The Energy Sector Under President Obama
Before turning to the impact of President Obama’s reelection on the energy sector, please note that we are making some changes to our portfolios with this issue. Our goal is to make The Energy Strategist easier to follow and to focus our portfolios on the very best recommendations.
When I took over as chief investment strategist of The Energy Strategist, I found that the Growth, Conservative and Aggressive portfolios are generally in accord with my energy sector outlook and investment approach. I’ve made some changes to the portfolios and will continue to do so as Buy and Sell opportunities arise. But for the most part, I haven’t felt the need to overhaul these core portfolios.
However, as I evaluated the portfolios and discussed The Energy Strategist with readers and friends, I decided to eliminate the Field Bets portfolio, which seemed much less followed and could distract attention from the main portfolios that contain our favorite energy stocks, sorted according to risk level. We’ll continue to cover the alternative energy, biofuels and nuclear subsectors and recommend stocks from these areas as part of the core portfolios as appropriate.
I also am streamlining the way we alert you to the Best Buys each issue. Starting today, each portfolio will include a column for the “Top 5” recommendations — the five most attractive securities within that portfolio. These will change over time, based mainly on valuation. While the Buy, Hold and Sell ratings in the “Advice” column provide my recommendation for each stock, the Top 5 gives you a simple, straightforward way to choose which make the most sense to buy at any given time.
So far, feedback to these portfolio changes has been very positive, which I appreciate. My goal is to make sure The Energy Strategist is not only informative but profitable, which requires our recommendations to be focused on the best opportunities. I am confident that the changes we’re making today will help you make more money going forward.
Let’s turn our attention now to the big political news of the past two weeks: President Obama’s reelection.
Following President Obama’s reelection, a number of fossil fuel stocks sold off based on the belief that Obama’s policies would prove harmful to the fossil fuel industry. But will the President manage to push through tough new regulations that raise the cost of production for fossil fuel companies?
Although President Obama often took an antagonistic position with respect to the fossil fuel industry during his first term, the industry actually fared pretty well. US oil production and dry natural gas production were both sharply higher during President Obama’s first term, but coal production fell slightly relative to President Bush’s second term.
To be clear, the production increases for oil and natural gas were not the result of President Obama’s energy policies. Rather it was due to persistently high oil and gas prices during the latter part of the last decade, which led to record investments by oil and gas companies into the development of new projects.
Source: Energy Information Administration.
High oil prices and improved horizontal drilling techniques made oil production in tight oil plays like the Eagle Ford Shale in Texas and the Bakken Formation in North Dakota economical for the first time. In fact, the oil boom has been so good in North Dakota that earlier this year it passed Alaska to become the country’s second-largest oil producer behind Texas.
We can deduce a couple of things from the graphic, “US Oil Production Under Bush and Obama.” One is that a sitting president has limited control over oil and gas production over the short term. Despite his famous proclamation that the US is addicted to oil, President Bush’s policies reflected a more pro-oil stance than his successor. Yet oil production fell for eight straight years under Bush, while oil production increased under Obama.
This leads to the second deduction from the graphic, and that is that there is a multi-year lag time between policy decisions and/or price signals, and subsequent changes in production. Because of this lag, politicians sometimes claim or receive credit for production increases that had nothing to do with their particular policies. In fact, in a campaign speech in February of this year President Obama did just that, stating: “Now, we absolutely need safe, responsible oil production here in America. That’s why under my administration, America is producing more oil today than at any time in the last eight years.”
An historical analogy of the recent oil production increase can be seen in the graphic below “US Oil Production 1900-2012.” In 1973 President Nixon pushed through the Trans-Alaska Pipeline Authorization Act, which cleared away legal challenges from environmentalists seeking to stop construction of the pipeline.
But the pipeline didn’t start production until 1977, during President Carter’s first year in office. As a result, after a sharp decline in oil production under President Nixon, oil production rose for the first two years of President Carter’s term. But just like the production increase over the past four years, the production increase in Carter’s first two years was a result of events that took place during an earlier administration.
The lesson here is that in the short term, the energy policies that President Obama is pursuing today are unlikely to impact oil or natural gas production for several years. If he continues to adopt an antagonistic stance toward domestic oil and gas producers, the impact will be felt most strongly after an appropriate lag time.
Performance of Fossil Fuel Companies Under Bush and Obama
Let’s consider the performance of some of the bellwether fossil fuel companies and indices under both presidents. Consider first the price performance of the AMEX Natural Gas Index.
This index consists of 20 companies involved in the production and distribution of natural gas such as Apache Corp. (NYSE: APA), Chesapeake Energy (NYSE: CHK), EOG Resources (NYSE: EOG), Devon Energy (NYSE: DVN), and Kinder Morgan. (NYSE: KMP). During President Bush’s second term, the index rose sharply with the price of natural gas until mid-2008, at which time the index collapsed along with the price of natural gas. Because of this collapse in price, when President Bush left office, the index’s price performance (not counting dividends) was only 21 percent higher at the end of his second term than it was at the beginning.
The rise in the index was not as steady during President Obama’s first term, but this was also a time of weakening natural gas prices. Nevertheless, the index increased by 85 percent from the beginning of President Obama’s inauguration and the present time.
This performance wasn’t limited to natural gas companies. During President Bush’s second term, Chevron Corp. (NYSE: CVX) share price rose by 48 percent, but it increased by 75 percent under President Obama. Schlumberger (NYSE: SLB) was up 19 percent during Bush’s second term and 98 percent during Obama’s first term. Coal producer Peabody Energy (NYSE: BTU) even performed slightly better under President Obama (22 percent increase) than during President Bush’s second term (18 percent increase).
This exercise is not meant to demonstrate that President Obama is better for fossil fuel companies than was President Bush. What the exercise demonstrates is that external factors grossly trump presidential policies when it comes to the performance of fossil fuel companies. Price is the most important determinant, but companies with superior management and that make good decisions can even make money when prices are softening.
The other item to note from the above exercise is that in every case, the returns were positive across both administrations — during a period that saw oil prices swing between the $30s to nearly $150/bbl.
But what if the Obama Administration continues the antagonism against the fossil fuel industry? Isn’t that a risk factor that must be considered? It is not as big a risk as some have argued.
Consider the issue of fossil fuel “subsidies,” and whether they are likely to end during Obama’s second term.
During his initial campaign for president, then-candidate Obama decried the unfairness that oil companies were making record profits in tough economic times. He promised to implement a windfall profits tax that would be used to rebate $1,000 back to American families, and he promised to get rid of oil company subsidies. He was unable to push these measures through, and is unlikely to push through his recent campaign talk of cutting more than $40 billion in tax breaks for oil, gas, and coal producers in the next decade.
Despite the immense populist appeal of eliminating these so-called subsidies, the reason it becomes so difficult to eliminate them is that they aren’t really subsidies in the way most people think of subsidies. They are not a transfer of money from the US Treasury to fossil fuel companies, which is what people envision when they hear the term “fossil fuel subsidies.” Anti-oil politicians call them subsidies, but when you and I do our taxes, we call them “tax deductions.”
Last year CNN put together a list of the so-called oil subsidies, and they identified the “largest single tax break” — amounting to $1.7 billion per year for the oil industry — as the manufacturer’s tax deduction that is defined in Section 199 of the IRS code. This is a tax credit designed to keep manufacturing in the US, but it isn’t limited to oil companies. It is a tax credit enjoyed by highly profitable companies like Microsoft and Apple, and even foreign companies that operate factories in the US. Further, the deduction for oil companies is already limited. Apple is able to take a 9 percent manufacturer’s tax deduction, but ExxonMobil is only allowed to take a 6 percent deduction.
It is certainly fair to debate whether the manufacturer’s tax credit is a subsidy that should be eliminated. But that debate has to consider three questions:
1) What is the purpose of the subsidy?
2) Is the tax credit working as intended?
3) What is the projected impact from eliminating it?
The intended purpose of Section 199 is to keep manufacturing in the US. It is irrelevant how profitable Apple might be; if there is a compelling financial advantage for them to build a factory overseas, they will do so. This tax credit provides incentive for them to keep manufacturing in the US.
Likewise, ExxonMobil has access to oil fields and refineries in many foreign countries. If they are comparing projects here and abroad, how that tax credit impacts upon project economics will be a factor in their decision. Whether it is enough to push them one way or another would best be answered by an independent analysis into the projected impact of removing the tax credit.
Many opponents of subsidies imagine that the impact will merely be taxpayer savings as ExxonMobil loses out on this tax credit. But the impact may be loss of domestic jobs as ExxonMobil shifts operations out of the US (something that tax credit was designed to prevent). The impact may be that we continue to use just as much oil, but more of it now comes from overseas because we placed our domestic producers at a competitive disadvantage.
Another identified fossil fuel subsidy is a $1 billion annual tax exemption for farm fuel. The justification for that tax exemption is that fuel taxes pay for roads, and the farm equipment that benefits from the tax exemption is not supposed to be using the roads. The Low-Income Home Energy Assistance Program has been identified as one of the nation’s largest “fossil fuel subsidies.”
This program is classified as a petroleum subsidy because it artificially reduces the price of oil. In fact, programs that help the poor afford fuel have been identified as the largest category of fossil fuel subsidies in the world. But many of the people who are most opposed to fossil fuel subsidies strongly support these programs, and hence you have people calling for an end to subsidies when they don’t even know what those subsidies entail.
Thus, the lesson is that the issue of fossil fuel subsidies is complex and those who expect President Obama to eliminate them may fail to appreciate the nuances involved. Although there could be changes to the tax code that will impact oil companies, I don’t believe it is likely that President Obama will be able to push through legislation that targets oil companies. So I would not curtail my energy investments on the basis of a potential loss of subsidies.
During his victory speech, President Obama said, “We want our children to live in an America that isn’t burdened by debt, that isn’t weakened by inequality, that isn’t threatened by the destructive power of a warming planet.” This has led some to believe that President Obama will put climate change regulation back on his agenda. Given that Democrats gained seats in the Senate — which is where cap-and-trade legislation ultimately died in 2010 — it may seem that the odds have increased for new regulations on carbon emissions.
However, two factors make new legislation unlikely, in my opinion.
The first factor is simply that the economy remains weak, and this was a major reason for the failure to achieve passage in 2010.
The second factor is more significant: Since 2006, carbon emissions in the US have declined at a faster rate than for any other country or region in the world — without any new restrictions on carbon emissions. From the International Energy Agency:
“US emissions have now fallen by 430 Mt (7.7 percent) since 2006, the largest reduction of all countries or regions. This development has arisen from lower oil use in the transport sector … and a substantial shift from coal to gas in the power sector.”
Note in the graph “Regional Carbon Dioxide Emissions 1965-2011” that the decline in the US is greater than that in the European Union, which does have a carbon emission trading scheme. Further, Asia Pacific’s explosive increase in carbon dioxide emissions overwhelms the decreases seen in the US and EU.
What I think is more likely is that new regulations on companies drilling on federal land may negatively impact domestic oil and gas production. In May of this year the Bureau of Land Management proposed additional regulations related to hydraulic fracturing on federal and Indian lands. Industry insiders believe that these regulations, as well as new regulations being floated by the EPA, will increase the cost of doing business during the next four years. This will not immediately impact oil production, but if projects are delayed or canceled as a result there could be a significant cumulative impact over the next decade.
Source: 2012 BP Statistical Review of World Energy
Coal is likely to emerge as the largest loser. Cheap natural gas and new restrictions on methane emissions from coal operations will accelerate the phase-out of coal-fired power in the US. The Energy Information Administration (EIA) reported earlier this year that nearly 27 gigawatts (GW) of power — 8.5 percent of all coal-fired electricity in the US — are set to be retired over the next five years. The 9 GW that was set to be retired in 2012 represents the largest retirement of coal-fired power in the nation’s history.
For all the talk, the potential for “clean coal” is low over the next decade. While there are a number of technologies that could be used to capture the carbon emissions from a coal-fired power plant, they drive the generation costs up too high to be economical. Thus, investors should not anticipate that new developments into clean coal technologies will soon improve the prospects for the domestic coal industry.
Oil and natural gas production over the next four years will predominantly be driven by oil and gas prices and the global economy — not by the President’s agenda. This is evident upon examining the production profile for both oil and gas over Bush’s two terms and Obama’s first term.
In the short term, growing supplies are likely to keep oil prices soft, and West Texas Intermediate (WTI) has a significant potential of temporarily falling below $80/bbl. However, this level is unlikely to be sustainable because it is well below the marginal production cost for oil. Ultimately producers will start to shut in production at those prices, and in the longer term the Keystone XL Pipeline extension — which I expect President Obama to approve next year — will help ease the bottleneck of Midwestern and Canadian crude and close the gap between WTI and Brent crude that developed as US production increased. Also in the longer term, new regulations being proposed by the Obama Administration on domestic oil and gas production could have a significant, negative impact if passed into law.
As for coal, the outlook is truly negative for the foreseeable future so I advise investors to shift assets toward more-attractive opportunities elsewhere in the energy sector. I will significantly reduce exposure to coal in our portfolios, effective today. Sell Peabody Energy Corp. (NYSE: BTU), Natural Resource Partners LP (NYSE: NRP) and Alliance Holdings GP LP (NSDQ: AHGP).
However, I continue to recommend PVR Partners LP (NYSE: PVR), especially for income investors, because its fixed-fee royalties, tied to long-term contracts, protect its cash flows from low coal and gas prices; it remains a low-risk holding appropriate for conservative investors. Buy PVR Partners LP below 29.