The Energy Sector Remains Attractive
by Joseph Dancy, LSGI Advisors, Inc.
Portfolio Manager, LSGI Fund
Adjunct Professor, SMU School of Law
November 10th, 2005
The hurricane season of 2005 has been the most prolific ever. Wilma's formation last month, followed by Alpha and Beta, gave us 23 named storms. The previous record - 21 storms - was set in 1933. According to hurricane expert Dr. Jeff Masters “We’re living history this year. . . . This is a once in a lifetime hurricane season.”
Dr. Masters describes the ferocity of the recent storms: “There has never been a hurricane like Wilma before. With an unbelievable round of intensification . . . Wilma smashed the all-time record for lowest pressure in an Atlantic hurricane. . . This is an incredibly compact, amazingly intense hurricane, the likes of which has never been seen. The Hurricane Season of 2005 keeps topping itself with new firsts, and now boasts three of the five most intense hurricanes of all time--Katrina, Rita, and Wilma.” (emphasis supplied)
Since around 20% of our natural gas supplies and 25% of U.S. crude oil production originate from fields in the Gulf of Mexico, the increased storm activity has had a major impact on the U.S. energy sector. The Minerals Management Service reports that 67% of crude oil production and 54% of the natural gas production in the Gulf of Mexico remains shut-in – over sixty days after the first hurricane made landfall! In addition, over 5% of U.S. refinery capacity remains off-line. Numerous natural gas processing plants and pipelines remain shut down or are operating at a reduced rate, as well as onshore oil and natural gas wells.
The Outlook for the Energy Sector
While we expect the energy markets to be volatile, we remain bullish on the energy sector for the following reasons:
- The first week of November traditionally marks the start of the heating season for the natural gas markets. At the end of the summer injection season natural gas volumes in storage will exceed 3.14 trillion cubic feet (tcf) – around 100 billion cubic feet below last year’s storage levels. Note that it took natural gas prices of $13 per thousand cubic feet (Mcf) this summer for the companies to acquire the necessary gas to fill the storage facilities versus around $7.75 per Mcf in the year ago period.In ‘normal’ years 3.14 tcf in storage would be considered satisfactory to meet expected winter heating demands. Around 80% of winter demand is met by production facilities and around 20% of demand is met from natural gas retrieved from storage facilities. With such a high proportion of the nation’s natural gas production remaining off line there is a high probability that larger than normal draws from storage will be required to meet winter demand. If we have a cold winter draws on storage will be much higher than we have seen in recent years. If this thesis proves correct expect natural gas prices to remain elevated, and possibly spike, this winter.
- This week natural gas futures traded for $13 per Mcf. Last year at this time natural gas sold for $7.75 per Mcf. The U.S. Department of Energy predicted the average heating bill this winter in the U.S. will increase 47% over last year’s level. The market clearing prices needed to allocate natural gas production remain elevated. Higher prices will result in higher cash flow and earnings for any companies in the natural gas extraction and marketing sectors.
- Long term forecasters at Accuweather predict a colder than normal winter in the Northeastern U.S. – which should provide healthy demand for both heating oil and natural gas. AccuWeather found a high historical correlation between active hurricane seasons and cold ensuing winters in the Northeast. Weather patterns existing in the "hyper-hurricane" seasons of 1933, 1969 and 1995 resulted in abnormally cold winters in the Northeast.Accuweather’s forecast calls for Northeastern U.S. temperatures to be as much as 3.5 degrees colder than normal – significantly below normal in a high population area.
- China’s economy grew by 9.4% in the third quarter – an incredible pace compared to most other economies. The Chinese economy is not as energy efficient as more developed countries, and the continued economic growth of this area of the world will require additional amounts of imported of crude oil. This incremental increase in demand, in addition to the supply issues faced by the U.S. and some of the other major energy producers, should keep upward pressure on global energy prices.
- Higher energy prices have increased drilling and production related activity. Demand for rigs, material, and equipment remain elevated. The total drilling rig count in the U.S. has increased to 1,474 versus 1,250 in the year ago period. Canadian rig counts have increased to 567 from 356 in the year ago period. (Source: Baker Hughes)
- The International Energy Agency’s latest report forecast that global oil demand was projected to increase by 1.75 million barrels per day in 2006 due to increased demand from China and continued global economic growth. This represents an increase in demand of approximately 2%. Supply is expected to increase by a smaller amount.
- Political issues continue to smolder in Iran, Iraq, and Venezuela – all major crude oil exporting countries. The Venezuelan government continues to press their claim that foreign oil companies owe that country millions in underpaid or unpaid taxes.
- The Louisiana Department of Natural Resources reports that 65% of onshore crude oil production (or 135,000 barrels per day) and 60% of onshore natural gas production (or 1.3 billion cubic feet per day) remain shut in from the hurricanes. No timetable has been advanced as to when this production will be restored. This shut in production is in addition to the offshore shut in Gulf of Mexico production reported by the Mineral Management Service (MMS data is presented in the chart above).
While we generally attempt to assemble a well diversified portfolio to reduce sector and company specific risks, we find the above factors are compelling in shifting the risk/reward relationship in our favor. We think the long term bullish trends in the supply and demand equation remain in place. As such, we will continue to over-weight the energy sector in our portfolio.
Contact Information
Joseph Dancy, Adjunct Professor
Oil & Gas Law, SMU School of Law
Advisor, LSGI Market Letter
Email l Website
