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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:

• Last month at least four U.S. based oil refineries had major unexpected operational issues. Either equipment failed to start after maintenance, fires or accidents caused surprise outages, or repairs were delayed due to equipment shortages. As a result gasoline inventories continued to decline to levels well below the five year average and now stand more than 6% below last year’s level at this time.

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 years.

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.

• Worldwide demand for crude oil continues to increase with economic growth, while excess productive capacity continues to lag.

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.

• With regard to natural gas, the decline rate for conventional wells continues to accelerate. Technology – including directional drilling, fracturing, workovers, compressors, 3D seismic and the like – allows producers to maximize their cash flow and production rates. As a result many conventional wells decline at rates that would have been considered unthinkable two decades ago. Experts note that annual decline rates of 14% in 1990 are now nearly 31%, and rising.

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% in 1990.

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 Association.

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:

‘Global demand and supply issues should push crude oil prices well above $70 a barrel before the Fourth of July. Expect fireworks in the energy sector this summer, with a potentially explosive move to the upside.’

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.

May 14, 2007
Joe Dancy
Email l lsgifund.com