Energy Investing: Your Questions Answered

For the past 10 years, I’ve had the pleasure of attending the World MoneyShow at the Gaylord Palms Resort in Orlando, Fla.

The highlight of each MoneyShow is the opportunity to meet and chat with subscribers during my organized speaking engagements and in informal discussions in the exhibition hall or the hotel lobby. Here’s a rundown of some of frequently asked questions during the Orlando MoneyShow and my responses.

Q: What’s your outlook for oil prices in the near term and next three years? I’ve read that oil demand is falling and there’s excess supply; to what extent do current prices reflect geopolitical developments?

A: According to the Energy Information Administration, US demand for oil and refined products has declined almost 5 percent from year-ago levels. But world oil consumption continues to grow. All the talk about falling oil demand stems from the sophistic assumption that what happens in the US reflects developments worldwide.

In reality, rising oil consumption in emerging markets more than offsets the incremental decline in US demand. Global oil demand reached an all-time high of about 89 million barrels per day in 2011, up about 700,000 barrels per day from 2010. Meanwhile, the International Energy Agency’s (IEA) most recent forecast calls for global oil demand to grow by roughly 1.1 million barrels per day in 2012.

The IEA had lowered its estimate of global oil demand growth in the back half of 2011, citing the slowing global economy and the EU’s ongoing sovereign-debt crisis. However, US economic growth has ticked up of late, and China’s economy has stabilized and should strengthen in 2012. This year will likely mark the first time that global oil demand tops 90 million barrels per day.

Thanks to frenzied drilling in unconventional oil fields such as the Bakken Shale in North Dakota and the Eagle Ford Shale in south Texas, US oil inventories have reached elevated levels.

This oversupply is most acute at the hub in Cushing, Okla., the delivery point for crude oil that underlies futures contracts traded on the New York Mercantile Exchange. An influx of oil from a Canadian pipeline and rising output from the Bakken Shale, coupled with insufficient takeaway capacity in the region, have resulted in a bottleneck and weighed on prices. For this reason, West Texas Intermediate crude oil trades at a substantial discount to Brent crude oil, light Louisiana sweet crude oil and other comparable benchmarks.

In 2011 global oil supply grew by only 45,000 barrels per day. In 2012 global oil supply is expected to increase by 1 million barrels per day–just shy of the IEA’s estimated demand growth. In other words, the world depends even more on OPEC’s spare capacity to meet incremental demand growth. The supply-demand balance in the global oil market continues to tighten.

The financial media tends to overemphasize geopolitical risks because this subject is far more exciting than a logical analysis of supply and demand trends. For decades, pundits have claimed that oil prices would be much lower if geopolitical risks abated. But this shortsighted argument ignores the fact that increases in demand continue to outpace supply growth. At the same time, geopolitical risk is a permanent feature of the market, not a short-term phenomenon like the supply glut at Cushing.

I expect Brent crude oil to average $110 per barrel in 2012, with occasional spikes toward $130 per barrel because of the tight supply-demand balance. For the same reasons, I expect oil prices to increase over the next three years.

Q: What’s your outlook for the price of natural gas? Do shares of smaller US gas producers represent a good value at current prices?

My outlook for natural gas prices in North America is far less sanguine than for oil: US natural gas prices will remain depressed because of a persistent oversupply. Although short-term supply and demand shocks could send US natural gas $4 per million British thermal units (Btu), expect prices to remain depresses for at least another two to three years.

Although US producers continue to slash drilling activity in Louisiana’s Haynesville Shale and other gas-focused plays, surging production from the low-cost Marcellus Shale and the Eagle Ford Shale and other liquids-rich fields will ensure that the supply overhang persists.

Don’t believe the hype about US liquefaction facilities providing a release valve that will rebalance the domestic market in the near term. These export terminals won’t come onstream for several years.

However, I expect natural gas prices to remain elevated in international markets. Japan’s demand for the thermal fuel skyrocketed after the disaster at Fukushima Daiichi prompted the government to idle much of its nuclear power capacity. Meanwhile, Germany’s plan to shutter its fleet of nuclear reactors will likewise increase the nation’s reliance on imported natural gas. Demand for cleaner-burning natural gas also continues to increase in China and other emerging markets.

I heard that there are massive shale oil and gas resources located outside North America? With these new sources of production coming onstream, won’t global oil and gas markets see an oversupply that pushes down prices?

A near-term surge in international oil and natural gas production from unconventional shale fields is a pipe dream. The financial media and industry pundits often treat reserves as facts rather than estimates. The idea that tapping these massive reserves is simply a matter of drilling wells is equally ludicrous.

Many countries with the most promising unconventional fields lack basic infrastructure, including pipelines, drilling rigs, pressure-pumping capacity and industry know-how. Local pricing dynamics and regulations are another concern.

Commentary from the services companies in their fourth quarter conference calls suggests that international shale oil and gas development is still in its infancy. There will be growth, but the idea that a wave of oil and gas supply is forthcoming is insane; it will take at least 10 years for these international shale fields to move the needle on supplies and prices.

My colleague Peter Staas earlier this week wrote an excellent article on this subject and next week will explore the outlook for shale oil and gas development in China and Argentina.

If you had to pick a single growth theme in energy for the year ahead, what would it be?

Deepwater. One of the most compelling trends to emerge from fourth-quarter earnings season was that spending on deepwater field developments is increasing more quickly than most had expected a few months ago.

This is partly a product of recent deepwater discoveries, particularly in the Kwanza Basin offshore of Angola. These pre-salt finds resemble the geology of the giant oil fields discovered offshore Brazil. Although these plays are in the early stages of evaluation, the industry’s excitement is palpable.

Meanwhile, spending on deepwater projects offshore Brazil continues to ramp up and activity in the Gulf of Mexico continues to recover. In fact, BP (LSE: BP, NYSE: BP) recently sanctioned its first deepwater development in the Gulf of Mexico since the Macondo oil spill.

A shortage of ultra-deepwater drilling rigs has sent the daily rates producers pay to lease these units to more than $600,000. Companies with available ultra-deepwater rigs stand to reap the reward.

You’ve advocated taking profits off the table on positions that have run up during the recent rally. What exactly should I do?

There’s an old saw on Wall Street that bulls make money, bears make money and pigs get slaughtered. Subscribers who have substantial gains in an open position should consider taking some profits off the table and letting their original investment ride.

Raising cash by selling overbought stocks will give you dry powder to put to work during a correction. By selling only enough shares to book your profits, you’ll still have exposure to any additional near-term upside.

Also, this may be a good time to consider taking on a hedge. For example, you might consider shorting First Trust ISE Revere Natural Gas (NYSE: FCG), an exchange-traded fund that owns a number of stocks levered to US natural gas production.

You’ve highlighted a lot of recent initial public offerings (IPO) lately. I heard that IPOs can be dangerous. Why do you like them?

There’s nothing inherently dangerous about a company that is new to the public markets. Every publicly traded company goes through the process at some point. Some IPOs are high-quality names that operate growing businesses; others represent a way for insiders to bail out and monetize their stakes.

I keep an eye on IPOs in all the industries I cover because the market’s inefficiency breeds opportunity. Although media coverage tends to focus on a handful of big IPOs–Facebook’s proposed public offering comes to mind–more than 230 IPOs have been priced in the US market over the past 12 months. Many of these fledgling stocks receive little attention, which presents opportunities for savvy investors.

For example, the registration statements that oil and gas trusts and master limited partnerships (MLP) file with the Securities and Exchange Commission (SEC) lay out how much cash these pass-through entities plan to distribute to investors during their first few quarters as a public company.  

These securities may yield 10 percent or more, but don’t show up on most investors’ radar screens until they’ve paid several quarterly distributions. Several subscribers have called me to tell me that these newly listed trusts and MLPs don’t pay dividends because their broker looked only at historical payouts, as opposed to the indicated yield.

When investors do become aware of a new, high-yielding security, they often jump all over the stock. One example of a promising prospective IPO is US royalty trust SandRidge Mississippian Trust II (NYSE: SDR), which will likely go public in April 2012. I analyzed this trust at length in Eagerly Awaiting the IPO of SandRidge Mississippian Trust II.

This opportunity isn’t restricted to dividend-paying stocks. Once a new company has reported several quarters of earnings, the major brokerage houses may pick up coverage of the stock, leading to an increase in share price and trading volume.

Few investors bother to examine the lengthy S-1 statements filed with the SEC–an enormous opportunity for investors who take the time to scrutinize the universe of upcoming IPOs for winners and losers.