Even though a large portion of the performance of our portfolio is due to our active management activities and not changes in energy prices, we remain overweight in the energy sector. We think the next three months will be very positive for all energy equities. Some of the more recent trends or developments in the sector include the following:

• World demand for crude oil should remain strong next year according to a forecast released last month. The International Energy Agency (IEA) trimmed its forecast for demand in 2006 but kept its predictions for 2007 unchanged. Demand in 2006 is forecast to grow by 1.1% instead of the 1.2% previously predicted by the IEA, to an average of 84.5 million barrels per day. In 2007, demand is forecast to expand 1.7% to 85.9 million barrels per day – an increase of 1.4 million barrels per day. Keep in mind worldwide excess crude oil production capacity is at a several decade low – and this will significantly add to energy price volatility in the coming year.

• U.S. natural gas well decline rates continue to increase at an accelerating pace as advanced completion technologies allow individual E&P companies to extract more gas from smaller reservoirs more quickly. Raymond James & Associates issued a research note last month that indicated that many natural gas wells drilling into reservoirs have decline rates well above ‘normal’. The average natural gas well decline rate last year in the  U.S. was estimated at 32% versus 21% a decade ago. Further, in the first year production from the average natural gas well declines over 50%. With natural gas well decline rates so high, even record drilling levels in the U.S. will have a difficult time maintaining deliverability levels.

• Consumer demand in the U.S. has not been impacted to any large degree by higher oil prices to date. The U.S., with 4.6% of the world population, uses 25% of the world's oil and  U.S. imports hit record levels in September. Imports of both crude and petroleum products accounted for 69 per cent of total U.S. demand last month, up from an average of 65.2 per cent in the same period in 2005. 

• China's oil imports in September of 2006 were 24% more than September 2005, and 2.4% more than the previous record set in the middle of January. As recently as 1992 China was self-sufficient in oil. Today the country imports 40% of its needs, and imports continue to increase each year. 

• China has begun to fill its new strategic petroleum reserve – the first time the country has established such a reserve. While details as to the fill rate and capacities are not disclosed, the size of the strategic reserves are intended to provide for 120 days of demand should oil supplies be interrupted. 

• China will pass Japan as the world’s second-largest vehicle market this year. Carmakers in China sold 5.76 million units this year through October, an increase of 25.6% from a year earlier. Both production and sales for 2006 are expected to top seven million units, which would set a new record and would exceed last year’s production by over a million autos.

• Daqing, the largest oilfield in China, is in decline.  China depends on this field for one-quarter of its oil production. In 2010 it is projected the field will produce 780,000 barrels per day, down from 1.1 million barrels per day in 1997. New discoveries in China are not keeping pace with the skyrocketing demand for oil and oil products.

The chief executive of Mexico state oil monopoly Pemex last month said production at its Cantarell oil field – one of the top three producing fields in the world – will decline by an average of 14 percent a year starting next year. The average annual decline will be equivalent to about 150,000 barrels a day.   Cantarell,  Mexico's largest source of crude oil, began declining from producing a record 2.1 million barrels a day in 2004 to roughly 1.8 million barrels a day this year.

• Reflecting the narrowing gap between excess crude oil productive capacity and demand the price of crude oil has trended upward the last five years. We expect these long term upward trends to continue. Chart at right courtesy of Diamond Hill Investments (DHIL). 

While we expect the crude oil and natural gas sectors to remain volatile, as we move into the winter months we expect energy prices to remain firm with the increasing demand. As such, we see a very positive next few months for companies in the energy and energy services sector.

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