Sizing up a risky energy marketby Anthony Rowley, Moderator
August 9th, 2006
William R. Thomson
HAS energy become the ultimate investment for the current decade and beyond? It is tempting to think so, because even if the extreme turmoil in the Middle East which has driven oil prices to extreme highs abates, the fundamental supply and demand situation appears likely to be become increasingly strained as China and India as well as other emerging economic powers compete on a global basis for energy resources.
Capital investment in bringing new resources on stream has lagged Surging demand for oil, both at the upstream and downstream level. Also, the imbalance in supply and demand and the fast deteriorating security situation provides a potent cocktail that could cause energy prices to 'explode' in the short term. As France's finance minister, Thierry Breton, has commented, the world is 'practically in an energy war'. BT's Investment Round Table this week looks at rewards and risks for investors in this often volatile sector.PARTICIPANTS
in the roundtable:
Anthony Rowley, BT's Tokyo correspondent
Sylvia Chan, utilities strategist and head of utilities research at Macquarie Securities Asia in Hong Kong.
Philip J McPherson, director of research for the C K Cooper private client group Oil and Gas Managed Fund in Irvine, California**.
Tatsuo Masuda, energy specialist and professor at the Tokyo Institute of Technology. He also serves as visiting professor at the University of Paris-Dauphine.
William Thomson, chairman of Private Capital Ltd, Hong Kong and senior adviser to Franklin Templeton Institutional Hong Kong and Axiom Opportunities Fund, London.
Anthony: Do you regard the energy sector as being of especial interest to portfolio investors at this point in time?
Philip: The current commodity price cycle started four or five years ago, and at that time portfolio investors had very little interest. Today, we are inundated with calls from new clients, most of whom are generalists wanting to learn about the energy sector. The first question is always about the price of oil or natural gas. The stigma with energy investing is the 'unknown', or fear of falling commodity prices. This was especially true when oil went from US$12 per barrel in 1998 to US$25 per barrel in 2000. Now, with oil at US$75, portfolio managers are worried about US$50 oil. I find this amusing because at US$50, companies are highly profitable and that price is more than double what it was just a few years back.
This cycle is currently in its 'middle innings', meaning we have another five to 10 years of higher commodity prices. First, the world economy is strong and therefore demand for oil is strong. Second, higher prices have just begun to encourage new exploration. Often this new exploration will require vast amounts of infrastructure to get the refined product to market. Infrastructure takes time, usually five to 10 years from concept to reality. For energy investors, it is this time frame that will provide the best opportunity.
Sylvia: The energy sector has always been interesting to investors as GDP growth will almost always result in greater energy use, although the current volatility of oil prices is a concern.
William: Energy is fundamental to any economy, and demand has grown enormously in developed and especially emerging economies in the past two decades without a commensurate investment in exploration, development and downstream facilities. As such, prices are likely to stay firm or increase further and energy should form an integral part of long term diversified portfolios, and in many cases should be overweight.
With oil, in particular, the low-hanging fruit in politically stable areas has already been discovered and newly discovered resources take time to bring on stream and are very much more costly than before. Peak oil may or may not be upon us but we need to discover a field the size of Prudhoe Bay in Alaska every year. That was discovered in 1969. Even the Middle East probably has less growth potential than assumed till recently. Central Asia has some. The oil majors, such as Royal Dutch Shell, are consistently unable fully to replenish the reserves they use through exploration. Great hope is held for oil shale, but the costs for profitable extraction keep mounting and are now estimated about US$50 a barrel in Alberta. Over time, China and other emerging economies will become much more efficient users but that does not help much in the short term.
Tatsuo: Regardless of the price levels of oil or other energy sources, the energy sector continues to be as an area of special interest due to its size and weight in the global economy. For example, the share of internationally traded oil in world commodity trade is by far the largest, followed by automobiles and automobile parts. The perception of continued high energy prices may further fuel the interest of investors.
Anthony: What are the principal factors that are likely to influence the price of energy in the short to medium-term?
Tatsuo: There are three factors affecting oil prices: fundamentals, geopolitical factors and others. However it is psychology or perception held by market players that finally determines price levels. I believe today's oil prices are well above the levels to be determined by market fundamentals alone. In other words, the international oil market has never been influenced so much by geopolitical factors as today. Therefore, high oil prices will prevail for a prolonged period so long as the market players, including the news media, are obsessed with a sense of oil scarcity.
William: Energy prices since 9/11 have been powered by factors that have changed the normal supply-demand equation. First, a global security premium has been added as countries such as China have made regular purchases to newly established strategic stockpiles. The growth of hedge funds has added to this premium as they have taken long positions, effectively establishing private strategic positions. Secondly, in addition to the global boom we have had a rise in anti-Americanism and instability among some Opec oil producers such as Iran, Venezuela and Nigeria. Iran definitely plans to use the oil weapon against the US if is attacked. The other two countries are cooperating with Iran and may do so again in a crisis.
Philip: Demand is the hardest variable to judge because there is such a time gap from the time the economy starts to slow and the time when it actually affects demand. Thus far, the world economy has weathered the storm of higher commodity prices and we are not seeing meaningful changes in consumption patterns. However, a significant amount of the world's consumer energy needs are subsidised by governments. This is especially true in emerging economies such as China and Indonesia. The government-owned refineries are actually losing money as they buy crude oil in the open market and then sell the refined product at a discount. Eventually, this practice will have to end, or governments will face a financial crisis.
Supply issues will remain for the next several decades. Most new exploration projects are in hostile areas of foreign countries. In some ways, it is the wealth that is created by the oil that turns some of these areas into 'danger zones'. Wealth invariably causes division. Even if security concerns were not as prevalent, the world is consuming almost as much as it produces. This leaves very little room for error. Refineries are running at more than 90 per cent of their capacity; machines, in general, are not meant to run at these levels. This results in more down time for maintenance, which adds fuel to the fire. Again, our ageing infrastructure will take time to catch up to the growing global economy.
Sylvia: The principal factor that is likely to influence the price of oil and gas in the medium-term is the level of capacity additions for oil. Specific to gas would be the continuing demand for the fuel. The principal factor that is likely to influence the price of oil and gas in the short-term is political risk such as war.
Anthony: What are the optimum ways for portfolio investors to invest in the energy sector?
Philip: Small cap exploration and production companies (E&P) typically have higher risk but offer great reward. The energy sector is a constant feeding patch, meaning the larger E&P companies have to continue to acquire smaller companies in order to grow. Our peer group of small cap E&P companies typically share one common bond, but they are trying to develop a niche, either in a new area, through new technology, or good management. That niche will eventually become attractive to a larger player. This cycle repeats itself over and over. It is analogous to a biotech company developing a new drug, and then having a big pharmaceutical company partner or buy them out. For investors who find stock-picking too risky, we offer a managed portfolio that invests in a basket of stocks from our peer group.
Sylvia: Optimum investment strategies should depend on risk appetite and on the investment horizon. For a growth-oriented play that takes advantage of the current high levels of oil prices, one could consider a hybrid basket of oil and alternative energy. While alternative energy plays have increased cost competitiveness when oil prices are high, they have an additional attractiveness due to declining costs of technology as well as have energy security benefits.
For a longer-term, low-risk, high-yield investment, one should consider infrastructure funds. Infrastructure funds in the context of energy are typically funds with energy infrastructure assets, such as gas transmission companies, electricity distribution companies. Infrastructure assets often have monopolistic characteristics and offer long-term investment opportunities with sustainable and predictable cashflows. For example, infrastructure generated an average annual return of 6.1 per cent 'lognormal' (or real versus nominal) returns from 1994 to 2006, compared with 3.3 per cent for bonds and 6.2 per cent for global equities, and with lower volatility than equities. An additional benefit of infrastructure assets is the diversification benefit: evidence suggests that the correlations between infrastructure and many asset classes (cash, equities, bonds) are low - implying that it can provide diversification benefits as well as boost returns in a portfolio dominated by fixed income securities.
William: The optimum method depends on individual circumstances, knowledge and risk profile. For the investor/trader I would recommend looking at the growing number of exchange traded funds (ETFs) available in the US and elsewhere. ETFs have the advantage of liquidity and very low transaction costs and also allow both long and short positions. Individual ETFs cover different sub sectors such as exploration and development or the oil service sub sector. Examples include IEO, and IGE, as well as the Goldman Sachs Commodity Index ETF GSG which has just started trading. The GSCI is about 60 per cent weighted to traded commodities in the energy sector.
For the somewhat more adventurous with more risk capital, both specialty energy hedge funds and funds of hedge funds field offers interesting opportunities. Some allow access to niche strategies such as carbon and electricity trading as well as macro sector plays and other strategies not easily accessed by the retail investor. For the conservative long term investor, present prices provide a very attractive entry position for long-term investment in global majors such as BP or Royal Dutch. At today's prices, they provide single digit price earnings ratios and inflation protected dividends of 3-4 per cent.
Anthony: What are the principal risks of investing in the energy sector?
Sylvia: One fact to pay attention to is the decline in reserves of conventional fuel sources such as oil. Production is a major part of the cost structure for almost all forms of energy (gas, oil) except for electricity.
A second risk is geopolitics. For example, when early in January this year Russia turned off gas supplies to Ukraine putting at risk Western European deliveries, everyone's attention suddenly refocused on the fact that Russia supplies 25 per cent of Europe's gas, much of it via Ukraine. This episode showed how sharply power has shifted from energy consumers to energy producers and suppliers in the past three years. Moreover, gas storage companies (such as Independent Resources, Star Energy although these are currently at high P/E levels) and LNG companies (such as 4Ga, which is coming to the market) could provide opportunities.
William: There is, of course, no such thing as a free lunch. Prices can go down as well as up, although I believe they are still headed higher. But energy tends nowadays to be found in politically less stable regions. So there is geopolitical risk investing in energy. Think the Middle East, Russia, Nigeria and the increasingly populist Latin America led by Venezuela and Bolivia. Even in more stable regions such as North America or Australia, one can get hit with licensing and environmental restrictions. The anti-developmental Green lobby seems to be growing in strength in all OECD countries. The NIMBY (not in my back yard) attitude has been superseded by BANANA (build absolutely nothing anywhere near anyone).
Philip: Commodity price risk is the obvious answer. It is a volatile sector with so much new portfolio money flowing in that a lot of generalists simply make their buy and sell decisions based upon the direction of oil for the day. This is not investing, this is day-trading. But I believe that those who take the time to learn the sector and understand the long-term picture can use this volatility to their advantage. This means that when stocks are down that is the best time to buy. It takes some courage, but the long-term argument for global demand versus global supply is extremely compelling. The other major risk is investing in start-ups. With so much money flowing into the sector, the access to capital is not only easy, but relatively cheap. This has spawned a plethora of start-ups, some of which have great potential; others are purely stock scams. The only way to avoid this is to do a lot of research on management and the company's business plan.
Tatsuo: Investment in the energy sector involves massive amount of money over a long period. Therefore, transparency, continuity, accountability and stability of the legal and financial framework of a host country are of the critical importance. This applies to all types of energy investment not limited to oil, natural gas or electricity. Re-emergence of resource nationalism is a typical example of such risk. Technology surprised us many times in the 20th century, and this will be the case in this century as well. Fossil fuel is expected to dominate the energy scene over the forthcoming decades. The role of new and renewable energy will not be something significant in the energy mix, it is believed, but a handful of geniuses could invent a completely new technology which may make fossil fuel obsolete. The ongoing high oil prices may accelerate such process.
Anthony: What do you regard as being the potential upside for energy prices in the short to medium term, and likewise what is the potential downside?
Philip: I think oil prices have peaked here at US$78 per barrel. This is due to the belief that the Iranian situation will eventually be resolved. However, if Iran continues persists in pushing its nuclear agenda, prices could exceed US$100 per barrel with ease. I would prefer to see oil retreat back to the mid-US$60 range as this range seems agreeable with the global economy, which in turn should allow for a healthy stock market. If the stock market anticipates a recession, energy stocks will not be spared. We witnessed this in April and May as the Dow dropped a 1,000 points due to inflation fears. Energy issues retreated as well.
Tatsuo: Starting with the potential upside for energy prices, it will be the normalisation of an abnormal geopolitical situation, which is unprecedented. Another element is a sense of oil scarcity widely shared today. It is not the geophysical reality or actual production of oil but the perception of market players that determines oil prices. The downside potential is the slowdown of energy demand. If economic theories are correct, any high-growth economy inevitably will have a downturn sooner or later. This was the case with Japan, and China will not be an exception. For example, the Chinese economy cannot grow fast without a growth in the US economy, the world largest. A sudden slowdown in the US economy, if any, will have more serious impact on the global economy than that slowdown of Chinese economy. In such a case, the growth of energy demand led by oil will slow down, thus causing an oil price drop or even collapse.
William: There is downside risk to oil prices, if we have a sharp slowdown in the US coupled with peace in the Middle East. On the downside oil could sell as low as US$50 but on the upside, if things go wrong, there is potential to go into the US$100-US$150 range. The potential upside is therefore three times the worst case downside risk at this point over the next few years. They are in some ways a hedge against the global security situation deteriorating further.
Sylvia: On the upside, demand for gas is continuing to rise - despite significant price increases. There is an increased production-demand gap in the US and in Europe. The environmental qualities and versatility of this fuel is increasingly recognised particularly in EU countries. The high price levels of gas would also encourage the extraction of coal methane gas and similar stranded gas. One the downside, increased recognition of the pollution cost of coal and oil will eventually decelerate the growth of and demand for these fuels.
Anthony: What is the attraction of investing in forms of energy other than oil and gas - and what is the best way to access these sub-sectors?
William: After thirty years when nuclear power has been a no-no in the English-speaking world, it is on the verge of revival. That creates opportunities in uranium discovery and extraction. Other alternative energy sources including coal, wind, solar and tidal power present investment opportunities. They are, however, often niche areas normally requiring government subsidy. A diversified energy portfolio should definitely have some exposure to coal and nuclear power. Coal can be accessed through large multinationals such as BHP Billiton, Xstrata and Anglo American. The South African producer of synthetic fuels Sasol is also interesting. With respect to nuclear, there are a number of smaller Canadian and South African uranium exploration and producing companies worth a look. SXR Uranium One is an example. It, like the other smaller firms, is quite speculative and the investor should be prepared for a volatile ride. For the less speculatively inclined, my earlier advice on ETFs and specialised funds applies.
Philip: Unfortunately, there aren't many ways to invest in nuclear energy unless you look at the engineering and construction companies that build the plants. However, the US currently has zero plants planned. Most nuclear growth is occurring in China, India, and Europe. As for coal, there are several large players harvesting and shipping it via rail to utilities. Leading names are Arch Coal and Peabody Energy Corp.
Sylvia: Coal: One of the more attractive investment areas is power generation equipment manufacturing - for example, Dongfang Electric and Harbin Power, two Chinese companies involved in the manufacture of equipment for thermal power stations, the former trading at eight times FY 2007 earnings. A related opportunity is in metering businesses - the world is turning to measuring electricity use and companies want to avoid misuse and theft of electricity. Another opportunity is in alternative energies - the key point to note is that the lo-awaited crossover point between the costs of clean energy and fossil fuels has arrived. Wind power and biofuels in particular are today often price-competitive with their conventional rivals - and in some cases, they are cheaper. One idea is to purchase a portfolio of stocks through an investment in a mutual fund, closed-end fund, or an exchange traded fund (ETF). Another is to focus on the few renewable energy companies with earnings power, such as Suzlon Energy.
The principal factor that is likely to influence the price of oil and gas in the medium-term is the level of capacity additions for oil.
A sudden slowdown of US economy would slow the growth of energy demand led by oil, causing an oil price drop or, even, collapse.
Increased recognition of the pollution cost of coal and oil will eventually decelerate the growth of and demand for these fuels.
High oil prices will prevail for a prolonged period so long as the market players, including the news media, are obsessed with a sense of oil scarcity.Submitted by:
William R. Thomson
by Anthony Rowley, Moderator
August 9th, 2006
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