Storm Clouds, Crises and Opportunities in Energy

By James J Puplava CFP, February 2, 2004

Nothing surprises the markets more than when the unexpected occurs. Surprise earnings, missed estimates, a sudden downturn or upturn in the economy or a geopolitical rogue wave such as the events of 9-11 can turn the markets around rather suddenly. Markets thrive on certainly and come unglued when events change or when the unexpected arrives. Economists, analysts, and investors prefer linear trends that move and act predictably. As long as things go as planned, the markets react well. When they don't, the markets can turn and react viciously.

Each day investors are subject to a variety of noises, rumors, facts, and untruths as brokers, traders, journalists make their way through a blizzard of white noise to make out the next trend or market moving event. Investors are bombarded by a smorgasbord of gossip, rumors, and facts. They must constantly feel their way through a blizzard of intel in an effort to discern the truth. The plain truth is that in most cases on a daily basis nobody knows anything and what passes as news is meaningless and irrelevant to current day trends. While forecasts may lend certainty in an uncertain world, the forecasters or fortunetellers are just as often taken by surprise or fooled by the markets' sudden twists and turns.

Still Wrong After Three Years

This is most evident in the field of energy where the fortunetellers have been forecasting lower energy prices for the last three years. As long as I can remember Wall Street analysts have been constantly predicting lower energy prices: lower oil and lower natural gas prices. This year is no different. The Street is still predicting $20-$24 oil. As of today, the price of crude oil is not at $20, but $34.74 a barrel. Natural gas is selling at $5.55 a cubic foot and not $3 a foot contrary to renewed forecasts for lower prices.

The energy markets are a mispriced market dominated by rumors, myths, and false perceptions that persist to this day. Despite the myriad reports and constant influx of data, the analysts and economists still keep getting it wrong. If their forecasts have missed the mark on energy prices they have been equally off the mark on energy profits. This is surprising given the higher prices for oil and natural gas these last three years. The energy sector last year accounted for nearly 60% of the profits in the S&P 500. That trend looks like it will continue as companies ranging from Exxon Mobil, ChevronTexaco and ConocoPhillips to Kerr-McGee reported record profits. In the case of Exxon Mobil, Q4 profits surged 63%. For all of 2003 Exxon Mobil's profits were a staggering $21.5 billion, the most reported by any U.S. company since 1998. Exxon Mobil's stock is down this year and is up only 23% over the last 52 weeks. The energy sector which has delivered the bulk of profits within the S&P 500 has enjoyed very little of the gains of last year's stellar market. Energy remains underowned, unloved and misunderstood by most analysts and investors.

Underowned, Unloved and Misunderstood

Part of the reason for today's misperceptions of both energy prices and energy stocks is the preponderance of rumors and myths that dominate the energy markets. One of the most persistence myths in the energy markets is that there is plenty of oil and natural gas around. This year's higher injection of natural gas prior to the winter heating season is one example of the myopic optimism that still pervades the energy sector. The conventional wisdom seems to be that as long as there is 3,000 billion cubic feet (bcf) of natural gas in storage prior to winter, things will be okay and any price spikes will only be temporary. However, having a large natural gas supply in storage is dependent on the vagaries of weather. In a prescient series of articles titled "Puncturing natural Gas Myths," energy expert Andrew Weissman points out that this year's higher-than-expected injections into underground storage had more to do with mild summer temperatures than it did large scale industrial demand destruction. To quote Weissman, "all of the larger-than-expected injections into storage that occurred this summer can be explained based upon decreases in the amount of natural gas used to generate electricity compared to the same months last year, not fuel switching by industrial users or other industrial demand destruction as so many analysts contend."[1]

The common myth in the natural gas markets was that higher storage levels were attributable to industrial users switching fuel sources from higher priced natural gas to alternative sources of energy. Weissman makes a convincing case why the higher than expected inventory build up of natural gas had more to do with benign summer weather requiring less use of natural gas generated electricity than it did fuel switching by industrial users. Weissman postures and reconciles that there were four factors at work contributing to haggier than expected storage levels as follows:

1. Lower electricity generation due primarily to differences in weather
2. No significant lost production due to hurricanes (weather)
3. Abnormally low air conditioning load in key urban areas
4. Mild fall weather in late October and a delay in build-up in the interstate pipelines until late November

The combination of the above factors leads to creating a larger buffer going into this year's winter heating season. However, forecasters should breathe no sigh of relief. A severe winter storm could take down inventory levels by 200 bcf/ week. Back-to-back winter storms or a series of cold fronts could reduce storage levels dramatically leading to sharp price spikes. As can be noted in the graphs of natural gas up above, the energy sector has become much more volatile and subject to changes in weather related patterns; mild weather leading to higher storage levels and severe weather to low storage levels and higher prices.

Energy Crisis on The Horizon

However, focusing strictly on price can be misleading and divert investors as well as policymakers away from disturbing long-term trends. The simple fact is that like oil production (which peaked in the U.S. in the early 1970s), natural gas production in most natural gas basins in the U.S. and in Canada has already peaked and is now declining at an alarming rate. In a recent report out by the National Petroleum Council to Secretary of Energy Spencer Abraham, entitled "Balancing Natural Gas Policy," the Council noted three alarming factors leading to a downward revision of its energy projections. The combinations of factors leading to this conclusion are listed below.

1. A significant reduction in known reserves
2. A far greater drop-off in production from existing gas fields
3. A dramatic decline in the size of new wells

Energy expert Mathew Simmons of Simmons & Co. International has long chronicled the decline in energy production in this country and in North America. His latest speech given at the North American Gas Summit was titled "The Gathering Storm: Our Natural Gas Crisis." In this speech Simmons details that despite record drilling leading into 2000, natural gas supplies failed to increase significantly. In addition Simmons

1. Access to gas fields and discoveries became further restricted.
2. New field discoveries shrank.
3. Shrinking size in reserve additions continued.
4. Drilling boom failed to grow supply.
5. Technology advances were hopes, not plans.
6. Declines continue to accelerate.[2]

Both Weissman and Simmons believe that we are headed for a serious energy crisis that could dominate the economic landscape for the remainder of this decade. In less than three years we have already gone through two energy spikes and we are at the beginning stage of the crisis. The U.S. has been increasingly relying on natural gas to fuels its growing energy and electricity needs as the preferred fuel of choice. At the same time that the United States has embarked on a program of building new natural gas power plants, it has placed natural gas reserves off limits for drilling and exploration by energy companies from the Pacific and

Very little has also been done to build new natural gas pipelines and expand the nation's electricity grid system. The power failures of last summer in the mid-west are but a precursor of things to come. We are relying heavily on natural gas as a fuel source for heating and electricity. At the same time, we are ignoring the fact that supply has remained flat despite record drilling and new gas fields. As Simmons has pointed out, natural gas production in the U.S. peaked over 30-years ago and has most recently peaked in Canada.

The Vicious Cycle Mounts

The energy crisis has already impacted several segments of the U.S. economy most notably the petrochemical and plastic industries. Higher fuel prices have forced companies within these industries to move offshore, shut down plants or to switch to other fuels. While this has helped to reduce industrial demand it has been more than made up for by residential consumption. Residential use of natural gas has increased due to an increase in residential construction as a result of the housing bubble and our digital society which consumes even greater amounts of electricity each year.

If the only energy problem was natural gas, the problem might be solvable by simply switching to alternative fuels. But access to new oil fields has also been restricted and the United States has built no new nuclear power plants or coal fired plants in decades. Energy policy in the U.S. has relied ever increasingly on foreign sources of energy for both oil and natural gas. Currently America imports about 53% of all of its oil needs and about 16% of all of its natural gas. These percentages are expected to increase over the next two decades as U.S. production of oil and natural gas rapidly decline. Because of environmental constraints, lack of understanding and attention at the national level, the crisis has gone unnoticed by most. The only time politicians pay serious attention to energy is when energy prices spike. Even then most of the time it is merely finger pointing. The U.S. Congress has failed to pass any energy bill. Congress dithers while our energy production falls and prices rise. Our only energy policy at the moment seems to consist mainly of carrier battle groups and troops on Middle East soil.

Global Demand is on the Rise

However, the days of energy complacency are going to come to an end. While the U.S. has about 4% of the world's population and consumes around 25% of the world's energy, Asia and specifically China are rapidly becoming a major consumer of oil. Chinese oil consumption has grown at an annual rate of 7% a year. Last year China's imports of foreign oil grew by over 30%. China is moving quickly to secure its energy supplies both in the Middle East and in the Caspian Sea. It is in the process of building formidable blue water navy to protect the sea lanes and secure oil from the Middle East at the same time it is working on building pipelines and negotiating energy contracts with major governments within the region.

In conclusion it has become obvious that the Wall Street analysts have all been wrong. We are not heading for $20 oil, instead $50 oil is more likely. Even then, depending on weather and how well things go in Iraq, even higher prices may be inevitable. Wall Street has yet to acknowledge the sweeping changes taking place in the energy sector or become cognizant of the geopolitical risks attached to the world's most prolific source of energy in the Middle East and the Caspian. Both areas are politically unstable. Besides being home to the world's largest gas station, the residents of the region walk around carrying matches. Instead of focusing on the longer-term problem, analysts, investors, and politicians focus on day-to-day prices and ever-changing inventory reports that conflict with each other. The EIA (Energy Information Agency) is calling for increased natural gas production while production coming out of U.S. publicly traded companies has been falling. Last year natural gas production fell by 3%. The EIA estimates include a fudge factor that has yet to be reconciled. In contrast to EIA estimates, U.S. industry numbers are actually certified. Analysis of industry data shows that despite the deployment of additional drilling rigs, overall

Even if Congress was to get off its duff and address America's growing energy risks, the coming energy crisis will not be averted but by the grace of God and good weather. Building a pipeline from Alaska, exploring the North slope, building alternative burning coal or nuclear power plants can take years if not a decade. The U.S. economy is highly exposed to the vagaries of the energy markets putting North American manufacturers and jobs at risk. The longer we take in addressing this issue, the worse the crisis may end up becoming. In the meantime expect greater energy price volatility, higher prices at the pump and on your monthly utility billing statement.

The Opportunities in Energy

On the brighter side of things the rising costs of energy will mean it will become more profitable to invest in the energy sector in the years ahead and indeed throughout this decade. Energy companies and companies operating within the energy sector remain one of the market's best kept secrets. The entire sector remains largely ignored by Wall Street and the investment public. Recently Wall Street firms have been busy downgrading the sector predicting lower oil prices and lower stock prices. One analyst thought the sector had gotten ahead of itself. As shown in the table below many of today's international oil companies and natural gas producers sell at below market multiples, pay above market dividends and remain grossly underowned and undervalued.

INTEGRATED OILS
Company Name	P/E	Div %	Price/Book	Price/Sales
Amerada Hess	11.0x	2.0%	1.1x	0.4
ChevronTexaco	12.2x	3.4%	2.6x	0.8
ConocoPhillips	9.6x	2.6%	1.4x	0.5
Exxon Mobil	15.9x	2.5%	3.2x	1.2
Marathon Oil	9.8x	3.1%	1.8x	0.3
Occidental Petroleum	10.4x	2.4%	2.3x	1.8
NATURAL GAS
Company Name	P/E	Div %	Price/Book	Price/Sales
Apache	10.5x	0.6%	1.9x	3.0
Anadarko Petroleum	9.6x	1.1%	1.6x	2.5
Burlington Resources	9.7x	1.1%	2.2x	2.5
EOG Resources	13.6x	0.4%	2.7x	3.0
Devon Energy	7.7x	0.4%	1.3x	2.0
Source: Bloomberg, 02/02/2004

Investors have largely ignored this sector throughout last year's run up in stock prices. Instead most money moving into the market is still chasing technology and Internet stocks where market multiples are approaching bubble-like valuations and earnings remain questionable. Cisco is still issuing tens of millions of shares in stock options forcing the company to use almost all of its profits to buy back stock to keep earnings from being diluted. A quick comparison of Cisco and Exxon Mobil tells the

As shown in the table below, it is clear which company has produced better values, consistent earnings, and a higher return on shareholder equity. Even more important to investors, Exxon Mobil sells at less than 16 times earnings and pays a 2.5% dividend. By contrast Cisco trades at over 42 times profits, pays no dividend and grossly understates its profits by excluding stock option expense. Investors will find this discrepancy throughout the tech sector. By the same measure they will find equally attractive bargains, greater consistency in earnings,

CISCO - EXXON Mobil COMPARISON
Company	1999	2000	2001	2002	2003	Cumulative
PROFITS (Billions)
Cisco	$2,023	$2,668	<$1,014>	$1,893	$3,578	$9,148
Exxon Mobil	$7,910	$17,720	$15,320	$11,460	$21,510	$73,920
SHARES OUTSTANDING (Billions)
Cisco	7,062	7,438	7,544	7,447	7,223
Exxon Mobil	7,036	7,034	6.941	6,803	6,662
EARNINGS PER SHARE
Cisco	0.29	0.36	<0.14>	0.25	0.50	1.26
Exxon Mobil	1.13	2.52	2.21	1.68	3.23	10.77
BOOK VALUE
Cisco	1.73	3.71	3.70	3.92	4.01
Exxon Mobil	9.13	10.21	10.74	11.13	12.90
RETURN ON EQUITY (ROE)
Cisco	21.3%	13.9%	<4.0%>	6.8%	12.6%
Exxon Mobil	15.3%	12.6%	26.4%	21.3%	15.5%

The energy crisis will be with us throughout this decade. Along with this crisis will come higher prices and higher profits for the energy sector. The only way this crisis will be solved is to let the invisible hand of the markets work their magic. The solution will not come from Washington. All politicians can do is fingerpoint, regulate, interfere and obfuscate the real issues. They are simply incapable of action unless pushed into a corner through a crisis. This means that we are stuck with higher and more volatile energy prices for a very long time. You can become a victim of political inaction or simply profit from it. Investors have clear choices. They can either prepare for a storm or become its victim.

Today's Market

It ended up being another mixed day for the markets on Monday. The Dow and S&P 500 advanced by small fractions while the NASDAQ gave back ground. The NASDAQ lost 3 points as investors sold off shares of semiconductor stocks. It was a very volatile day in all markets with the Dow losing 53 points until a sudden spike at the end of the day pushed the Dow back into positive territory. Investors are becoming increasingly nervous over valuations and economic data. The President revised the government's budget deficit for this year upward to $521 billion.

Economic numbers out today from the Institute of Supply Management was weaker than expected rising just 0.2 % to 63.6. Treasury prices fell late in the session on news of an increasing fiscal deficit. Benchmark yields on the 10-year note rose to 4.16%. Gold

Volume swelled to 1.6 billion on the Big Board and 1.9 billion on the NASDAQ. Market breath was positive by 17-15 on the NYSE and negative by the same margin on the NASDAQ.

[1] "Puncturing Natural Gas Myths" Part I, II, III. 11/21/03,11/24/03,12/03/03, www.energypulse.net
[2] "The Gathering Storm: Our Natural Gas Crisis", By Matthew Simmons, www.simmonsco-intl.com

RECOMMENDED
FSO Contributor, Bill Powers' Get Ready for $50US Oil!

Chart source: www.stockcharts.com

James Puplava

© 2004 James Puplava

Contact Information

James J. Puplava CFP
PFS Group
PO Box 503147
San Diego, CA 92150-3147
(888) 486-3939 Toll Free
(858) 487-3939 Tel
(858) 487-3969 Fax
Email