Energy Prices and the Investor

Introduction

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Only 18 months ago, the vast majority of professional Wall Street prognosticators were steering investors away from the energy sector.  Their reasoning was very simple—upon victory in the second Iraq war, the price of oil (which had increased leading up to the war) would return to much lower levels. After all, that’s what happened in the first Iraq war and to some extent, happened every time in the last 40 years that the price of oil went above $25 per barrel.  Why should this time be any different?

We’re going to discuss why there are major problems with the future supply of oil and gas that did not exist 50 years ago, but first I must make one fact very clear.  I am not an expert in the energy markets.  I do, however; have connections to people who are independent oil & gas analysts.  Most of them have been writing reports for years about the dwindling reserves of fossil energy.   These reports have been largely ignored by nearly all of the mainstream Wall Street market strategists.  They believe instead that the world is awash in oil (both above and below ground) and we have the technology to find it whenever we really want to.  Therefore, any increase in the price of oil above $25 is temporary.

Why the Confusion?

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The main cause of the puzzlement on energy prices is that most Wall Street firms, and even most oil companies, use internal staff to evaluate the energy markets.  As with most dedicated employees looking to keep their jobs, they have a tendency to report what their employers want to hear. In general, companies that sell stocks don’t want reports warning that higher energy prices may harm the economy. Neither do companies that refine oil products care to dwell on statistics that indicate the commodity, which constitutes the lifeblood of its profits, is quickly becoming much less available.  At the very least, they don’t want this information to be made public.

However, independent analysts, having no conflicts of interest with either investment firms or the oil industry, have become increasingly concerned with the reduction in discovered oil & gas reserves.   Their work seems to confirm the 1974 prediction of geophysicist M. King Hubbert that a global peak in oil production would occur by 1995 and a sharp drop-off would follow.  (In a report published in 1956, Hubbert accurately predicted the U.S. would experience a production peak by 1970.)

Seeming to confirm Hubbert’s prediction, Dr. Colin Campbell, a former oil industry geologist, submitted a paper in October of 2000 stating that worldwide production of conventional oil would begin an irreversible decline between 2005 and 2010. (We are now at a point where we produce four barrels for every one we discover.) Campbell’s term of “conventional oil” consists of traditional reservoirs, but not oil found in coal, shale, oil sands, the Polar regions or deepwater tracts.  It should be noted that not every prediction made in this paper has come to pass.  It does still remain valid in terms of general resource terms.

Global Oil Production Problems

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Where will increased production of oil and natural gas come from?   Unfortunately, with the exception of Canada and a few Middle Eastern countries, there are widespread production problems that may limit future oil exports to the United States.

Venezuela, once a great energy hope in the America’s has experienced tremendous mismanagement of its resources over the years that threatens its future as an oil exporter.  Energy Analyst Bill Powers writes in his publication Canadian Energy Viewpoints, “The country’s aging oil fields, minor exploration prospects and political turmoil have all combined to put (Venezuela’s) oil production into a permanent and irreversible decline.”

Many energy experts believe Russia has massive oil reserves and exploration potential which will surely drive the price of oil back down to $20 per barrel.  But according to commodity investor and world traveler, Jim Rogers, “Russia is a disaster going on a catastrophe.”  In the early 1960’s, the Soviet Union was the second largest oil producer in the world.  Over the next 30 years, they heavily overproduced their fields and production levels eventually fell to nearly half of its peak in 1988.  After the fall of communism, the Russians privatized their energy assets in an effort to rebuild production back to its previous height.  But the foreign capital needed to accomplish this has all but dried up due to one financial disaster after another. In addition, no major new discoveries have been made and Jeremy Rifkin, author of “The Hydrogen Economy”, believes that Russia has seriously overstated its proven reserves.  In short, Russian oil production is unlikely to grow much beyond current levels.

Even within the Middle East nations, like Saudi Arabia, some analysts predict only a modest production increase, despite the higher prices that are in effect. This information goes against the assumption of many that OPEC will suddenly “rescue us” by simply opening the spigots in order to take advantage of increased prices of the commodity. Unfortunately, the politically unstable Middle Eastern nations have the only oil fields where major new discoveries are likely.

Avoiding Disaster Scenarios

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In reading these predictions about the scarcity of our most traditional energy sources, it’s easy to imagine that we may soon be living in what seems like the plot of a Hollywood disaster movie. Before you begin plans to bury a large fuel storage tank in your back yard, let’s look at some of the alternatives that are either available right now, or are on the horizon.

Just like with investments, it’s never wise to depend on just one asset source to supply critical requirements.  Diversity is important.  In the United States, we’ve become much too dependent on natural gas and oil as our primary energy sources for both transportation electrical generation.  It will be necessary to go back to some old sources of energy and also to develop new ones.

TRANSPORTATION

The long-term future of the gasoline powered automobile is in serious trouble for the reasons discussed above. Two thirds of the oil utilized in the U.S. ultimately winds up as fuel for cars, trucks and aircraft.  There has been some progress made in the introduction of hybrid vehicles, which can burn a combination of gas or hydrogen as fuel. But the technology and infrastructure needed to see hydrogen replace gas as the main fuel is 15 to 20 years away. Although requiring higher mileage standards for new cars is politically unpopular now, if oil prices ever get to $100 per barrel, the public may demand it.  

ELECTRICITY

Coal produces 52% of the electricity in this country, and although the days of cheap coal may be over, it is still very plentiful in North America. New technology may allow us to burn a cleaner version of coal, but if an energy shortage occurs, we will need variances to the clean air laws to allow the use of “dirty” coal in some areas on a limited basis.  

Natural gas is being used increasing to generate electricity because it pollutes the air much less than coal.  But the supply of natural gas around the world is diminishing as fast as oil and we must import more of it every year. In the Rocky Mountain States, coal bed methane, or CBM, is in abundant supply as an additional source for natural gas. New methods of extraction may soon make the production of CBM more economically feasible. Some scientists postulate that methane hydrates, found in abundance on the ocean floors, will be the energy future.  But again, significant advancements in technology must occur before this can be discussed seriously. 

Nuclear energy accounts for about 20% of this country’s electricity production.  Although the probability of more nuclear plants being built any time soon in the U.S. is very small, other countries are looking to nuclear power in a big way.  According to the International Atomic Energy Agency, Switzerland produces nearly 40% of its electricity with uranium and France is at 78%!  More importantly, the two most populous (and growing) countries of India and China are rapidly turning to nuclear power to meet future demand. It is possible that new technology and research may develop better reactor designs and safe methods of disposing of radioactive waste. Americans may one day reconsider the importance this inexpensive and clean source of energy production.  If we don’t, we will almost certainly be at a competitive disadvantage economically to those nations that have embraced nuclear power.

As you can see, we will be reliant on oil and natural gas for at least the next 40 to 50 years until we can develop and efficiently distribute alternatives to these conventional fuels.  Let’s hope that America has the collective will to build a healthy blend of coal, gas, oil, nuclear, hydrogen, and to a lesser extent, biomass, wind and solar energy assets from a wide variety of sources..

SUPPLY AND DEMAND

Energy is vital to both maintaining and growing global economic activity.  Expanding electrical generation, transportation, manufacturing or developing new industries all require affordable energy.  After the brief global recession early in this decade, the world is again experiencing increased demand for energy in every region, but most notably from the rapidly growing economies of India and China.

As investors, we do not want to experience the negative consequences to our portfolios that $100 per barrel oil would bring.  As citizens, we don’t want to see our lifestyle, or that of future generations, changed significantly for the worse.  What we need is properly balanced supply and demand.  When this balance is achieved, energy is affordable to consumers and energy providers make a reasonable profit.  Right now, that balance appears to be somewhere in a range of $28 to $34 per barrel for oil and around $6.00 mcf for natural gas.   At these prices, the economies of the world are not threatened and energy companies earn enough to explore for new sources of supply.  Most oil industry companies can profit very nicely when oil stays in this range for an extended period. 

ENERGY INVESTMENTS

For several years now, True Financial Review has suggested investments in the energy sector, despite objections (until very recently) from Wall Street analysts who believed the higher energy prices would spur additional production and return us to cheap energy once again. Where are we now?  Higher electricity rates, higher prices for natural gas, higher gasoline prices and higher costs for airline travel. Today, the very same people who suggested you not invest in energy four years ago are publicly wondering if the new reality of higher energy prices may spur inflation and derail the economy.  A few cling to the belief that OPEC will spew extra oil in our direction has soon as the price is high enough.

Keep this fact in mind.  Energy prices are VERY volatile.  This is not new—oil and gas commodities have always been speculative in nature. Even the slightest change in news events can send these highly leveraged markets reeling in either direction. The commodity price of oil and gas will ultimately affect the stock price of any company involved in the exploration, production or delivery of oil or gas.  That said, I still recommend that consideration be given to holding a modest position in selected energy companies. (I am not advocating that an abnormally high percentage of your total holdings be in the energy sector.  A modest holding of 15% or so will give you plenty of benefits if oil prices hold in the $28-$34 range.)

I’m partial to Canadian energy stocks or trusts.  In general, the regulatory requirements for businesses engaged in the exploration and production of natural resources is friendlier than in the U.S.  There is also a monetary advantage right now in holding companies reporting earnings in the Canadian dollar.

Like anything else with investments, it is important to diversify within the energy sector.  Explorers (drillers) with diversified assets (fields in different parts of the country or globe), pipelines and integrated companies (explore, produce and deliver) are all important to own.  Also, keep a mix of energy stocks--some that have high growth potential and others with total return characteristics (modest growth plus dividends).

Asset Allocation

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