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Hurricanes May Blow Energy Sector Off Course

by Joseph Dancy, LSGI Advisors, Inc. | August 7, 2008


A number of records on the tropical storm front were set last month: (1) It was the first time on record that three July tropical storms were active on the same day in the Atlantic - Bertha, Cristobal, and Dolly; (2) Bertha was the longest-lived July hurricane on record; and (3) Bertha was also the farthest east forming tropical storm and hurricane for so early in the season.

July ranked fifth all time for the number of named storms in that month, and also ranked second in the last 68 years for the amount of Accumulated Cyclone Energy (ACE) units (a measurement of energy generated by tropical storms) – exceeded only by the July, 2005 activity.

July tropical storm activity historically correlates very closely with the amount of storm activity seen for the entire hurricane season – witness the 2005 season had the highest ACE units for both July and the highest ever for an entire hurricane season. Long term forecasters have predicted an active 2008 hurricane season – and from early activity it appears they are on-point.

One measure of the energy generated by tropical storms is the Accumulated Cyclone Energy (ACE) unit, an approximation of the energy generated by a storm calculated using measurements of wind speed and tropical storm duration. The statistic has been measured and calculated for decades.


If we go back 57 years and look for those years where the month of July Accumulated Cyclone Energy exceeds 10 units in the Atlantic, we find this event has only occurred 8 times in the 1950-2007 period – or 14% of the time. In each case the season saw at least one hurricane form in the Gulf of Mexico.

Of those eight years where the ACE exceeded 10 units in July six of eight of those seasons – or 75% of the time – were classified as ‘hyperactive’ due to the intense tropical storm and hurricane activity. This year we have only the eigth time since 1950 the ACE readings will exceed 10 units. History tells us that when this occurs an active hurricane season is likely.

pastprofileAT.gifKeep in mind also we are in the first inning of a nine-inning season. In a normal year in July we have roughly 2 named storms in the Atlantic, one of which is a hurricane. Last month saw four named storms, two of which were hurricanes – twice the normal frequency based on historical standards.

Historically the next 10 weeks has seen storm activity pick up substantially. The storms generally become more powerful in September as higher water temperatures add energy to the disturbances. We expect this pattern will repeat this year also.

A weather expert we follow indicates that the current weather patterns in the Atlantic are such it is ‘very likely’ we will see at least one category 3 or higher hurricane that disrupts oil and gas production in the Gulf of Mexico in the next eight to ten weeks – a period when the probability of hurricane formation increases substantially over July levels.

Seasonality & the Stock Market. We are cognizant of the fact that in general the stock market has performed poorly in the summer months. ‘Sell in May and go away’ is the slogan, which has some statistical validity.

But we are also cognizant that when we have major disruptions in the Gulf of Mexico, home to roughly 25% of the nation’s crude oil supply and 18% of the natural gas supply, energy companies perform very well.

While higher crude oil and natural gas prices have encouraged conservation, the ability of producers to increase supplies to meet growing global demand in our mind remains in question. Export volumes from some of the largest global crude oil exporters were declining in the first half of 2008, which tends to support higher prices. Natural gas in storage remains well below levels seen the last two years in the U.S., while demand continues to increase, again supporting higher prices.

Even though our seasonality research indicates that the stock markets may perform relatively poorly during the summer months, we think the risk/reward relationship is favorable. We therefore remain fully invested.

Energy Sector Update: Bullish Trends Still in Place Last month was a brutal month for much of the energy sector. Crude oil prices and natural gas prices declined substantially during the month. None-the-less we think the bullish trend remains in place. We have the following comments on the sector:

  1. If we examine the performance of crude oil (as measured by the commodity price), energy stock prices (as measured by the Energy Spider XLE), and the S&P 500 index we find over the last twelve months we have a major divergence between the price of crude oil (in blue) and the price of energy stocks (in red). Longer term this performance discrepancy does not exist, or is much smaller.

    We expect the divergence between the price of crude oil and the performance of energy equities to narrow over the next 12 months – with most of the narrowing resulting from energy stock prices increasing in value.
  2. The International Energy Agency’s (IEA) report issued last month was striking. The adjustments that were made in the forecasted non-OPEC production since last year are very bullish for long term oil prices. In last year’s IEA report Russian production was forecast to grow in 2008 and the ensuing years – in this year’s version Russian production is forecast to fall.

    Keep in mind that between 1996 and 2007 Russian production grew by 130% - and provided most of the incremental supply gains on the global crude oil markets. Without continued gains in production from Russian fields – and with shrinking exports of this year – the supply/demand relationship remains tilted toward higher prices.

    The IEA report also noted the non-OPEC world is struggling to grow production. The growth in production from the non-OPEC areas was 2% per annum between 1998 and 2003, 1% from 2003-2008 and is forecast 0.5% from 2008-2013. Keep in mind these IEA predictions may be too optimistic. Houston investment banker Matthew Simmons claims non-OPEC production will decline going forward, even with rising crude oil prices.
  3. Crude output from Mexico's Cantarell field, the world's third-largest, is falling at the fastest pace in 12 years - dropping 34 percent in May from a year earlier. Falling production is curbing exports to the U.S., which buys about 80 percent of Mexico’s oil exports. Pemex may need to cut crude exports this year to meet domestic Mexican demand as production falls. The trend in production, and exports, is down.
  4. Nigeria’s violence continues to interfere with crude oil exports. Last month the bombing of several pipelines led a major producer to declare force majeure, reducing exports significantly.
  5. Stock Price Graphs.U.S crude oil stocks remain on the low side of average for this time of year, but nothing unusual. Imports of gasoline have been above normal for much of the year, as are gasoline inventories, which should help moderate prices over the next few months. Prices of all the petroleum products remain well above year ago levels. Higher prices are reducing product demand to varying degrees.
  6. Natural gas injections remain ’behind the curve’ - unless injections substantially increase over the next few months we will end the injection season well short of what is a ‘reasonable’ storage level going into winter. This year’s storage levels are roughly 12% below the level we had last year at this time.

Canadian Gas ImportsLNG Imports
LNG and Canadian imports of natural gas have declined from year earlier levels, while demand has increased.

Production has also increased substantially due to development of shale reservoirs, but storage levels are such that we think natural gas prices will have to increase, or at the least maintain their current elevated levels, to get facilities filled by the end of injection season in the fall. Less than three months are left to fill storage – so the new production available for that task has to be on-line now, or at least very close to being on-line.

© 2008 Joseph Dancy

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

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