Energy’s prospects pervade virtually all sectors. Next to water, oil is the single most important commodity in the modern world. The mere threat of supply interruptions can wreak economic havoc. And there’s no better barometer of global health than oil prices, as demand inevitably follows economic growth.
Even the worst economic crisis in 80 years couldn’t keep oil prices down for long. Between July 11 and December 19, 2008, the price of a barrel of benchmark West Texas Intermediate Crude fell from a high of $147 and change to barely $32. But less than six months later—and despite a devastating US recession—oil had more than doubled off the lows and was well on its way back to the century mark.
The US has been a vitally important market for crude for a century plus. What’s changed in the past decade or so, however, is it’s no longer the most important one. That distinction has now passed to China. And with demand intensity just beginning to take off there, the Middle Kingdom’s importance for oil will only grow in coming years.
That’s the bull case and it’s compelling. In fact, rising Asian demand is likely to keep global oil prices moving up for years to come, particularly once Europe returns to growth.
That’s already reflected in Brent crude, the primary global benchmark price for oil, which is currently north of $110 a barrel. Because oil can be exported from North America as well as imported, gains will be felt in the price here as well.
The Bear Case
Black gold also has a bear case, however, and particularly on these shores. Paradoxically, it lies in one of the most bullish developments in decades for the country as a whole.
As with natural gas, hydraulic fracturing has made it possible to tap into vast reserves of light oil that were previously uneconomic. Once untouched regions such as the Bakken in the upper Midwest and Eagle Ford in Texas are now booming. Domestic US output is at its highest level in 15 years and the nation by some estimates is on pace to pass Saudi Arabia as the world’s largest producer by 2020.
Net petroleum imports are down by 38 percent from their 2005 peak. They’ll likely fall further in coming months, as US producers deploy a record number of drilling rigs. The Bakken formation alone is estimated to contain 27 billion to 45 billion recoverable barrels of oil.
The problem is the transport infrastructure—mainly pipelines—is not yet in place to get surging output to global markets. Bakken producers, for example, have resorted to using trains and trucks to move oil out of the remote region. And the Cushing transportation hub in Oklahoma has become a major bottleneck for crude moving from the interior to refineries on the coast of the Gulf of Mexico.
The result is the rise of huge price “differentials” between oil produced in different regions of North America. The more remote the oil is when produced, the cheaper it will sell for.
Private enterprise is filling the gap, particularly master limited partnerships (MLPs). Notable case in point: The Cushing-to-the-Gulf “Seaway” pipeline of Personal Finance Income Portfolio pick Enterprise Products Partners LP (NYSE: EPD) will reach flows of 400,000 barrels of oil next week, alleviating some of the glut in Oklahoma and lining the partnership’s pockets in the process.
In late November, however, ONEOK Partners (NYSE: OKS) actually tabled a pipeline that would have brought Bakken oil south. The reason was inability to secure long-term capacity contracts, as producers were unwilling to commit amid current volatility in energy prices.
The fact that the partnership cancelled rather than risk heavy losses at completion speaks to management conservatism that’s good for ONEOK unitholders. But it’s also a sign that even MLPs aren’t adopting a speculative “build it and they will come” approach. Consequently, the building program for bringing new oil supplies to market will only happen over a period of years.
Consequently, these price differentials are likely to endure, though they will wax and wane. Similarly, the price of natural gas and gas liquids will stay low due to lack of ability to export, at least until major liquefied natural gas facilities are built. For example, the price of ethane—a substitute for petroleum in manufacturing plastics—recently hit a 22-month low, despite what appears to be robust global demand.
The big picture is that North American energy is abundant as never before. The technology is there. And with the federal government strongly supportive of US energy independence, there are arguably fewer regulatory obstacles to developing it than in many years.
Long term, that means prosperity for those in the business of drilling, producing, processing, transporting and marketing oil, natural gas and natural gas liquids in North America. The domestic energy boom is a plus for scores of non-energy related industries, for which it conveys a compelling competitive advantage on costs.
Over the near term, however, bottlenecks and uneven production mean divergent industry performance at best. And that’s not including the potential fallout from what I call “sudden austerity” resulting from Washington’s efforts to rein in the federal budget.
Only the Strong
As I pointed out in Wednesday’s alert to Personal Finance readers, the compromise on federal tax policy hammered out on New Year’s Day does prevent the worst case—i.e., $600 billion in immediate tax increases and spending cuts.
The deal also contains better-than-expected provisions for investors, including no change in tax rates for dividends and capital gains on income of up to $400,000 for individuals and $450,000 for couples. Even the new top rate for dividends and capital gains paid on income above those thresholds aren’t onerous, at 20 percent.
However, once spending cuts are negotiated this spring, we’ll see the most contractionary fiscal policy for the US in decades. Factoring in the two-percentage point boost in Social Security taxes, the total bite is equal to 1.9 percent of US gross domestic product. That’s more austerity than Britain, France and Spain are implementing, and all three of those countries are wallowing in recession.
If austerity does draw the US into recession as some fear, the impact on oil prices in 2013 will almost surely be negative. We’d likely see the same fallout for natural gas and NGLs markets as well.
The bottom line for energy: Long-term positive, short-term highly uncertain. That’s the kind of environment that rewards a measure of caution, and holds the risk of severe punishment for those who take risks that prove to be unlucky.
This is not the time to abandon positions in high-quality energy stocks, such as super oils, pipelines and well-capitalized smaller producers such as Growth Portfolio pick Linn Energy LLC (NSDQ: LINE). Now is a great time to buy companies that have strong balance sheets, well-covered dividends and a clear path toward raising production.
Their share prices have been beaten down with the rest of their sector. But they carry none of the risks of the exposed fry. In fact, they’re in prime position to profit from rivals’ difficulties.
In a worst case, patient buyers may see their investments in these stocks languish again in 2013, as most energy producers did in 2012. But sooner or later, prices will rebound and the well positioned will be off to the races.
Sudden austerity or no, energy remains one of my favorite sectors for bargain hunting in early 2013. But buyers must be patient as well as wary. We may have to wait for big gains and history is clear that not every company in this often-volatile industry will make it. Buy energy, but only the strong.
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