Profits in the Pipeline

Even those living under a rock are probably aware that the US is undergoing a revolution in oil and gas drilling. Because if your rock is shale it’s probably vibrating under a drill bit.

Over the past four years, US oil production has posted strong gains after nearly 40 years of steady declines. US oil production rose above the 6 million barrels per day (bpd) mark in late 2011 for the first time since 1998, according to the Energy Information Administration (EIA). By the end of last summer, production had risen by another half million bpd.

How special was 2012? Last week the American Petroleum Institute (API) released its Monthly Statistical Report [pdf], which puts things into perspective. According to the API, US oil production increased by 779,000 bpd, or 13.8 percent, last year — the largest annual increase in US history.

US crude output chart

In the previous issue of The Energy Strategist, I discussed the cyclical nature of the oil industry. Typically, oil prices slump once production capacity starts to grow rapidly and outstrip demand growth. In recent years, oil production capacity in the US has grown rapidly yet prices have hardly collapsed.

As US production was increasing sharply, demand for oil in the US actually declined. As a result, some people — prominent politicians among them — wondered why oil prices remained stubbornly high.

The answer forms an important part of my investment philosophy, and that is that we are entering a new paradigm that marks an end to the conventional boom and bust cycles of the oil industry. If I am correct, investors in the energy sectors — especially those that invest in the appropriate oil and oil services companies — stand to reap substantial rewards.

Oil prices did in fact decline in the US, as might be expected when supply goes up and demand goes down. Between March and December 2012 the price of West Texas Intermediate declined by about $20 per barrel before turning back up. And the price differential between semi-stranded US crude and globally traded Brent crude grew to a discount of up to $25 a barrel on West Texas Intermediate, which used to trade at a small premium to Brent.

But global oil prices didn’t collapse based on the oil production revolution in the US as the world salted away the extra barrels for the rainy day. I doubt that it will ever collapse again, except perhaps briefly under extreme duress, as occurred in second half of 2008.

To the contrary, I believe when oil prices break out it will be to the upside. Some are predicting that will be soon. Jeffrey Currie, an oil analyst who heads commodity research at Goldman Sachs, recently said the price of Brent could reach $150 per barrel by this summer.

I don’t think it will happen that soon, but I strongly feel that it will happen. There are a number of portfolio holdings — regardless of your risk tolerance — that should deliver strong long-term growth even if oil prices trade sideways this year.

The biggest opportunities can be found among producers of bottlenecked US and Canadian crudes. While Brent now fetches $112 per barrel and WTI $93, crude from Hardisty, Alberta can presently be had for less than $60 per barrel. This price differential partly recognizes the heavier, harder-to-refine nature of the Canadian crudes, but mostly reflects the difficulty of transporting the Albertan crude to global markets.

A number of projects underway should reduce the WTI and Canadian discounts to Brent crude. If that happens, operators in the Bakken shale formation and in Canada’s oil sands have potentially the most upside when oil prices move higher. We especially like the Bakken play and Aggressive Portfolio star Oasis Petroleum (NYSE: OAS), as well as EOG Resources (NYSE: EOG) and Canadian oil sands producer Suncor (TSX,NYSE: SU) from the Growth Portfolio.

Some railroads have already benefited enormously from the inadequate pipeline capacity. Last year, delivery of petroleum by rail increased by 38 percent, according to the EIA. This trend should continue. Two weeks ago Canadian Pacific Railway (NYSE: CP) announced a deal with Phillips 66 (NYSE: PSX) to ship 50,000 bpd from the Bakken in North Dakota to Phillips’ Bayway Refinery in Linden, New Jersey. The deal will reportedly add $78 million in revenue this year and $90 million in 2014 for CP — and gives Phillips a chance to profit from the WTI-Brent differential at one of its East Coast refineries.

Of course the pipeline companies themselves are rushing to build new pipeline capacity to help alleviate these crude oil bottlenecks. The most famous is the Keystone XL Pipeline, delayed by opposition from environmentalists and election-year politics.

The Keystone Pipeline is owned by TransCanada (TSX, NYSE: TRP). It moves oil from the Athabasca oil sands region in Alberta, Canada to hubs and refineries in the US. The pipeline system spans 2,150 miles and currently has the capacity to deliver up to 590,000 bpd of crude oil from Canada into the US markets.

Keystone XL pipeline mao
Source: State Department

The first phase of the pipeline began operating in 2010, and moved oil from Alberta to Illinois. In 2011, the second phase of Keystone connected Steele City, Nebraska, to the major oil hub in Cushing, Oklahoma. The oil flowing into Cushing contributed to a crude oil bottleneck there, and was one of the reasons that the Brent-WTI differential developed.  

There are two proposed expansions of the Keystone Pipeline that are collectively called Keystone XL (“XL” stands for export limited). The southern leg of the pipeline is under construction, and is scheduled to come online this year. This Keystone-Cushing extension will have an initial capacity to transport 700,000 barrels of oil per day from Cushing to Gulf Coast refineries.

The northern leg, however, has yet to be approved.  This proposed 1,180-mile addition would extend from Hardisty, Alberta to Steele City, Nebraska. It would have the capacity to carry 830,000 bpd of crude from the oil sands in Alberta and the Bakken oil fields in North Dakota. Because the proposed pipeline would cross the US border it will require a State Department permit determining the project to be in the national interest.

In addition to the southern leg of the Keystone XL pipeline, Seaway Crude Pipeline Company—a 50/50 joint venture between Enterprise Products Partners (NYSE:EPD) and Enbridge (NYSE: ENB)—reversed the flow direction of the Seaway Pipeline. This initially allowed the transport of 150,000 bpd of crude oil from Cushing to Gulf Coast refineries near Houston, but this month the capacity will be increased by 250,000 barrels a day.


We like all of our portfolio companies, but we would start by buying stocks trading at the largest discount to the recommend buy price.

In the Growth Portfolio, two standouts are Eagle Rock Energy Partners (Nasdaq: EROC) and Schlumberger (NYSE: SLB). EROC is primarily an upstream company involved in the production of crude oil, natural gas, and natural gas liquids in Texas, southern Alabama and Oklahoma. EROC had a down year in 2012—as did many energy companies—in the face of soft oil and gas prices. Look for the stock to rebound strongly when oil prices do break out. EROC currently yields 9.4 percent and is more than 20 percent below our buy target. EROC is a recommended buy up to $12.

Energy services bellwether Schlumberger needs no introduction. It has just turned in a solid fourth quarter (see the last Energy Letter) and remains a Best Buy at a 22 percent discount to our $100 buying point.

In the Conservative Portfolio, Chevron (NYSE: CVX) is a perpetual favorite, but it has made a strong upward move over the past two months. Investors who bought at our recommended price of $105 have been rewarded with a double-digit return since mid-November, but Chevron is now 10% above that threshold. We would recommend picking up shares on any sign of weakness.

Two other oil majors are more attractive than Chevron at current prices. Eni (Milan: ENI, NYSE: E) and Total (NYSE: TOT) are presently below our recommended buy targets, and each sports a dividend yield north of 5% (versus 3.4% for Chevron).

In the Aggressive Portfolio, Oasis Petroleum (NYSE: OAS), is a Best Buy and one of our favorites. Oasis is nearly a pure play on high-quality oil from the Bakken Shale. It drills in the West Williston and East Nesson areas of the Bakken and has enormous capacity to increase production in the years to come. Buy Oasis Petroleum below 38.

Stock Talk

Guest One


To what extent will the increase of oil production in the US have a negative effect on companies which are in the businness of shipping oil like NAT?

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