened during cold months, November through March, in many years.

Geopolitical events such as wars, government reforms, nationalization of resources or privatization of publicly owned resources and many other events can also move energy prices, at least temporarily. Such events come and go but eventually global supply and demand finds an equilibrium within a price range. But these events are also less predictable and less common than seasonal changes in the weather. So, this discussion ignores the geopolitical events of the future and only touches briefly on the more significant of such events in history. I will not be making any major predictions about wars breaking out or governments falling.

To get a sense of just how localized natural gas pricing can be, take a look at this chart from eia.gov to see the difference in prices of natural gas imported by point of entry. The range in price as of April 2015 is $1.64 per mcf from Mexico to $5.40 per mcf coming from Canada into Massena, NY. When only one pipeline is available to a destination, the price can be artificially high. But the highest prices on the chart do not accrue regularly to Massena; the entry price in Calais, ME hit $16.69 per mcf in February. Demand rose due to lower than usual temperatures while supply was restricted by a lack of sources.

Now I want to take a look at price differentials on a more global scale. Look at the following chart from businessinsider.com to compare natural gas prices in the US to those in Europe and Japan.

If the lines were extended further, the price in the US would show current prices below $2. There is an obvious arbitrage opportunity here that I will explain in greater detail, once again, later in this series.

Before the shale oil and gas boom, the US was a major importer of natural gas. We built liquefied natural gas [LNG] import terminals to receive LNG via specialized tankers and pipelines from Canada and Mexico to supply our growing dependence on natural gas. Prices for natural gas would spike along with prices in Europe and Japan, and sometimes even higher when supplies were disrupted or due to cold weather spikes. Since the US began tapping into its shale reserves, prices have diverged with prices in Japan rising higher due to that nation having made a commitment to shut down its nuclear electric generation capacity and switch to natural gas. In the US, the price has fallen due to increases in supply well above demand.

Now for a look at demand/consumption on a global scale. In the four-year period from 2009 to 2013 (latest data available from eia.gov), global natural gas consumption rose more than 15.2 percent from 105,326 billion cubic feet [bcf] to 121,357 bcf. China, of course, had the largest percentage increase of 84 percent over that period. Europe, as a whole, actually decreased its consumption of natural gas as the continent has made significant investments in renewable/alternative energy and conservation. Of course, recession and near-recessionary economies also tend to result in reduced energy usage and much of Europe has been struggling since the financial crisis.

Finally, a look at the supply side for natural gas will help us gain a better picture of global demand supply imbalances. The US has increased production of dry natural gas by nearly 18 percent during the 2009-2013 period. European production has declined by over six percent during that same period. Russia has increased production by 14.7 percent, the Middle East increased by 35 percent with Qatar accounting for the largest increase at over 77 percent. In Asia and Oceana, the highest increases have occurred in Australia (46 percent), Thailand (35 percent), and China (34 percent) with China increasing the most by volume. But, even with the significant increase, China still imported about 44 percent of its natural gas consumption in 2013. Overall, global production increased by 15.2 percent just keeping pace with the rate of increase in consumption.

When we put the two pieces together, supply and demand, we realize that there is a balance being maintained and that with additional supply availability demand would likely increase to absorb reasonable increases. But, until the US does begin to export liquefied natural gas, we will maintain a surplus while much of the rest of the world suffers in short supply. Thus, the significant price differences by region. This puts the US natural gas industry in a very enviable position for the future. Remember that the prices here in the US are considerably lower than in other major industrialized regions. Also, as emerging economies grow their respective middle classes, energy will be both a major driver of growth as well as a resource increasingly in demand.

Been Here Before but This Time there is a Difference

This time there is a difference, there is middle ground. From now on, at least until the shale plays in the U.S. have been nearly sucked dry, the U.S. will play an expanded role in the price of oil. The Saudis can determine the bottom but we will be in a position to determine the top. I will explain this point in more detail in Part II.

In terms of natural gas, the advent of exports from the US beginning as early as later this year or early 2016 will bring greater global balance between supply and demand making more natural gas available where it is needed. This requires the build out of many new import and export terminals around the globe, much of which is already underway. Again, I will provide more detail to the movements in progress to transition natural gas from being a localized commodity to more of a globally traded commodity and the relative price movements we can expect as a result.

Previously, OPEC (and especially the Middle East) has been the predominant producing power able to effect price changes to meet its goals, both economic and cultural. For the last few decades, the US has been primarily a driver on the demand side. Today and going forward, North America, especially the US, will play an increasing role and counter balance in global energy pricing.

Summary

Each industry within the energy sector has its own complexities that need to be understood by investors. This article is meant as a brief look back for perspective into some of the changes throughout history that have affected prices of oil and natural gas. The rest of the series will build upon this foundation to expand the understanding by readers of factors influencing energy prices today and into the future. Once I complete the three part series, I will delve more into the complexities of each industry with another focused article on each industry.

Introduction to the Rest of the Series

Part II of this series will focus primarily on the current state of the energy sector and discuss the moving parts and players involved in the transitional period the sector is going through. It will include an assessment of my expectations for short-term prices and a discussion of what types of events could result in temporary or sustained changes over the coming six to twelve months.

Part III will include two main themes: intermediate and long-term pricing of energy commodities along with the primary factors to support those expectations and what role energy should play in a portfolio. This second part will be based largely on my own predispositions and use of energy holdings within my portfolio but will also attempt to provide a framework to be used by others in determining an appropriate allocation for one's own portfolio. When I write about each individual industry, I will also include my current rating of whether I believe the industry as overweight, market weight, underweight, or avoid. I will also provide a description of how companies in each industry derive the majority of revenue as well as important expense categories that are key to the industry.

Some companies are well diversified, such as Exxon Mobil (NYSE:XOM), and maintain diversified operations, which compete with many of the more "pure play" companies that focus in one or two areas, such as Kinder Morgan (NYSE:KMI), which is more focused on the transportation and terminal facility operations of energy commodities. I will attempt to illustrate the advantages and disadvantages of owning each.

As always, I welcome comments and questions about my articles. The discussions that follow articles here in SA often contain valuable insights from readers and sometimes the comments spur authors to clarify what seemed obvious in the writing process but somehow did not quite illuminate readers to the extent intended. Here at SA, we have the opportunity to learn from each other.

Proceed to Part II

Disclosure: I am/we are long XOM.

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.

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