Energy over the oil barrel

The energy game is changing rapidly, and investors need to be very switched on.

Summary: Not all that long ago, there was a widespread belief that the world would soon be running empty. Oil supplies were dwindling, and the race was on to find alternative energy sources. Fast forward to now and, thanks to new technologies and discoveries, the oil tank is full again. For investors, the need to be switched on when assessing allocating funds to the energy sector is greater than ever.
Key take-out: Thanks to the effect of rising production, the oil price is more likely to fall than rise. Indeed, the days of assuming steadily rising energy prices could well be over.
Key beneficiaries: General investors. Category: Commodities.

Remember the “Peak Oil” theory? It was a belief popular for much of the past 20 years that said the price of oil would surge as the world consumed its scarce resources of liquid fuel. But take another look today because Peak Oil has been postponed, potentially for a long time.

The repercussions of oil production rising, and the price of oil falling, could be bad news for investors with heavy exposure to the energy sector – and that means any part of the energy sector, including renewables.

Multiple factors are always at work in the oil industry, but the big issues today include the rise of US production, which has resulted in a glut of oil and gas, the imminent re-entry of full-scale Iranian production, and the spread of drilling and rock-fracturing technologies that will open up geological structures once regarded as impervious – the so-called “shale gas” revolution.

As a “big picture” investment thesis, it is possible to see a pattern forming. It points to energy prices continuing to fall, thanks to the oil and gas revival.

It might be a simplistic way of looking at the situation, but from an investment perspective it looks like the rules of the game have changed. Investors playing by the old rules could find themselves in a financial sin bin.

Coal, for example, will be under pressure from gas as a fuel to generate electricity, a trend which has already led to the US expanding its coal exports, to the cost of Australian coal exporters who are suddenly having to compete with a new rival.

Renewable energy suppliers using wind or solar radiation as their heat source are also finding that lower energy prices mean they need a higher level of government subsidies at a time when governments around the world are under intense budget pressure.

Tell-tale signs of a fundamental shift in one of the most basic ingredients of the global economy, the provision of electric power, have been emerging for several years.

I got an early glimpse three years ago of the changes now accelerating in the energy sector during a visit to Rice University in the US energy capital, Houston. It is home to the James Baker Research Centre, which has energy as one of its specialties.

Back in 2010 the shale gas revolution was in its infancy, but some academics could see how rising (not falling) oil and gas production from shale and other hard rocks could have major geopolitical implications.

Those forecasts are proving to be remarkably perceptive, because a glut of oil (rather than a shortage) will have a profound effect on the way the world works. In one sense, it’s as if the world is receiving a large tax cut. In another, it is as if an entire section of the investment world (oil, coal and renewable companies) are being forced to take a hard look at their future revenue assumptions.

Around the Gulf of Mexico in the southern states of the US, a glut of oil is driving down the oil price. Louisiana Light Crude has fallen over the past few weeks to around $US102 a barrel, well below Europe’s benchmark oil price, Brent crude, which is trading at around $US118/bbl.

In time, the glut of crude oil in the US will find its way into the global market, simply because oil is such an easily traded commodity and the arbitrage gap is too much for traders to ignore – just as coal traders in the western states of the US are re-directing their surplus coal into the Australian coal-market backyards of Japan and China.

Professionals investors have spotted the changed rules of the energy game and are withdrawing funds from energy exposed funds, along with most other commodities.

Big British bank Barclays reported earlier this week that the outflow of funds from commodity-linked funds was accelerating, and that oil could be the next sector to be hit by a significant outflow.

“Oil might be at a turning point,” Barclays told clients. “The supply of oil has increased strongly in recent years, mostly due to gains made by US producers, and could grow at the fastest rate in 30 years in 2014.”

Barclays argues that Brent crude oil could stay above $US100/bbl even while other types of oil weaken more rapidly, with benchmark US crude oils such as West Texas Intermediate possibly heading below $80/bbl – or even down to $US40/bbl, a price last seen in early 2009.

The key point as an investment thesis is not to look too closely at the price on a day-to-day basis. Look at the trend, because the days of assuming steadily rising energy prices could well be over thanks to the revival underway in the oil and sector.

The change of energy rules caused by the death of Peak Oil means that any future energy investment must be based on profits rather than promises of rising production, and that means investing in companies with low production costs rather than plans to expand.

Woodside Petroleum has already taken strong measures to distance itself from a potential disaster in the onshore phase of the Browse liquefied natural gas (LNG) development, which was revealed earlier this week as having a potential price tag of $80 billion; possibly enough to destroy Woodside if it had decided on an onshore project, only to start production in a lower oil-price environment.

Other oil companies are also starting to avoid high-cost, high-risk projects. Most of the world’s major oil companies declined to participate in an auction of highly prospective oilfields off the coast of Brazil because the asking price was too high.

Chevron last week said it might not proceed with a $10 billion investment in the Rosebank oilfield in the North Atlantic because of concerns about the commercial viability of the project.

BHP Billiton has said it will focus on low-cost, high-margin, oil and gas projects in North America rather than higher-risk, higher-cost gas projects in Australia.

The common thread linking the decisions of the big oil companies is a view that the oil price is more likely to fall than rise, thanks to the effect of rising production.

Investors would do well to take note of what the oil industry is doing and focus on the best and most profitable oil and gas producers and limit their exposure to high-cost, high-risk producers and explorers.

As for renewable energy producers, it might be convenient to see them as a being in a different category driven by a belief in producing clean energy.

But unless they can continue to receive generous government subsidies, most renewable energy companies will wilt under the blast of cheap oil.

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