Introduction

In last week’s issue of The Energy Letter, I discussed my January prediction that the average natural gas price in the US would be higher this year than last year. While that prediction is looking pretty safe because of the extremely cold winter, I also predicted that “Brent and West Texas Intermediate (WTI) crude prices will average less in 2014 than in 2013.” Let’s see how that one is faring.

I also predicted lower oil prices for 2013, and ended up being only partially right. In 2013 the average price of Brent crude was 2.8 percent lower than in 2012 with an average of $108.56/barrel (bbl). West Texas Intermediate (WTI) was up 4 percent in 2013 to an average daily price of $97.98/bbl. So in 2013 I was right on the direction of Brent, and wrong on the direction of WTI. (I also predicted that the differential between the two would decline, which it did).

As I write this, the price of WTI has so far averaged $97.75 this year (only three cents lower than last year’s average), while the price of Brent has averaged $108.55 (a penny below last year’s average). At this point this year’s average is nearly identical to last year’s average. But with WTI presently trading at $102.55 and Brent at $109 it won’t take long for average prices to rise above my prediction.

The Argument for Lower Prices

Given the rapid expansion of oil production in the US, it is certainly possible that local supplies could temporarily outstrip demand in the short term, or that temporary logistical constraints could develop. Either of these factors would favor lower short-term WTI pricing. In fact, this is reflected somewhat in the price differential between WTI and Brent.

Until 2010 WTI generally traded at a slight premium to Brent, but the rapid rise in oil production in the US and the logistical constraints in getting that oil to market have had it trading at a discount since. That discount has at times exceeded $20/bbl, which has been very fortunate for oil refiners.

While there is still a federal ban in place on crude oil exports, refiners can export finished products. These finished products — fuels like gasoline and diesel — are generally priced based on Brent. So refiners can buy crude at WTI prices and sell finished products at Brent prices. A general rule of thumb I use is that when the Brent-WTI spread is over $10/bbl, quarterly results for refiners will be pretty good. If the spread is $20, results will be fantastic.

So even though growing US production is reflected in the WTI discount, the price of oil is still hovering around $100/bbl despite many predictions that prices would soften. In fact, a year ago analysts at Bank of America Merrill Lynch suggested oil could fall to $50/bbl within two years, and Ed Morse at Citi expects crude prices to average $80/bbl through 2020. At the other end of the spectrum Oswald Clint at Sanford Bernstein projects nearly double that price at $158 a barrel in 2020.

Demand Keeps Pace

Why have oil prices remained so stubbornly high, despite huge increases in US oil production? In a nutshell, it’s the demand side of the equation keeping pace with the growing supply. Over the past decade, demand in the US and the EU fell, but this was more than compensated for by growing demand in developing countries. This kept the price of oil high, despite supply/demand fundamentals that in isolated countries would have encouraged lower prices.

But the world’s oil markets aren’t local. And now demand in the US is starting to regain strength, recently rising to the highest level since 2008. The International Energy Agency has estimated that global demand for oil will increase this year by 1.2 million barrels a day. For perspective, over the past five years the world has increased oil production by nearly 3.9 million barrels (2 million of which was from the US) — an average increase each year of 770,000 barrels per year.

So the increase in oil production has been gobbled up by an energy hungry world just as fast as crude could come out of the ground, and that trend is likely to continue long-term. Nevertheless, the easing of sanctions on Iran, the continued growth of oil production in Iraq, and another year of expansion for the US oil industry could combine to oversupply the market in the short term. This may be offset, however, by deteriorating events in Venezuela and Libya.

Conclusions

For now, investors in natural gas companies can be happy that my natural gas prediction is proving to be correct, but investors in oil companies can also be happy that my prediction for lower oil prices hasn’t yet materialized.

In any event, I believe the long-term direction for both commodities is inevitably higher prices, so while I still expect a sideways to slightly negative direction for oil prices over the next couple of years, over the long haul this sector will continue to deliver.

(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)

Portfolio Update

MarkWest’s Expensive Growth   

The good news for Mark West Energy Partners (NYSE: MWE) is that it has a huge growth runway as it builds out the midstream gas processing infrastructure to meet the needs of customers in the Marcellus and the Utica. And that’s also the bad news, as elevated capital spending needs for these growth projects will sap distribution growth, with increases of only a penny per unit per quarter now likely through the end of next year, management confirmed on the recent conference call.

At that point, MarkWest hopes to get back to the double-digit per-unit distribution growth rate it had maintained in the decade since its IPO until quite recently. But that will depend on its big capital investments earning adequate returns, which will in turn require its customers in the Marcellus and the Utica to come through on the expected rapid growth in production.

For many analysts, that was a lot of ifs to get through in the two years before seeing the rewards, and following MarkWest’s results it was downgraded to the equivalent of a Neutral rating by former fans at Wells Fargo, Morgan Stanley, UBS, RBC Capital Markets and Wunderlichs; Jefferies had fired the first shot ahead of the numbers.

But MarkWest is very different from recent MLP disaster stories Boardwalk Pipeline Partners (NYSE: BWP) and El Paso Pipeline Partners (NYSE: EPB) in that its underlying business continues to thrive and grow fast, only the growth in immediate returns has been compromised.

We’re encouraged by the fact that, despite the multitude of downgrades, shares are so far holding their December lows, and by the fact that MarkWest remains in the sweet spot of the growth in Northeast energy production. This is a desirable, strategic region for big national MLPs, and if MarkWest were ever to really fall into the market’s doghouse, it would be an attractive takeover target. For the moment, though, expect the bulk of the returns to come via the 5.4 percent annual yield. Buy MWE below $70.         

— Igor Greenwald

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