Energy Sector Developments Remain Positive

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Developments in the energy sector last month remain positive in our opinion – especially for domestic crude oil producers:

  • The International Energy Agency (IEA) announced that for the first time in history crude oil demand from developing countries will exceed the oil demand from developed economies. This is not a surprise, but has significant pricing implications in our opinion.

The demand sensitivity to rising crude oil prices is much lower in developing countries, in part because per capita energy use is so low in those areas compared to the North America or Europe. Demand growth in developing nations is not impacted as much by higher oil prices.

  • The IEA released its world oil demand forecast for 2013, projecting a 1.0 million barrel per day increase in demand (to 90.9 million barrels per day - a record level of demand). As noted above demand growth will be driven by developing economies such as China, India, and the Middle East. The U.S., Europe, and Japan are expected to see stagnant consumption.
  • The IEA’s forecast for global demand growth in 2013 (1.0 million b/d) is higher than in 2011 when demand grew by 0.7 million barrels per day, and is higher than the forecast growth of 0.8 million barrels per day this year (2012) (to 89.9 million barrels per day - also a record). The IEA forecasts indicate that global oil demand growth is accelerating.
  • The U.S. Energy Information Administration (EIA) forecasts crude oil demand will grow by 0.7 million barrels per day in 2013. OPEC sees global growth next year at around 0.8 million barrels higher per day. All these estimates were released last month. All three agencies forecast record demand.
  • Due to the high price of corn some politicians are requesting that the Obama Administration temporarily reduce or suspend the ethanol biofuels mandate. Last month U.S. ethanol production was around 800,000 barrels per day. Should the mandate be temporarily suspended U.S. crude oil imports are expected to increase – adding to global oil demand.
  • Rice University professor Amy Myers Jaffe published a paper last month addressing the impact of the Arab Spring on crude oil production. Her thoughts are similar to ours on the issue. She concludes:

History teaches us that abrupt regime change in oil-producing states can lead to a prolonged period of low oil output, which often lasts decades. This possibility comes not just from potential damage to facilities from civil conflict, but also from political changes that may thwart steady investment in oil and gas resources.

  • The North Sea oil and gas industry was last year hit by its biggest ever fall in production with another slide in output forecast for this year. Industry figures revealed that output plunged by 19% in 2011 to 656 million barrels of oil equivalent - half the rate of production in 2005.
  • Indian oil demand has been heavily affected by the massive electricity shutdown and summertime flooding. The use of independent power-generators has led to massive diesel usage countrywide. Furthermore, the shutdown of most of Japan's nuclear power plants has led to excess use of crude and fuel oil burning. China’s economy is slowing, but crude oil consumption continues to increase year over year according to the most recent data.
  • Dan Steffens of Houston’s Energy Prospectus Group (EPG), a long time industry executive and valuation expert, noted that “I have been amazed that we haven’t seen more merger and acquisition activity. My guess is that it has something to do with the large investment bankers not wanting to back the deals or boards fearful of making a mistake. Normally, when proven reserves are this cheap on Wall Street you see more takeovers.”
  • On a similar note Frank Holmes of US Global Investors made the following comments last month on valuations in the energy sector and merger and acquisition activity:

In my presentations, I’ve discussed how resources companies have significantly underperformed their underlying commodities. During 2009 and most of 2010, the performance between oil and the S&P 500 Oil & Gas Exploration and Production Index was closely correlated. By the middle of 2011, oil and oil stocks started to separate, with crude continuing to rise while stocks deteriorated. Even with the recent drop in oil prices, oil stocks have continued to lag.

oil stocks underperforming oil 2009 to 2012

The disparities mean that the cheapest resources are not found in the ground—they’re listed, and it’s been confirmed by recent energy company acquisitions. Chinese oil company CNOOC put in a bid of $15 billion to purchase Canada’s Nexen. This was at a 61 percent premium to Nexen’s share price on July 20 . . . . not only did the takeout announcement close the gap, now the company is outperforming the price of oil.

We also expect to see more merger and acquisition activity in the energy sector due to the gross undervaluation of many publicly traded firms.

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