Energy Sector Outlook - Part III

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Includes: CAT, CMI, GE, NSC, UNP
by: Mark Bern, CFA

Summary

Introduction to series.

Factors that will affect global oil and natural gas supply and demand.

Intermediate & long-term price expectations for Oil & Natural Gas.

How I allocate portfolio funds between and within sectors.

Summary and Conclusions.

Back to Part II

Introduction

This is the final part of this series on energy. I will drill down deeper into individual industries and companies within the sector in coming weeks. Part I was a presentation of the history of energy prices focusing on oil and going back to the 1970s. The primary emphasis of that piece was to put today's prices into perspective because we have been in a very similar situation previously. Part II was focused on my expectations for short-term (six to twelve months) prices for oil and natural gas. My projections were based upon the factors that have created the global glut in oil and the domestic glut in natural gas along with what I consider transformational changes occurring here and around the globe in energy supply and demand. Part III is to be dedicated to the intermediate to long-term prices ranges I expect for both oil and natural gas. I generally define intermediate as more than one year and up to five years. The long-term is then, by default, what happens beyond five years. As always, the further out we try to predict the more difficult it can be. Thus, the ranges I apply for each period will widen somewhat but also provide an expectation as to the bias that prices will likely have toward the upper or lower bounds of the range. At the end of this article I provide a framework for determining the allocation of a portfolio one could consider for investing into energy shares. This is how I do it. There are alternative methods, of course, and none is right for everyone.

Factors that will affect Global Oil Supply and Demand

I should point out at the outset that my predictions are based upon my expectations and views of how future events will play out. I have a perspective that is based upon following the energy sector since the mid-1970s. Mine is an educated guess, nothing more. Rely on my expectations at your own risk. But I present my expectations, none-the-less, to provide one more frame of reference for those who want to understand the energy sector better. Mine is not the only interpretation upon which readers should rely. Try to take in as much information about a subject as you can from multiple sources. Then try to make sense of the reasoning process used by each source and come to your own conclusions.

One could consider climate change as a potential factor, but short-term weather patterns are no longer at issue because we are not thinking in terms of short-term price movements. But I will try not to get into a discussion on what affects climate change, outside of solar activity, because long-run historical data shows that temperatures shift with some regularity due to changes in solar activity and ocean temperatures and currents (the latter being heavily influenced by the former). Another El Nino will come (probably beginning this winter) and potentially end the drought in California. Temperatures and precipitation will be affected in several regions of the U.S. Scientist now expect that solar activity will decrease substantially beginning around 2030 (also a temporary phenomenon that runs in cycles) resulting in substantially lower temperatures in the northern hemisphere. In making predictions about the short-term and intermediate these events will have some impact. However, when looking at global supply and demand for energy, such things only move the needle fractionally on an annual basis. In 15 years, should the solar activity lessen enough, the degree to which demand rises could potentially be slightly higher.

Geopolitical events

Geopolitical events such as large-scale wars or revolutions that include energy-producing nations can have significant impacts on energy prices, usually upward, until the inevitable end becomes clear. Such events can last months or even years and can have an impact on the intermediate term price range but have very little effect on long term supply and demand functions of price. The Middle East is a perennial powder keg and large-scale warfare could break out at almost any time. This is one of the potential events, if it occurs, that could have a significant impact by limiting supply and raising prices. Be ready to profit if or when there appears to be the potential for major supplies being curtailed for more than a few days. If I already own shares that go up too much in such a circumstance I will either hedge my position (most likely) or take some profits when the valuations get unsustainable.

Substitution of natural gas for coal, oil and nuclear

This movement is already obvious here in the U.S. and is even further advanced in Japan and some countries in Europe, especially since the Fukushima incident. Germany is phasing out nuclear power generation. Japan had closed nuclear plants but last year did an about face and decided to reopen nuclear power facilities.

Coal fired electricity generation plants are being shut down due to the higher cost of meeting new government regulations. Natural gas plants are being built to replace most of that capacity. This probably means that electricity rates for most of us will climb in future years because natural gas, while cheap, is still more expensive than coal when it comes to generating electricity. Also, natural gas prices are more likely to rise in the future from historically low levels as the U.S. begins to export LNG and its capacity to do so increases over the next several years.

Cummins (NYSE:CMI) appears to be the leader in developing natural gas engines to be used by commercial trucks. That technology was being adopted at a much higher rate when diesel fuel prices were higher. Today, the impetus has been hindered because the cost advantage of using compressed natural gas [CNG] or liquefied natural gas [LNG] has diminished. But Cummins is not alone in the area of developing engines that will run on natural gas. Railroad companies are also experimenting with natural gas powered locomotives. Even small savings per mile can add up to tremendous savings over hundreds of thousands of miles. GE (NYSE:GE) and Caterpillar (NYSE:CAT) are both engaged in this development as are Berkshire's (BRK-B) Burlington Northern Santé Fe, Union Pacific (NYSE:UNP) and Norfolk Southern (NYSE:NSC) in testing the concept.

Emerging market expansion and conservation efforts in developed countries

Continued growth in emerging economies including electricity, transportation, heating and cooling, chemicals, and agriculture has thus far offset most of these efforts on a global scale. The world population is projected to expand from seven billion to around nine billion and one of the most important elements necessary to improve the standard of living of many people is access to electricity. Without it, people are disadvantaged economically. Thus, governments around the globe continue the effort of bringing electricity to people who need it. More people means more demand for electricity. More demand for more electricity means more demand for sources of energy. But there is another side to this equation.

In developed nations, there is an enduring effort to conserve energy in every way imaginable. Obviously, more rigorous mileage standards on automobiles and trucks are being mandated by government to reduce future usage of gasoline and diesel fuels. Hybrid vehicles are helping in this area and electric vehicles are also adding to improvements, but even the standard internal combustion engine continues to be improved to meet the stringent new standards. Employers are encouraging employees to ride the bus, metro rail, or to car pool primarily to reduce emission of pollutants and improve air quality. But these efforts also make a difference in reducing energy usage. As electricity rates rise, many people will turn the thermostat down in the winter (and wear more warm clothing) and turn the thermostat up during the summer (and…well, use your imagination). Companies and individuals will install new HVAC systems that monitor energy use and make adjustments automatically to conserve. More motion detection light switches will be deployed so the lights go off when a room is vacated. There is no end to what we could do to conserve more energy. The little things do add up.

Alternative sources of energy

Over the intermediate term I do not expect the level of progress that is needed to make solar, wind or other types of alternative power generation economically viable. My reasoning is that most developed governments are dealing with stagnant economic growth and rising budget deficits that make pledging more funds toward subsidizing major alternative power generation projects unrealistic. Until the global economy can stand on its own two feet without continued central bank intervention, such efforts will need to become more self-dependent and rely less on governments for support. This, in turn, will slow technological advances that are needed to bring down costs to competitive levels in line with fossil fuels.

The other piece that is still missing from the alternative energy equation is economical energy storage; batteries. We need enormous batteries that can store huge amounts of electricity for very little cost. Without that, the intermittent nature of most alternative sources will not be able to proliferate and become the reliable, constant source of power that is required. There are several efforts in this category that show promise, but none has shown itself to be the complete answer thus far. Here is a good example of one such effort to build a mega-sized battery at low cost. Grid storage will take more time and huge investments.

Technological advances in drilling and extraction.

It now costs less to drill and extract oil and gas from shale formations than it did just three years ago. In other words, the sunk costs of many shale producers may be causing an uncompetitive disadvantage and will probably lead to bankruptcy. These bankruptcies are a natural part of the process, though. As small companies take on too much debt without appropriately hedging against the potential risks that come with falling oil and gas prices, those companies assets are purchased at steep discounts to the original costs. Often the assets have been used as collateral for debt which is eventually sold by banks and investors to larger, more financially stable energy companies for pennies on the dollar. Through bankruptcy the debts are washed away and new owners can start from a much more advantageous cost basis. The leases go down in value. The day rates for drilling rigs go down. The hourly pay levels needed to lure workers go down as do some of the benefit costs. Suddenly, the new owners can produce oil and gas at a significantly lower cost per unit. Then the second wave of bankruptcies begins as those companies that had done many things right like selling a large percentage of forward production for three to five years out (hedging) see those advantages decaying over time. So, in three years, the process of more bankruptcies will begin anew and the larger, well capitalized energy companies will pick up some more assets again at bargain prices. The really big energy companies involved in the shale fields were committing only a very small portion of capital resources to develop and compete in the new oil plays. Mostly, those companies needed a presence with feet on the ground to identify the best assets to buy later and to identify the best potential new employees. The big survive and prosper once again and are able to employ the most innovative technologies available because they can hire those who designed and developed those techniques. Those innovators will continue to innovate, but now they will do so within the shrouded cocoon of the energy majors. New innovators will arrive again and the process will start all over again.

In other areas of technological advances, there are huge resources that have been considered uneconomical to develop that will someday, because of human ingenuity or higher prices (not as high as we have experienced before, though), will become economically feasible. One potential example is the huge floating liquefied natural gas plant being built by Shell (RDS-B). Natural gas may be exceptionally cheap in the U.S., but it is much higher in many parts of the globe, especially Asia, where Shell is planning to use the new floating structure (they do not call it a ship). The current plan is to anchor the floating platform in the Indian Ocean to liquefy natural gas from fields off the coast of Australia. If can produce enough LNG to more than meet all the needs of Hong Kong. It is massive, displacing 600,000 metric tons of water and with total storage capacity equivalent to 175 Olympic swimming pools, and it is designed to remain moored above the gas field even in the strongest of typhoons.

Many other innovative efforts will become mainstream in the future and costs will continue to come down.

The fate of nuclear energy

There are three primary factors standing in the way of greater reliance on nuclear energy:

  1. Cost
  2. Safety and concerns of proliferation
  3. Long-term waste

Once a nuclear plant is build and producing energy the actual cost of producing electricity is the lowest of current forms of electricity generation, with the exception of hydroelectric. Nuclear power generation costs an average of about 2.1 cents per kilowatt hour while for hydroelectric generation the average is about .85 cents per kilowatt hour. But potential expansion of hydroelectric power is limited whereas the limits on increasing nuclear power generation are more psychological.

Source: instituteforenergyresearch.org

The most interesting potential technological opportunity in nuclear is one that uses the 99 percent of radioactive material that now comprises waste as fuel. This process more fully depletes the uranium fuel stock nearly eliminating radioactive waste. Take a look at this video featuring Bill Gates (for the part that highlights the promise of nuclear go to the 13:20 minute mark). There are only a couple of minutes that are really pertinent to this concept. If it works there would be enough fuel available from the spent fuel storage facilities to generate all the power we need for several hundred years! And did I mention that there would be no CO2 released into the atmosphere. While the concept is still far from realization (that is why it is called a concept), the technology would be a dramatic game changer for the energy sector so it is worth keeping an eye on over time.

If it does work, it will reduce costs, reduce safety concerns related to radioactive waste, reduce waste dramatically, and reduce CO2 emissions. There are still the problems of operational safety and potential proliferation that concern many people, but at least one of those two have also been significantly diminished. Fail safe systems no longer require humans to shut down a reactor in new models as the system will automatically shut itself down as heat levels approach danger levels. Humans will still be there as a backup measure, but the systems will be self-monitoring. Thus, no more Three Mile Island or Chernobyl if we build new plants. It is sometimes hard to understand, from a safety aspect, why people would rather let the old reactors continue in service than replace them with improved technology. The proliferation becomes less of a problem because the new technology, as I understand it, does not require enrichment of the existing spent fuel. It is the enrichment technology that is crucial to developing nuclear bombs. Removing the requirement of enriched fuels could make this a viable option for any country that wants to pursue it without the threat of nuclear bomb proliferation. So, I guess it may be able to address all three problems.

Intermediate & Long-Term Price Expectations for Oil

Over the next five years I believe that oil prices will remain range bound between $35 and $85. I do not see how the price of oil can be sustained above the $70 level for very long since too much relatively cheap to extract oil will become profitable at or below that level. It could happen temporarily due to a geopolitical or weather event, but would short-lived. Such events would, in my estimation, provide either trading opportunities or good profit-taking prospects to lock in unexpected long-term gains. On the lower end of the spectrum, at $35 to $45 per barrel for WTI, I would consider initiating new long-term positions by scaling in as prices fall. I will write more about this in the focus articles I intend to write about individual companies in the weeks ahead.

Longer term prices, looking out six to fifteen years, could very well be more of a roller coaster ride, not that I do not expect volatility in the intermediate term, but rather because the highs could be higher and the lows, believe it or not, could be even lower. Higher growth will return to more regions of the world as new emerging markets (think Africa) seek to raise the quality of life for billions more. India is still early in its growth curve; Vietnam, Indonesia, Nigeria, Pakistan and others also contain large populations but are still far behind in development. Electricity is the initial infrastructure that allows countries to raise more people out of poverty. I suspect we could see another peak in oil prices near the $130-140 per barrel, even higher in geopolitical upheavals, sometime in the next 20 years. The low end of the range could reach $30 or less over that period. When energy prices are high more capital is thrown into the mix and innovations abound. We may get more supply than we need, similar to our predicament today.

In the end, I must admit that I believe innovation will find a solution to massive electricity storage making more alternative sources reliable. I do not know how far into the future that will be, but when it comes it could create another massive imbalance that will adjust prices lower as demand for fossil fuels adjusts lower. But, of course, once prices of fossil fuels get low enough the competitive cost advantage returns in favor of deteriorated dinosaurs again. Spin. Cycle. Repeat.

Things always change and sometime very drastically!

Intermediate & Long-Term Price Expectations for Natural Gas

I expect that the intermediate term price for natural gas will soon begin a gradual sustained uptrend that could last for several years. The primary determining factors will be the rate of substitution that occurs (gas for oil, coal and nuclear) and the pace of global infrastructure build out necessary to harness the full potential of natural gas.

If the substitution rate happens too slowly the trend may be weaker than it would otherwise be. If the rate of substitution occurs too rapidly there could be temporary shortages as supply may be unable to ramp up quickly enough to fill demand, resulting in price spikes.

At the same time, if the infrastructure (specialized LNG carriers, liquefaction facilities, import/export terminals, storage facilities, etc.) build out goes too slowly, the trend for natural gas prices could be more robust than otherwise, since availability of supply may not be able to meet demand. Conversely, if the build out proceeds too fast, competitors will lower margins in hopes of filling unneeded capacity and the result could be excess supply leading to prices being lower than otherwise expected.

But, the underlying dimension of all this complexity is that demand will rise and the imbalance of prices around the globe will eventually be diminished. That means that plentiful, cheap natural gas in the U.S. will become less cheap and more expensive areas where current demand outstrips supply, such as Asia and Europe, will see prices fall. A global market will be created much like there is for oil. Differentials will still exist, but the range will narrow.

Prices will spike for all of the same reasons as in the past. But the lower bound of natural gas prices will rise gradually as supplies can more readily be matched with demands in a global marketplace. The important thing for producers is the lower bound of prices and as that level rises over time more natural gas producers will become more profitable. The current lower bound in the range of U.S. natural gas prices in just below $2 mcf. Over the next five years I expect that the bottom of the range for U.S. natural gas prices will move up to over $3 mcf.

Over the longer term, going out beyond five years to ten year or more, I expect the low end of the range for natural gas prices to increase to around $3.50 mcf. When that happens is purely a guess as there are too many variables that need to create the right balance between supply and demand. If the price were sustained too much above that level, other forms of energy sources will become more viable and competition will bring the rate back down to preserve the cost advantage.

How I Allocate Portfolio Funds between and within Sectors

This is a simple example of a process that I use loosely to help me allocate my portfolio holdings between and within sectors. I do not intend to get into how I allocate between asset types here, so I will addressing on the equity portion of my portfolio.

I begin with the weighting of sectors used by the S&P 500 Index. Here is the breakdown by sector as of the end of June from S&P:

Information Technology

19.6%

Financials

16.6%

Health Care

15.4%

Consumer Discretionary

12.8%

Industrials

10.1%

Consumer Staples

9.4%

Energy

7.9%

Materials

3.1%

Utilities

2.8%

Telecommunications Services

2.3%

I then decide whether I want to overweight or underweight each sector based upon my long-term confidence in the ability of each to perform against the overall index. This, of course, is nothing new. But there is an added piece to how I evaluate each sector: whether I believe that my understanding of the sector is strong enough to choose the best performers from within the sector. If I do not believe myself able to decipher the complexities of a sector I will underweight it. I prefer to invest in what I understand best. I tend to underweight those sectors that are the least transparent.

Another factor involved in my weighting of sectors is where each sector is in its cycle of being favored by Wall Street. If a sector is currently out of favor and I believe that circumstance to be either temporary or overdone I will overweight the sector. If the sector is out of favor for a good reason I will underweight or stay on the sidelines until I believe future prospects are more favorable. Conversely, if a sector is getting frothy with unsustainable valuations, I will lighten my weighting.

I should point out that when I say that I lighten my weighting there are two ways to accomplish it. First, I can simply refrain from making any new purchases in the sector while adding to other sectors. Or, I can sell a portion of any position(s) that appear to be over-valued by more than 15 percent. How I accomplish this is a topic for another article (I have actually written quite a lot about it in the past). I tend to sell calls on my stock holdings to increase yield. I sell the calls when a stock is at or above my estimate of fair value. The more above fair value a stock becomes the closer to in-the-money calls I use, assuming that the stock will eventually return to fair value and give me an opportunity to buy back shares that were called away.

When a sector is out of favor, such as energy is now, I will generally begin building positions by scaling into that position, buying a 25 percent stake when I think a company that I want to own is significantly undervalued. If the stock falls by ten percent or more I buy an additional 25 percent of the full position I want to eventually own. Down another five percent? Add some more. This is just my way of building a full position.

How do I determine when a company is undervalued and where I should start building a position? First, let me say that I generally buy only stocks that pay a dividend. Also, I prefer that the company has a strong history of raising dividends regularly. So it makes sense for me to use the dividend discount model to value companies. I also look at historical yields provided by the companies and decide what the minimum dividend yield I will accept from the company. I begin to buy once the dividend yield is above that level and after the stock price stabilizes. It may fall more if the sector has more potentially bad news coming in the future, but I will continue to increase my average yield with each purchase and lower my cost basis at the same time.

For me, energy has a rhythm to it and is somewhat predictable, especially when dealing with the very large, well-capitalized companies that will be around long after I am gone. That is why I like energy. I also believe that human beings will need more energy in the future and that prices will eventually rebound buoying the share price of the best run companies in the sector. At current levels I believe energy to be below its long-term value, taken as a whole, and thus am in the process of building new positions that will result in an overweighting in my portfolio, to the tune of 15 percent. I am also currently moving to an overweighting in consumer staples, health care and utilities. I am near an even weighting in information technology, industrials and telecommunications services. I am underweight financials and materials now and moving in that direction with consumer discretionary. I am keeping my eye on materials, looking for a bottom.

Summary and Conclusions

Long term, the energy sector can provide average returns and good income. But when we enter the right companies in this sector at the right price and yield, we can get above average returns. For my money, the entry part of investing in energy may be the most important. This sector is very cyclical. It deals in commodities. Commodity prices are volatile and cyclical. When we are at or near the bottom of the cycle for a commodity price it is time to start purchasing shares to hold for the long term. I tend to focus on the yield on invested capital because, assuming I chose a quality company, my income will remain relatively safe and rising.

I believe that, in certain industries within the energy sector, there are outsized potential gains to be made. With change comes opportunity and the energy sector is undergoing some monumental changes over the next few years. I intend to write many articles about those industries and the companies that I believe are best positioned to take advantage of those changes.

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 sometime 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.

Disclosure: I am/we are long CMI, UNP.

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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