Recognition, Revaluation, & Reallocation
By James J Puplava CFP, March 14, 2005
Energy demand in the United States and China has been relentless. The appetite for more oil in the two fastest growing economies in the world goes on unabated. Instead of a slowdown in energy use this year, demand will be up again. Worldwide demand will grow by 2.2 percent. The relief that everyone was expecting isn't there. The IEA just raised its forecast for demand to 84.3 million barrels per day. Oil demand in China is slowing down, but it is still growing. The IEA estimates that Chinese oil demand will grow by 100,000 barrels to 500,000 a day. China's economy is expected to grow by 7.9 percent this year. That is down from the 9.4 percent growth rate in the fourth quarter of last year. An 8 percent growth rate is still substantial and it requires more energy to sustain it.
Barrels Per Day (millions)
|Source: Simmons & Co. International|
Currently global production is running at the rate needed to satisfy demand - but just barely. Forecasters expect demand to grow again next year to 86.1 million barrels a day. Where is that oil to come from? Non-OPEC countries are pumping at full capacity. In addition to full capacity, non-OPEC production is in decline. Everyone is hoping that OPEC will make up the difference, but many have their doubts. Experts believe that OPEC has less than 1 million barrels of capacity left. This weekend Algeria's minister for energy and mines said that OPEC has reached its limits. According to the IEA, oil consumption has caught up with crude production and refining capacity. It is one reason that prices have remained this high.
Demand is growing faster than supply and there are very few new sources of supply. Since 1998 production has grown by a measly 3 percent, a growth rate of only 0.6 percent per year. We have had growth in oil consumption in 87 out of the last 100 years. According to energy investment banker Matthew Simmons, 20 percent of the world consumes 60 percent of the oil and the other 80 percent are just getting addicted.
Peak Oil around The Corner
Simmons and others believe that "peak oil" may soon be upon us. In his new book "Beyond Oil" geologist Kenneth S. Deffeyes believes that we may hit peak oil as soon as this November or early next year. Peak oil is reached when 50% of known supplies have been used up. From that point forward supplies begin to decline. The geologists believe that "peak oil" will arrive in this decade. Deffeyes believes it happens this year. We will know that it has arrived only though hindsight. What we do know is that there have been no major oil discoveries in the last 30 years. The last big discoveries were in Alaska in the late 60's and the North Sea in the early 70's. Both of these discoveries are now in decline.
All future oil demand projections are based on the belief that there will be new sources of supply to meet it. But is that view correct? Non-OPEC supply has been flat if not declining. The belief is that OPEC will be able to meet future demand needs. However, several OPEC producers are already past peak supply.
|Barrels Per Day (millions)|
|Country||Peak Year||Peak Production||Current
|Source: IEA / Simmons & Co. International|
Large suppliers such as Venezuela, Iran, Iraq, and Kuwait peaked years ago. That leaves only Saudi Arabia. Here too there are doubts. Simmons believes that Saudi production will have reached a peak when Ghawar, their largest oil field, goes into decline.
Where Is the New Supply?
So where are the new supplies of oil to come from? The IEA estimates that oil demand will grow to 95 mmb/d in 2010, 105 mmb/d by 2020, and 115 mmb/d by 2030. The plug figure for that future demand comes from Saudi Arabia. Simmons believes that cannot happen. His new book out this fall, "Twilight in the Desert: the Coming Saudi Oil Shock and the World Economy" Matthew Simmons documents why this will not happen. The factual basis of the book is based on over 200 technical papers published over the last 20 years detailing wells and particular fields in the kingdom. The bulk of Saudi oil production comes from four fields. As shown below, the bulk of that production comes from one field, Ghawar - which already appears to be in decline.
|Saudi Arabian Fields|
|Oil Field||Discovery||Peak Production||Current (Estimate)|
|Source: IEA / Simmons & Co. International|
When oil fields reach their peak in production, they fall fast. When do we reach peak oil? We reach it when Saudi Arabian production goes into decline. The geologists believe that is soon. When we hit peak oil, supply will not be able to meet demand regardless of price. Higher prices then become the limiter. They allocate demand to those who can afford to pay for it. That means an end to global economic growth until a new energy source is discovered. Lifestyles will have to change to accommodate less supply while governments resort to energy rationing.
Peak oil will soon be upon us and we have done nothing to prepare for it. Americans are driving bigger and less fuel-efficient cars. The speed limit has been raised on most highways and we are still building more freeways. In the area of energy we assume it will always be there. We have done very little in the way of energy research or looked at alternative fuels. Our main concern has been the environment without any thought of the consequences of peak oil. As Simmons is fond of saying, we have no "Plan B." That is why oil prices are as high as they are today.
We Need a Re-Think
Wall Street has been forecasting $20 oil for the last 3 years. A few investment houses have raised their oil projections to $30 a barrel. Instead of $20 oil, we should be thinking about the consequences of $80 and $100 oil. We are more likely to experience $80 oil than we are ever to see $20 oil again--and $80 may not be too far off the horizon. We should also be thinking about alternatives such as wind, solar, shale, coal and nuclear power. Unfortunately the only thing we have done is to focus on military power and foreign sources of supply. Here too the U.S. is running into stiff competition from China, India and other Asian countries whose energy needs are growing far faster than the U.S.'
Because we have ignored all of the early warnings of peak oil, it is unlikely that we will discover an immediate substitute for oil and natural gas. The time clock is ticking and there is no time for research and development. According to Deffeyes we should look at existing options and begin developing them. Deffeyes' short list of options is as follows:
- Convert to high-efficiency diesel cars and hybrids
- Coal-fired electrical plants
- Wind turbines
- Nuclear power plants
We should also begin to fund energy investments from coal, nuclear power, wind, and solar as well as investments in oil and natural gas, especially shale--of which we have an abundance. The problem with energy is there is no silver bullet. We�ll need to try and use all of the alternatives. The difficulty is that we need to begin this program now. With American energy politics deadlocked with neither side willing to compromise, higher prices and blackouts will be the impetus for change. We have already been warned here in California that if we experience warm weather this summer to expect blackouts in southern California.
As for the wishful thinking on the part of Wall Street analysts for $20 oil, that is never going to happen. Oil prices may touch briefly in the $30 range, but they won't stay there for long. Higher "not lower prices" will become the norm. Energy which has been on a stellar ride since Q3 of last year has plenty more going for it. The chart below of oil shows that energy prices were below $30 for most of the first quarter of last year.
So year-over-year comparisons will be easy for most energy companies. Prices have risen from the mid-40's to the mid-50's during the first quarter of this year as opposed to $30 last year. Oil companies are going to make a bundle of money this quarter and the next assuming that prices remain in the $45-$55 range. Year-over-year comparisons don't become difficult until the third quarter. If the experts are correct on peak oil, we should see $60 oil later this fall if not $80 if a crisis erupts in the supply chain somewhere.
|Oil Gushers (millions)|
|Source: Bloomberg L.P.|
Wake Up Wall Street
Wall Street still isn't fond of the energy sector. Compare the number of upgrades from brokerage firms for technology companies versus their oil recommendations. The bias with Wall Street and investors remains focused on tech even though technology earnings have peaked. According to Fred Hickey the semiconductor bulls are calling for an imminent turn up in business, while tech's customers' businesses aren't improving. Dell, Intel's biggest customer, is still struggling to meet their numbers. Even worse for the industry, competition is getting tougher with new sources of supply coming on stream. Pricing power is fleeting. While sales and profits have improved during this recovery, technology leaders are no longer the growth companies they once were in the early 90's.
|Tech vs. Oil|
|2yr Earnings Growth %||P/E||Yield %||ROE|
|Source: Bloomberg L.P.|
As shown in the table above, profits have improved over the last two years, but they pale in comparison to the energy sector. Moreover it doesn't appear that energy sector profits have peaked as they have in the technology sector. Unlike the techs, the energy sector has pricing power. Oil prices have appeared to be inelastic. If you need oil to power your economy, you have to pay the going market rate. That doesn't hold true for the tech sector where we're seeing stiff competition. Oil is oil and you pay what the market demands. There are no substantial substitutes for gasoline, jet fuels, or natural gas. Even the wellbeing of alternative energy sources depends on higher oil and natural gas prices.
Oil Sector Still Profitable
Many analysts believe the sector has peaked in terms of earnings. I'm not one of them. I still believe the sector can advance another 15-20 percent, even more if we experience higher record oil prices this fall and winter. As shown in the table below, the sector remains very profitable.
|Pretax Margin||Return on Assest||Return on Com Equity|
|Source: Bloomberg L.P.|
Unlike the past, companies are concentrating on shareholder value. They are buying back stock, shedding unprofitable or marginal projects, cutting costs, and generating returns far in excess of the cost of capital. Per-share metrics has become the new norm and it is starting to show in the improvement in the returns on assets and on equity.
While the returns in the industry have improved, the sector still remains undervalued. The reason is that profits have grown much faster than earnings multiples have expanded. The energy sector still gets no respect from investors. While P/E ratios have expanded from 8-10 & 11 times earnings, they are still below the norm from past cycles. Furthermore they remain far below the major indexes. The Dow is selling at 18 times earnings, the S&P 500 is selling at 20 times earnings and the Nasdaq is still at nose bleed levels with a P/E multiple of 55. Exxon/Mobil, which is the most expensive large cap oil, is still cheap when you look at its profit potential, return on equity and ability to generate cash. Exxon/Mobil raised its dividend 8 percent last year and other large cap oils are following suit. ConnocoPhillips has raised its dividend twice in the last two years. The dividend has increased from $0.40 a quarter to $0.50 in the third quarter - a 25% increase in just two years.
|Still Cheap After All These Years|
|Source: Bloomberg L.P.|
Look across the energy spectrum and you will find management raising dividends, buying back stock and increasing the returns earned on capital. The increase in cash flow is also giving companies the wherewithal to make acquisitions, drill new prospects and improve the returns on their existing portfolio. As shown in the table below industry metrics keep improving.
|Average. U.S. Upstream Unit Economics|
|Realized Oil Price/bbl.||$15.88||$24.66||$35.00|
|Realized gas price/Mcf||$1.98||$3.91||$5.50|
|Equivalent gas price (Mcfe 6:1)||$2.31||$4.01||$5.67|
|Finding and development cost/Mcfe||$0.84||$1.52||$1.70|
|Estimated after-tax return||7%||15%||25%|
Source: Oil & Gas Investor
Oil service costs have gone up along with all other costs, but fortunately for the energy sector, those costs - in percentage terms - have not kept pace with wellhead prices. In addition to favorable profit margins, dramatic improvements in technology over the last decade have made the industry more efficient. Technology improvements such as horizontal drilling, 3-D seismic processing, multizone completions, and new fracture-stimulation have more than offset the impact of rising oil-service costs year. This is also allowing companies to get at more of the oil and natural gas that remains in their portfolio. In short it is a good time to be in the energy business. It is also a good time to be an energy investor. As to those skeptics that keep waiting for $20 oil, the world is passing you by. It is time to recognize that a new bull market has begun. It is time to revalue and compare the returns offered on traditional equities to the returns offered on hard assets. It is also time to reallocate your portfolio. As for the energy cornucopians among you, it is time to familiarize yourself with "peak oil" - it has or will soon arrive.
Stock indexes managed to end the day in the black as interest rates receded from last week's highs. A flurry of merger deals took place on Monday. The Dow Jones Industrial Average gained 30.15 points to close at 10,804.51. The Nasdaq rose 9.44 points to 2,015.04, and the S&P 500 tacked on 6.75 points to finish the session at 1,206.83.
The 10-year note ended up 6/32nds with the yield falling to 4.52%. Crude oil prices edged up $0.52 to $54.95, natural gas prices also rose $0.366 to $7.138. Gold and silver prices retreated with gold falling $5.20 to $441.60 and silver losing $0.16 to $7.41.
Volume was light with 1.4 billion shares trading hands on the Big Board and 1.7 billion shares trading on the Nasdaq. In merger deals, IBM acquired Asential Software for $1.1 billion in cash. Altria is offering to buy Indonesian tobacco company PT HM Sampoerna for $5.2 billion, and Qwest Communications is expected to acquire MCI.
© 2005 James Puplava