PORTFOLIO POINT: The energy sector is tremendously complex, but investors ignore it at their peril. Here's my personal view on what's ahead for oil, gas and thermal coal prices.
One of the most common complaints about power companies is that their bills are too complicated. If only customers really knew. The energy industry is one of the most complex around, and right now it's even more so with political uncertainty in the Persian Gulf, recent laws on carbon emissions and a host of new competing technologies complicating what was otherwise once the relatively simple business of getting stuff out of the ground and getting it to the consumer in usable form.
Still, just because it's complex doesn't mean investors should ignore the energy sector. Even if you – for very good reason – wish to stay away from the unproven business models of Australian shale gas (see Tim Treadgold's recent article Gas boom builds steam) or the uncertain technologies of renewable energy, the prices of oil, gas and base-load power have a tremendous impact on all parts of the economy, not to mention market psychology, interest rates (tomorrow – no change likely), household decisions and political events.
You ignore energy prices at your peril and to be a good investor you need to have a view on them, just as you would hold a view on the growth potential of your share portfolio or the future value of your investment property. And while your views may not always turn out to be correct – virtually all the best investors and analysts get it wrong from time to time – they can at least help you refine and improve your investment decision-making process.
In the case of energy, I could write a whole book on how this feeds into virtually every asset class in the modern world. Yet because I know my articles have tended to go way over the word limit lately I'll limit discussion to just three outlooks: oil, gas and thermal coal. And as for how to trade on these outlooks, a series of investing ideas are outlined as well.
Late last year I put forward Twelve predictions for 2012, including the prediction that oil prices, measured in Brent Crude, would remain above $US110 a barrel, possibly increasing to $US150 at some point. So far that prediction has borne out, with Brent rising from $US107 on December 30 to trade between $US110 and $US114 since the beginning of the year.
Yet I also predicted that the US dollar would appreciate (see Friday's piece for ways to trade on that idea and last Monday for more background), which suggests that Brent would need to rise further in trade-weighted terms, meaning either increased demand or reduced supply. For so far at least, the price of oil in a currency can tell you more about what's happening to that currency than it can tell you about the price of oil.
Source: Index Mundi
Source: Index Mundi
Yet as currency markets find direction and trading becomes less about just “risk-on” and “risk-off”, I believe the fundamental supply and demand drivers of oil will become more important.
First, in terms of supply, we have elevated geopolitical risk. Production has largely come back on-stream in Libya, yet the European Union's embargo on Iranian oil comes into effect in July (possibly earlier in effect if Iran “bans” European purchases first). This is already having a distorting effect on markets despite the fact that China and India will most certainly take up the slack in demand.
Yet the situation in Iran is more than just about embargoes. The Islamic Republic's efforts to produce a nuclear industry (and, arguably, nuclear weapons) is surely nuts in a country so prone to earthquakes, but using the example of North Korea and Pakistan as a guide, nuclear capabilities bring to the table an immense strategic deterrence, which Iran has always craved in its long history of foreign interference.
And this is what Iran wants: deterrence and advantage in the region, chiefly against its 20th century rivals Saudi Arabia and Israel, in addition to their heavily-armed patron, America. Whether or not it gets to a stage where it could develop sufficient nuclear material to build a bomb (let alone mount it on a missile that could realistically be used in combat), Iran will use the current situation to push this objective, which can only mean increased tensions, increased uncertainty and increased oil prices.
Judging from the country’s recent history of bluster without follow-through and its internal vulnerabilities, Iran is unlikely to attempt to block the Straits of Hormuz, through which most of the Gulf's seaborne oil exports pass. This would spell a quick and embarrassing end to Iran’s naval capabilities and this is something the regime can ill-afford considering how unpopular it is among many constituencies.
What Iran could do, however, is use its proven abilities in asymmetric and proxy warfare to just as devastating effect. While the writing is on the wall for Iran's major regional ally, Syria, despite China and Russia’s veto of a Security Council resolution this weekend, Iran’s influence is still felt in segments of Iraq, where US troops have left a power vacuum between Sunni and Shia Muslims; the latter arguably being swayed by Iran’s mullahs. And although it would be stupid to predict something like state-sponsored terrorism in an investment publication without real evidence, I wouldn't be surprised to see collateral damage to Iraq's recovering oil industry should Iran feel truly cornered by America or Israel. Similarly, I wouldn't be surprised to see an escalation in violence in Syria, Bahrain or Eastern Saudi Arabia should Iran wish to deploy its proven ability to foment distraction elsewhere.
And in terms of supply, Iran isn't the only major oil exporter facing a potential geopolitical showdown in 2012. Nigeria, which saw an alleged attack on an oil pipeline on Saturday, is facing worsening violence between the Christian south and Muslim north (click here for a very early prediction on Nigerian unrest we made last year), while Venezuela is heading towards a potentially violent presidential election that could have ramifications for its oil exports.
Back in the Middle East, of course, the Arab Spring isn't over either. Just as the violence hasn't abated since the fall of President Mubarak in Egypt a year ago, the present calm in Libya could easily prove to be the eye of the storm should the post-Gaddafi regime find itself split along historic tribal and regional factions. What's more, predictions for a significant uprising in Saudi Arabia shouldn't be discounted when its populous and volatile neighbour to the south, Yemen, continues to convulse as its president recuperates from surgery in an American hospital bed. The same could be said for other oil-rich states in Central Asia or Pakistan, through which a proposed pipeline would pass carrying natural gas from Turkmenistan to India.
Source: US Global Investors, US Energy Information Administration, BP World Energy Statistics 2011
Most of all, if civil unrest emerges in Saudi Arabia, not only does this present the risk for increased Iranian agitation, but it presents the risk of increased unrest in neighbouring Gulf oil producers as well. As importantly, however, although a new era of transparency for the world's last major absolute monarchy would be the best possible outcome for Saudi democrats, it may be the worst possible outcome for the oil markets.
While it's too early to call a conspiracy, one of the most explosive revelations from Wikileaks were suggestions that Saudi Arabia's oil reserves were overstated by as much as 40%. Should the House of Saud fall and it's found that's the house was built on sand, not oil, the consequences will be huge.
In terms of demand, meanwhile, oil has a self-correcting habit of stabilising demand with supply should prices rise as they did in 2008, only to fall by a near equal and opposite intensity. Yet with the huge stock of motor vehicles that only operate on petrol and a resistance in many parts of the rich world (ie, America) to public or alternative transportation, a rise in oil prices can be sustained for longer than most people would otherwise think.
And whether or not oil prices rise from supply-side pressures, demand can be expected to rise in America as its economic recovery continues. While demand can be expected to remain flat or decrease, in Europe I believe the recent surprise increase in US stockpiles will be temporary and the US recovery is real. Gulf of Mexico production is facing a use-by-date, new Brazilian deep-water supply is still years away, a decision on a new tar-sands oil pipeline from Canada, the Keystone XL, will remain deferred until well after the presidential election and increases in motor vehicle fuel efficiency can be expected to plateau without continued government support. Although US demand can be expected to increase, judging from the retroactive mood in Washington, subsidised support for green technology that will be among the very first things to be cut in an austerity-obsessed budget.
Finally, there's future expected demand from emerging markets, which even when generously accounting for expected new supply will push prices further. My views on the unsustainability of China's economic model are well known, but one thing I am bullish about is the long-term growth of domestic Chinese household consumption, including of oil. As I wrote on Friday, China's motor vehicle penetration remains tiny even as it already has First-World levels of steel and coking coal consumption. When China catches up to the developed world in transportation patterns that will be felt in the price of oil.
Hopefully some of that will be mitigated in terms of emissions taxation, greener vehicles and alternative fuel sources, but either way I remain bullish on oil prices in the medium term.
At this point we have a natural segue into a discussion on gas, because it is widely held that new supplies of shale gas will have a downward impact on oil prices, especially in the United States. Developments in hydraulic fracturing technologies and techniques (fracking) have opened up a tremendous new energy reserve base for America, which could eventually lead to American energy independence and thus a new era of energy geopolitics where the resource-curse of the Middle East and Central Asia is dramatically diminished.
Yet this is a very long-term picture and in the short and medium term, the impact of shale on America's energy mix has been greatly exaggerated.
Not only does shale gas face obstacles in terms of environmental restrictions and local opposition almost everywhere it is found, but the economics of shale's EROEI (Energy Returned on Energy Invested) don't stack up anywhere like oil's. Most of all, however, just because there's plenty of gas doesn't mean oil supplies don’t matter. If that were the case oil prices would be vastly lower because there's plenty of gas without shale anyway.
I'm bearish on increasingly fungible gas prices, as opposed to oil, in both the short and the medium-term. I'm especially bearish on investments that are predicated on long-dated future projects, which means I'm sceptical on the validity of most Australian gas explorers and developers as sensible investment choices.
So much supply is coming on stream over the coming years across Australia, the United States, Europe and elsewhere that it's not funny. It is further estimated by the US Department of Energy that there are 862 trillion cubic feet (24 trillion cubic metres) of shale gas out of 72 trillion cubic metres of total domestic gas reserves, while in Europe it is estimated that there exists 639 trillion cubic feet of shale gas against a whopping 1275 trillion cubic feet of shale in China.
And while the freezing weather in Europe this week has demonstrated the need for abundant and continuous gas supplies, this is more an issue of pipelines and politics, rather than gas availability at the source. Russia and some countries of Central Asia have proven themselves to be unreliable and capricious energy exporters and the best of times, but just because Australia will be favoured as far as international supply contracts are concerned, Russia only needs to turn on the taps a bit more to make some of those contracts uneconomical. Russia only pumped out 612 billion cubic metres of gas in 2010 against America's 611 billion cubic metres, yet in terms of proven reserves, Russia's tower above America's by a multiple of 6.9. Further, we're not even talking about extant gas reserves in places like Qatar (13.39% of global reserves) and, again, Iran (17.52%).
For this year at least, I can only expect tumbling gas prices to continue.
Finally on thermal coal, I'm in two minds. Like oil, I expect demand to remain relatively robust, but like gas, there's plenty of it. High grade and easily extractable thermal coal supplies like those found in Australia will continue to account for a great deal of exports well after the coking (metallurgical) coal story is shunted by the near-inevitable collapse of China's fixed-asset boom, yet the substitution threats to coal as a primary source of base-load energy in the long term are greater than the substitution threats to oil as a primary source for transportation energy.
While advances in renewable energy are still probably years away from making sources such as solar, wind and hot rocks truly competitive to coal under most circumstances, I believe nuclear energy – which is competitive – will have a post-Fukushima renaissance before then.
Despite the understandable fears of many after Japan's nuclear disaster, the fact is that most modern nuclear plants are far more resilient in design and that few, if any, will be built on such unstable geology (with perhaps the notable exception of Iran). Further, the cost and time frame of building a nuclear plant has decreased dramatically from the era when most of Europe and America's nuclear supply was built. While at the same time I don't expect a short-term rally in uranium prices, I think a longer-term bull market is possible. Human memories, after all, are very short.
Considering the abysmal standards of internal supply in places such as India and China, I'm bullish on Australian thermal coal exports, at least in the short term. Having said that, many investors won’t own coal stocks for ethical reasons.
Building on Friday's note, the strong Australian dollar makes overseas exposures to commodity investments perhaps more compelling than local equities (though currency risk and a possible lack of dividend income, let alone franking credits, needs to be weighed up). My preferred US dollar-denominated energy company, Royal Dutch Shell, appeared on Friday's list of stocks and although Shell is exposed to many types of energy supply, including gas, it is predominantly an oil company.
The big risk for Shell in light of the above, is that its share price will be hammered should there be any major disturbance to Nigeria's oil supply. For that reason it may be best to augment your exposure via local Australian-listed names. And one of the best ways may, ironically perhaps, be via Woodside Petroleum (ASX:WPL), which Shell recently announced it will be selling out of. This leaves Woodside's share price not only downtrodden, but the company is now potentially open to a takeover offer from BHP Billiton or another major. While there are plenty of commentators who see this as waiting for Godot, and although Woodside also has exposure to possibly disappointing returns on its gas investments, at current prices – $34.09 on Friday's close and still near its lowest points of 2008 – downside risk is minimised.
In terms of small cap exposures, I still like Horizon Oil (ASX:HZN – click here), though its performance has been mixed since I covered it in mid-2010, rising to over 40¢ a share from 29¢ at the time of coverage, then back down to under 20¢. It closed on Friday at 26.5¢. As for thermal coal, mining expert Tim Treadgold likes Stanmore (ASX:SMR), Coalspur (ASX:CPL), Cockatoo Coal (ASX:COK), Carabellar (ASX:CLR), Bathurst (ASX:BTU) and Metro Coal (ASX:MTE). Of other pundits, Bathurst and Coalspur seem the most popular pure-play exposures (click here for Tim's feature, Stoke up on coal).
Investing directly in energy stocks can open your portfolio up to further volatility, but with the negative impact of higher energy prices on virtually all other sectors being mitigated by the positive impact of larger profits for energy companies, there is always a strong case for investing in energy as a portfolio hedge.
You don't need to be a believer in peak oil, let alone peak gas or coal, to know that supply is difficult and demand is growing. And while in the long-term humanity may find the holy grail of free energy, or find ways to make our machines and lives more energy-efficient, in the meantime the dirty business of fossil fuels will remain a big business.
Follow Michael Feller on Twitter: @MFellerEureka