Energy Industry Outlook June 22, 2005
When we started Thunder Energy in October 2001 the investment climate at the time for the energy industry could best be described as utter contempt. The near-term outlook for the industry was overwhelmed by the short-term negative implications of the US natural gas market which went drastically out of balance. A huge spike in natural gas prices in early 2001 led to a surge in domestic drilling just as the spike began to have a dramatic impact on domestic industrial demand for natural gas. Much of this industrial demand destruction could be classified as final in nature as it became more apparent that foreign gas supplies were more abundant and better positioned to produce end products such as ammonia and others that are big users of natural gas. As we expected, the supply response from the increase in drilling was much more disappointing than generally perceived at the time by the industry and the excesses were worked off in much shorter order than previous imbalances. Meanwhile, the punishing stock market response strengthened the resolve of oil companies to only commit capital to find or produce new reserves with much lower price expectations in mind. This resulted in the industry setting higher than disclosed hurdle rates to ensure profitability of capital projects.
In every facet since the genesis of tighter energy markets, the response has been an underestimation of the actual supply-demand situation. The reluctance of the public to forego their gas guzzling SUV’s is a typical response to higher energy prices seen to date. There seems to be a lackadaisical attitude toward the sustainability of higher energy prices and that alone is a sign that the trend of higher energy prices will sustain longer than currently expected. This fact alone convinces us that we are very early in the energy bull market of the next decade. This general disbelief of the attractiveness of energy for investment was reflected in a total lack of interest in the energy fund until mid-2004 where we first saw some mild interest. Interest is currently running very high so this cautions us to a near-term pullback. An important lesson learned is that investors that have similarly identified the long-term trends at hand would best be discovered by their willingness to make investments during sharp pullbacks. This eliminates the counter-productive experience of the typical fund of fund approach to jump on the latest hot trend and bail on price corrections that would otherwise be most beneficial.
The sentiment of analysts and Wall Street has changed 180 degrees since 2001. The best example of this can be seen from commentary by Goldman Sachs. In September 2001, after the downing of the towers of the World Trade Center which has been attributed to Middle Eastern terrorists, and continual altercations between Israel and Palestine, their call was that energy prices may well spike but the spike would be short-lived due to its effects on the economy which would almost immediately lead to lower prices. These statements caused crude prices to plunge to around $18 per barrel. Contrast that today with Goldman’s current call that prices may spike to $105 per barrel and you have a sense of the optimism that has built. While these changes in perception are important to monitor, it is most important to stay focused on the attractive long term fundamentals. Among the most obvious is the long period of underinvestment in the industry; for example, there has not been one elephant oil well found in the last 35 years. This glaring lack of response by both the industry and no visible efforts toward conservation by consumers despite a doubling in prices, leaves the country dangerously exposed to an oil shock as suggested by Goldman. There are multiple supply disruption threats around the globe not the least of which is Venezuela led by its rebellious leader Hugo Chavez.
The global scramble to procure long-term energy supply as well as many other commodities has clearly gathered a head of steam. The rapid industrializations of China, as well as India, are in the forefront of this quest for scarce resources. While per capita consumption of oil in China and India are among the lowest in the world at 1.7 and 0.7 barrels of oil per year, respectively; these rates are poised to explode higher as these countries rapidly modernize. Compared with America’s 27 barrels per capita, their growth is much more likely to be understated rather than overestimated. A good example of this was the rapid development of South Korea beginning in the 1970’s. At that time South Korea’s per capita oil usage was 1.9 barrels a year. By 1985, this rate more than doubled to 4.5 barrels a year and by 1994 per capita usage reached 14 barrels a year! With China and India the main targets of economic outsourcing, trends are rapidly accelerating as labor cost advantages are arbitraged.
When you combine the political risk of oil supply disruptions with rapidly industrializing economies, you have a backdrop for potentially wild volatility. A sharp spike in the oil price as suggested by Goldman could result in longer run implications such as a new awareness and movement toward conservation bringing into play the old adage, “the best cure for high energy prices is high energy prices”. These risks can be minimized by identifying the sectors of the energy industry that would not be as influenced by such an occurrence and this is how we plan to navigate the excellent opportunities in energy over the next decade.
While prices can change dramatically when a long-term opportunity becomes better known, we believe there are certain sub-sectors of energy that are still very under-exploited compared with the opportunity. Three of our favorite areas currently are: uranium, coal, and drilling contractors. While the drillers have had the best recent performance we will just mention a few key points since we expect better entry points will be forthcoming. Utilization rates are currently extremely high both on land and offshore, at levels that provide excellent pricing leverage. Deepwater specialists such as Transocean and Diamond Offshore are seeing the biggest dayrate increases. This is an especially good sign since such rigs are extremely expensive and represent a strong long-term commitment on the part of the big money players such as Exxon and Chevron to commit capital in search of big new reserves. Recently, Transocean announced a contract that will see the dayrate of a rig more than double from a rate of $145k per day to $320k per day.
The uranium area is by far our favorite area and represents our highest weighting due to its obvious choice as a solution to the lack of sufficient resources in the electricity generation area. For years, the 103 US and 404 worldwide nuclear power plants have depended on the conversion of uranium from nuclear warheads to supplement production. Global uranium production only amounts to 102 million pounds annually while consumption was 173 million pounds last year. Going forward, production requirements will go up as stockpiles go down and new nuclear power reactors are built. China, India, Japan, and South Korea alone currently have 24 reactors under construction. China and India already have plans for 40 more. While 20 years ago there were 26 uranium mills operating, there are now only 4 mills remaining. One of the most exciting factors for the future of uranium is that a sharp rise in the price to even $100 per pound would not detract from the economics. It would, however, be tremendous for the stocks we are invested in. The objections to nuclear power are in rapid decline, surprisingly, for environmental reasons. Fossil fuel is causing increasing amounts of pollution while new technologies, namely the pebble bed modular reactors, have sharply increased safety and lowered expense.
While the long-term outlook for energy is solid, near-term inventories of oil and gas appear adequate with few shortages. With the political outlook of the world, however, this could change in a flash. The uranium group appears to be finishing up on a sharp correction that makes our strategy for energy particularly attractive at the current moment. There are a few stocks in the sector we recently began building positions in and would sharply accelerate that process with any new funds at this time.
Richard J. Greene