ENERGY SECTOR COILED TO SPRING
by Joseph Dancy, LSGI Advisors, Inc.
Adjunct Professor, SMU School of Law
June 25, 2007

Living quiet, unpretentious lives Mr. and Mrs. Othmer - a professor of chemical engineering and a former teacher - died a few years ago in their nineties. When the Othmer's died, friends were shocked to learn that their estate was worth $800 million. 

How did the Othmer’s get so rich? Like many long term investors, they put their money into well managed undervalued companies and left it there. The Othmers had an additional benefit: in the early 1960s they each invested $25,000 with Warren Buffett.

Choosing An Attractive & Profitable Sector 

No less an expert than Mr. Buffett points out the importance of choosing investments that are well positioned in a growing and profitable industries. He identifies his largest investment mistake was buying the company his firm is still named after (Berkshire Hathaway) - not because the company was flawed, but because the industry it was in (textiles) was so unattractive. 

No matter how well managed, Berkshire would always have subnormal returns. The textile industry was a commodity business, competitors had facilities located overseas that were low cost producers, and substantial excess capacity existed worldwide. 

Looking for a growing, undervalued, and profitable industry in which to invest we can think of no better area to look for opportunities than the energy sector. That said, we found the following developments in the energy sector of interest last month:

• While a number of U.S. refineries have experienced operational issues gasoline demand has continued to rise. As a result companies are importing more gasoline to meet demand. Imported gasoline now accounts for more than 11 percent of the total gasoline used in the U.S. This is roughly double the share of imports a decade ago according to the Energy Information Administration. Our reliance on imported gasoline is expected to grow.

• Fuel demand in the U.S. averaged 20.9 million barrels a day in the four weeks ended May 25, up 2.4 percent from a year earlier. The Energy Department measures shipments from refineries, pipelines and terminals to calculate demand. With supply issues created by the refinery outages, increasing demand has added to price pressures.

• A KPMG survey of 553 financial executives from oil and gas companies revealed that sixty percent of the executives believe the developing trend of declining oil reserves is irreversible. When asked what the impact of emerging markets, such as China, will have on declining oil reserves almost 70 percent of the executives said that it would lead the situation to worsen.

• The Energy Information Administration reports that as of 2006 the nation's 149 refiners could process more than 17.3 million barrels of crude oil a day. As recently as 2001 there were 155 refineries nationwide that had a maximum capacity of 16.6 million barrels of crude a day. Refinery capacity peaked in 1981, when there were 324 refineries that could process a total of 18.6 million barrels of crude oil per day. Economies of scale seem to be prevalent in this sector, with fewer but larger facilities.

• Some experts speculate the new EPA mandates reducing the amount of sulfur allowed in diesel fuel has had the unintended consequence of causing more refinery outages. Removing the sulfur requires operators to run the refining units harder and at higher temperatures and higher pressure, possibly leading to equipment failure.

• In an April report, The International Energy Agency wrote, "Anecdotal evidence suggests refinery reliability is deteriorating due to existing sulphur removal requirements, lowering average utilization rates. The need to run these units harder to meet the tighter specifications is leading to a higher incidence of unit failures, posing additional problems for refiners."

• Increasing state ownership and rising resource nationalism are emerging as two of the main long-term threats to global oil supplies according to a report by a well known consulting group. The report highlights the shift in power towards state-controlled national oil companies. Multinationals own or have access to less than 10 per cent of world oil resources.

• Energy traders closely follow the Atlantic hurricane season for clues if the weather may disrupt energy production in the Gulf of Mexico. Hurricane season starts June 1^st. The Gulf accounts for 30 percent of U.S. crude oil and 21 percent of its natural gas production. In a normal year, historical data indicates just under six hurricanes will form. 

• Colorado State University researchers forecast nine hurricanes this season, five of which will reach Category 3 levels or stronger. National Weather Service forecasters expect seven to ten hurricanes. Accuweather also noted that there is an above-average chance that a major hurricane will hit the U.S. Gulf Coast this year, predicting the Texas Gulf coast is twice as likely to be hit as in an average year.

• "We are on a treadmill to get [natural gas] supply going, and consumption is outpacing that," William Hussey, senior vice president of origination for ConocoPhillips Gas & Power, told attendees at GasMart 2007 last month. 

• Even though US drilling activity is at an all-time high, with more than 30,000 wells are set for completion this year, overall output continues to fall because newer wells are less productive and experience rapid decline rates. As traditional fields are depleted, forms of gas that are more costly to produce--particularly gas from shale and tight sands--will assume a larger share of the production pie according to Hussey.

• The World Bank last month raised its 2007 forecast for China's economic growth to 10.4 percent from 9.6 percent. China's economy expanded by 10.7 percent in 2006, its fourth straight year of double-digit growth, and by 11.1 percent in the first quarter of this year. Economic growth and energy use are strongly correlated, and China’s economy is not as energy efficient as more developed nations.

© 2007 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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