The power plays of 2013

Last year’s collapse in coal prices did more than damage the value of every ASX-listed coal mining company. It was a warning that the entire energy sector has become a much harder place to make money.

No change is expected this year, with oil, coal and uranium prices still under pressure. This means that investors cannot expect an easy uplift despite evidence of a return to strong growth in global energy demand, led by the revival in China’s economy.

Unexpected events, such as greater instability in the Middle East or war with Iran, could totally change the energy outlook, but to invest on the assumption of a future disaster is speculating not investing – a valid approach but loaded with more risk than most genuine investors can tolerate.

A more likely situation is that energy prices, particularly for oil, the bellwether of the sector, will steady as global growth accelerates. But oil has the potential to slip lower, raising the potential for energy to be the “big short” of the next decade, with profits stagnating or falling.

Unlike the minerals sector covered in Capturing the commodities comeback last week, where there are genuine questions over future supply shortages for basic raw materials such as copper, zinc and some of the exotic commodities such as rare earths, there is no shortage of energy and a steady stream of new sources rising to meet demand.

The worst of the 2012 coal-price collapse has probably passed, but it was a warning that only low-cost producers with quality projects and competent management will succeed in an unexpected change to the energy climate that runs counter to what most investors had been told to expect. This was the promised era of “peak oil”, a time of permanent decline in oil production and strong price rises.

Unfortunately for peddlers of the peak oil story, it has been postponed. Not forever, but long enough to cause a careful investor to adjust, and for energy companies to become much better managers of their capital if they want to attract investment.

In the oil and gas sector, that means sector leaders such as Woodside, Santos, Oil Search and Origin will retain appeal for most private portfolios if only because more generous dividends or share buybacks will be required to keep their share prices up.

In the coal sector, the best exposure to an industry being forced to close mines and cancel expansion plans will come through the diversified miners such as BHP Billiton and Rio Tinto, or one of the few remaining pure-play miners, such as the takeover targets Whitehaven or New Hope.

In the uranium sector there are even fewer attractive investments, with Paladin the only pure-play ASX-listed producer of a low-priced, over-supplied fuel that continues to be dogged by controversy.

The oversupply of uranium, coupled with a slowdown in the nuclear power sector after the meltdown at Japan’s Fukushima power complex, was a factor (along with a botched design and fear of a massive cost blow-out) in BHP Billiton shelving its planned expansion of South Australia’s Olympic Dam copper and uranium mine.

The underlying and inescapable problem for all parts of the energy industry is that it really has entered a time of surplus, not the deficit that was at the core of the peak oil theory.

The biggest factor at work today is the transformation of the US energy industry, which is undergoing a revolution thanks to the discovery of methods to extract previously uneconomic deposits of oil and gas trapped in hard rocks such as shale –so called unconventional oil and gas which is fast becoming conventional.

Rather than being a perpetual energy importer, the US is moving towards the status of energy exporter. Booming gas production is expected to soon see the country pass Russia as the world’s biggest gas producer, followed in a few years by the overtaking of Saudi Arabia as the world’s biggest oil producer.

What’s happening in the US will spread worldwide, admittedly at a slower pace than what’s happened in North America with its rich endowment of pipelines and other infrastructure, but driven by the geological reality that oil-rich shales are not confined to one region. They are everywhere, including China, Europe and Australia.

Investors interested in the shale revolution can reflect on forecasts made after the original 19^th century discovery of oil in Pennsylvania – that it was confined to that region and would never be found elsewhere.

That forecast changed to oil never being found west of the Appalachian, to never being found west of the Mississippi. Every forecast of oil being confined to a particular location was proved wrong, and the same thing will now happen with shale oil and shale gas, which really are global game-changing discoveries.

Just how rapidly the game is changing can be tested in two ways. Firstly, there is the latest analysis of global energy demand from the oil major, BP. It argues that “tight” or unconventional oil and gas will provide all net growth in oil supply over the next seven years, with global output of shale gas trebling by 2030 and global tight oil growing sixfold.

The second test is in the budget of mid-sized US oil producer, Hess Corporation, which last week released its exploration and production estimates for 2013. More money ($2.7 billion) is to be spent on searching for unconventional oil and gas than on conventional oil and gas ($1.85 billion).

What the Hess budget and the BP report demonstrate is that the unconventional is fast becoming the conventional.

Peter Voser, chief executive of the world’s biggest oil company, Royal Dutch Shell, is also betting on a fundamental change to the world’s energy mix by investing more heavily in gas than in oil.

His energy equation, outlined last week in an interview with the Wall Street Journal newspaper, is for total world energy demand to double over the next 40 years, but with renewables accounting for roughly one-third of new demand, and nuclear between 5% and 10%. This leaves the rest to the family of traditional fossil fuels – coal, oil and gas.

Voser also sees China as potentially being a bigger producer of oil and gas from shale than the US.

There is another problem for energy investors; the rising supply of electricity from multiple new sources of renewable energy, ranging from wind to solar, albeit with handsome government subsidies that have become a significant distorting influence in the energy market, especially in Europe where a totally unexpected coal revival is underway.

More on coal later. Right now it’s important to recognise that what you might have expected as recently as last year, an easy ride on energy stocks, no longer applies. And there is unlikely to be a sudden return to the relative comfort of rising prices if peak oil had arrived as forecast.

When looking at any part of the energy sector, whether it is coal or renewables, the benchmark test is the price of oil.

Over time, all other energy prices move with the oil price and there are few forecasts today for a strong rise in the price of oil. The consensus view is that oil will trade between $US75 a barrel and $US125 a barrel over 2013, with the high price forecast coming from the investment banking unit of Barclays and the low from the US-based energy consultancy, PK Verleger.

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Right now, oil as measured by the European standard, Brent, is at $US112 a barrel, almost precisely where it was 12-months ago. West Texas Intermediate, the world’s other oil yardstick, is at $US93 a barrel, down $US7 a barrel on 12-months ago, but reflecting the growing oil and gas glut in the US.

Maintaining oil at around the $US100 a barrel mark has become a difficult job for the once-powerful cartel of producers, the Organisation of Petroleum Exporting Countries (OPEC), with Saudi Arabia cutting production late last year from 9.7 million barrels a day to 9 million barrels a day.

The actions of OPEC in opening and closing its production spigots to manipulate the oil price is one of many distorting factors in the energy industry. Other distortions include government subsidies on the production of renewable electricity, and heavy taxes designed to limit coal consumption.

Unfortunately, as with peak oil theory, the market – not government environmental edicts – are dictating events. Coal use in Europe is soaring because it has become the cheapest energy source.

Last month, in an analysis as surprising as the rise of shale oil and gas, the International Energy Agency forecast that coal production (and consumption) was rising so rapidly that it would match oil as a primary source of power by 2017.

Potentially a boost for coal producers, if the price rises with forecast consumption, the continued growth in coal demand is a fascinating reaction to European energy policy, with the high cost of renewable energy from wind and solar (even with government subsidies) encouraging the burning of coal.

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In Germany alone there are 16 new coal-fired power stations under construction, a direct reaction to the closure of the country’s eight nuclear power plants. Around the world there are 1200 new coal-fired power plants planned or under construction, with most of them in Asia.

For investors, energy has become a much more complex industry than at any time in the past 30 years, with rising production of multiple energy sources keeping pace with, and at times moving faster than, global energy demand.

For Australian investors the challenge is to find an entry point in a complex market that is being distorted by new sources of supply and government activity, whether through subsidies or a combination of tax and environmental policies.

The best, and safest, entry points in a sector that is struggling to match supply with demand are:

Oil and Gas:

1. Woodside Petroleum (WPL) as it overcomes the negative publicity associated with major cost overruns and completion delays at its Pluto LNG project in WA. In the December quarter production from Pluto significantly outstripped design, setting Woodside on a path to lift profit beyond $2.1 billion this financial year, and lift its annual dividend from $1.10 to at least $1.22 a share. Interest in Woodside will grow as a yield play, but with the potential for negative news if the Browse LNG project is postponed and its investment in an Israeli LNG project hits problems, which are always possible in the Middle East.
2. Santos (STO), which is also on track for a substantial profit increase as new projects come on line, including the planned 2014 start-up of a big new LNG project in Papua New Guinea, in which it has a minority stake. Its dividend is expected to remain at 30c a share, but big broking houses such as Goldman Sachs rate the stock a buy with a 12-month price target of $14.45 versus a recent price of $11.78.
3. Beach Energy (BPT), one of the leading participants in the emerging Australian shale gas sector and well-placed to capitalise from a forecast gas shortage in east coast markets. The flow of discovery news, and shale-gas testing in Beach’s primary area of interest, the Cooper Basin of central Australia, will maintain interest in the stock. It has been trading at around $1.41, but brokers tip a 12-month target of $1.75.

Coal:

1. Whitehaven (WHC), despite negative news surrounding its majority shareholder, Nathan Tinkler, continues to grow. Behind the froth and bubble of Tinkler’s troubles with creditors, and a high-profile hoax involving the alleged cancellation of a loan from the ANZ Bank Whitehaven is a solid coal producer. Analysts at Bell Potter tip it as a stock to buy up to $4.40, about 20% more than its recent price of $3.58.
2. New Hope Corporation (NHC), despite once being unkindly dubbed “No Hope” by one of its directors, has been a steady producer and a surprisingly profitable business during the coal-price downturn. With prices showing signs of recovery, New Hope is set to deliver strong cash flow of more than $550 million this year. This will potentially boost its cash reserves to around $2 billion, and set it up for a fresh attack by takeover suitors, or assist New Hope itself to grow by acquisition. Either way, the stock seems primed for corporate activity, and a share price higher than its current $4.32.

Uranium:

1. Paladin (PDN) is a suggestion that goes against the grain, thanks to the stock’s perpetual capacity to disappoint and ongoing uncertainty about the uranium price. A recent share price bounce from 74c to $1.24 last week could be as good as it gets for the stock, which is a hold at best.

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Renewables:

Summed up in two words: stay away.