Long-term Energy Bull Prepared to Ride out Short-term Weakness
Commodities / Energy Resources Nov 19, 2007 - 02:34 AMBy: Roger_Conrad
OK, I'll admit it. I've been basically long-term bullish on energy since I came into this business in the mid-1980s. Long term, of course, I've been spot on. My first ever article recommending actual stocks was entitled “There's Still Money to Be Made in Oil,” and it featured the very un-utility like FREEPORT-MCMORAN, a diversified energy and minerals producer then trading under the symbol FTX. That company's myriad spinoffs and mergers have multiplied the value of a January 1987 investment many times.
Over the years, I've repeatedly recommended stocks of many other energy producers, ranging from Super Oils to utility/producers and Canadian trusts, and almost everything has ultimately worked out. That includes my own purchases of dividend reinvestment plans of companies such as CHEVRON CORP (then Texaco) and ENERGEN CORP, the Alabama gas distributor-turned-producer.
Of course, energy hasn't always been in a bullish mode during the past 20-plus years. After surging in the late '80s, oil prices hit a wall by the early '90s. The balance of market power had shifted from producers (as in the '70s) to the world's consumers.
A decade-plus of conservation and movement to alternatives—a massive fleet of nuclear power plants replaced oil used to generate electricity—reduced demand on a long-term basis at the same time new discoveries of conventional oil and gas reserves outside of Organization of the Petroleum Exporting Countries (OPEC) brought on new supplies. By the mid-'80s, Saudi Arabia was sick and tired of perpetually cutting its own output in order to shore up the price of black gold as the “swing producer.” And when it let go, oil did, too.
The rebound of oil a couple years later was more related to the extreme weakness in the US dollar than anything else. Oil got a final push when former Iraqi dictator Saddam Hussein invaded Kuwait. But with the US economy on the rise and the greenback surging in the '90s, that support for energy prices ultimately broke down.
By the time oil prices had bottomed under $10 per barrel in the late '90s, confessed energy bulls were virtually nonexistent on Wall Street. Rather, the consensus was the world was permanently awash in oil and that prices would only fall further.
The years since have more than vindicated anyone who had a contrary view over those years. But this is also a cautionary tale for anyone who gets too wrapped up in a story and forgets the first rule of markets: What's happening today will almost certainly happen differently tomorrow, if not oppositely.
You can do well if you're right on a very long-term trend like rising energy demand and slipping supplies. But you can do even better if you pay attention to the market.
When you own stock in a company backed by a healthy, growing business, the biggest returns are going to come from holding it long-term. That's riding out the inevitable market and economic cycles and watching it become increasingly valuable.
The profits realized by Chevron, Energen and Freeport investors over the past two decades are clear proof this “buy the franchise” strategy is possible in the energy business. More than any other corner of the market, however, commodity-based businesses are extremely cyclical.
Huge profits can become hair-pulling losses virtually overnight. And only a small handful of companies have the chance to become the “next Freeport.” In fact, many, if not most, natural resource companies don't have what it takes to survive a down cycle.
Energy stocks have made some pretty spectacular gains over the past five years or so, recent pullback notwithstanding. But as I look out over the next 10 years for energy, I'm more bullish than ever.
Even in the dark days of 1998-99, energy use was still climbing on a global scale. Today, those developing economies such as China and India are much larger, and their energy needs are far greater. The US is no longer the only driver for energy demand.
And even if every available wind power site in the world was developed—and nuclear plant construction unleashed from the chokehold of regulation—demand for oil, natural gas and coal would continue to rise. Finally, with China and emerging Asia, the Middle East and Central and Eastern Europe economies growing at near double-digit annual rates, not even a recession in the US is likely to really slow demand as it did in the early '80s.
Energy, too, is a highly cyclical business. It's always a fair question to ask if prices have run too far, too fast, and/or if a bull run is on its last legs. The answers are critical today to deciding whether it makes sense to ride out this correction in energy or if you should be locking in remaining profits and moving onto something else.
PROGNOSIS GREEN
In my view, energy is still very much in the bull market that began in the late '90s. Oil's run toward $100 per barrel may take a pause or even a giant step back. That certainly wouldn't be out of order for a commodity this pivotal that's run up 40 percent in just a few months.
The long-term fundamentals underscoring oil's rise since the late '90s, however, are still very much intact. That's basically surging demand and tight supplies, which have shifted the balance of market power from energy consumers to producers.
The seeds of this bull market were sown in the '90s, when market power resided with consumers. With oil at $10 a barrel, there was little or no incentive to conserve and SUVs replaced small cars as the vehicles of choice. Genuine alternative energy development collapsed, and a massive fleet of natural gas-fired power plants were built.
Low energy prices eliminated any incentive for oil and gas producers to seek anything but the very cheapest reserves. Drilling activity stagnated, and the industry entered a deep depression in which it stopped investing in growth or even long-term sustainability. A virtual hiring freeze choked off the supply of college graduates ready to enter the business.
The bottom line: All the factors that ended oil's rise of the '70s—conservation, alternative energy, new discoveries like the North Sea and a slower developing world growth—eventually disappeared. What replaced them was shrinking supplies and surging demand, ultimately ending the dominance of consumers and sending prices surging.
It's economics 101 that every commodity price cycle eventually ends. And there are already signs of the kind of activity that will end this one.
Sales of hybrid vehicles are picking up around the US, for example. There are indications that oil sands production costs may be coming down, making it ultimately more competitive with conventional oil and gas. And producers are ramping up capital spending budgets to at least try to replace output.
We're still a long way, however, from the magnitude of the changes that finally tilted the balance in the '70s and '80s. Moreover, resource nationalism is resurgent, which means host governments will be looking for an ever-greater take of what's extracted within their national borders.
Few countries will follow the example of Venezuela's Hugo Chavez, whose hardball tactics with Super Oil developers now threaten to dramatically reduce his country's output. But more will adopt the lead of Russia's government, which is slowly taking a controlling interest in projects there through GAZPROM. Even the Canadian province of Alberta has increased its royalty regime this year, though the rates are tied to energy prices and reserve grades and are, therefore, a lot more benign than originally feared.
I'm deeply skeptical of peak oil-type theories that promote the idea that a given commodity will one day run out. Rather, the history of capitalism is that we adapt.
The idea of kicking America's imported oil addition has been batted around since the days of Jimmy Carter, when a handful of Arab sheikhdoms held the global economy hostage because of their dominance over the fuel. That time we didn't totally kick our habit. But we did cut it enough to dramatically shift the balance of power and bring oil and gas prices as low as they'd ever been adjusted for inflation.
Thirty years later, the country is facing a similar challenge with a few additional wrinkles, such as runaway demand in other countries like China. Now, as then, we're slowly and surely meeting it. But we're not going to solve the problem overnight.
Rather, it's going to take years of hard work—and the incentive of high energy prices—to get the job done. No one is going to wave a magic wand.
Until that hard work is done, this energy bull market will remain alive and well. That means oil and gas prices are going to head a lot higher. And it means energy stocks—which, to date, haven't kept up with energy prices—are going a lot higher.
THE STRONG AND THE WEAK
That doesn't mean, however, that there won't be some jarring ups and downs along the way. In fact, it's likely that the higher we go for oil, the more volatile things will get, including for rival fuels like gas and coal.
Natural gas, for example, is now four to five times as expensive as it was in the late '90s, when scores of power plants were built to run on it. But it's been in a decided slump now for the better part of the last two years. In fact, we're seeing production cutbacks and a dramatic drop-off in drilling activity, particularly in Canada where rig utilization rates are now a fraction of their levels even a year ago.
Coal prices—for both low and high metallurgical grade—have been in a similar slump. Part of the reason is low gas prices.
But it's also been hit by concerns that carbon regulation will push up costs and reduce global use. We've already seen numerous cancellations of plans to build new coal-based power plants, including state-of-the-art clean burning facilities.
This week, SOUTHERN CO canceled construction of an integrated gasification combined cycle (IGCC) plant in Florida, two full months after breaking ground on the project with the necessary permits in hand. The reason, as cited by management, was uncertainly about potential state regulation of greenhouse gas emissions.
Though there are numerous less efficient and more polluting coal plants in the state that IGCC plants could replace, no one wants to commit the capital to build them, at least until the rules of the game are clarified. The fact that the Southern project was backed by the US Dept of Energy—as part of a federally backed $2 billion 10-year effort to promote clean coal—is a clear sign that no one wants to jump when so much is uncertain. And the patchwork quilt of state regulation with a say in such matters only heightens the risk and uncertainty.
Coal, however, remains an essential piece of America's energy puzzle. It still accounts for half of electricity generated in this county and a lion's share of the output in other countries as well. And with wind and renewables limited in capacity—and new nuclear plants at best a decade away—it's literally impossible to imagine a scenario under which consumer nations will be able to tilt the global balance of power in energy without it.
With even Republican presidential candidates calling for it, some form of carbon regulation looks inevitable beginning in 2009, when the Bush administration leaves office. Depending on the specifics, legislation could be very disruptive for the coal power industry or relatively benign.
A bill proposed by US Sen. Joe Lieberman (I-Conn.) and Sen. John Warner (R-Va.) would require an auction for a large portion of carbon emission allowances. That's already being opposed by <b>Duke Energy</b> CEO Jim Rogers, who in the past has been a vocal proponent of carbon regulation, on the grounds that it would create regional winners and losers. And his arguments are certain to be echoed by the congressional representatives of the Southern and Midwestern states, which are home to the bulk of the nation's coal-fired capacity.
Regardless of how this comes out, coal will become more expensive to burn in coming years. But there's also a large, building incentive to create the innovations that will reduce or eliminate the carbon emissions from burning coal to generate electricity. Sooner or later, they'll become available, and the general public will again view America's massive coal endowment as a treasure rather than a travesty.
Until they do, however, there's little chance we'll see significantly more coal used in the US. That will keep the country using a lot of natural gas—increasingly imported via liquid natural gas (LNG)—as well as imported oil. As a result, the prognosis is still green for go in energy.
THE NEXT SIX MONTHS
With the long-term bullish outlook, the most significant threats to energy prices are all in the short term. The biggest is the risk of a severe global recession, which would curtail demand for energy in the US and reduce growth in usage even in countries such as China where demand has been in an inexorable uptrend for decades.
This is, in fact, the risk the markets are reacting to here in mid-November. Basically, every hint the subprime mortgage crisis is worsening is knocking energy stocks for a loop. Selling is magnified by profit-taking, quite understandable given the massive gains many energy-related stocks have tacked on this year.
Some of the more bearish are now forecasting a drop of $20 or more per barrel of oil from current levels. Again, that wouldn't be out of the ordinary for a market like this. In fact, should that happen, oil prices would still be firmly entrenched in an uptrend.
It's worth pointing out that we've heard this song before during this energy bull market. In 2003, bears blamed the so-called Iraq “war premium” for the run-up in oil that accompanied the US invasion and occupation of the country, assuring everyone that prices would revert to “normal” once the real fighting had ended.
Since then, bears have continually switched their reasons, but their forecast has always been the same: Some short-term event was pushing up oil prices, and once it had run its course, prices were going to come crashing down.
Each time, of course, energy has pulled back. But the correction has always ended at a higher level than the last one, while the subsequent surge has topped out at a new high.
That's the nature of bull markets. They always climb a wall of worry. With oil and energy, however, the peaks and valleys are usually quite severe, and even long-term investors don't want to be on the wrong side of the action.
You may not want to sell every time prices rise. But you certainly don't want to buy heavily just after they have. And you don't want to give up the ghost after prices have just come down.
In my view, no one should be invested in energy stocks if they're not willing to ride them down a bit more from here. The good news is we've already seen a considerable selloff in many areas and valuations are no longer so stretched. Chevron, for example, currently trades at just 96 percent of its most recent 12-month sales and barely 10 times both trailing and projected forward earnings.
Smaller but faster growing CHESAPEAKE ENERGY sells for just 11 times forward earnings—which are discounting very weak natural gas prices. PENN WEST ENERGY TRUST, the largest of the Canadian oil and gas producer trusts and very solid, sells for just 1.43 times book value and pays a well-protected monthly dividend of more than 15 percent. Battered energy-producing US limited partnership LINN ENERGY sells for just 1.3 times book value and yields almost 9 percent.
Those are hardly valuations that evoke memories of a speculative buying frenzy. Rather, they look a whole lot more like what happens when everyone turns bearish on a sector at once and runs for the hills.
If we do see a major recession grip the world in the early part of 2008 as some predict, even these stocks would likely slip further. Interesting, though, these energy producers are probably better prepared for lower energy prices as businesses than they are for higher prices. All are basically hedged and capable of maintaining output, controlling debt and paying dividends even if oil falls $20 a barrel.
They've simply never revamped their business plans in the expectation that higher prices would last. That may come back to burn them in the long run if they fail to make the right investments and energy prices rise. But it does make all of them pretty solid against the possibility of lower energy prices going forward.
Moreover, all of these producers may be on the verge of catching a major break: a drop in operating costs that have risen sharply over the past several years. With activity diminishing in Canada's gas patch—and, in fact, throughout North America in gas—energy services companies are moderating prices. Coupled with producers continued moves to cut debt, that makes them further proofed against falling energy prices.
It's also noteworthy Super Oils like Chevron are major refiners. This has been the weakest part of the energy industry in recent months. The reason is shrinking profit margins: Crude oil prices have soared, while the prices of refined products such as gasoline have risen much less.
That was the major reason for the much ballyhooed third quarter earnings shortfall in the Supers, and it will almost surely be reversed in coming quarters, either by a pullback in crude or a jump in refined products. That's another good reason to buy Chevron, TOTAL and other giants on this dip. With their huge cash flow, minimal debt and dominant position in the world's most vital commodity, they're the surest stocks in the world.
The bottom line: I'm comfortable holding positions in good energy stocks, come what may over the next several months. Also, although it's never advisable to over-commit to any one stock or sector, we're going to be looking at some very strong values in coming weeks. And this is one sector you won't want to be short on for the long haul, whether you're a conservative income investor or a more aggressive sort.
By Roger Conrad
KCI Communications
Copyright © 2007 Roger Conrad
Roger Conrad is regularly featured on television, radio and at investment seminars. He has been the editor of Utiliy Forecaster for 15 years and is also the editor of Canadian Edge and Utility & Income . In addition, he's associate editor of Personal Finance , where his regular beat is the Income Report. Uniquely qualified to provide advice on income-producing equity securities, he founded the newsletter, Utility Forecaster in 1989. Since then, it's become the nation's leading advisory on electric, natural gas, telecommunications, water and foreign utility stocks, bonds and preferred stocks.
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