LSGI Investment Commentary:
Fireworks in the Energy Sector: Explosive Move to the Upside Ahead
Joseph Dancy, LSGI Venture Fund
Adjunct Professor of Energy Law, SMU School of Law
May 14, 2007
Charlie Munger, Warren Buffett’s partner
in many of his investment ventures, was asked to explain his astounding
success in the investment arena. Munger noted that good investments
are difficult to find, so an investor has to be patient.
Serious investors must continually evaluate
the numerous investment opportunities that present themselves every
month. In the evaluation process most investment opportunities will
be rejected for one reason or another. But when a situation arises where
the probabilities are heavily weighted in the investor’s favor Munger
notes an investor should act decisively.
Munger claims that a few major investment
decisions, made when the odds were heavily weighted in his favor, explain
a large portion of his overall investment success.
With Munger’s comments in mind, we
continue to be impressed with opportunities in the energy sector. Many
smaller companies in this area are undervalued, growing, and have an
impressive market niche. Some of the reasons we like the energy sector,
and specifically smaller firms in that sector, include:
While inventories dropped, demand
for gasoline in the U.S. continues to climb to record levels. Demand
increased year over year by more than 2.2% according to government data.
Measured on a days of supply basis, the inventory level has dropped
to just under 21 days of demand – the lowest level in the last 50
In some areas of the country retail
gasoline supplies are already extremely low due to the refinery outages,
with stations being rationed by their suppliers. Due to environmental
restrictions on gasoline and diesel fuel, and the declining quality
of crude oil inputs, refining processes have become much more complex
over the years.
When a processing link in the refining
sequence breaks down many times the whole unit has to be shut down or
is forced to run on a reduced output basis. Most refineries are not
new – the last new refinery was built in the U.S. over 30 years ago,
so unexpected equipment failures occur.
What is of concern to some analysts
is the fact that gasoline demand is cyclical. With inventory levels
at their current low status, the fact that demand generally increases
through August points to continued supply and pricing issues this spring
and summer. Imports have generally made up much of the seasonal shortfall,
however issues in Venezuela and a potential refinery strike in Europe
might make imports more costly – if they are available at all.
The International Energy Agency
forecast last month that global demand for oil will increase by 1.8
percent in 2007, or 1.5 million barrels per day. Total oil demand will
reach roughly 86 million barrels per day later this year according to
oilman T. Boone Pickens, a level that will be difficult to maintain
in light of ongoing supply issues.
Mexico announced last month that
production from the Cantarell field, the second largest field in the
world by output, declined 17% in March from year earlier levels. This
decline was mitigated by increases in production from the nearby KZM
field, but none-the-less total crude oil production year over year from
Mexico was down 5%.
Venezuela nationalized its’ oil
fields last month, taking over control of operations from the major
oil firms who had been operating and developing the fields. Due to the
operational complexity, and difficulty drilling these heavy oil reservoirs,
it is expected that crude oil output will stagnate if not decline.
Production from Iraq continues
to lag pre-invasion levels, and debate over the proposed national legislation
which would regulate oil development remains mired in controversy. And
of course the nation continues to be mired in a low-level civil war.
Similarly, issues with Iran remain unresolved, and production increases
from that country are not expected.
Nigeria, exporting over 1 million
barrels of oil per day to the U.S., just completed elections that were
deeply flawed according to observers to choose new leaders. While the
ruling party candidate won in a landslide, opposition parties have promised
mass protests. Violence continues to flare in the oil producing regions
of the country.
Saudi Arabia leaders announced
they might not need to increase crude oil output after 2009 due to developments
regarding alternative fuels and conservation. These statements, coupled
with third party concerns over the health of the Ghawar field – the
largest producing field in the world – raise questions about the ability
of the Saudi’s to increase production to meet the growth in global
demand. Operational details regarding the Ghawar field, and all of the
Saudi operations, are closely held by the Saudi government.
The decline in production from
major fields will not be reversed quickly. The North Sea fields have
declined to the extent that the U.K. is now a net importer, and major
fields like the North Slope in Alaska have been declining for years
even with substantial expenditures to maintain production. Technology
has assisted in enhancing production and field development, but has
also accelerated decline rates of existing fields.
Experts estimate we have been consuming
three barrels of oil or more for each barrel we have found in the last
decade. Sooner or later this trend will impact the demand/supply equation
– and we will see higher prices for energy resources to ration supplies.
In addition to facing the increasing
decline rates, or as a result of it, there is an ongoing shift by producers
to unconventional natural gas sources of supply which includes shale
gas, tight sands, and coalbed methane. According to recent studies unconventional
resources comprised 56% of domestic gas supply in 2005, up from 22%
Due to the difficult nature of
the reserves, developing unconventional natural gas resources generally
requires more wells to be drilled, more workovers, compressors, and
oilfield services and equipment. In part, due to the activity
in the sector, spending by U.S. exploration-and-production companies
nearly tripled from 2003 to 2006 according to the Natural Gas Supply
Canadian drilling activity has
fallen significantly over the last year, and some analysts expect natural
gas imports from Canada will fall substantially over the next 12 months.
Canadian exports make up slightly more than 10% of U.S. supplies. Any
decline in imports would be quickly felt in the spot market.
Demand for natural gas is cyclical,
with demand peaking in the winter (for heating) and in mid-summer (for
electrical generation ‘peaking’ plants). In both cases demand is
highly correlated with the weather. Should the U.S. have a hot summer,
incremental peaker plant demand for natural gas will be substantial
and will have a serious impact on natural gas prices. Even a ‘normal’
summer, weather-wise, should support current natural gas price levels
since U.S. electrical consumption this week was 4% above year earlier
levels due to economic growth.
In light of these factors, and others,
when Barron’s interviewed us last month we summarized our take on
the sector as follows:
Returning to Munger’s comments on investment
success, due to the ongoing global trends we think investors will find
significant investment opportunities in the energy sector – opportunities
where the probabilities are strongly tilted in their favor.
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