Not So Easy
Back in 1965, Saudi Arabia produced less than 2.3 million barrels of crude oil per day, roughly a quarter of what the US was supplying at the time. In fact, 40 years ago, the Desert Kingdom was far from the key supplier it is today–the country’s production accounted for less than 7 percent of the global total.
But what a difference a decade can make. By 1975, the Saudis were already pumping more than 7 million barrels per day and in 1980 the Kingdom’s prolific fields were flowing more than 10 million barrels per day. Its market share jumped to over 16 percent of the world total, surpassing the US in production terms by 1980. In short: the Saudis were the supplier of last resort for much of the 1970s, particularly after US production peaked in 1971-72.
Source: BP
Once again, the world is seeing rapid energy demand growth. But this time around, it won’t be easy for the Saudis to grow or maintain their production levels, let alone to achieve the sort of dramatic production growth seen in the early ‘70s. The great Saudi fields are aging and the Kingdom can’t supply its current 10 million to 11 million barrels per day from a handful of low-tech wells; Saudi Aramco is already using advanced production technology on its fields. Adding additional production capacity in Saudi Arabia will require much larger monetary investments this time around.
These technical difficulties are a headache for Saudi Aramco, the national oil company. But Aramco’s problems are music to the ears of the oil services business. A handful of global services players, including Wildcatters Portfolio holding Weatherford and services giant Schlumberger are seeing huge growth from their operations in the Middle East. And while contract driller Rowan’s main base of operations is thousands of miles away from the Middle East in the heart of the Gulf of Mexico, it too is benefiting in a big way from Saudi Arabia’s spending largesse.
Increasing or simply maintaining oil production outside the Middle East is no easier or technically less challenging. Earth’s land and shallow-water reserves have been fully explored. These reserves remain an absolutely crucial piece of the global oil production puzzle. But some of the largest projects being developed today are located in deeper waters, and production companies are scrambling to secure deepwater rigs to undertake exploration and development projects slated for the next two years.
Based on rising demand for its services, I’m adding deepwater contract drilling specialist Transocean to the Wildcatters Portfolio.
Deepwater fields are technologically complex and require a very unique set of infrastructure investments. The subsea equipment providers sell specialized equipment that’s installed directly on the sea floor. The best play on that business is Cooper Cameron, a stock that recently reported tremendous growth in its backlog of subsea orders. I’m also adding Cooper to Wildcatters.
Supplying coal to the US utilities this winter is presenting its own set of technical challenges. As I’ve noted on several occasions, mining giant Peabody Energy has indicated that several of its utility customers simply don’t have enough coal on hand; a handful have less than five days’ supply of coal in their coal yards. The railroads, already full and running at full capacity, are having trouble transporting coal to customers.
Another more speculative piece of the coal transport puzzle, American Commercial Lines, is a barge operator that transports this key fuel via the nation’s canals and intra-coastal waterways.
To summarize, I’m adding or reiterating my buy recommendations on the following stocks:
· Weatherford International (NYSE: WFT)
· Schlumberger (NYSE: SLB)
· Cooper Cameron (NYSE: CAM)
· Transocean (NYSE: RIG)
· American Commercial Lines (NSDQ: ACLI)
· Rowan Companies (NYSE: RDC)
I’m also placing a sell recommendation on Devon Energy and cutting Wildcatter BG Group to a hold.
Finally, Associate Editor Yiannis Mostrous will take a look at some of the short-term pricing risks in the natural gas market. He’ll examine what companies are more vulnerable to any pullback in natural gas pricing.
The Saudi Miracle
Saudi Arabia was able to rapidly ramp up oil production in the 1970s to meet global demand (see chart above). This was particularly important given that US production peaked in 1971-72 and then began a gradual downtrend. The Saudis picked up the slack.
The fact that Saudi Arabia was able to increase its production by a factor of nearly five in only 15 years is amazing; such rapid and sustained production growth has not been repeated elsewhere. But what’s even more amazing is that it was comparatively easy to do. Giant oilfields, by far the most prolific ever discovered anywhere in the world, flowed easily in those early years and could be produced using relatively unsophisticated techniques. The country didn’t need a huge number of wells or more advanced horizontal drilling techniques and “intelligent” wells to produce its fields.
The same basic production pattern is evident in all sorts of oilfields all over the world. See “The Alaska Experience” below, a chart of Alaskan crude production below.
Source: Energy Information Administration
The big find in Alaska was the Prudhoe Bay field, discovered in the late ‘70s. Production ramped up quickly through the early ‘80s and then plateaued. Prudhoe Bay actually stayed at near-peak production for an unusually long period of time and didn’t peak until the late ‘80s because the operators were careful not to overproduce the field. By deliberately producing a field at less than full capacity, it’s possible to sustain high levels of production for longer periods of time. Overproducing a field can actually damage the reservoir and lower the amount of oil ultimately recovered.
While operators have used increasingly high-tech methods to produce Prudhoe Bay, it has seen declining production since that late-‘80s peak. The point is it’s easier to grow or maintain production on the left side of this bell-curve than on the right side.
Fast forward another 25 years to the present day and Saudi Arabia is once again the focus of the global oil market. It produces roughly 13 percent of global oil consumption and, more importantly, is the only nation with at least a plausible claim of spare capacity, and has infrastructure in place to quickly increase production of oil to meet global needs or offset supply shocks elsewhere in the world.
It’s no secret that oil demand is booming. By 2025, the Energy Information Administration (EIA) projects global oil demand of more than 120 million barrels per day, up from approximately 80 to 85 million today. That’s a 50 percent jump in demand.
In this era of booming global demand, the importance of Saudi production can’t be overstated. The world is already depending on another turbocharged spurt of production growth from Saudi Arabia to meet future needs (see the chart below).
Source: Energy Information Administration
This reliance on Saudi Arabian supply is obvious from the EIA’s 2005 Annual Energy Outlook survey. The EIA is projecting only slight oil production growth from the industrialized world. Meanwhile, the developing world–including Russia and the former Soviet republics–is projected to kick in slightly higher growth.
But the real growth in production is projected to come from the Middle East. In fact, the EIA is projecting a near doubling in annual oil production from this region, a large chunk of that coming from the Saudis.
The Saudis have publicly supported this outlook. They’ve repeatedly insisted they’ll be able to increase their production capacity over the next few years to meet all that new demand. And historically the Saudis have lived up to this role, ramping up supply whenever necessary.
But several cracks have recently appeared in the Saudi miracle. Rising demand from the developing world has meant that Saudi Arabia’s spare capacity is shrinking. Annual production stood at 9 million barrels per day in 1999 and grew to more than 10.5 million barrels last year. Spare capacity is simply mothballed wells (wells not flowing at full capacity). As oil demand grows, the Desert Kingdom has been ramping up production and that spare capacity has been shrinking.
By most estimates, the Saudis’ current production capacity is 11 million barrels per day. If they’re producing approximately 10.5 million, that means they have just 0.5 million in share capacity against closer to 2.5 million to 3 million just six years ago. With global oil demand at more than 80 million barrels per day, Saudi spare capacity now sits at less than 1 percent of daily demand–tight by any measure.
This is why any disruption in the global oil supply can lead to huge jumps in the price of crude. When spare capacity is large, and there’s a sudden drop in production somewhere in the world, the capacity cushions that supply shock. But when Hurricane Katrina hit and oil prices spiked, Saudi Arabia all but admitted it couldn’t make up for all the lost production.
Saudi Arabia’s entire oil industry is veiled in secrecy, and there are plenty of signs its oil reserve and production potential have been massively overstated. There’s plenty of evidence the Saudis are already experiencing high water cuts–they’re producing increasingly large amounts of salt water mixed with their crude oil. Rising water cuts are typical of more mature fields and make it more expensive to produce oil. This is also partly due to the country’s long-standing aggressive water flooding–injecting water into its oil fields to push oil towards the wells. (I’ve outlined the history of Saudi Arabian reserves and some of their current production woes in The Energy Letter, July 8, 2005, A Question Of Reserves.)
But even if we hold to the optimistic belief the Saudis can increase their production capacity, it’s abundantly clear this will require massive investments. It’s easier to increase production from relatively young fields than it is to ramp up production from more mature reservoirs. And Saudi Aramco has described some of its largest fields as mature on multiple occasions.
Bottom line: If it is possible for the Saudis to grow their production and capacity, the task will be neither easy nor cheap.
The Saudis are looking to boost their capacity from 11 million to 12.5 million barrels per day over the next few years. This would at least slightly widen that spare capacity cushion. To that end they’re already ramping up their drilling activity in a big way; the Saudi rig count now stands at a 25 year high (see chart “The Saudis Are Drilling”).
Source: Baker Hughes
The rapid rise of active drilling rigs since the late ‘90s is proof-positive that Saudi Arabia is working to enhance its production capacity. Eventually, the Saudis are expected to boost their total fleet of operating rigs to around 70 or 80 from the current 40. This would represent a more than tripling of the rig count since the mid-‘90s.
The real winners of this increased activity and expensive investments are the oil services stocks, more particularly the big, internationally levered names.
The obvious player in this space is Schlumberger, a well-established player in Saudi Arabia and across the Middle East. It specializes in technically complex services–exactly the sort of technology that Saudi Arabia is using to try to increase capacity. Schlumberger’s a leader in most of the fields in which it operates. More rigs drilling in Saudi Arabia means more business for Schlumberger (see TES, November 9, 2005, ‘Tis The Season, for more on Schlumberger.)
Schlumberger (NYSE: SLB) remains a buy in How They Rate and I’ll look to add it to the Wildcatters Portfolio on any weakness.
I also outlined the case for Weatherford in the November 9, 2005, TES. This company already has a major sales operation in place in the Middle East, and it just made a major acquisition that added to its competencies in key services that Saudi Arabia will demand. Weatherford should be able to ramp up its business in the Middle East rapidly over the next few years.
Weatherford (NYSE: WFT) remains a buy in the Wildcatters Portfolio.
The other major positive for these internationally levered services names is that they’re relatively insulated from commodity pricing. It would be irresponsible for me to say that the services stocks don’t tend to fall when oil falls. However, international drilling and development projects tend to have long lead times and be planned some time in advance. They’re unlikely to be canceled just because oil drops to $50 per barrel. This is particularly true for the Saudis–the Kingdom has made a firm commitment to increase its capacity.
From Gulf To Gulf
Saudi Arabia also has some important fields located in the Persian Gulf. These fields are not in particularly deep water and thus don’t require deepwater rigs. Instead, the Kingdom can use what are known as jack-up rigs. These rigs have legs that rest directly on the bottom; they’re used for drilling in waters up to a few hundred feet deep.
Recall that drilling rigs are not owned directly by the major production companies; this is, instead, the province of the contract drillers. These companies own the rigs and rent them out to the producers at a daily rental fee known as a day-rate.
Historically, the contract drillers have moved rigs around the world in search of the best rates. Often in the past some markets would be supply-constrained, offering high day-rates while others would be in a glut. But this cycle is different: Jack-up rigs are in high demand globally. Strong demand in the Persian Gulf can actually have a major effect on demand in the Gulf of Mexico.
Rowan Companies operates a fleet of mainly jack-up rigs in the Gulf of Mexico. Last summer, however, Rowan announced it was planning to move five jack-ups to Saudi Arabia to be put on longer-term contracts at day-rates above what was available in the Gulf at that time.
But demand in the Gulf was already tight and day-rates had already been rising for even the least advanced jack-ups. Rowan’s announcement spelled a reduction in supply for a market that was already short of rigs. Day-rates immediately began rising again.
To make matters worse, hurricanes Katrina and Rita destroyed or severely damaged a number of rigs in the region. Rowan was the hardest hit driller in the Gulf, losing a total of four rigs, including two of the five rigs slated for Saudi Arabia.
The hurricane damage and expectations of more rigs leaving the Gulf have led to an explosion in jack-up day-rates. Rates are running well over $100,000 per day for some types of jack-up, more than three times the rates paid just a few years ago. The reason is simple: Operators in the Gulf are desperate not to delay their projects and are willing to pay up for rig availability. Even better, they are competing against not just other operators in the Gulf of Mexico but also with the likes of Saudi Aramco.
Even more interesting is the emergence of term contracts in the Gulf. Rigs can be contracted out for relatively short periods of time, perhaps to drill a single well, just one to three months. This is normally done at or near the spot rate, the prevailing market rate. Alternatively, a producer can choose to tie up rigs on much longer-term contracts of a year or more–these are term contracts.
Term contracts ensure rig availability for producers–the rig can’t just roll over to another operator at a higher day-rate a month or two after it’s contracted. For the drillers, term contracts can be attractive because they lock in a particular day-rate for a longer period of time. The driller is saved from constant exposure to the volatile spot market.
If supply of rigs is relatively high, producers may be able to negotiate a discount to prevailing spot rates. This is because the drillers want to lock in a reasonable rate of return rather than being exposed to the risk of falling day-rates.
But in the capacity-strained Gulf of Mexico, day-rates for term contracts are actually being set at prices near or above the highs for the spot market. And one of Rowan’s competitors in the Gulf, Pride Corporation, recently signed an adjusting term contract of one year’s duration. This contract will be re-priced to the current prevailing spot day-rate every 90 days for the duration of the contract. In other words, this contract gives Pride substantially all of the benefits of the rising day-rate environment and allows the company to ensure the rig is out on contract for at least a year. The initial rate for this rig was at the high end of where current contracts have been priced.
This stinks of desperation. The Gulf market is so tight that there is some real competition for rigs. As Rowan remains one of the largest operators in the Gulf even after the loss of its rigs, it’s uniquely levered to this environment. Even better, Rowan has been underperforming the other Gulf-focused shallow-water drillers (such as Todco)–there’s room for the stock to play catch-up.
The only storm cloud I see on the horizon is that there are several dozen new jack-up rigs being built and scheduled for delivery between now and 2009. This includes roughly 11 scheduled for delivery in 2006.
I believe the market is tight enough to absorb all that supply and more. What’s more, those 11 rigs next year will do little more than replace rigs being retired or those destroyed by the hurricanes this year. If next year’s hurricane season is as bad as this year’s, we could be faced with yet another big loss of supply in 2006. Rowan is an excellent play on global rig demand, and is particularly levered to the red-hot Gulf of Mexico.
Going Deep
Saudi Arabia’s spending boom will power some impressive trends for the oil services names and some of the contract drillers over the next few years. But the Desert Kingdom is most certainly not the only place where increasing production is harder than it used to be.
A perfect example of this is the deepwater. Drilling in deep water presents myriad challenges and is far more technically complex than producing a land or shallow water field. Building a production platform, subsea pipeline system and other deepwater infrastructure takes years of planning and billions in total investments. Nevertheless, some of the largest and most exciting new discoveries are in the deepwater. This is the world’s last big exploration frontier and will be a critical part of meeting demand.
Transocean is the largest deepwater contract driller and owns some of the most advanced drilling rigs in the business capable of drilling in water miles deep. The company’s deepwater rigs fall under two broad types, deepwater semisubmersibles and drillships.
Drillships look like normal ships; some can drill in water of as deep as 10,000 feet. A drillship drilling in deepwater can’t be supported directly on the bottom like a jackup rig. Most are dynamically positioned–held in place using computer-controlled thrusters. Some are also moored using multiple tethers and anchors.
Semisubmersibles (or semis) are equipped with large, pontoon-like chambers that can be pumped full of air, allowing the semi to float and be moved into location (see picture below). Once in location, the chambers are pumped full of water, partially submerging the lower part of the rig. This provides stability, especially in rough seas. Like drillships, semis can be dynamically positioned and anchored via a series of moorings. Note that both semis and drillships are sometimes called floaters–these rigs are not supported on the bottom like jackups and are designed to float into location.
Source: Getty Images
Semisubmersibles’ pontoon-like chambers are pumped full of air for flotation and placement.
I’m not recommending Transocean just because it has the largest fleet of high-specification floaters. The driller has two main advantages over the competition: a large number of uncommitted rigs for 2006 and 2007 and some term drilling contracts at very high day-rates locked in through 2010.
The fact is that many deepwater drillers have already committed their rigs on contracts for 2006 and, to some extent, 2007. Most have secured solid day-rates for these rigs. While there’s nothing necessarily wrong with that, it means that they won’t enjoy all of the benefit of rising day-rates over the next year or so.
Several major producers have already been forced to delay big deepwater projects because there aren’t any available rigs to do the work. And only around eight deepwater rigs are uncommitted for 2006 and 20 or so (out of a fleet of 70) aren’t committed for 2007. Any company looking to do deepwater drilling work over the next few years will have trouble finding rigs. Demand from deepwater rigs is running well above available supply, helping the contract drillers to attract record high day-rates for their rigs.
Keep in mind that deepwater developments are major projects generally pursued by the integrated or large independent firms. Drilling plans in deepwater aren’t likely to be delayed even if there’s a significant drop in oil and natural gas prices over the next two years. That means this tight supply is likely to remain at least somewhat independent of the commodity markets.
The primary consideration among the producers isn’t how much these rigs will cost, but availability for projects. And if you need a rig, Transocean is one of the only players with spare capacity. Transocean has five of next year’s eight uncommitted rigs and roughly 40 percent of its most advanced floaters and 80 percent of its other floaters remain uncommitted for 2007.
Operators are also signaling their desperate need for rigs by attempting to contract with Transocean to reactivate some other deepwater rigs that had been coldstacked–in storage and sitting idle. Three rigs are slated for reactivation in 2006, being brought online at high day-rates.
Management indicated in its recent call that its also been approached about rig newbuilds, highly advanced ultra deepwater rigs that cost upwards of $500 million to build. Operators have offered to sign contracts that would cover Transocean’s cost of reactivating coldstacked rigs and allow for solid profit potential.
In the near term, Transocean has already agreed to upgrade at a cost of $300 million one of its older semis for Royal Dutch Shell. The rig will be upgraded to handle deepwater environments and then put out on a three-year term contract with Shell. According to management, it’s quite likely that two more rigs will also be upgraded in 2006 under similar arrangements. These rigs’ initial contracts should offer more than a 100 percent payback of the cost of upgrading the rigs.
Uncommitted rigs and the ability to bring new deepwater floaters into the market over the next few years give Transocean plenty of leverage to rising day-rates. As older contracts run out and Transocean puts its rigs back out on new contracts, the growth in day-rates will be dramatic. Because rig supply is so tight, the company stands to receive a scarcity premium as the supplier of last resort for deepwater rigs.
Equally impressive, however, has been Transocean’s success in signing long-term contracts at very high day-rates. In an effort to lock in rig availability, some operators have been willing to sign up for contracts lasting out well into 2010 at very high day-rates.
Anadarko has entered into a contract for the deepwater drillship Discoverer Spirit starting in June 2007 and lasting through June 2010 at a day-rate of $475,000. This rig is currently under contract to Chevron through the end of this year at $204,000 and will go on contract with Shell at the end of this year up to June 2007 at a day-rate of $270,000. In other words, Transocean has managed to win a contract starting in 2007 for a day-rate of about twice what it’s currently receiving. The leverage here is obvious.
And because the company has several of these longer-term contracts at high rates, there’s plenty of visibility as to earnings and cash flows over the next few years. These premium day-rates are clearly not a one-off windfall benefit for the drillers.
Transocean (NYSE: RIG) is added to the Wildcatters Portfolio.
My other favorite deepwater play is subsea equipment (see TES, April 13, 2005, Going Deep). In developing deepwater reserves, a lot of the valves, control equipment and separation equipment can be located directly on the seafloor over the well, protected from inclement weather. These subsea wells can then be tied back to a production platform located some distance from the well. I like two players in this pace, Cooper Cameron and FMC Technologies.
I’m adding Cooper Cameron (NYSE: CAM) to the Wildcatters Portfolio and upgrading FMC Technologies (NYSE: FTI) to a buy in How They Rate.
Cooper Cameron actually operates in a number of important businesses, including subsea and surface-based. It makes a variety of valves and gas/oil separation equipment, blowout preventers (BOPs)–used to keep wells from gushing oil and gas uncontrollably–as well as pipes and risers used on drilling rigs. Cameron benefits from the upturn in global drilling activity: All those new wells need Christmas trees, sets of valves and pipes placed on wells after completion, and a variety of valves and fittings to produce. Even better, Cameron makes much of the equipment that’s installed on drilling rigs; as new land-based and offshore rigs are built, Cameron sells more parts. Cameron reported in its third quarter call that its order book was basically full for 2006 and it has already started booking orders for 2007, a sign of strong demand.
In the longer term, subsea is an exciting business. In its third quarter call, Cameron said that it hasn’t been earning the sort of margins it thinks it can from subsea. Management pointed out that subsea systems are far more technologically advanced and are normally purpose-built and designed for a particular project. In the surface business, there is less customization–it’s much more a commodity business. Yet the surface business tends to offer better margins.
But Cameron highlighted a catalyst for change. What’s depressed margins in the past is aggressive bidding on very large subsea contracts. A perfect example cited by the management team was Exxon’s Kizomba C project–the company passed on the project because it has plenty of other opportunities and the return was not sufficient. But historically the industry has tended to chase these large contracts.
Cameron sees more small orders coming through. These would be orders for just a few subsea trees that tend to attract fewer bids. Cameron actually sees these smaller orders as less competitive in terms of pricing. Margins are actually better on the smaller projects.
Additionally, Cameron highlighted the strong showing of subsea during the recent hurricanes. The subsea equipment remained largely unaffected even as surface-based operations were damaged or destroyed. While this hasn’t yet filtered through into higher orders, it’s one factor that could increase interest in subsea completions in the future.
Buy Cooper Cameron (NYSE: CAM).
Coal Barge
I’ve written extensively on the US railroad industry and how it’s benefiting from strong demand for hauling coal, particularly from the Powder River Basin (PRB) in the Western US to utilities along the East Coast. This demand for hauling coal is unlikely to decelerate because coal inventories in many US utilities are dangerously low right now.
It’s quite possible that at least a handful of coal-fired plants ion this country are running so low on coal they’ll be forced to scale back output. (I outlined the evidence of this in The Energy Letter, November 4, 2005, Not Always The Obvious Play). But the railroads aren’t the only method used to transport coal in the US.
Coal can also be transported by water on barges.
The US has an extensive system of rivers and canals that form an inland waterway system. This network is used extensively to haul all sorts of products including coal, grains and even petrochemicals. In fact, domestic water shipping account for nearly 17 percent of total US freight volume, behind railroads (40 percent) and trucking (28 percent). Coal, in turn, is the largest dry bulk cargo shipped on barges, accounting fro roughly a third of total barge tonnage.
American Commercial Lines is the second-largest hauler of dry barge cargos in the US with a near 16 percent overall market share. The company is also the largest publicly traded company of its type in the US.
Coal shipping revenues currently account for only about 11 percent of American Commercials total revenue base. But that’s changing rapidly, and the company appears to be picking up market share in this area.
Particularly interesting is a deal it’s working on with favored railroad Burlington Northern SantaFe (NYSE: BNI), a stock I track in How They Rate, and one I’ve recommended as a trade. Burlington has the most extensive network of rail lines in the Powder River Basin. Burlington would unload some of this coal in St. Louis on to American Commercial’s barges; the coal would then be transported east to Pittsburgh.
In addition, American Commercial gets another big chunk of its revenues from transporting grains. High demand for all sorts of basic foodstuffs from the developing world has made this yet another growth business.
On the supply side, foreign-owned companies are effectively locked out of the barge market by an act of Congress, the Jones Act. This prohibits transport on barges that aren’t US owned, operated and built. And domestically, a number of barges have been retired over the past few years with another chunk due for retirement as a result of updated safety regulations. Manufacturing capacity is limited as the barges can’t be imported–supply growth will likely remain modest.
American Commercial is rather speculative. Due mainly to years of weak demand and an ill-fated, debt-financed international expansion, the company went bankrupt back in 2003, emerging early in 2005. The company still has a large amount of debt and remains a turnaround story; higher hauling rates are helping to accelerate this recovery. American Commercial Lines (NSDQ: ACLI) is an interesting buy only for speculative investors below 31 with a stop-loss at 25. I’ll continue to follow it in How They Rate.
Natural Gas Worries
By Yiannis Mostrous
The Energy Strategist was born of the belief the energy sector is only in the early stages of a many-years’ bull market. We do expect many ups and downs along the way, and during such times investors should make a point of rearranging their holdings.
Current weakness in the natural gas market will develop into a more serious correction: Prices could correct all the way down to $10 per thousand cubic feet, if not lower, based on old-fashioned supply and demand.
Industry analysts have repeatedly pointed out that, unlike residential consumption, industrial consumption usually ebbs when prices increase dramatically. Given that more than 80 percent of natural gas usage in the US is industry-related, prices will obviously adjust downward if industry cuts back its use.
Does this mean the long-term natural gas story is over?
On the contrary: As with oil, gas will correct to a higher level (in other words, a “higher” low) then restart its upward move from there. But as discussed in the October 26 TES, potential weakness in the global economy could force industrial users to cut demand drastically. If this happens the commodity will correct sharply.
If demand is stronger than expected, gas will stay strong. For the time being we prefer to err on the side of caution, and therefore suggest some changes.
Wildcatters Portfolio holding BG Group PLC (NYSE: BRG) is now a hold.
We still like the company, but if the low-demand scenario materializes, BG Group will have problems keeping up its earnings. Do not allocate new capital to it. Hold BG Group.
Devon Energy (NYSE: DVN), tracked in How They Rate, is a sell.
The company is a high-cost producer that has not been able to grow to its potential. Devon is also in the midst of a turnaround that may prove to be more difficult to complete if the natural gas market weakens. Sell Devon.
But what a difference a decade can make. By 1975, the Saudis were already pumping more than 7 million barrels per day and in 1980 the Kingdom’s prolific fields were flowing more than 10 million barrels per day. Its market share jumped to over 16 percent of the world total, surpassing the US in production terms by 1980. In short: the Saudis were the supplier of last resort for much of the 1970s, particularly after US production peaked in 1971-72.
Source: BP
Once again, the world is seeing rapid energy demand growth. But this time around, it won’t be easy for the Saudis to grow or maintain their production levels, let alone to achieve the sort of dramatic production growth seen in the early ‘70s. The great Saudi fields are aging and the Kingdom can’t supply its current 10 million to 11 million barrels per day from a handful of low-tech wells; Saudi Aramco is already using advanced production technology on its fields. Adding additional production capacity in Saudi Arabia will require much larger monetary investments this time around.
These technical difficulties are a headache for Saudi Aramco, the national oil company. But Aramco’s problems are music to the ears of the oil services business. A handful of global services players, including Wildcatters Portfolio holding Weatherford and services giant Schlumberger are seeing huge growth from their operations in the Middle East. And while contract driller Rowan’s main base of operations is thousands of miles away from the Middle East in the heart of the Gulf of Mexico, it too is benefiting in a big way from Saudi Arabia’s spending largesse.
Increasing or simply maintaining oil production outside the Middle East is no easier or technically less challenging. Earth’s land and shallow-water reserves have been fully explored. These reserves remain an absolutely crucial piece of the global oil production puzzle. But some of the largest projects being developed today are located in deeper waters, and production companies are scrambling to secure deepwater rigs to undertake exploration and development projects slated for the next two years.
Based on rising demand for its services, I’m adding deepwater contract drilling specialist Transocean to the Wildcatters Portfolio.
Deepwater fields are technologically complex and require a very unique set of infrastructure investments. The subsea equipment providers sell specialized equipment that’s installed directly on the sea floor. The best play on that business is Cooper Cameron, a stock that recently reported tremendous growth in its backlog of subsea orders. I’m also adding Cooper to Wildcatters.
Supplying coal to the US utilities this winter is presenting its own set of technical challenges. As I’ve noted on several occasions, mining giant Peabody Energy has indicated that several of its utility customers simply don’t have enough coal on hand; a handful have less than five days’ supply of coal in their coal yards. The railroads, already full and running at full capacity, are having trouble transporting coal to customers.
Another more speculative piece of the coal transport puzzle, American Commercial Lines, is a barge operator that transports this key fuel via the nation’s canals and intra-coastal waterways.
To summarize, I’m adding or reiterating my buy recommendations on the following stocks:
· Weatherford International (NYSE: WFT)
· Schlumberger (NYSE: SLB)
· Cooper Cameron (NYSE: CAM)
· Transocean (NYSE: RIG)
· American Commercial Lines (NSDQ: ACLI)
· Rowan Companies (NYSE: RDC)
I’m also placing a sell recommendation on Devon Energy and cutting Wildcatter BG Group to a hold.
Finally, Associate Editor Yiannis Mostrous will take a look at some of the short-term pricing risks in the natural gas market. He’ll examine what companies are more vulnerable to any pullback in natural gas pricing.
The Saudi Miracle
Saudi Arabia was able to rapidly ramp up oil production in the 1970s to meet global demand (see chart above). This was particularly important given that US production peaked in 1971-72 and then began a gradual downtrend. The Saudis picked up the slack.
The fact that Saudi Arabia was able to increase its production by a factor of nearly five in only 15 years is amazing; such rapid and sustained production growth has not been repeated elsewhere. But what’s even more amazing is that it was comparatively easy to do. Giant oilfields, by far the most prolific ever discovered anywhere in the world, flowed easily in those early years and could be produced using relatively unsophisticated techniques. The country didn’t need a huge number of wells or more advanced horizontal drilling techniques and “intelligent” wells to produce its fields.
The same basic production pattern is evident in all sorts of oilfields all over the world. See “The Alaska Experience” below, a chart of Alaskan crude production below.
Source: Energy Information Administration
The big find in Alaska was the Prudhoe Bay field, discovered in the late ‘70s. Production ramped up quickly through the early ‘80s and then plateaued. Prudhoe Bay actually stayed at near-peak production for an unusually long period of time and didn’t peak until the late ‘80s because the operators were careful not to overproduce the field. By deliberately producing a field at less than full capacity, it’s possible to sustain high levels of production for longer periods of time. Overproducing a field can actually damage the reservoir and lower the amount of oil ultimately recovered.
While operators have used increasingly high-tech methods to produce Prudhoe Bay, it has seen declining production since that late-‘80s peak. The point is it’s easier to grow or maintain production on the left side of this bell-curve than on the right side.
Fast forward another 25 years to the present day and Saudi Arabia is once again the focus of the global oil market. It produces roughly 13 percent of global oil consumption and, more importantly, is the only nation with at least a plausible claim of spare capacity, and has infrastructure in place to quickly increase production of oil to meet global needs or offset supply shocks elsewhere in the world.
It’s no secret that oil demand is booming. By 2025, the Energy Information Administration (EIA) projects global oil demand of more than 120 million barrels per day, up from approximately 80 to 85 million today. That’s a 50 percent jump in demand.
In this era of booming global demand, the importance of Saudi production can’t be overstated. The world is already depending on another turbocharged spurt of production growth from Saudi Arabia to meet future needs (see the chart below).
Source: Energy Information Administration
This reliance on Saudi Arabian supply is obvious from the EIA’s 2005 Annual Energy Outlook survey. The EIA is projecting only slight oil production growth from the industrialized world. Meanwhile, the developing world–including Russia and the former Soviet republics–is projected to kick in slightly higher growth.
But the real growth in production is projected to come from the Middle East. In fact, the EIA is projecting a near doubling in annual oil production from this region, a large chunk of that coming from the Saudis.
The Saudis have publicly supported this outlook. They’ve repeatedly insisted they’ll be able to increase their production capacity over the next few years to meet all that new demand. And historically the Saudis have lived up to this role, ramping up supply whenever necessary.
But several cracks have recently appeared in the Saudi miracle. Rising demand from the developing world has meant that Saudi Arabia’s spare capacity is shrinking. Annual production stood at 9 million barrels per day in 1999 and grew to more than 10.5 million barrels last year. Spare capacity is simply mothballed wells (wells not flowing at full capacity). As oil demand grows, the Desert Kingdom has been ramping up production and that spare capacity has been shrinking.
By most estimates, the Saudis’ current production capacity is 11 million barrels per day. If they’re producing approximately 10.5 million, that means they have just 0.5 million in share capacity against closer to 2.5 million to 3 million just six years ago. With global oil demand at more than 80 million barrels per day, Saudi spare capacity now sits at less than 1 percent of daily demand–tight by any measure.
This is why any disruption in the global oil supply can lead to huge jumps in the price of crude. When spare capacity is large, and there’s a sudden drop in production somewhere in the world, the capacity cushions that supply shock. But when Hurricane Katrina hit and oil prices spiked, Saudi Arabia all but admitted it couldn’t make up for all the lost production.
Saudi Arabia’s entire oil industry is veiled in secrecy, and there are plenty of signs its oil reserve and production potential have been massively overstated. There’s plenty of evidence the Saudis are already experiencing high water cuts–they’re producing increasingly large amounts of salt water mixed with their crude oil. Rising water cuts are typical of more mature fields and make it more expensive to produce oil. This is also partly due to the country’s long-standing aggressive water flooding–injecting water into its oil fields to push oil towards the wells. (I’ve outlined the history of Saudi Arabian reserves and some of their current production woes in The Energy Letter, July 8, 2005, A Question Of Reserves.)
But even if we hold to the optimistic belief the Saudis can increase their production capacity, it’s abundantly clear this will require massive investments. It’s easier to increase production from relatively young fields than it is to ramp up production from more mature reservoirs. And Saudi Aramco has described some of its largest fields as mature on multiple occasions.
Bottom line: If it is possible for the Saudis to grow their production and capacity, the task will be neither easy nor cheap.
The Saudis are looking to boost their capacity from 11 million to 12.5 million barrels per day over the next few years. This would at least slightly widen that spare capacity cushion. To that end they’re already ramping up their drilling activity in a big way; the Saudi rig count now stands at a 25 year high (see chart “The Saudis Are Drilling”).
Source: Baker Hughes
The rapid rise of active drilling rigs since the late ‘90s is proof-positive that Saudi Arabia is working to enhance its production capacity. Eventually, the Saudis are expected to boost their total fleet of operating rigs to around 70 or 80 from the current 40. This would represent a more than tripling of the rig count since the mid-‘90s.
The real winners of this increased activity and expensive investments are the oil services stocks, more particularly the big, internationally levered names.
The obvious player in this space is Schlumberger, a well-established player in Saudi Arabia and across the Middle East. It specializes in technically complex services–exactly the sort of technology that Saudi Arabia is using to try to increase capacity. Schlumberger’s a leader in most of the fields in which it operates. More rigs drilling in Saudi Arabia means more business for Schlumberger (see TES, November 9, 2005, ‘Tis The Season, for more on Schlumberger.)
Schlumberger (NYSE: SLB) remains a buy in How They Rate and I’ll look to add it to the Wildcatters Portfolio on any weakness.
I also outlined the case for Weatherford in the November 9, 2005, TES. This company already has a major sales operation in place in the Middle East, and it just made a major acquisition that added to its competencies in key services that Saudi Arabia will demand. Weatherford should be able to ramp up its business in the Middle East rapidly over the next few years.
Weatherford (NYSE: WFT) remains a buy in the Wildcatters Portfolio.
The other major positive for these internationally levered services names is that they’re relatively insulated from commodity pricing. It would be irresponsible for me to say that the services stocks don’t tend to fall when oil falls. However, international drilling and development projects tend to have long lead times and be planned some time in advance. They’re unlikely to be canceled just because oil drops to $50 per barrel. This is particularly true for the Saudis–the Kingdom has made a firm commitment to increase its capacity.
From Gulf To Gulf
Saudi Arabia also has some important fields located in the Persian Gulf. These fields are not in particularly deep water and thus don’t require deepwater rigs. Instead, the Kingdom can use what are known as jack-up rigs. These rigs have legs that rest directly on the bottom; they’re used for drilling in waters up to a few hundred feet deep.
Recall that drilling rigs are not owned directly by the major production companies; this is, instead, the province of the contract drillers. These companies own the rigs and rent them out to the producers at a daily rental fee known as a day-rate.
Historically, the contract drillers have moved rigs around the world in search of the best rates. Often in the past some markets would be supply-constrained, offering high day-rates while others would be in a glut. But this cycle is different: Jack-up rigs are in high demand globally. Strong demand in the Persian Gulf can actually have a major effect on demand in the Gulf of Mexico.
Rowan Companies operates a fleet of mainly jack-up rigs in the Gulf of Mexico. Last summer, however, Rowan announced it was planning to move five jack-ups to Saudi Arabia to be put on longer-term contracts at day-rates above what was available in the Gulf at that time.
But demand in the Gulf was already tight and day-rates had already been rising for even the least advanced jack-ups. Rowan’s announcement spelled a reduction in supply for a market that was already short of rigs. Day-rates immediately began rising again.
To make matters worse, hurricanes Katrina and Rita destroyed or severely damaged a number of rigs in the region. Rowan was the hardest hit driller in the Gulf, losing a total of four rigs, including two of the five rigs slated for Saudi Arabia.
The hurricane damage and expectations of more rigs leaving the Gulf have led to an explosion in jack-up day-rates. Rates are running well over $100,000 per day for some types of jack-up, more than three times the rates paid just a few years ago. The reason is simple: Operators in the Gulf are desperate not to delay their projects and are willing to pay up for rig availability. Even better, they are competing against not just other operators in the Gulf of Mexico but also with the likes of Saudi Aramco.
Even more interesting is the emergence of term contracts in the Gulf. Rigs can be contracted out for relatively short periods of time, perhaps to drill a single well, just one to three months. This is normally done at or near the spot rate, the prevailing market rate. Alternatively, a producer can choose to tie up rigs on much longer-term contracts of a year or more–these are term contracts.
Term contracts ensure rig availability for producers–the rig can’t just roll over to another operator at a higher day-rate a month or two after it’s contracted. For the drillers, term contracts can be attractive because they lock in a particular day-rate for a longer period of time. The driller is saved from constant exposure to the volatile spot market.
If supply of rigs is relatively high, producers may be able to negotiate a discount to prevailing spot rates. This is because the drillers want to lock in a reasonable rate of return rather than being exposed to the risk of falling day-rates.
But in the capacity-strained Gulf of Mexico, day-rates for term contracts are actually being set at prices near or above the highs for the spot market. And one of Rowan’s competitors in the Gulf, Pride Corporation, recently signed an adjusting term contract of one year’s duration. This contract will be re-priced to the current prevailing spot day-rate every 90 days for the duration of the contract. In other words, this contract gives Pride substantially all of the benefits of the rising day-rate environment and allows the company to ensure the rig is out on contract for at least a year. The initial rate for this rig was at the high end of where current contracts have been priced.
This stinks of desperation. The Gulf market is so tight that there is some real competition for rigs. As Rowan remains one of the largest operators in the Gulf even after the loss of its rigs, it’s uniquely levered to this environment. Even better, Rowan has been underperforming the other Gulf-focused shallow-water drillers (such as Todco)–there’s room for the stock to play catch-up.
The only storm cloud I see on the horizon is that there are several dozen new jack-up rigs being built and scheduled for delivery between now and 2009. This includes roughly 11 scheduled for delivery in 2006.
I believe the market is tight enough to absorb all that supply and more. What’s more, those 11 rigs next year will do little more than replace rigs being retired or those destroyed by the hurricanes this year. If next year’s hurricane season is as bad as this year’s, we could be faced with yet another big loss of supply in 2006. Rowan is an excellent play on global rig demand, and is particularly levered to the red-hot Gulf of Mexico.
Going Deep
Saudi Arabia’s spending boom will power some impressive trends for the oil services names and some of the contract drillers over the next few years. But the Desert Kingdom is most certainly not the only place where increasing production is harder than it used to be.
A perfect example of this is the deepwater. Drilling in deep water presents myriad challenges and is far more technically complex than producing a land or shallow water field. Building a production platform, subsea pipeline system and other deepwater infrastructure takes years of planning and billions in total investments. Nevertheless, some of the largest and most exciting new discoveries are in the deepwater. This is the world’s last big exploration frontier and will be a critical part of meeting demand.
Transocean is the largest deepwater contract driller and owns some of the most advanced drilling rigs in the business capable of drilling in water miles deep. The company’s deepwater rigs fall under two broad types, deepwater semisubmersibles and drillships.
Drillships look like normal ships; some can drill in water of as deep as 10,000 feet. A drillship drilling in deepwater can’t be supported directly on the bottom like a jackup rig. Most are dynamically positioned–held in place using computer-controlled thrusters. Some are also moored using multiple tethers and anchors.
Semisubmersibles (or semis) are equipped with large, pontoon-like chambers that can be pumped full of air, allowing the semi to float and be moved into location (see picture below). Once in location, the chambers are pumped full of water, partially submerging the lower part of the rig. This provides stability, especially in rough seas. Like drillships, semis can be dynamically positioned and anchored via a series of moorings. Note that both semis and drillships are sometimes called floaters–these rigs are not supported on the bottom like jackups and are designed to float into location.
Source: Getty Images
Semisubmersibles’ pontoon-like chambers are pumped full of air for flotation and placement.
I’m not recommending Transocean just because it has the largest fleet of high-specification floaters. The driller has two main advantages over the competition: a large number of uncommitted rigs for 2006 and 2007 and some term drilling contracts at very high day-rates locked in through 2010.
The fact is that many deepwater drillers have already committed their rigs on contracts for 2006 and, to some extent, 2007. Most have secured solid day-rates for these rigs. While there’s nothing necessarily wrong with that, it means that they won’t enjoy all of the benefit of rising day-rates over the next year or so.
Several major producers have already been forced to delay big deepwater projects because there aren’t any available rigs to do the work. And only around eight deepwater rigs are uncommitted for 2006 and 20 or so (out of a fleet of 70) aren’t committed for 2007. Any company looking to do deepwater drilling work over the next few years will have trouble finding rigs. Demand from deepwater rigs is running well above available supply, helping the contract drillers to attract record high day-rates for their rigs.
Keep in mind that deepwater developments are major projects generally pursued by the integrated or large independent firms. Drilling plans in deepwater aren’t likely to be delayed even if there’s a significant drop in oil and natural gas prices over the next two years. That means this tight supply is likely to remain at least somewhat independent of the commodity markets.
The primary consideration among the producers isn’t how much these rigs will cost, but availability for projects. And if you need a rig, Transocean is one of the only players with spare capacity. Transocean has five of next year’s eight uncommitted rigs and roughly 40 percent of its most advanced floaters and 80 percent of its other floaters remain uncommitted for 2007.
Operators are also signaling their desperate need for rigs by attempting to contract with Transocean to reactivate some other deepwater rigs that had been coldstacked–in storage and sitting idle. Three rigs are slated for reactivation in 2006, being brought online at high day-rates.
Management indicated in its recent call that its also been approached about rig newbuilds, highly advanced ultra deepwater rigs that cost upwards of $500 million to build. Operators have offered to sign contracts that would cover Transocean’s cost of reactivating coldstacked rigs and allow for solid profit potential.
In the near term, Transocean has already agreed to upgrade at a cost of $300 million one of its older semis for Royal Dutch Shell. The rig will be upgraded to handle deepwater environments and then put out on a three-year term contract with Shell. According to management, it’s quite likely that two more rigs will also be upgraded in 2006 under similar arrangements. These rigs’ initial contracts should offer more than a 100 percent payback of the cost of upgrading the rigs.
Uncommitted rigs and the ability to bring new deepwater floaters into the market over the next few years give Transocean plenty of leverage to rising day-rates. As older contracts run out and Transocean puts its rigs back out on new contracts, the growth in day-rates will be dramatic. Because rig supply is so tight, the company stands to receive a scarcity premium as the supplier of last resort for deepwater rigs.
Equally impressive, however, has been Transocean’s success in signing long-term contracts at very high day-rates. In an effort to lock in rig availability, some operators have been willing to sign up for contracts lasting out well into 2010 at very high day-rates.
Anadarko has entered into a contract for the deepwater drillship Discoverer Spirit starting in June 2007 and lasting through June 2010 at a day-rate of $475,000. This rig is currently under contract to Chevron through the end of this year at $204,000 and will go on contract with Shell at the end of this year up to June 2007 at a day-rate of $270,000. In other words, Transocean has managed to win a contract starting in 2007 for a day-rate of about twice what it’s currently receiving. The leverage here is obvious.
And because the company has several of these longer-term contracts at high rates, there’s plenty of visibility as to earnings and cash flows over the next few years. These premium day-rates are clearly not a one-off windfall benefit for the drillers.
Transocean (NYSE: RIG) is added to the Wildcatters Portfolio.
My other favorite deepwater play is subsea equipment (see TES, April 13, 2005, Going Deep). In developing deepwater reserves, a lot of the valves, control equipment and separation equipment can be located directly on the seafloor over the well, protected from inclement weather. These subsea wells can then be tied back to a production platform located some distance from the well. I like two players in this pace, Cooper Cameron and FMC Technologies.
I’m adding Cooper Cameron (NYSE: CAM) to the Wildcatters Portfolio and upgrading FMC Technologies (NYSE: FTI) to a buy in How They Rate.
Cooper Cameron actually operates in a number of important businesses, including subsea and surface-based. It makes a variety of valves and gas/oil separation equipment, blowout preventers (BOPs)–used to keep wells from gushing oil and gas uncontrollably–as well as pipes and risers used on drilling rigs. Cameron benefits from the upturn in global drilling activity: All those new wells need Christmas trees, sets of valves and pipes placed on wells after completion, and a variety of valves and fittings to produce. Even better, Cameron makes much of the equipment that’s installed on drilling rigs; as new land-based and offshore rigs are built, Cameron sells more parts. Cameron reported in its third quarter call that its order book was basically full for 2006 and it has already started booking orders for 2007, a sign of strong demand.
In the longer term, subsea is an exciting business. In its third quarter call, Cameron said that it hasn’t been earning the sort of margins it thinks it can from subsea. Management pointed out that subsea systems are far more technologically advanced and are normally purpose-built and designed for a particular project. In the surface business, there is less customization–it’s much more a commodity business. Yet the surface business tends to offer better margins.
But Cameron highlighted a catalyst for change. What’s depressed margins in the past is aggressive bidding on very large subsea contracts. A perfect example cited by the management team was Exxon’s Kizomba C project–the company passed on the project because it has plenty of other opportunities and the return was not sufficient. But historically the industry has tended to chase these large contracts.
Cameron sees more small orders coming through. These would be orders for just a few subsea trees that tend to attract fewer bids. Cameron actually sees these smaller orders as less competitive in terms of pricing. Margins are actually better on the smaller projects.
Additionally, Cameron highlighted the strong showing of subsea during the recent hurricanes. The subsea equipment remained largely unaffected even as surface-based operations were damaged or destroyed. While this hasn’t yet filtered through into higher orders, it’s one factor that could increase interest in subsea completions in the future.
Buy Cooper Cameron (NYSE: CAM).
Coal Barge
I’ve written extensively on the US railroad industry and how it’s benefiting from strong demand for hauling coal, particularly from the Powder River Basin (PRB) in the Western US to utilities along the East Coast. This demand for hauling coal is unlikely to decelerate because coal inventories in many US utilities are dangerously low right now.
It’s quite possible that at least a handful of coal-fired plants ion this country are running so low on coal they’ll be forced to scale back output. (I outlined the evidence of this in The Energy Letter, November 4, 2005, Not Always The Obvious Play). But the railroads aren’t the only method used to transport coal in the US.
Coal can also be transported by water on barges.
The US has an extensive system of rivers and canals that form an inland waterway system. This network is used extensively to haul all sorts of products including coal, grains and even petrochemicals. In fact, domestic water shipping account for nearly 17 percent of total US freight volume, behind railroads (40 percent) and trucking (28 percent). Coal, in turn, is the largest dry bulk cargo shipped on barges, accounting fro roughly a third of total barge tonnage.
American Commercial Lines is the second-largest hauler of dry barge cargos in the US with a near 16 percent overall market share. The company is also the largest publicly traded company of its type in the US.
Coal shipping revenues currently account for only about 11 percent of American Commercials total revenue base. But that’s changing rapidly, and the company appears to be picking up market share in this area.
Particularly interesting is a deal it’s working on with favored railroad Burlington Northern SantaFe (NYSE: BNI), a stock I track in How They Rate, and one I’ve recommended as a trade. Burlington has the most extensive network of rail lines in the Powder River Basin. Burlington would unload some of this coal in St. Louis on to American Commercial’s barges; the coal would then be transported east to Pittsburgh.
In addition, American Commercial gets another big chunk of its revenues from transporting grains. High demand for all sorts of basic foodstuffs from the developing world has made this yet another growth business.
On the supply side, foreign-owned companies are effectively locked out of the barge market by an act of Congress, the Jones Act. This prohibits transport on barges that aren’t US owned, operated and built. And domestically, a number of barges have been retired over the past few years with another chunk due for retirement as a result of updated safety regulations. Manufacturing capacity is limited as the barges can’t be imported–supply growth will likely remain modest.
American Commercial is rather speculative. Due mainly to years of weak demand and an ill-fated, debt-financed international expansion, the company went bankrupt back in 2003, emerging early in 2005. The company still has a large amount of debt and remains a turnaround story; higher hauling rates are helping to accelerate this recovery. American Commercial Lines (NSDQ: ACLI) is an interesting buy only for speculative investors below 31 with a stop-loss at 25. I’ll continue to follow it in How They Rate.
Natural Gas Worries
By Yiannis Mostrous
The Energy Strategist was born of the belief the energy sector is only in the early stages of a many-years’ bull market. We do expect many ups and downs along the way, and during such times investors should make a point of rearranging their holdings.
Current weakness in the natural gas market will develop into a more serious correction: Prices could correct all the way down to $10 per thousand cubic feet, if not lower, based on old-fashioned supply and demand.
Industry analysts have repeatedly pointed out that, unlike residential consumption, industrial consumption usually ebbs when prices increase dramatically. Given that more than 80 percent of natural gas usage in the US is industry-related, prices will obviously adjust downward if industry cuts back its use.
Does this mean the long-term natural gas story is over?
On the contrary: As with oil, gas will correct to a higher level (in other words, a “higher” low) then restart its upward move from there. But as discussed in the October 26 TES, potential weakness in the global economy could force industrial users to cut demand drastically. If this happens the commodity will correct sharply.
If demand is stronger than expected, gas will stay strong. For the time being we prefer to err on the side of caution, and therefore suggest some changes.
Wildcatters Portfolio holding BG Group PLC (NYSE: BRG) is now a hold.
We still like the company, but if the low-demand scenario materializes, BG Group will have problems keeping up its earnings. Do not allocate new capital to it. Hold BG Group.
Devon Energy (NYSE: DVN), tracked in How They Rate, is a sell.
The company is a high-cost producer that has not been able to grow to its potential. Devon is also in the midst of a turnaround that may prove to be more difficult to complete if the natural gas market weakens. Sell Devon.
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