Energy Sector: Positive Trends Continue

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Several very positive developments have occurred in the energy sector in the last several week, many of which should be bullish for companies in the sector:

China Economy Expands

China announced that their rapid economic growth continued in the last quarter. Growth remained robust last quarter at 9.5 percent, slightly lower than the 9.7 percent in the previous quarter. China’s Industrial output growth rose 15.1 per cent in June from a year earlier, quickening sharply from May’s 13.3 per cent and beating market expectations of 13.1 per cent. Bloomberg noted the “growth figures underlined the resilience of the world’s second-largest economy, thanks to the country’s rapid urbanization, and could soothe investor concerns about a hard landing that would dent demand for global commodities”.

As long as China’s economy continues to expand at near double digit levels global we expect demand for crude oil will continue to increase – and global demand levels are expected to reach record levels in 2011. We think this is very positive for energy holdings. 

EIA Oil Report

The International Energy Agency (IEA) released their monthly report on the oil sector in early July. In our opinion it was a real ‘shocker’ to the extent that the IEA is usually has the most conservative outlook with regard to the crude oil markets—they have a tendency to understate demand and to overstate available supplies.

The IEA monthly report warned that unless OPEC increases production by at least 1.5 million barrels a day, world oil demand will surpass available supply during the second half of the year. The bottom line is that supply will fall short of the 89 million barrels of oil the global economy is expected to consume, which should push world oil prices higher – potentially substantially higher depending on global inventory levels.

Global oil production remains constrained by the Libyan conflict, the recent violence in Iraq, Yemen conflicts, and the fact that Saudi Arabia’s excess crude oil supplies are heavier and more ‘sour’ than off line production – and much more difficult to refine. China and Japan continue to face electrical power shortages, relying on additional diesel and oil fired generation facilities to meet industrial and consumer demand. Pakistan and several Middle East countries are also facing power shortages and are also using diesel generators and/or using more production to fire oil based generation facilities. Due to domestic demand some exporters are reducing oil volumes available for export.

Jeff Rubin in the Globe & Mail summarizes the implications of soaring demand in the face of constrained supplies:

With the prospect of even a tighter oil market over the balance of the year, the IEA is warning motorists in member countries to get ready to pay more at the pumps. And the IEA has already suggested it might release additional oil from its strategic reserves to moderate further price increases.

But considering the recent release of 60 million barrels from member countries’ strategic stockpiles could barely hold down Brent world oil prices for more than a week, the IEA may have to come up with something a little more substantial the next time than the fuel equivalent for another 16 hours of world oil demand.

Saudi production

One of the more significant forecasts in the EIA report was that Saudi Arabia's oil exports could be capped by increasing demand for its own crude for domestic power generation. Despite increasing production the amount of oil available for export may decline. While the Saudi’s increased production in June by 0.7 million barrels per day around one-half went to Saudi power plants or refineries. Internal use of production has been a long term trend in most exporters, in part due to the fact that many of these markets are heavily subsidized.

OPEC statement

The Organization of Petroleum Exporting Countries (OPEC) yesterday predicted that global demand will be the highest in history this year. While OPEC thinks global demand will continue to increase, their monthly report said that demand will grow a bit less than previously forecast.

The cartel said daily world consumption will increase this year by 1.36 million barrels -- down from a previous estimate of 1.38 million barrels -- to an average 88.18 million barrels. The decreased demand estimate was a very minor change – the fact is that meeting the 1.3 million barrels per day of additional demand will be a major challenge for the global industry.

Goldman Sachs forecast

The Wall Street Journal reported yesterday that Goldman Sachs and other major investment firms remain bullish on the oil markets for the reasons mentioned above:

Goldman Sachs Group Inc. said oil supplies will become "critically tight" in 2012, largely because production leader Saudi Arabia won't be able to pump as much extra oil as many people believe. Robust global economic growth will continue to drive oil demand that outstrips supply, so "it is only a matter of time before inventories and OPEC spare capacity become effectively exhausted, requiring higher oil prices to restrain demand," Goldman said.

The report amplified previous warnings of a supply-constrained oil market by the U.S. investment bank, which in recent months has repeatedly questioned the ability of Saudi "spare capacity" to meet rising demand. If the market becomes convinced of the Goldman view, prices could rise sharply. . .

Recent history shows a close correlation between spare production capacity and oil prices. When spare capacity is low, the risk of a supply disruption grows and prices rise. Two of the strongest periods of oil-price inflation—2003 to 2005 and 2007 to 2008—coincided with OPEC spare capacity falling to historic lows. . . In May, Goldman raised its Brent crude forecast for the end of 2012 to $140 a barrel from $120 a barrel and its 2011 year-end forecast to $120 a barrel from $105 a barrel. . . .

M&A activity resumes

Merger and acquisition activity resumed in the energy sector reflecting what we consider the extreme undervaluation of many companies in light of price trends and long term global supply and demand issues.

BHP Billiton agreed to buy US firm Petrohawk Energy at a roughly 60% premium to the closing market price. The transaction is roughly $12 billion in size. The transaction gives BHP access to shale oil and gas assets across one million acres in Texas and Louisiana. In a separate deal last month BHP agreed  to buy Chesapeake Energy's Arkansas-based gas business for $4.75 billion.

Also, the Williams Companies raised their offer for the Southern Union Company to $5.5 billion. A bidding war for the pipeline operator has broken out, with the bid topping a revised $5.1 billion bid for Southern Union from Energy Transfer Equity. Under the terms of its new offer, Williams would pay $44 a share in cash for Southern Union, above both its original $39 offer and the $40 cash-and-stock bid from Energy Transfer.

And ArcelorMittal and Peabody Energy Corp. made an offer to acquire Macarthur Coal Ltd. For roughly $5 billion. Macarthur Coal produces metallurgical coal, a needed input to make steel.

SPR release

The IEA last month announced it was releasing 60 million barrels of crude oil into world markets from the global Strategic Petroleum Reserves. Daily consumption is pushing 87 million barrels per day on a global basis, so this is a relatively small volume compared to demand.

From its creation after the 1973 OPEC oil embargo up until this summer, the U.S. SPR had only been tapped twice. It released 17 million barrels in conjunction with the invasion of Iraq in 1991 and another 11 million barrels after Hurricane Katrina knocked out crude production and natural gas output in the Gulf of Mexico in 2005. This time, only the third emergency release ever, the U.S. released more oil than in the two previous events combined. And it only took a week for prices to recover to pre-release levels.

Investment implications

We continue to believe that long term trends in supply and demand, and global economic growth, will assert upward pressure on commodity prices. Companies that operate in the sector should be the main beneficiaries, including those in the energy, materials, and agricultural sectors.

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