The energy sector delivered neck-snapping twist and turns in 2008. The outlook for the first half of 2009 should be quite boring, by comparison. However, by the second half of 2009, investors need to prepare for a sharp rebound in energy prices. That should help fuel a nice a rally in shares of companies that are drilling for oil and natural gas.
A whole host of factors conspired to push oil prices past $140 per barrel by last spring, including:
Fears that continued economic growth in China, India and other emerging markets would push fuel consumption far beyond the limits of production.
Rising global tensions between the U.S. and OPEC members such as Iran and Venezuela.
A decision by Russia, a key energy producer, to nationalize much of its energy sector, which historically leads to less productive oil fields through reduced capital investment.
Of course, a massive global economic slowdown moved all those concerns to the sidelines, and oil prices fell from $140 per barrel last summer to a recent $45. But investors should pay heed to the longer-term rhythms of the industry. When prices are high, investments in production capacity rise higher, eventually creating enough new supply to push down prices. But once prices are depressed, as they are now, producers lose interest in developing any more new production.
With the economy weakening, investors are ignoring the fact that production of oil and gas is falling at a rapid clip. Just this week, we received word that OPEC is cutting two million barrels from its daily production quota, with stated intentions to cut further this winter if oil doesn't rebound above $50. And the number of active natural gas rigs in the U.S. has fallen 12% from its September peak, with some analysts predicting that another 10%-15% of currently active gas rigs will be taken off-line in coming months as they are economically infeasible when natural gas prices are low.
Although energy prices appear set to slip further in the next few months as the global downturn deepens, we are setting the stage for a sharp rebound in energy prices, as demand eventually strengthens to a rate above the reduced level of supply. Goldman Sachs has weighed in with a new lower forecast for oil prices, and the trend is clear. The firm's analysts think oil prices will bottom at $30 per barrel in the first quarter, and they anticipate that they will rise $10 every quarter, hitting $60 by the end of 2009. The firm sees oil hitting $70 by 2010, and surpassing $100 per barrel by 2012.
As a result, with share prices of many energy companies well below their recent highs, this may signal a time to buy. You can play the sector in one of two ways: "safe and sound" major oil companies or more speculative investments in some of the operators that have been hardest hit by the energy slump.
Exxon Mobil (XOM) and Conoco Philips (COP) can certainly be counted on as the relatively safe blue chips in the sector. These companies are still generating prodigious cash flow, even at lower energy prices, and have a high degree of financial flexibility. In the case of Exxon Mobil, that means ongoing stock buybacks (2% of the share count was bought back in the last quarter alone) and a 2% dividend yield. The company has $37 billion in cash, and is generating another $10-$20 billion in free cash flow each year (depending on oil prices).
Conoco Philips, which also possesses a large amount of untapped energy reserves, offers a bit more risk and a bit more reward. The company's exposure to oil refining has pressured shares, as gasoline prices did not fall as fast as oil prices. But refining margins are starting to improve, and the earnings outlook should start to strengthen in coming months as analysts incorporate more robust profit margins in the refining segment. Moreover, Conoco is equally exposed to the oil and natural gas markets, and as noted earlier, cutbacks in global production now should set the stage for higher energy prices, and profits for Conoco, by 2010.
The Case for Gas
If Exxon Mobil's solidity has enabled shares to hold their own, and Conoco Philips' hybrid model has moderately pressured shares, natural gas producers have had an
. Conversely, they may hold the greatest appeal to aggressive investors. As the chart below shows, the price of natural gas has fallen steadily since hitting a multi-year peak in July, and now fetches just $5.80 per million cubic feet (MCF).
Despite the blow-off, natural gas demand should strengthen as the economy starts to rebound, which should coincide with weaker supply trends noted earlier. Few expect natural gas prices to return to their 2008 highs, but the $8-$9 range seen in 2007 as quite feasible once supply and demand come back into balance. And that could spell strong profits for the key industry players.
Even with natural gas trading around $6 per MCF, Credit Suisse still sees strong values in some industry players, based on the value of their gas reserves in place. For example, shares of Anadarko Petroleum (APC) and Chesapeake Energy (CHK) trade for just 61% of their Net Asset Value (NAV). Assuming natural gas prices rebound back toward the $8 mark, those discounts to NAV will be even greater.
Why the emphasis on NAV? Because earnings are depressed when the underlying commodity's price is so low, that they give the appearance that these companies hold little appeal from a profit perspective.
For example, Anadarko is on track to earn more than $5 a share this year, thanks to the spike in prices earlier in the year. But per share profits are likely to fall back to around $1-$2 next year, on expectations of continued weakness in natural gas prices. That makes shares, at a recent $39, look seemingly pricey. But shares look far more attractive in the context of gas reserves and the likely $4-$5 a share that Anadarko typically earns over the long haul.
Shares prices in the energy patch reflect the gloomy economic environment. But they fail to reflect the current production pullbacks that should lead to higher energy prices down the road.
Energy prices were pushed higher last year due to emerging market growth, international tensions between consumers and producers, and the nationalization of Russia's energy industry.
Despite the slowing economy, reductions in supply should start to boost energy prices in the new year.
Natural gas is another area of potential profits, as the commodity's plunge from its highs in July will most likely rebound with energy prices as a whole.