One of the biggest mistakes investors make, one which I am also guilty of committing, is equating price volatility with risk. I believe the key to successful investing is finding investment trends before they are recognized by the masses and having the conviction in your beliefs to stay invested. This is not an easy task. Many of history’s greatest investors have been able to spot trends early on and profit over a period of many years. One example would be Sir John Templeton’s identifying the Japanese equity market as a great investment theme in the 1960s.  This was at a time when most people associated Japan with cheap knock off products -- long before the masses gave Japanese investing any thought. In addition to recognizing an investment theme with outstanding potential, Templeton also had the conviction to hold his Japanese investments during volatile periods. Templeton’s insight and strength in his beliefs allowed him to make a fortune over the years.

The volatility in the price of oil and gas has caused many to believe that energy investing is “risky” and contains very little investment potential. I believe that volatility has created tremendous opportunities for astute investors to take advantage of the long-term bull market in energy.

The war in Iraq has generated a tremendous amount of volatility in oil prices. Oil spiked to within a penny of $40 in mid-March, prior to the commencement of the war. However once the war started, oil proceeded to fall under $27 for a brief period before settling in the $30 range. The price of oil moved up and down during the war almost exclusively based on news from the front lines. When it was reported that the Iraqi army set ablaze only a handful of wells at the start of the war, the price of oil dropped quickly. However, when US forces were met with stiff resistance in some of Iraq’s southern cities, oil prices firmed. With the conclusion of the war in Iraq, look for oil market observers to re-focus their attention on the very bullish supply/demand picture.

Natural gas is widely recognized as one of the most volatile commodities traded today. In the past three years, we have seen an unprecedented level of volatility in the spot and futures markets for natural gas. Some of the volatility of recent years can be attributed to unlawful behavior by many of the now struggling merchant energy firms. The Federal Energy Regulatory Commission (FERC) recently singled out seven subsidiaries of Enron and several other companies for taking advantage of a dysfunctional power market in California. To punish those involved, FERC has banned eight companies from selling natural gas in California.

The volatility in the natural gas market cannot all be tied to the foul play in the California energy markets. The weekly storage report prepared by the Energy Information Agency can cause wild swings in futures prices. If a storage report is higher or lower than what was widely expected, it is not uncommon for futures prices to move over 5% in one trading session.

Weather related events can also cause significant moves in natural gas futures.  Every summer when price of oil moved up and down during the war almost the hurricane season begins, rumors of a supply disruption can send future prices spiking upward.  Extreme or mild weather forecasts can also send spot and futures prices spiraling up or down.

What does all of this volatility mean for investors in energy equities?
I believe volatility in the oil and gas markets is a long-term investor’s best friend. Here is why.

Extreme volatility makes capital expenditure planning very difficult. After the spike in natural gas prices in the winter of 2000/2001 and their subsequent fall, many firms have been slower to ramp up drilling this time around. This is not to say that drilling has not increased. According to Baker Hughes International (BHI), the average number of rigs drilling for natural gas in the US has increased to 767 during March 2003. This represents a 24% increase over the 617 rigs that were actively drilling in March 2002. However, today’s rig count is still down significantly from March 2001 when there was an average of 913 rigs drilling for natural gas.

The BHI Canadian rig count averaged 449 during March 2003 versus only 311 during March 2002. While the Canadian rig count has returned to levels not seen since the drilling boom of 2001, production has not picked up. Part of the reason for the increase in Canadian drilling is the tremendous decline in natural gas production from the Ladyfern field in British Columbia. Ladyfern production, which peaked at over 700 million cubic feet per day (mmcfd) in 2001, is expected to decline to 100 mmcfd in 2003. Therefore, Canada’s current drilling boom will not grow the country’s natural gas production this year, it will only keep it from declining more than 2%. This decline and a likely decrease in exports to the US will break Canada’s 16-year record of increasing production and exports to the US.

Volatility benefits long-term investors in other ways outside of restraining rig counts. Volatility also keeps long-range supply solutions on the drawing board. For example, the capital markets no longer have any appetite for energy’s dramatic price volatility. I am familiar with one privately held US E&P firm that declared bankruptcy last year after its bank pulled its line of credit during last summer’s weakness in natural gas prices. The firm is now selling off assets and using cash flow from its production to pay creditors. More importantly, the firm can no longer afford to do any exploration on its substantial acreage at a time of strong prices. After reviewing the balance sheets of many publicly held Canadian firms, I have come to the conclusion that many are underleveraged. While I do not consider it prudent to take on massive amounts of debt to grow a business, I believe there to be substantial value in taking on reasonable amounts of debt when there is an excellent chance of earning an internal rate of return that is higher than the cost of borrowing.  The current environment for the independent Canadian exploration and production firms is unlike any period in history. We are seeing high commodity prices, low interest rates and very reasonable rig rates. Despite such a favorable environment, I believe few firms are willing to take on additional debt to increase growth due to fears that substantially lower prices are around the corner.

Given the rig counts we have seen in recent months, the outlook for US natural gas production is quite grim.  Today there are 767 rigs drilling for natural gas in the US. This is 40% less than the number needed to keep US natural gas production flat. Based on well productivity and average decline rates, I have estimated that the US needs 1,100 rigs actively drilling for natural gas to keep production flat. I predict that we will experience a 5% decline in US natural gas production in 2003. A 5% production decline, along with very low storage levels, should be recognized as a very bullish situation for investors.

Widely fluctuating oil and gas prices also influence political decisions related to energy. For example, the US Senate recently voted down a bill that would have opened up part of the Alaska National Wildlife Refuge (ANWR) for exploratory drilling. The vote, which was extremely close, would likely have been decided in favor of opening ANWR if it were not the widely held belief in Washington that today’s high oil prices are only temporary.  Volatile natural gas prices have ensured that the building of an Arctic natural gas pipeline is pushed out further into the future. The fear among the politicians in Washington, who are being asked to subsidize the US pipeline by the major oil companies, is that we are headed for a period of lower natural gas prices. They cannot be seen by their constituents as providing corporate welfare to major oil companies if they ever want to get re-elected. I see very little chance of a sustained period of low natural gas prices based on the extremely bullish fundamentals that currently exist for North American natural gas. Unfortunately for the US, the supply situation has become so dire that significant and permanent economic damage will be done before the first cubic foot of Arctic natural gas ever arrives.

While there are always risks in investing in the energy sector, long term investors should not become overly concerned with the daily rise and fall of commodity prices. They should recognize that we are in the early stages of a multi-year and quite possibly multi-decade bull market in energy and should adjust their portfolios accordingly.

Loonie Hits High and BOC Raises Rates

On Friday April 11^th, the Canadian dollar hit a 3-year high against the US dollar. One US dollar now buys $1.45C of Canadian assets. I believe this most recent high for the Canadian dollar is a continuation of a long-term trend in which the two dollars are headed to parity. Since the first publication of the Canadian Energy Viewpoint on October 1, 2002, the Canadian dollar has risen 9% in value. This has given nice boost to the US dollar return of the Model Portfolio.

It is becoming quite apparent that the currencies of the US and Canada are headed in opposite directions. As weakness continues to haunt the US economy, the US Federal Reserve is likely to lower its key overnight lending rate later this year. The Bank of Canada recently raised its key overnight lending rate for the second time this year. Canada’s key overnight lending rate now stands at 3.25%.

In addition to comparatively tighter monetary policy in Canada, the Canadian dollar is likely to rise against the greenback for several other reasons. Canada has reduced its net federal debt five years in a row, whereas the US government continues to expand the burden on future generations at record rates. From a budget perspective, Canada is likely to continue their five-year trend of running federal budget surpluses. The US Treasury just announced a record federal deficit for the first half of fiscal 2003.

Since US investors have a significant portion of their assets in their home currency, I cannot overemphasize the importance of investing in assets denominated in Canadian dollars.

Low NG Storage = High Prices

Unusually cold weather in early April caused an unprecedented 48 billion cubic foot (bcf) withdrawal from US natural gas storage for the week ending April 11^th  -- leaving US natural gas in storage at 623  bcf. This figure represents a 883 bcf decline from the same week one year ago. Such a low level of inventory almost guarantees that US natural gas storage will be nowhere near full when the winter heating season begins on November 1^st.

I believe we have seen the low point in natural gas prices for 2003.  As the summer cooling season heats up with very low levels of storage in place, look for natural gas prices to steadily march towards $10.00US per million cubic feet by November 1. While many might look upon this prediction as overly bold, I do not see it as overly optimistic. Investors should remember that it is unlikely that US storage levels will reach 2.6 trillion cubic feet (tcf) by November 1st without the demand destruction that $10US natural gas would bring.

Nigeria and Venezuela

While all of the media attention has been focused on the war in Iraq, investors should keep a close watch on developments in Nigeria and Venezuela. From mid-March through mid-April, Nigerian oil production fell 40% to 1.2 million barrels a day. The drop was due to several major oil firms shutting down production to avoid the wide scale ethnic clashes leading up to the country’s national elections, which were held on April 12th. Nigeria is the fifth largest supplier of crude to the US. A large portion of imported Nigerian oil is refined into gasoline due to its low sulfur content. If ethnic violence does not subside quickly, look for substantially higher US gasoline prices this summer.

Venezuela’s oil industry continues to deteriorate. With nearly half of the country’s oil workers having been fired, including a significant portion of PDVSA’s senior technical staff, there is no hope for the country to return to pre-strike levels any time soon. Unfortunately, the strike has created a situation in Venezuela that is almost certain to end badly for its citizens. In a country that is faced with some of the steepest oil production decline rates of any OPEC country, nearly 25% a year, the decline in oil revenue is certain to create additional political unrest. Without the needed billions of dollars of investment to keep production flat and the technical staff to manage its fields, Venezuela is likely to see oil production fall permanently below 2 million barrels a day by the end of 2003.

© 2003 Bill Powers, Editor
Canadian Energy Viewpoint
See Mr. Powers' Cover Page for Bio and Archived Editorials

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Bill Powers
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Information presented in this newsletter was obtained from sources believed to be reliable, but accuracy and completeness and opinions based on this information are not guaranteed. Under no circumstances is this an offer to sell or a solicitation to buy securities suggested herein. The editor may have an interest in the companies mentioned. All data and information and opinions expressed are subject to change without notice.