Most in the media hailed the House of Representative’s passage of climate change legislation as a major victory for President Barack Obama. Clearly, the president lobbied hard for bill to clear the House before the July 4 holiday; the president is trying to push both health care and climate change legislation through Congress this year. 

But the bill passed by just 7 votes, as a large number of Democrats crossed the aisle to oppose the measure. The road through the Senate looks even tougher, and the bill’s key provisions are likely to be further diluted. Moreover, an analysis of the legislation shows that it is not as damaging to the energy industry as it could have been thanks to several key compromises. In this issue, we’ll take a look at how carbon legislation is likely to affect your energy investments and look at a handful of companies that may actually benefit from carbon cap-and-trade.

In This Issue

Not surprisingly, there’s a great deal of confusion surrounding “The American Clean Energy and Security Act”–part and parcel with any 1,200-page bill. I examine the major elements, from the oft-discussed cap-and-trade program for carbon emissions to the less prominent (but just as important) provisions on renewables and energy efficiency. See HR 2454.

There are winners and losers with any new legislation, both on Capitol Hill and in the markets. Although HR 2454 will cause pain for some in the energy sector, others stand to benefit. I highlight a field bet of my favorites in alternative energy. See HR 2454 Winners and Losers.

I revisit my projections for crude oil, making the case for investing in select oil services firms and highlighting a new trade to hedge against a pullback in oil prices. See Crude Awakening.

Finally, I discuss sundry news items related to portfolio holdings and the energy sector. See Updates.

House Resolution 2454

On the evening of June 26, the US House of Representatives passed HR 2454 “The American Clean Energy and Security Act,” more commonly known as the climate bill, by a narrow 219-to-212 margin. For the Obama administration, the timing could not have been more fortuitous; there had been speculation that the House wouldn’t pass climate legislation until after the Independence Day recess. 

A lengthy delay would have inconvenienced the administration; climate talks will again be at the top of the agenda when the G8 Summit kicks off next week in L’Aquila, Italy. In addition, the existing Kyoto Protocol is due to sunset in 2012, and the Copenhagen Climate Summit scheduled for December is expected to yield a framework for post-Kyoto Protocol carbon emissions reductions targets. With the Copenhagen Summit looming, carbon emissions will be an even more pressing topic in Italy next week, and President Obama undoubtedly does not want to arrive empty-handed with no discernible movement on a US climate bill.

In the European Union for the next week and a half, I’ll be covering the G8 Summit and offering my conclusions and reactions via Twitter, on my publisher’s blog At These Levels, and via flash alerts and updates on The Energy Strategist website if more urgent updates are warranted. I will offer a deeper and more reflective analysis in the July 22 installment of TES.

Though it makes little sense to many observers outside Washington, the administration effectively has until the end of the year to tackle major policy initiatives health care and climate change. Next year is a mid-term election year and, despite a majority in both houses of Congress, it will be far harder to push through controversial legislation, especially if Obama’s approval ratings begin to slip. That means trying to squeeze in a vote on both climate change and health care as quickly as possible this summer. 

Although the speedy House vote was a victory for Obama, the climate bill is by no means a done deal. Obama and the Democratic leadership in the House lobbied hard for the HR 2454 over the last few weeks; given the political capital expended, the bill’s failure would have been a major setback for the administration.

Despite intense opposition, the bill passed by an extremely narrow 219-to-212 margin, with 44 Democrats voting against the bill and 8 Republicans voting in favor. The bill’s passage indicates the President still has significant power to push his agenda in Congress if he lobbies hard enough, but it hardly shows overwhelming Congressional support for cap-and-trade legislation.

The Senate will be an even more hostile venue for the proposed climate bill than the House. Although the President likely will lobby the Senate hard for passage, the bill has little or no chance of passing in its current form; there are simply too many moderate Democrats who will side with Republicans to water down certain provisions. I suspect that the earliest a climate bill would pass into law is September or October of this year, but it’s quite possible that no such law will pass this year. Any bill that does gain approval probably will look substantially different than HR 2454 and involve substantial concessions to the opposition.

Long-time Energy Strategist readers know that I don’t enter the global warming debate in this newsletter. I’m not here to save the world or make judgments about whether global warming is real, caused by humans or extent to which it will affect the global climate.

However, that does not mean we can afford to ignore the issue; the energy industry is, by its very nature, the most heavily impacted by legislation like HR 2454. Such legislation has been and will continue to affect your investments, acting as an upside catalyst for some sub-sectors and a potential headwind for others. To ignore the impact of new greenhouse gas (GHG) regulations and the politics of climate change on our investments would be pure folly–not to mention a waste of potential opportunities.

HR 2454 is a 1,200-page mammoth bill filled with many complex clauses and definitions. What follows is a rundown of some of the main issues, provisions and controversies.

Cap and Trade

The bill amends the US Clean Air Act, establishing a cap-and-trade system designed to reduce US greenhouse gas (GHG) emissions 17 percent by 2020 and 83 percent by 2050. The baseline year for calculating US GHG emissions reductions under the Act would be 2005, when the nation emitted the equivalent of about 7,250 million metric tons of carbon dioxide.  

Under a cap-and-trade system, the government sets absolute caps on the total amount of emissions and then allows emitters to trade allowances amongst themselves; in this case, each emissions credit would be worth 1 metric ton of carbon dioxide equivalent. For example, if one utility emits too much carbon in a given year, it could buy emissions credits from a firm that emits less than allowed. This effectively puts a price on carbon emissions, encouraging firms that emit too much carbon to cut back and directly rewarding those companies that emit less than allowed. The basic mechanism is similar to the existing cap-and-trade system for sulfur dioxide emissions that cause acid rain.

There are also provisions that allow companies to save some of their credits for use in later years, effectively spreading the cost of reductions out over time. And, companies can borrow credits from the following year, effectively making the entire system a two-year rolling compliance window.

There are a couple of additional complexities worth noting. First, the government isn’t setting direct caps on individual consumers; rather the caps would only pertain to companies emitting more than 25,000 tons of carbon or more per year. Such firms, accounting for about 85 percent of US emissions, are known as covered entities. The headline reduction figures of 17 percent by 2020 and 83 percent by 2050 pertain to emissions from covered entities, not to the economy as a whole. These firms would include upstream producers like energy companies, refiners and gas producers as well as downstream emitters like power companies (utilities), industrial plants and local gas distribution firms. In total, the Congressional Budget Office estimates that around 7,400 entities that would be subject to direct caps under this system. The Environmental Protection Agency (EPA) has projected that dropping the minimum definition of a covered entity from 25,000 to 10,000 tons per year would result in another 7,000 covered entities but would bring only 0.6 percent of additional US GHG emissions under the program–in other words, the legislation targets primarily the largest emitters.

But the bill doesn’t restrict carbon emissions trading to covered entities: Banks and other financial institutions can buy and sell credits to and from covered entities or other banks. Some object to allowing banks and other non-industry players into the carbon trading game, but this is a facet of most cap-and-trade systems globally and tends to increase liquidity. The bill does establish some guidelines for the Commodity Futures Trading Commission (CFTC) to regulate trading in carbon emissions and futures based on the credits.

It’s a lot easier to control emissions from 7,000 entities, but individual households also will be affected indirectly; caps on carbon emissions will raise the price of energy for consumers. The amount of this increase is open to debate, but most groups–liberal and conservative–agree that energy prices will go up.

Allocate vs. Auction

Another key area of debate has been how the government would distribute carbon emission credits to covered entities. At the risk of overgeneralization, it’s fair to say that more liberal elements and environmental groups typically favor the auction of credits. Under such a system the government would establish the total amount of allowances available and then auction them off to the highest bidder, decreasing the supply of credits each year in line with emissions reduction goals. This method likely would result in higher prices for emissions immediately and would directly raise revenues (a sort of tax) for the federal government. Some proponents of auctions also propose easing the impact of higher electricity prices by transferring revenues generated under the system to consumers. This could be accomplished via a number of mechanisms–for instance, direct rebates to low-income households.

A second method for distributing allowances is through allocations. Under such a system some or all of the credits are given away to certain companies which can then sell those credits to other covered entities or to non-covered entities (like banks) for trading. This approach would still put an effective price on carbon, as the credits would be worth something on the secondary market; however, the ramp up in carbon prices would likely be smaller and more gradual. Industry groups and conservative policymakers typically favor this system.

During the presidential campaign and early in his term, Obama repeatedly favored a 100 percent auction system; the White House has backpedaled a bit on this issue once it became clear that such a solution would be a tough sell in the legislature. 

In the end, HR 2454 settles the debate with a sort of compromise. At first, most emissions credits will be distributed for free to certain covered and non-covered entities.

Although it might seem odd to give away credits to companies that aren’t subject to emissions caps, the credits still have value; by allocating credits to companies, the system essentially subsidizes their activity. For example, credits could be assigned to energy research and development projects as a means of funding those deals or to auto manufacturer to encourage the production of fuel-efficient vehicles.

Gradually, the system shifts towards a 100-percent auction system. In 2016, for example, only 17.5 percent of total allowances will be auctioned, but that percentage jumps to 71.7 percent in 2030 and to 100 percent by 2033. The decision to include a front-end loaded allocation system reflects efforts to dampen the higher energy prices that would surely result if a 100-percent auction system were implemented immediately.

Here’s a chart showing how credits will be allocated in 2016.


Source: Congressional Research Service

As you can see, most of the allocations go to local distribution companies (LDCs), utilities that sell electricity and natural gas to consumers at regulated rates. In turn, these companies must apply much of the value associated with these credits to programs designed to lessen the impact of higher energy prices on consumers. This could be accomplished through direct rebates, funding energy efficiency programs or providing support to low-income users. Much of the value the Federal government receives will also accrue to consumers, at least in the early years of the plan; of the credits slated for auction in 2016, 15 percent (86 percent of the value of auctioned credits) would be re-directed back to low-income consumers.

Offsets

HR 2454 also includes a mechanism for carbon offsets, a feature of most existing carbon trading schemes around the world; if you’ve recently booked a trip with a European air carrier, you may notice that many offer you the opportunity to voluntarily offset your carbon emissions for a fee. This program enables companies to offset some of their emissions by funding projects designed to reduce global GHG emissions. For example, if a company were to plant trees in Brazil to counteract deforestation–trees take in carbon dioxide as part of photosynthesis–such a project might be used to offset emissions from a coal-fired power plant in Ohio or New York.

There are provisions in the bill that outline exactly how many offsets a covered entity can use to meet its targets. After 2017, domestic emissions credits and international offsets will no longer be equivalent on a 1-for-1 basis; it will take 5 metric tons of offsets to equal 4 metric tons worth of emissions credits. Depending on how widely the offset system is used, some groups estimate that it could reduce the cost of emissions credits by as much as 50 percent compared to a system that doesn’t allow international offsets.

Trade and Leakage

This particular element of the bill is highly controversial, though it has been significantly watered down. Carbon leakage refers to the risk that if the US establishes a carbon cap and trade system, companies will shift production abroad to regions where there is no such system or the terms are more favorable. Goods imported into the US from regions without cap and trade systems have a competitive advantage over US-produced goods, which would suffer from higher production costs.

The proposal included in HR 2454 is to create a de facto tariff on imported goods from countries deemed to have “insufficient” cap-and-trade policies. Those importing energy-intensive goods from such countries would also have to purchase “international reserve allowances” based on the amount of carbon produced before those goods would be allowed into the US.

There are numerous problems with such a clause. The two biggest are that it would be likely to spark a trade war with countries like China and is probably illegal under international trade rules. HR 2454, however, states that this provision can’t go into effect until after 2025 and is contingent upon the then president’s approval. 

Renewable Energy and Efficiency Standards

Many investors believe that HR 2454 is a bill solely designed to reduce carbon emissions gradually via a cap-and-trade system. But there is another significant aspect of the bill that gets little or no press attention: A renewable energy standard (RES). I find the lack of attention on RES surprising; in some respects, it poses even bigger challenges for energy firms than carbon cap-and-trade.

The bill states that retail electricity suppliers must meet at least 20 percent of electricity demand via renewable energy sources such as wind, solar, waste-to-energy and geothermal power. The exact schedule of targets laid out under HR 2454 is summarized in the following chart.


Source: Congressional Research Service

The requirement for RES ramps up quickly starting in 2012. The bill not only effectively requires companies to reduce their GHG emissions but also mandates how they’re to accomplish that task.

Just as important as the RES is the debate over what constitutes “renewable” energy. According to standard definitions used by the Energy Information Administration (EIA) and other governmental and non-governmental groups, renewable energy would include wind, solar and other alternatives as well as hydropower. But if the purpose of RES is to reduce carbon-emissions, some have suggested that any RES should be expanded to include nuclear power.

HR 2454, however, adopts a fairly specific definition of renewable energy. The list includes solar, wind, geothermal and other lesser-known alternatives such as wave and tidal generation.  In addition, HR 2454 classifies some hydropower sources as renewable energy, but the qualifications are stringent: There can be no water elevation changes at existing dams. There’s speculation that this requirement will ultimately be relaxed in the final version of the bill, allowing far more hydropower plants to qualify under the RES system.

Under the terms of the bill, generators must submit enough renewable energy credits (REC) each year to meet their RES targets. Companies receive RECs based on the amount of renewable energy they generate–there’s no auction or allocation. RECs function in a way that resembles carbon emissions credits; each REC represents 1 megawatt-hour of renewable generation in much the same way as 1 emissions target equals the emission of 1 metric ton of carbon dioxide. Also, like emissions credits, RECs can be traded and banked; companies that generate higher percentages of RECs than required can sell excess RECs to other firms. Companies can also save RECs as needed to meet future requirements.

It’s also worth noting that the bill would allow companies to meet up to 20 percent of the RES by promoting energy efficiency rather than generating alterative energy. Examples of efficiency initiatives include the use of combined heat and power plants, dual-purpose facilities that generate heat for industrial uses and electricity. Efficiency credits are also available for the use of solar water heaters or the installation of smart meters and other so-called “Smart Grid” technologies. Rather than overhauling the traditional electric grid, Smart Grid technologies make it easier to monitor and manage the flow and use of power through the existing system. In addition, the governors of individual states would be able to request that the allowance for efficiency credits increase from 20 to 40 percent.

In summary, the RES in HR 2454 offers companies a number of different ways to meet these requirements, including more renewable generation, the purchase of REC credits, or energy efficiency investments. As written, the RES would not define nuclear power as a renewable energy and would exclude most hydropower stations; I would not be surprised to see a Senate version add more incentives for nuclear power or widen the definition of qualified hydropower.

Back to In This Issue

HR 2454 Winners and Losers

HR 2454 has received a decidedly mixed reception from the industry. Several of the major utility companies, including Duke Energy (NYSE: DUK) and Exelon (NYSE: EXC), have broadly endorsed the legislation. Although the bill certainly isn’t a positive for their business and will raise costs, I suspect the utilities that have supported HR 2454 recognize that a climate bill of some sort was inevitable. These firms chose to get involved in crafting the legislation rather than opposing it outright; the auctioning of credits, rolling compliance window, international offsets and the large efficiency component of the RES are all elements of the bill that are relatively friendly to electric utilities.

Two of the more obscure provisions reveal the electric power industry’s handwriting in the bill. First, the bill essentially leaves loan guarantees for the nuclear power industry in place. Although power companies undoubtedly would have preferred to see nuclear included in the RES, HR 2454 isn’t as clearly anti-nuclear as might have been expected. Second, the bill also contains language mandating that the government take steps to clear regulatory hurdles for carbon capture and sequestration (CCS) technologies. By capturing carbon dioxide emitted from power plants and storing that gas permanently underground, CCS represents a way to make coal plants more economic in a world where carbon dioxide emissions are regulated.

Other groups such as the American Petroleum Institute (API) oppose the bill, arguing that the allocations of allowances is inequitable and that it will raise gasoline and electricity prices for consumers. As you can see from the pie chart above, refiners receive a small allocation of free credits but it’s tiny relative to the amount earmarked for electricity LDCs. Also bear in mind that there are no free credits for oil or natural gas producers (the companies represented by API). It’s unclear exactly how high energy prices will rise, but there’s no such thing as a free lunch; consumers will ultimately pay more for energy in a carbon-regulated world.

Broadly speaking, it’s fair to say that the bill is not as negative for the energy industry as a whole. And, I expect that the bill will undergo further industry-friendly revisions if it’s to pass the Senate. Perhaps even more important, in typical Washington fashion, the politicians have more or less kicked the proverbial can down the road; as written, the bill wouldn’t go into effect until 2012, and the reductions mandated are relatively small in the first few years after the cap-and-trade system goes into effect.

Back in April I attended the Energy Information Administration’s (EIA) conference in Washington, DC. One of the speakers was Mike Rowe, CEO of Exelon. One of the key points he made is that reducing emissions is relatively inexpensive up to a point–there is a good deal of low-hanging fruit to be picked. Exelon put together a chart that estimated the costs of various carbon abatement methods. According to that presentation, Exelon believes that some energy efficiency initiatives and upgrades to existing plants actually have a negative cost, meaning that such measures save more money than they cost to put in place. According to the company’s internal estimates, carbon savings up to around 5 or 6 million metric tons would essentially be free.

But there is a point where companies have to spend money to cut emissions. For example, additional nuclear generation capacity would cost about $45 per metric ton of carbon dioxide saved. Alternative energy solutions incur even higher costs; for example, solar photovoltaics (PV) cost more than $700 per ton of carbon without subsidies and more than $250 under the current subsidy regime. To put these numbers into context, every $10 spent on saving 1 ton of carbon emissions raises electricity prices by about 1 cent per kilowatt-hour. As of March, the average price of electricity delivered to residential customers was just under 11.4 cents per kilowatt hour; it’s easy to see how quickly carbon abatement can have a meaningful impact on actual electricity prices.

Rowe went on to explain how renewable energy standards can be even more expensive depending upon how they’re enacted. The reason is simple: Alternatives like solar PV and wind are among the more expensive carbon abatement methods–any law that requires a certain percentage of renewable power will be expensive.  According to one estimate referenced in Rowe’s presentation, California’s strict renewable portfolios standard would raise the average retail price of electricity in the state from an already high 15 cents per kilowatt hour to about 30 cents per kilowatt hour.

Bottom line: The short-term impact of HR 2454 will be fairly mild as companies pick the low-hanging fruit to cut emissions, but it will become increasingly expensive as time goes on. The RES included in the bill is relatively benign compared to some of the State-imposed standards currently in place, so its impact will also be minimal in the short term.

Alternative energy companies are probably getting the most attention as potential beneficiaries of HR 2454; after all, the use of these technologies would be mandated by the RES, and putting a price on carbon tends to make energy sources that don’t emit carbon more attractive. There’s some truth to these points over the long run, but it’s a mistake to use the bill as your sole rationale to aggressively buy alternative energy firms across the board–selectivity is key. 


Source: Bloomberg

This chart shows the returns from three energy indexes since early March: the Bloomberg global alternative energy index, the Philadelphia Oil Services Index (OSX) and the S&P 500 Energy Index. All three have performed well since the March lows, and alternative energy stocks have outperformed the relatively conservative S&P 500 Energy Index. But the alternative index has underperformed the Philadelphia Oil Services Index, a fairly leveraged play on the energy sector. At best, it’s fair to say that alternatives have performed in-line with the rest of the sector but no better.

I suspect there are two major reasons for that. First, everyone expected some sort of carbon legislation this year, so HR 2454 wasn’t a big positive surprise. And second, investors recognize that the near-term earnings impact of cap-and-trade for the alternative energy firms will be minimal.

To the extent that HR 2454 does benefit alternative energy, I would prefer to focus on wind power and efficiency firms over those involved in the solar industry. Solar PV is among the most expensive sources of energy on a per kilowatt basis, even if you factor in current subsidies. I have no doubt that solar will see strong growth, but wind power is a more practical near-term option for companies looking to meet RES.

And the solar power industry faces other headwinds. Companies overbuilt their capacity to produce PV panels, and the excess supply has depressed prices measurably. As the global economy recovers and credit markets revivify, the number of solar installations should increase, reducing the glut of unsold panels. Although HR 2454 included no such provisions, I wouldn’t be surprised if the US or other countries introduced new energy bills that offer more generous subsidies to PV firms.

Still, with most of the solar names trading at sky-high valuations, there’s ample room for further disappointment.

Wind power, on the other hand, is cheaper than solar and a more viable option for companies seeking to meet RES. According to Exelon, wind costs about $40 to $60 per metric ton of carbon abatement compared to $250 for PV. And wind-power firms don’t face the same oversupply issues as solar-power companies.

Long-time readers know that I prefer to play alternative energy via a “field bet.” For those unfamiliar with this concept, it’s a diversified mini-portfolio designed to play major multi-year trends in the energy markets. Instead of recommending just one or two high-risk plays, I offer a list of five to ten specific picks in each sector. I recommend that subscribers place a small amount of capital in each stock, around 20 to 25 percent of what you’d put in a normal TES recommendation.

Although each pick may be risky on its own, as a whole, the list represents a safer, more-diversified bet on these long-term trends. This general strategy has paid off handsomely for us in the past; we’ve racked up some nice gains on field bets in nuclear, biofuels and alternatives. One point to keep in mind: I rarely advise selling a field bet recommendation outright because they’re designed to play long-term trends. Periodically, I’ll advise readers to take profits off the table–for example, my timely recommendation to sell part of our previous alternative energy field bet last May in the issue “Earth, Wind and Fire.”

Here’s my current alternative energy field bet.


Source: The Energy Strategist, Bloomberg

My top plays on this list right now are two wind-focused firms, Vestas Wind Systems (Denmark: VWS, OTC: VWSYF) and Hansen Transmissions (London: HSN, OTC: HSNTF). Vestas is the world’s largest producer of wind turbines, controlling about a 20 percent of the global market share. Based in Denmark, the company has long focused on selling turbines in Europe, which for years was the largest market for wind power turbines.

Lately Vestas has refocused its attention on the US and Asia, two markets that should grow faster than Europe in coming years thanks to big government subsidies and renewable standards such as those imposed in the climate bill. Vestas is already either the No. 1 or No. 2 supplier in most of the world’s largest markets, including the US.

Renewable energy projects are usually financed in part by debt; the credit crunch hit Vestas and its peers hard late last year. However, I expect credit markets to continue to improve, accelerating a recovery in the business this year. Vestas remains a buy.

Hansen Transmissions manufactures gearboxes used in wind turbines. Gearboxes are an absolutely crucial part of turbines, and Hansen controls a quarter of the market share in this business and 50 percent of the market for large turbine gearboxes. In recent years, demand for large turbines has picked up; the company’s position in that business is a major advantage.

Hansen is more than 68 percent owned by India’s Suzlon Energy (India: 532667), one of the world’s largest wind-turbine manufacturers.  Because emerging markets are likely to be key growth drivers for the renewable power industry, the company’s relationship with Suzlon is a huge positive. In addition, Hansen is expanding its direct presence in the two most important markets by building manufacturing plants in both India and China.

Finally, I’m adding Itron (NSDQ: ITRI) to this field bet on the alternative energy space. Itron is a leading play on energy efficiency and smart grid technologies, a key, near-term component of cutting carbon emissions and meeting RES. In addition, both HR 2454 and the stimulus bill passed earlier this year include direct subsidies aimed at promoting efficiency and building a more intelligent electric grid.

Itron is already a leader in automatic meters. Traditional gas and electric meters require a utility technician to manually read each display in each home and business. Automatic meters, however, transmit data via a radio signal directly to technicians, accelerating the meter reading process and cutting costs for utilities.

Itron has a 50 percent market share for automatic meters in the US and close to a third globally.
Smart meters are the next step. These meters will not only transmit data about how much energy a residence or business uses but also valuable data about how energy is used. This information can be used to cut costs and enhance efficiency. For example, businesses could benefit from performing certain energy-intensive tasks at off-peak hours when total demand for power is low. Data from smart meters could be used to identify those potential savings or even to automatically manage power demand.

The European Union (EU) recently passed a mandate to upgrade the majority of meters to more advanced automatic and smart meters, a policy that should juice Itron’s revenues. Meanwhile, HR 2454 is likely to help accelerate investments in smart meters in the US as well. Buy Itron.    

Beyond the alternative-energy space, nuclear power and natural gas should also benefit from HR2454–topics that I have covered in depth in previous issues. Suffice it to say that the promised loan guarantees for new nuclear plants remain intact in the climate bill and will help to kick-start the construction of a new generation of nuclear plants in the US. Moreover, nuclear remains the largest source of carbon-free energy in the US; putting a price on carbon emissions makes nuclear less expensive relative to other forms of energy production. Because nuclear power is a baseload source, it will ultimately play a larger role in meeting US power demand and carbon emissions guidelines than either wind or solar. Finally, I suspect a Senate version of the climate bill might even include some more direct subsidies for nuclear power.

I offer a more detailed rundown of nuclear power and my top picks in the January 21, 2009 issue, “Uranium Revisited” and in the more recent May 6, 2009 issue, “A Turn for the Better.” I see tremendous additional upside for my uranium field bet picks. Uranium prices are now on the rise and recently topped $55 per pound amid strong demand for uranium among utilities and speculators.

Natural gas benefits from carbon legislation because natural gas-fired plants produce roughly 40 to 50 percent of the carbon dioxide that a coal plant emits to yield the same amount of power. Even with gas prices at close to twice the current level, building gas plants is economic relative to most other power sources and would be a relatively quick way for a utility to meet customers’ power demand and reduce emissions.

Secondly, alternative energy sources like wind and solar are by definition intermittent. Power isn’t stored on the electric grid, but supply and demand must be balanced at any given point in time. Therefore, the spikes and lulls in output from alternative energy sources must be balanced by shadow capacity. In other words, when power output from wind facilities hits a lull, producers need to have gas plants that can be fired up quickly to feed power to the grid and compensate. Countries that have major wind power capacity have typically relied on gas as this back-up source of power; I suspect the same will be true in the US.
Granted, this is a long-term, multi-year argument in favour of gas, not a short-term catalyst. Nonetheless, I have other reasons to be bullish gas that I explained at length in the May 28, 2009 Flash Alert, “Gas Up.”

Back to In This Issue

Crude Awakening

Long-time readers know that I have been consistently bullish on crude oil prices this year and have long been projecting prices to top $70 a barrel. I am maintaining my outlook for oil to reach $80 to $85 a barrel by the end of 2009 and prices to top $100 at some point in 2010. And, despite what you have probably been hearing from pundits on television and in other media, I do not believe the rise in oil prices is solely the result of reckless speculation or the decline in the value of the dollar. As I recently pointed out in “$70 Oil: Myths and Reality,” the argument that oil is just a weak dollar trade just doesn’t hold water when you consider that oil prices have doubled in euro and gold terms since the beginning of the year.

The primary reason for crude’s run-up: growing expectations that oil demand has bottomed out coupled with concerns over falling global production. I analyze these fundamentals at length in the June 3, 2009 issue of TES, “The New Super-Cycle.” 

There are some additional positive signs emerging in the global crude oil market. For one, US oil demand is clearly stabilizing; in last week’s inventory report, the EIA noted that gasoline demand is up 0.4 percent over the past four weeks compared to the same period one year ago. Demand will likely continue to remain tied to economic growth, and news on that front is also positive.

I pay careful attention to the Conference Board’s Leading Economic Indicators (LEI) data, which helped us to call theUS recession back in early 2008 and is now pointing to recovery–a forecast I explained at some length in last weekend’s issue of PF Weekly, “An End in Sight.” 

For readers who are unfamiliar with my line of thinking, here’s a quick summary. In May the LEI data surged 1.2 percent, following a 1.1 percent jump in April. To put this into context, consider that going back to 1971 there have been only six occasions when the LEI has managed a 1-percent jump or better in a month. And looking back over the past 500 months’ worth of data, there’s never been an instance where the LEI has registered two consecutive gains above 1 percent.Clusters of positive monthly gains in LEI above 0.5 percent typically suggest an end to recession. Given this backdrop, I’m sticking with my projection that the recession in the US will end either late in the third quarter of 2009 or early in the fourth quarter.

It’s also worth noting that the shape of the US crude oil futures curve no longer offers big rewards to store oil. A good indicator to watch in that respect is the value of front-month crude oil futures minus futures for delivery 6 months into the future. The chart below provides a closer look.


Source: EIA

When the first-to-six spread is low it indicates that oil prices for near-term delivery are much lower than crude prices for delivery six months in the future. This is a situation futures traders call contango. Large contango encourages storage of oil.

The storage trade is simple. Traders buy oil on the spot market at depressed prices. The trader can then turn around and sell oil futures expiring six or 12 months in the future, locking in a much higher price for the oil. If that trader can store the crude, it’s possible to realize a riskless profit equal to the spread between spot and futures prices. The lower the first-to-six spread, the higher the profits available from storing oil; in early February of this year this spread reached extreme levels, contributing to a big build of oil in storage. But with the contango in the futures market now far less pronounced, there is no longer an incentive to buy oil and store it. This is helping to gradually bring bloated US crude oil inventories back under control.

Given the rise in oil prices over the past few months, there is growing evidence of an uptick in drilling and exploration activity in certain parts of the world. In the US, the oil-directed rig count (i.e., the number of rigs actively drilling for oil) has ticked higher lately, even as the gas-directed active rig count continues to fall. This suggests that oil prices have risen enough to stabilize activity.

The best long-term play on rising oil prices and constrained supply remain the services, contract drilling and equipment firms. These companies do not make money directly from rising oil prices as they do not sell crude or natural gas. Rather, services and drilling firms perform absolutely crucial functions related to the exploration and production of oil and gas and stand to benefit handsomely from rising drilling activity levels.

 I suspect some of these companies, particularly those focused outside North America, will generate upside surprises in their second quarter earnings releases due out over the next few weeks. The reason is that most analysts didn’t expect oil prices to rise as quickly or as far as was the case in the second quarter, suggesting that many may have not factored in a bounce-back in drilling activity.

My favorite plays in this regard include Weatherford International (NYSE: WFT), Schlumberger (NYSE: SLB), National Oilwell Varco (NYSE: NOV), Dril-Quip (NYSE: DRQ) and Noble International (NYSE: NE).

Weatherford is the fastest growing oil services company in my coverage universe. The company has a solid position in Mexico, a market that has remained surprisingly strong throughout the past year’s rollercoaster ride in oil prices. I suspect that Mexican spending on its Chicontepec oil field development where Weatherford and Schlumberger are major players will continue to grow; Mexico is desperately looking for ways to offset the rapid decline in production from it largest oil field, Cantarell. I explained this market at some length in the April 1, 2009 issue of TES, “Islands of Growth.”

I also like Weatherford’s latest deal to purchase the oil services division of TNK-BP,  British oil giant BP’s (NYSE: BP) 50 percent owned joint venture in Russia.  The deal beefs up Weatherford’s position in the key Russian oil and gas industry and includes 75 drilling rigs and 280 rigs used to repair and maintain existing wells.

The Russian market saw a severe downturn last year as oil prices collapsed and drilling activity slowed to a crawl. But until the middle of last year, Russia was among the strongest energy markets in the world. Weatherford has slyly picked up the oil services business while Russia’s oilfield activity remains relatively weak; a year ago, I doubt the company could have closed the deal for anything close to the $450 million price tag it recently agreed to.  Consider that TNK-BP recently stated that the business earned well over $600 million in 2008 so Weatherford is picking up the unit at a discount to sales.

This deal also makes Weatherford a close No. 2 to oil services giant Schlumberger in terms of its presence in the key Russian market. Weatherford is a smaller firm than Schlumberger, but the company keeps making the right moves and is challenging Schlumberger’s dominance in key markets like Russia and Mexico. Buy Weatherford and look at any dip as an opportunity to load up on the stock.

Schlumberger (NYSE: SLB) remains a long-term must-own for every energy investor though I prefer Weatherford as a near-term play. The company is far and away the most technically advanced of the services firms and has its hands in every imaginable oil-producing market. Schlumberger has traditionally been seen as an exploration-focused company rather than a company specializing in developing existing fields. There’s some truth to this; the company’s WesternGeco seismic division benefits from higher exploration activity.

Exploration activity will likely be slower to pick up than development because producers are still reeling from the collapse in oil and gas prices over the past year and will probably be slow to resume spending on exploration. This is the only reason I prefer Weatherford to Schlumberger near-term.

National Oilwell Varco (NYSE: NOV) and Dril-Quip (NYSE: DRQ) are both equipment firms. National Oilwell builds the key equipment on drilling rigs and has a leadership position in building rigs used in deepwater environments. Dril-Quip supplies subsea equipment that is needed to produce deepwater wells. I explain my rationale for recommending both stocks on the April 1 installment of TES. Both remain buys, and the recent dip offers a good opportunity to jump in. 

Finally, I highlighted my rationale for owning Noble at great length in the most recent issue of TES, “The Drilling Dozen.”

One final point to note: In the June 3, 2009 issue of TES, “The New Super-Cycle,” I explained the potential for a short-term correction in energy prices and in related stocks. Energy stocks have seen a correction since then, with the Oil Services Index pulling back around 20 percent since its mid-May highs. Oil prices have not really followed suit and continue to hover over $70 a barrel, near recent highs. Investors who took my hedging advice in that issue have locked in some nice gains on major recommended holdings. I don’t see a great deal of additional downside in energy stocks; the recent correction looks to be nothing more than healthy profit-taking.

That said, crude oil prices could see some downside this summer as the commodity has rallied a great deal on expectations of a global economic recovery. Economic recoveries are never a smooth process and there will undoubtedly be confusing data giving mixed signals; the weaker-than-expected consumer confidence data released earlier this week is just one example of that. 

Another factor to watch is that OPEC compliance is slipping slightly. That means that some OPEC members are producing more than their official quotas in an effort to take advantage of rising oil prices. If this trend continues or there is further evidence that OPEC’s resolve is faltering, this could also put weigh on crude prices over the next month or two.

I see any selloff in crude well supported in the $60 to $65 a barrel region, and ultimately it will prove a buying opportunity. But to guard against the potential for a near-term pullback, I am adding a trade for aggressive investors to my Gushers Portfolio, the PowerShares Double Crude Oil Short (NYSE: DTO). DTO is an exchange-traded Note (ETN), similar in many ways to an exchange-traded fund (ETF)–the ETN trades throughout the day on the NYSE just like a stock. The ETN is designed to gain in value when crude oil falls in value; in this case, DTO should gain value at roughly twice the pace that oil falls in value.

The ETN is a great hedge against a short-term pullback in oil prices this summer. This trade will require more monitoring than other positions because it’s highly volatile.  Also note that I have set a loose stop, meaning that the stop-loss order I’m recommending is significantly below the current price. I suggest those wanting to jump into the trade adjust their position size to account for the added risk.

Buy the PowerShares Double Crude Oil Short (NYSE: DTO) under 77 with a stop at 60.

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Updates

Wildcatter Portfolio recommendation Hess (NYSE: HES) has been hit lately over concerns about its BM-22 well in Brazil. Brazil’s deepwater sector is arguably one of the hottest regions for exploration in the world today, and there has been considerable excitement over recent massive discoveries like Tupi. Therefore, investors were excited about the potential for Hess’s BM-22 well to be a major find.
It doesn’t appear that’s the case. The company has announced it’s still doing some drilling and testing of the well, but if it were a major, conclusive find you can bet they would have come out with a press release to get investors’ attention. It appears likely that the well isn’t a total loss but that it didn’t live up to lofty expectations. Meanwhile, BM-22 is just one well on a massive offshore plot that still has plenty of exploration targets that Hess and its partners in the field haven’t explored yet.

In addition, Hess does have a number of exploration projects in other oil-producing regions like Africa. Well results from these plays are also due out in coming months, so there remains the potential for a major find to act as an upside catalyst for the stock.

Bottom line: The news is bad news for Hess, but unproductive wells are just part of the oil business and I continue to like Hess’ exploration potential over the next few years. Hess remains a buy.

Iraq’s oil development auction earlier this week appears to have been a failure. Most of the big oil companies that bid on contracts backed out after they couldn’t agree on terms with the Iraqi government. In fact, the government awarded only one of the eight contracts on offer to British integrated giant BP, which is working in partnership with China National Petroleum.

BP agreed to terms that look marginal at best. It’s a 20-year deal for Rumaila, Iraq’s largest field, in which BP is paid a per barrel fee for every barrel of crude it pumps above a certain minimum target. BP had asked for $3.99 per barrel and the government offered $2, which BP  accepted. Other producers were asking for per-barrel fees of close to $5 and then walked away when the government wouldn’t oblige.

Iraq is not an upside catalyst for producers because above-ground risks such as terrorism are high and the terms BP agreed to appear poor. The companies that will really benefit from Iraq’s oil developments are services firms like Weatherford that have existing contracts to perform work and maintenance on Iraq’s major oil fields. 

The failed Iraqi auction also highlights ongoing oil supply challenges. Iraq’s stated target to more than double its oil output near term looks even more unobtainable given the poor results of this auction. This is bullish for crude longer term.

Finally, The EIA announced its report EIA-914, detailing US gas production trends through the month of April. The EIA reported another drop in production of 0.2 percent from the lower 48 States, the second monthly drop in production. This indicates that the drastic drop in the US rig count since last summer is finally beginning to result in falling production.

It takes as long as six months for a falling rig count to impact production. This means that we’re likely to see the declines in production accelerate starting in May or June, six months after the rig count started to drop most precipitously. Data for May production on EIA-914 will be released late this month and will be a key upside catalyst for natural gas in my view.

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