Energy Sector Remains Out-of-Favor With Investors

Several interesting charts and analysis were published last month relating to the energy sector:

US Global Investors. Frank Holmes with U.S. Global Investors points out that global energy stocks are severely underweighted by fund managers who are focusing on other sectors. Undervaluation coupled with sector under-weightings creates substantial opportunities for investors according to Holmes. The last time the sector was this underweighted was at the end of 2008 and 2009 – which turned out to be an attractive time to invest in the sector.

Holmes makes the following comment on the energy, materials, and commodity sectors:

“The global asset class positioning during the first week of April compared to historical data shows that energy positions are close to 3 standard deviations below the long-term average. An allocation to materials is more than 2 standard deviations below its long-term average and commodity exposure is close to 2 standard deviations below its historical measure.”

Based on statistical data a three standard deviation level for the energy sector would occur only 0.15% of the time. Generally, when markets move to these extremes, investors tend to realize outsized returns going forward.

Goldman Sachs. Last month Goldman Sachs published a list of the “40 most undervalued stocks” in its research base. Of those undervalued mid and large cap firms eighteen (almost half) were in the energy sector. While Goldman was not overly enthusiastic with regard to the overall market outlook for the rest of the year they were of the opinion that firms in the energy sector should do well. We would agree with the Goldman thesis but add that the smaller the energy firm, the more they tend to be undervalued and mis-priced by the market.

Exploration Costs - Financial Times. An article in the Financial Times discussed how the cost of oil and gas exploration and development is rising relentlessly. Exploration frontiers are in deeper water or at more extreme locations onshore, require deeper wells with more complex completion methods, and require more expensive infrastructure to get the product to market. As a result the average returns on capital expenditures for exploration and production have been falling even with the price of crude oil at elevated levels (charts at right courtesy Financial Times).

Gas Demand - Wall Street Journal. The Wall Street Journal published an article and chart discussing the increasing domestic demand for natural gas. Over the last decade the amount of natural gas used for electrical generation has increased substantially, in part due to the environmental advantages of burning the fuel versus coal and more recently due to the favorable economics of burning low-cost natural gas. While the price of natural gas has rebounded from lows set last summer it is still competitive with coal, but any significant increases in natural gas prices will likely cause a shift back to coal fired generation in markets with excess generation capacity (chart courtesy Wall Street Journal).

China Growth – Financial Times. The Financial Times discussed the fact that economic growth has declined from over 10% to around 7% in China, and the implications this slower growth has for the energy sector and world economy. While economic growth in China has slowed on a percentage basis, a 7% gain in absolute terms today is much larger than a 10% gain a decade ago due to the compounded economic growth seen over the last 30 years. So while it might sound that the demand for commodities will be decreasing with slower growth, the fact is the world will consume record levels of crude oil this year.

China Oil Demand - Staniford Study. Stuart Staniford prepared an interesting study of China’s historic and projected oil consumption. His first chart, at left, indicates that China’s crude oil consumption has been rising by about 7% per year for the last decade (blue line, scale on left of chart).

This consistent demand growth has been in the face of sharply higher prices for the commodity in the last decade (brown line, scale on right of chart). China’s energy use and economic growth have correlated closely, but demand growth has not been particularly price sensitive.

Staniford’s second chart reflects what the consistent growth in crude oil demand from China looks like over the last four decades. The data runs from 1965 to 2011 (2012 data was not available when the chart was prepared). Data was from the Energy Information Administration (EIA) as well as British Petroleum (BP).

Last, should future demand for oil in China continue to grow at 7% per year the demand curve would look similar to the one at left. The majority of the global demand growth for oil is originating in China, and in the future this incremental demand will only become larger.

If China’s historical consumption growth continues, and if demand remains relatively price insensitive, the growth in demand for oil will be ‘relentless’ according to Staniford. A similar analysis, with similar conclusions, was published last month by the Organization for Economic Cooperation and Development (OECD).

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SMU School of Law Professor
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