A Report on the Energy Sector After Hurricane Katrina by Joseph Dancy 09/08/2005

A REPORT ON THE ENERGY SECTOR AFTER HURRICANE KATRINA
by Joseph Dancy, LSGI Advisors, Inc.
Adjunct Professor, SMU School of Law
September 8, 2005

If you examine the advanced economies in the world most have one thing in common: a functioning stock market that allocates capital to companies in attractive business sectors. Unfortunately, the stock markets are not always as efficient as they should be. For example, as the demand for energy and basic materials rose impressively over the last decade with the globalization of the economy, the markets did not look especially favorably on investments in these areas compared to the technology sector.

We have had more than a decade of under-investment in the energy and basic material sectors, and the demand growth has begun to outstrip the ability of the sector to supply consumer's needs. When this occurs prices naturally trend upward.

Over the next decade we think massive amounts of capital will be needed in the energy and basic materials sectors as the world attempts to increase global productive capacity to meet the needs of rapidly growing countries such as China and India � and the millions of citizens that are attempting to attain a �middle-class� lifestyle.

We think Hurricane Katrina was the catalyst that will ignite a long term interest in the energy sector. Many investors who here-to-date have expected energy prices to fall back to levels seen in the 1990's will be surprised at the durability of energy price levels. If we are correct in our analysis we are in the second inning of a nine inning game � and we expect the interest in the energy sector to continue to expand in the investment community.

Supply and demand issues for crude oil, natural gas, and coal should keep prices firm for at least a year - most likely much longer. The following developments last month reinforce our bullish outlook:

The U.S. drilling rig count stands at 1,444 versus 1,239 working rigs in the year ago period. Spot crude oil prices remain near the $70 a barrel level compared to $43 a barrel a year ago. Natural gas futures were trading at roughly $9.85 versus $5.20 in the year ago period. All are bullish signs for the sector.
At least eight Gulf Coast refineries in the path of Hurricane Katrina shut down or reduced operations according to the U.S. Department of Energy. The eight represent about 2.3 million barrels of daily refining capacity � roughly 10-15% of the nation's capacity. Electricity is still not available at some of these facilities � and may not be available for weeks. Many submerged electronic components will need to be replaced before the facilities are restarted.
The percentage of the Gulf of Mexico's daily oil output that is offline due Hurricane Katrina is 95.2% or 1.4 million barrels per day. Around 81.3% of the natural gas (or 8.8 billion cubic feet) is offline. A significant amount of this production is expected to be offline for several weeks � or longer.
After Hurricane Ivan last year many had the initial impression that damage to oil facilities was minor. Only after several weeks did the extent of damage become clear. Hurricane Katrina was much more powerful, much larger, and had a path much closer to important oil and gas facilities than Hurricane Ivan. From initial reports that we have reviewed, we expect the damage to oil and gas facilities from Hurricane Katrina to be stunning.
Natural gas injected into underground storage facilities in the U.S. was more than 215 billion cubic feet above levels a year ago at the beginning of the injection season on April 1^st. Following twenty-one straight weeks of injections we are now at a 62 bcf deficit from the year ago storage levels � and the storage deficit will skyrocket with the amount of natural gas production shut in after Katrina. Injection season runs through October. Natural gas underground storage levels most likely will be at an abnormally low level at the start of the heating season.
The Russian Trade Ministry reduced its forecasts last month for crude oil production and exports. Oil production is now forecast to increase 3.3 percent from 2004 instead of the 3.5 percent increase predicted earlier. Oil exports are predicted to exceed the 2004 figure by 4.3 percent instead of the 5.0 percent predicted earlier.
A new electricity usage record was set last month in Texas. A record 60,279 megawatts of power was used on August 23rd, exceeding the previous all-time peak of 60,095 megawatts set on August 7, 2003. By comparison, peak electricity used in the region in 1999 was 54,849 megawatts. Much of the incremental demand was met with natural gas powered peaking plants.
Accuweather issued its� long term forecast last month � a colder than normal winter in the Eastern U.S. is expected. This would mean additional incremental demand for natural gas and heating oil. Accuweather also predicted a �book end� hurricane season � with a flurry of storm activity in the last month of the season.
Colorado State University meteorology professor William Gray increased his prediction for the number of storms we would see this hurricane season � calling for 20 named storms, including 10 hurricanes and six major hurricanes. That's more than twice the long-term average of 9.6 named storms, 5.9 hurricanes and 2.3 intense hurricanes per year. He estimates a nearly 45% chance of another hurricane will enter the Gulf this season according to published reports.
Railroad issues continue to impact the delivery of coal from the Power River Basin as the track from that area continues to be repaired. With increased power generation due to the summer heat, coal inventories at power plants remain below normal compared to historical and year earlier levels. Low water levels in portions of the Mississippi River and Hurricane Katrina have reduced barge traffic, reducing coal deliveries.
As a result of Hurricane Katrina, regulators in Florida issued a power generation alert due to the disruption of natural gas supplies that are used as a fuel for around 35% of the generating capacity in the Florida peninsula. Backup fuels such as distillate are currently being used, but cannot be replenished at a rate to maintain current power loads. Customers were asked to conserve power.

Our portfolio remains over-weighted in energy related stocks. We maintain our positions � and added to several of them last month. Our thinking from an investment manager standpoint might be explained by the following observations:

Charles Munger, Warren Buffett's partner at Berkshire Hathaway, notes that good investment opportunities are not all that common. An investor needs to be patient, but when a good opportunity presents itself there is a need to act decisively. Of all the factors that led to his investment success, Mr. Munger credits the patience to wait for an excellent investment opportunity and the fortitude to act decisively on those opportunities as the most important. Long term global trends have created an excellent investment opportunity in the energy sector.
Warren Buffett notes that it is easier for management to deliver excellent returns to their investors when the business sector is viable and expanding. He would rather invest in a good business sector with mediocre management, than invest in a poor business sector with excellent management. In our opinion the energy and basic material sectors will be excellent areas to be invested in over the next few years due to long term global trends in demand and supply.
Both Mr. Buffett and Munger have not been afraid to concentrate their portfolio by investing in small, profitable, and growing businesses that are attractive from both a valuation and growth standpoint. Excess diversification is not necessarily an objective of a portfolio manager where the investor is seeking to maximize returns.

Contact Information

Joseph Dancy, Adjunct Professor, Oil & Gas Law, SMU School of Law, Advisor, LSGI Market Letter | Joseph Dancy's Book Reviews | E-mail