Last month the Energy Information Administration (EIA), a branch of the U.S. Department of Energy, released their official long term forecast for the U.S. energy markets. The twenty-five year forecast of energy production and consumption is radically different than the one issued last year – with major changes in their assumptions:

“world oil prices have risen sharply as supply has tightened, first as a result of strong demand in developing economies such as China and later as a result of supply constraints resulting from disruptions and inadequate investment to meet demand growth. As a result . . . [the current study] includes much higher world oil prices than were projected in [the year earlier study]”

How much higher is the new price estimate? The EIA increased their long term crude oil pricing estimates by 66%. And this is not a short term issue either – the EIA sees the price pressure lasting decades, with demand “keeping pressure on prices through 2030.” This change in their long term forecast may not seem significant – and few in the press even picked up on the change - but it has huge implications for investors.

• The EIA Study: Three Major Changes

In addition to forecasting substantially higher crude oil prices, the EIA’s base or ‘reference’ case has two other major changes from last year. Liquefied natural gas (LNG) imports to the U.S., required to meet the shortfall of domestic natural gas production, will not be as large as projected – in fact will be one-third lower in 2025 than projected last year:

“More rapid growth in worldwide demand for natural gas in the [current study] reduces the availability of LNG supplies to the United States and raises worldwide natural gas prices, making LNG less economical in U.S. markets.”

Robust global natural gas prices will promote conservation efforts in the U.S. the EIA reasons, and will also make many marginal or difficult natural gas formations more attractive for development by domestic exploration and production companies. LNG will still play a major role in meeting natural gas demand in the U.S., just not quite as large as projected last year. The other major change is the EIA’s projection that crude oil production in the United States will increase until around 2014 “as a result of increased production offshore, predominantly from the deep waters of the Gulf of Mexico.”  The trend in petroleum production, which includes natural gas liquids and refinery gains in addition to crude oil, has clearly been downward the last several decades. (See EIA chart at right). Note the new study has the petroleum downward trend changing directions and heading upward through 2014, then resuming a decline.

• Economic Growth

The EIA estimated that the U.S. gross domestic product, a measure of economic growth, will grow at 3.0% per year- the same as last year’s study. Historically, economic growth and energy use are closely correlated, although over time smaller amounts of energy are needed per unit of economic growth. 

Part of this trend is due to energy efficiency, part of this is due to the fact that many energy intensive industries are now locating overseas.

Regardless, the EIA estimates that total energy consumption in the U.S. is projected to increase at 1.1% per year, with electrical consumption increasing 1.6% per year.

The bottom line is that as the economy expands, and as the population grows, more energy will be needed. Note the upward trends in each sector in the EIA chart above.

• Implications of EIA Report for Investors

What we find interesting about the EIA report is the implications it could have for investors. First, many Wall Street analysts have repeatedly used a long term oil price of around $30-$35 per barrel in their models – a price that in the past they noted was supported by EIA studies.

Now that the long term EIA price assumptions have been dramatically changed, if analysts use a discounted cash flow model using the higher EIA forecast prices the proper valuation of many production related properties will be multiples higher than they were under the old assumptions. If the EIA forecast is correct at some point investors should realize energy firms are undervalued based on their projected income – and firms with large reserves will be worth substantially more in today’s market.

If Wall Street analysts don’t use the higher projected prices in their determination of fair value, expect those who believe the EIA forecast to institute a flurry of property acquisitions since market prices for the most part will not reflect robust long term energy price assumptions. Increased acquisition activity has already begun in the sector, and will push the stock price of energy firms upward toward more reasonable valuations.

Investors should find an attractive environment in which they can select firms from a profitable, growing sector, with positive long term trends. In our opinion the energy sector remains very appealing for investors in 2006, and beyond.

Other Developments in the Energy Sector

	ong-Long-term forecasts by both Accuweather and Atmospheric and Environmental Research Inc. (AAER) both continue to predict colder than normal temperatures in the Northeastern U.S. For January, February, and March AAER’s model (at right) shows cold temperatures in the Northeast and the Great Lakes. The Northern Plains and the Rockies will be warmer than normal. The AAER model uses El Nino, recent temperature trends and Siberian snow cover, as well as sea-level pressure anomalies, in its winter forecast. Accuweather’s forecast for January forecasts a cold Eastern coast due to the orientation of the jet stream. Like the AAER model Accuweather calls for a cold winter season in the East, a bullish scenario for natural gas and heating oil markets (see “January Temperatures” map left).

Accuweather also notes that the coldest part of winter is just ahead – something which should be very interesting in that massive amounts of natural gas were withdrawn from storage to meet early December heating demands.

The number of rigs drilling for oil and natural gas in North America increased to 1,471 last week, an increase from 1,243 in the year ago period. Crude oil futures prices were $61.04 per barrel, compared to $43.45 in the year ago period. Natural gas futures prices were $11.22 per thousand cubic feet versus $6.15 in the year earlier period.

Alaskan crude oil production is falling much quicker than expected. The fall 2003 State estimate had North Slope production averaging 937,000 barrel a day from 2006 to 2015. By the spring of 2005 that estimate was down to 876,000 barrels per day. Last month that estimate was reduced further – to 827,000 barrels per day. The ability to maintain production in the face of natural field declines has become a major issue.

Before the hurricanes this summer the Gulf of Mexico produced around 10 billion cubic feet of natural gas per day (bcf/d) out of a nationwide total of 50 bcf/d. As of Christmas day around 2 billion cubic feet of natural gas remain shut-in due to the storms.

China's economy is 17% larger and growing faster than previous estimates, according to a year-long census released in Beijing that revealed the existence of millions of previously unaccounted for businesses. The findings vaulted China ahead of Italy as the world’s sixth largest economy. When the study is complete next month it may vault China into the number four position – with the Chinese economy larger than the U.K.’s.

The updated census added the equivalent of Austria's annual output to the world's fastest-growing major economy. Economic growth and energy use are highly correlated – and this is another indication of the impact China is having on the energy and basic material sectors.

The growth rate of the Chinese economy next year is expected to be close to 9% according to another report released by China’s State Information Center. In 2003 and 2004 the country’s annual economic growth rate was 9.5%, and in the first three quarters this year the figure was 9.4%.

Morgan Stanley’s Stephen Roach offers a more modest growth estimate of 6.7% for China next year. In either case, should China’s economy grow at anywhere near these rates the incremental demand for energy and basic materials will exert upward pressure on global commodity prices.

China's oil imports have risen at an annual average of 24% in the last decade, after being a net oil exporter until 1993. Of the 6.7 million barrels of oil a day that China consumed in 2004, almost half came from imports. The United States imported about 10 million barrels a day in 2004. China’s incremental demand for energy will continue to place upward pressure on commodity prices.

US energy giant ExxonMobil said it was evaluating its position in Venezuela after receiving an ultimatum from the country's left-wing government to join a state-backed venture. ExxonMobil is now the only foreign major active in the world's fifth-largest oil exporter that has refused to scrap its current contract and accept a minority partnership with Venezuela's state oil firm.

President Chávez's government is demanding private companies operating 32 oil fields under contract to form state-controlled joint ventures by the year's end, and has billed the companies $3 billion in ‘unpaid’ taxes. Other firms have agreed to the demands – but energy related investment in the country is expected to decline.

Venezuela's oil ministry will ask for increases in the income tax rate for foreign companies operating in the country's heavy-oil Orinoco belt from 34% to 50%. In late 2004, the royalty rate for the four Orinoco projects was raised to 16.6% from 1%. The Orinoco projects collectively pump around 600,000 barrels a day of tar oil -- converted into synthetic crude at special upgrading facilities -- accounting for around a fifth of Venezuela's total oil production.

Bolivia elected a new president whose leftist leanings will be “a nightmare” for the U.S. (his quote). Bolivia has the second largest natural gas reserves in South America. The new leader has aligned himself with President Chavez in Venezuela, a major energy exporter, and has threatened to nationalize the energy sector. This development reduces the probability that major global firms will participate in major energy developmental projects in that country.

The Energy Information Administration reported that U.S. demand for petroleum reached 22 million barrels per day – a record, even with the higher price levels. Higher energy prices do not appear to be moderating demand in the U.S., or globally.

Worldwide demand for crude oil this winter could exceed worldwide supply by 1 to 4 million barrels per day. The global energy system has not experienced such a shortfall recently, and it could pressure inventories and impact prices. Demand for crude oil will be highly correlated with winter temperature over the next few months. 

© 2006 Joseph Dancy
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Joseph Dancy, Adjunct Professor
Oil & Gas Law, SMU School of Law
Advisor, LSGI Market Letter
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