Top Three Energy Themes
While perusing a popular investment website last week, I came across a piece penned by a well-known pundit. In this bullish article, the author compared the current economic and market recovery to prior cycles. Within a week of its publication, the posting had garnered well over 400 responses, roughly 80 percent of which were bearish. Many of these comments were openly hostile to the author’s views, forecasting a huge crash around the corner.
Though purely anecdotal in nature, this unscientific barometer of market sentiment reflects the mood I’ve sensed from many individual investors in recent months. By and large, retail investors are bearish on the market and aren’t sold on the sustainability of the economic recovery.
Longtime readers know that I expect the markets and economy to enjoy a cyclical recovery this year, a rally that I suspect will continue into 2010. Although I share some of the bears’ concerns–for example, a chastened US consumer and unprecedented government deficits–these are longer-term problems that will take time to reach fruition.
I wouldn’t rule out a shallow correction in the broader market, but it’s hard to imagine stocks reaching a top when sentiment is so overwhelmingly bearish. The market appears to be climbing the proverbial “wall of worry” this fall, and I’m looking for the S&P 500 to trade above 1,200 by the end of 2009. Broader market strength and further evidence of a cyclical economic recovery will disproportionally benefit the energy sector in coming months.
Regardless of these shorter-term market swings, the long-term outlook for energy remains bright. The sector is emerging from the downturn that began in summer 2008 and is in the early stages of a major advance, similar to the move that occurred from 2004 to mid-2008. Energy prices are benefiting from recovering demand in the US and developed world, but increased energy consumption in emerging markets remains the primary driver of commodity prices.
In this issue I highlight three of my top investing themes for the coming rally in energy-related stocks, focusing on both short-term and longer-term trends. I’ll also explain a few tactical shifts and add two new names to the model portfolios.
In This Issue
A range of economic data suggests that the US and global economies have stabilized and are now in growth mode. That’s good news for commodities prices and stocks in the energy patch. See Returning to Growth.
The end of easy oil has been a longstanding theme in this publication and remains arguably the most powerful driver in the sector, though the unprecedented drop-off in demand that occurred in the wake of the credit crisis and resultant economic dislocation has obscured this long-term trend. But with the global economy and credit markets now on the mend, this theme should come back with a vengeance over the next few quarters. See The End of Easy (and Cheap) Oil.
After laying out the case for the end of cheap oil, I highlight my favorite ways to play this long-term theme. See Drilling Down.
I remain bullish on the prospects for natural gas prices in 2010. I reiterate the logic behind this call and highlight my favorite picks. See 2010 Gas Rally.
Finally, the media attention to renewable energy sources has made coal the Rodney Dangerfield of fuels–it gets no respect. Don’t believe the hype. Coal is here to stay for the foreseeable future and prices should benefit from increasing demand in emerging markets. I add a new recommendation to the portfolios to play this theme. See Old King Coal.
Over the past two issues, I’ve laid out my basic case for energy stocks: That the down-cycle for most energy-related groups that began in summer 2008 has passed its nadir and the sector is in the early stages of what’s likely to be a multi-year growth phase. In the August 19 installment of TES, Mapping the Cycle, I took a closer look at the oil-services sector and long-term profitability trends in the group. The September 2 issue, The Gas Puzzle, and last week’s Flash Alert, Natural Gas Rally, outlined the potential for a major rally in natural gas prices and gas-levered stocks into early 2010.
The evidence continues to mount that the cycle for energy stocks has turned. Second-quarter earnings season was broadly a positive catalyst for the stock market, as positive results buoyed investor sentiment. At the same time, bears rightly have pointed out that although most companies beat analysts’ expectations in the second quarter, these earnings surprises stemmed from cost-cutting initiatives–not growing demand or revenue. The percentage of S&P 500 firms beating consensus revenue estimates was no higher than historical norms, even as around 80 percent of companies in the index beat on the bottom line.
Energy firms did their share of cost-cutting, but that’s not a negative for the group in the short term. After all, most US companies now have much leaner cost structures than before the recession; that gives those firms plenty of profit upside, or operational leverage, when revenue growth does resume. However, growth based on cost-cutting alone isn’t sustainable; companies can only cut their expenses so far without hobbling long-term growth.
Now the market is looking ahead to third-quarter earnings. Based on analysts’ estimates and companies’ guidance trends, there is room for some optimism on the revenue and earnings fronts. For most of the ten official S&P 500 economic sectors, analysts have steadily boosted their expectations for third quarter earnings. (I explained and discussed the implications of this positive earnings revision cycle in Mapping the Cycle). But only three of the ten S&P 500 economic sectors have seen any significant upside in revenue estimates for the third quarter: technology, energy and health care.
Health care is a less cyclical and economy-sensitive sector than either energy or technology, to which the benefits of the global economic recovery appear to be accruing much faster. I expect these two sectors to lead any rallies.
The evidence also continues to mount that the pace of global economic recovery is picking up. Longtime readers know that I follow the Conference Board’s Index of Leading Economic Indicators (LEI) closely. On September 21 the Conference Board announced the LEI jumped by 0.6 percent in August, slightly less than the 0.7 percent expected. But the group revised the July reading from 0.6 percent to 0.9 percent; the overall improvement in the indicator was better than expected. The graph below depicts the year-over-year change in LEI over the past decade.
Source: Bloomberg
Positive year-over-year changes in LEI have a solid track record of pinpointing the end of recessions. That happened in July, and I suspect the National Bureau of Economic Research’s Business Cycle Dating Committee will ultimately declare that the recession which started in December 2007 ended over the summer.
And LEI isn’t the only sign of a turn in US economic conditions. The latest industrial-production data, which is also a good indicator of industrial demand for natural gas, is also showing signs of improvement.
Source: Bloomberg
US industrial production is still down more than 12 percent from a year ago, but it’s recovering quickly; earlier in 2009 this figure was down more than 15 percent. A quick comparison with prior cycles indicates that the pace of recovery is similar to the decline in industrial production that occurred from 1973 to 1974. With industrial production on the mend, expect industrial demand for natural gas to pick up–as I detail later in this issue, recent data suggests that such a recovery is underway.
For another real-time indicator that the US economy is showing signs of life, check out the most recent issue of PF Weekly, On Track for Recovery. In it, I discuss railcar loadings data which indicates that freight volumes on US railroads have increased significantly since May. Although volumes are still lower compared to a year ago, the trend is undeniably positive–and more goods and commodities moving around the country is among the most reliable indications that growth is back on track.
Traffic at US containership ports, such as the Port of Long Beach, likewise suggests that the US economy is growing again.
Source: Port of Long Beach
Statistics on container traffic are usually quoted in terms of the total volume of 20-foot equivalent units (TEUs) handled. Basically, these are standardized containers measuring 20 feet in length, 8 feet in height and 8 feet in width. Standardizing the size of containers makes it easier to move them from ships to trains and trucks on their journey from producers to consumers.
I have added granularity to the data, breaking it down into both loaded inbound and outbound cargos–the former is good representation of import volume, while the latter shows exports traffic.
The graph clearly shows a sharp slowdown in volumes after October 2008. Total containers moved fell an unprecedented 43 percent from that inflection point through February 2009; this tumble is easily distinguishable from the seasonal rises and falls in traffic. However, since February, volumes have risen sharply once again, reaching 380,000 TEUs in August, the highest level since last October. In most years, traffic remains elevated through December before slowing down in the New Year; if that pattern continues containership traffic easily could surge to over 400,000 TEUs in coming months.
Of course, one can no longer rely solely on US data when analyzing energy markets. Although the US remains the world’s most important consumer of oil, it’s no longer the source of marginal demand growth. In fact, contrary to popular belief, US demand for crude started falling long before the recession started. According to BP’s (NYSE: BP) Statistical Review of World Energy 2009, last year US oil consumption was up less than 2.6 percent from the prior decade’s levels. And oil demand has actually fallen over 1 million barrels per day from the highs achieved in 2005.
The major improvement in key emerging-market economies began months before there was any sign of a turn in the US. For example, China’s Purchasing Manager’s Index (PMI) for manufacturing hit a low of less than 39 in November 2008–numbers under 50 indicate a contraction in manufacturing activity. But the PMI improved quickly in 2009, touching 49 in February and breaching 50 by March. Accordingly, most emerging-market stock indexes bottomed in November 2008, whereas most developed-world markets didn’t hit their lows until March 2009–and stocks are a leading indicator of economic activity.
The Organization for Economic Cooperation and Development (OECD) also publishes its own Leading Economic Index for most global economies. Here’s a look at the index for China.
Source: Bloomberg
Unlike the US LEI, China’s LEI never turned negative on a year-over-year basis and its economy likely never shrank outright. Nevertheless, the slowdown in growth from the sky-high levels of 2006 and 2007 certainly approximated a recession in terms of its impact on demand for energy products.
But note how quickly LEI has returned to levels last seen before the collapse of Lehman Brothers. This supports the view that China’s economy will grow at least 8 percent this year. Indian growth and LEI data also suggest a sharp reacceleration of that powerhouse economy.
The International Energy Agency (IEA) and US Energy Information Administration (EIA) are beginning to factor this strong reacceleration of developing-world economies into demand estimates. In mid-September, the IEA boosted its estimates of global oil demand by 500,000 barrels per day for both 2009 and 2010, citing a cyclical recovery in the US and stronger-than-expected demand growth among non-OECD countries in Asia, a proxy for developing Asian economies. And the EIA is projecting that global oil demand will grow again in the fourth quarter, led mainly by non-OECD Asia.
Several pundits on business television and various websites claim that there’s no sign that oil demand is recovering, a seemingly compelling argument unraveled by its untruth.
The latest data from the EIA indicate that total US demand for oil and refined products over the past 4 weeks is actually 3.7 percent higher than it was a year ago. That’s a far cry from the year-over-year demand declines witnessed earlier this year that exceeded 10 percent. The EIA expects global demand will increase by 900,000 barrels per day in 2010, thanks to stable demand in the developed world and a sharp increase in consumption among developing countries in Asia.
The graph below depicts historical EIA data through August of this year and the Agency’s estimates through the end of 2010.
Source: EIA
As you can see, global oil demand likely hit a low in the spring and by the end of 2010 should be approaching levels last seen in early to mid-2008. Although such projections are subject to a fair amount of forecast error, economic data suggest the EIA is at least directionally correct.
Ironically, the main risk to the EIA’s demand projections is that if oil prices rise more than forecast, demand likely would be choked off, particularly in the developed world. Simply put, the danger remains on the supply side: If declines in non-OPEC production and higher demand combine to force OPEC to boost output beyond expected levels, oil prices could jump to well over USD100 a barrel–levels that would certainly prompt demand destruction in the US. Of course, this would also be bullish for global energy stocks.
The End of Easy (and Cheap) Oil
The end of easy oil has been a longstanding theme in this publication and remains arguably the most powerful driver in the sector, though the unprecedented drop-off in demand that occurred in the wake of the credit crisis and resultant economic dislocation has obscured this long-term trend. But with the global economy and credit markets now on the mend, this theme should come back with a vengeance over the next few quarters.
I have written about the end of easy oil on several occasions in recent months, most recently in Mapping the Cycle; I won’t belabor the point here and will instead update the fundamentals, review of our current plays on this theme and a look at a handful of new additions to our coverage universe.
Supply concerns are at the heart of the end of easy oil. Non-OPEC oil production will, at best, remain steady in coming years; additional production from nonconventional sources, such as oil sands and deepwater, will offset declines from mature onshore and shallow-water fields.
In other words, production from easy and cheap-to-produce large onshore fields with less- complicated geology will be replaced with more expensive-to-produce offshore fields. That translates into rising marginal costs for crude oil production and elevated oil prices to incentivize undertake the massive investment needed to produce oil sands and deepwater projects.
In coming years, the amount of oil OPEC must produce to balance demand (the so-called “call”) will increase gradually as demand from developing countries rises and non-OPEC supply declines. OPEC countries have a number of planned projects slated for completion in the next seven years that should increase the organization’s production capacity. The bulk of this new capacity will come from Saudi Arabia. Of course, there remains a big question mark as to whether these planned expansions ultimately will increase capacity to the extent expected.
And even if production capacity does rise, the combination of flat-to-declining non-OPEC supply and rising demand will increase the call on OPEC to make up the difference. In short, OPEC’s spare capacity–production capacity that can be ramped up quickly and maintained–will likely continue to drop gradually over the coming five to ten years. The graph below offers a closer look.
Source: BP Statistical Review of World Energy 2009
This chart shows the call on OPEC dating back to the mid-1960s. To facilitate comparison between different periods, I expressed that call as a percentage of global consumption. Beginning in the late 1970s, the percentage declined, and that downward trend accelerated into the mid-1980s. This was a period when OPEC’s spare capacity grew sharply due to increased non-OPEC supply from regions such as the North Sea and Mexico. In 1985 it’s estimated that OPEC’s spare capacity hit highs above 15 percent of total global demand. In other words, back then the world truly was awash in plentiful crude. Generally speaking, this was also a period of weak oil prices.
The period after 2002 is also noteworthy. As the call on OPEC gradually increased after 2002, spare capacity as a percentage of global consumption declined, hitting lows of roughly 2 percent of global demand in 2005. At that time the oil market literally had only a razor-thin margin of excess capacity. Any shocks to oil supply or demand were enough to send prices soaring. This is the main reason oil prices rallied so much during this period.
The global credit crisis prompted a drop in demand for oil this year and corresponding cuts in OPEC output. In other words, the call on OPEC has fallen with oil demand, and OPEC’s production cuts have increased spare capacity. But nothing has really changed on the supply side; in fact, a severe decline in spending on drilling and exploration will ultimately hasten the fall in non-OPEC output. Even within OPEC, low oil prices late in 2008 and early this year have prompted the delay or outright cancellation of many projects. In other words, the increase in spare capacity is wholly a function of a short-term drop in demand; as demand returns, spare capacity will fall once again.
Subscribers often ask me about the potential impact of a surge in production from new sources, such as deepwater fields in the Gulf of Mexico and Brazil. These gigantic fields that are undoubtedly important finds for the companies involved. But the media tends to overhype the total reserves of these fields, which feeds a common misconception that reserves of oil and production are somehow interchangeable. It’s important not to get drawn in to the seductive logic of this fallacy. What really matters is not how much oil is in the ground, but how quickly that oil can be produced without damaging the geology of the field.
For example, as I explain at great length in the September 5 installment of Personal Finance Weekly, Giant Oilfield Spells Upside for Prices, the massive Tiber oilfield discovered by BP in the deepwater Gulf of Mexico might ultimately generate an incremental 200,000 barrels of oil production per day by 2020.
Although the media emphasized that the field contains billions of barrels of oil reserves, the reality is that at peak production capacity the field might account for around 0.25 percent of global oil consumption. But 200,000 barrels a day of incremental production 11 years from now just doesn’t sound as exciting as more than 3 billion barrels of oil in 65 million year-old rocks under the seafloor.
The long and short of this is that production from complex fields and unconventional sources will simply make up for declines in production from maturing fields outside OPEC. And even OPEC countries will have to spend unprecedented sums to bring smaller and more complex fields into production; increasing OPEC’s production capacity won’t be as easy as it was in the 1970s; the region’s huge, easy-to-produce fields, such as Saudi Arabia’s Ghawar, have matured and likely are already experiencing declining production.
This basic theme suggests two key investing angles:
- Oil services and equipment firms that have the advanced technologies required to produce more complex fields in regions such as the deepwater Gulf. Consider that the Tiber well in the Gulf is located in waters more than 4,000 feet (1,220 meters) deep, and the total length of the well itself is more than 35,000 feet (10,685 meters)–more than 6.5 miles long from the bottom of the drilling rig to the bottom of the well. The pressures and temperatures encountered at such depths tests the physical limits of drilling materials and technology. In fact, just a few years ago most producers and industry pundits felt drilling such a long well in deepwater was technically impossible. Drilling such wells requires far more participation from service and equipment companies than drilling a in onshore regions of Texas or the Middle East
- Oil producers with the capacity to increase oil production meaningfully in coming years. In a world where most of the mammoth integrated oil companies are likely to show declining or, at best, flat production, there’s a handful of producers that have the capacity to grow production meaningfully in coming years.
Check out the table below for a look at the stocks currently in The Energy Strategist Portfolios that represent plays on this theme as well as a handful of new plays on the end of easy oil.
Source: Bloomberg, The Energy Strategist
I’ve written extensively about some of the existing TES recommendations in recent issues and will keep updates on recently updated picks relatively brief. I will spend more time covering potential new plays.
Drilling DownEOG Resources (NYSE: EOG) – Traditionally regarded as a natural gas play, EOG has increased its exposure to US-based unconventional oil and natural gas liquids (NGL) opportunities such as the Barnett Oil Combo play and the Bakken Shale. I outlined my investment case for EOG at great length in the previous installment of TES, The Gas Puzzle. Wildcatters Portfolio Holding EOG Resources rates a Buy under 100.
Suncor Energy (NYSE: SU) – Suncor is the largest player in Canada’s vast oil sands but temporarily halted a number of expansion projects earlier this year because of low commodity prices. As energy prices stabilize at a level above USD70 a barrel, expect the company to restart its expansion plans. In addition, the firm recently completed its merger with Petro-Canada, creating a Canadian energy giant. I highlighted the stock at some length in The Gas Puzzle. The only meaningful addition I would make to that write-up is that Suncor recently reported that its oil-sands operations produced around 312,000 barrels of oil per day. That suggests production is tracking above the company’s prior guidance and could provide the stock with some upside. I’m raising my Buy target on Wildcatters Portfolio holding Suncor Energy from USD37 to USD43.
Hess (NYSE: HES) – I originally recommended Hess earlier this year because of its exposure to exciting new oil and gas plays in Africa and Brazil. The company focuses on exploration; the key catalysts for Hess remain the announcement of results from new well tests. The stock had a nice run after some solid discoveries in Africa earlier this year but took a hit when the firm announced disappointing results from a deepwater well test in Brazil.
Hess has a number of new wells slated for testing that could provide upside for the stock. However, other names have better prospects for new discoveries. I’m cutting my recommendation on Hess from a Buy to a Hold; I recommend that investors consider booking at least some of the 20 percent gain in Hess and reinvesting the proceeds into my other “End of Easy Oil” recommendations.
Tullow Oil (London: TLW, OTC: TUWLY) – I haven’t written about London-based Tullow in recent weeks because this Gushers Portfolio holding remains somewhat expensive–the stock has more than doubled since my original recommendation. That being said, I’d be remiss not to note the company’s impressive drilling results in Africa. Last week the firm announced its most recent major find, the Venus well offshore of Sierra Leone, a large column of oil located in water 5,900 feet deep. Tullow owns 10 percent of this well; Anadarko Petroleum (NYSE: APC) is the biggest stakeholder. The success of the Venus well further delineates an impressive deepwater region offshore of several countries in West Africa.
Source: The Mape Project
Although Venus is off the coast of Sierra Leone, the West Africa deepwater region appears to stretch south more than 700 miles to Ghana’s Jubilee field, the largest deepwater field in Africa. That doesn’t mean the entire area contains oil, but there do appear to be similar underground structures of interest located in this area.
Tullow has also announced a number of onshore finds. And although Tullow is a relatively small company it owns a large number of leases and interests in key wells across Africa and offshore Africa. This large backlog of drilling targets increases in value every time Tullow or one of its partners announces a new find, and there are several new well tests scheduled for coming months.
This is a major reason Tullow is considered one of the most likely takeover targets in the industry and could be worth more than 1,300 pence per share on a takeover (13 British Pounds). That’s roughly another 10 to 15 percent of upside from current levels. Given the limited upside potential in a takeover, I am going to retain my Hold recommendation on the stock for now. For those interested in the West Africa offshore exploration potential, check out new Portfolio addition, Anadarko Petroleum.
Integrated Oil Companies – I’ve written extensively about the integrated companies in the past, including a detailed explanation of the group in the December 3, 2008, issue, “Crisis Equals Opportunity.” Most integrated oil firms derive their earnings from two main sources: refining and the production of oil and gas. In the case of most integrated firms, the latter business generally contributes a higher percentage of total revenue, though Marathon Oil (NYSE: MRO) and some other companies rely more on refining.
Among investors, the biggest integrated oil companies are generally regarded as the most defensive plays in the energy patch; these companies tend to perform best when oil and gas prices are generally weak. From a longer-term perspective, however, investors should be extremely selective when buying into this group; some will actually be casualties of the end of easy oil–that doesn’t mean that I necessarily expect these stocks to fall in price, but many of the names in this category will likely underperform the broader energy sector in coming years.
State-owned national oil companies (NOCs) traditionally have partnered with Big Oil on projects because they needed their technical know-how to produce fields. But NOCs are turning increasingly to services firms such as Portfolio recommendations Schlumberger (NYSE: SLB) and Weatherford International (NYSE: WFT). NOCs are locking even the largest integrated oil companies out of the best plays or demanding much higher returns in exchange for partnering with these companies. Deepwater fields represent one of the final frontiers for big oil firms, but production growth for most of these behemoths will be relatively weak in the coming years.
Chevron (NYSE: CVX) – Chevron is one of my two outright recommendations among the Super Oils, primarily because the firm boasts a number of major new projects in regions like the deepwater Gulf of Mexico and offshore Australia. And in the second quarter, management boosted its annual production guidance. In short, Chevron is one of the few Super Oils that has the potential to grow production significantly in the coming years and reap the benefits of higher energy prices.
Chevron also recently signed a deal with Korea Gas Corporation (Seoul: 036460) to supply liquefied natural gas (LNG) from its Gorgon project in Australia; Gorgon appears to be progressing well, and Chevron is having no problems signing long-term supply agreements–many Asian firms are anxious to secure their gas supply. And a widely watched video on YouTube suggests that the Ecuadorean judge involved in an environmental case against Chevron might be tainted by corruption. (Readers interested in following the case can follow its progress on the company’s website.) These revelations mean that it’s unlikely that Chevron would be required to pay any major environmental damages relating to the suit. With the specter of its legal troubles beginning to dissipate, Chevron is a solid defensive play and remains a Buy under USD85 in the Proven Reserves Portfolio.
Eni (NYSE: E) – Like Chevron, the Italian energy giant has a number of promising new projects slated for completion over the next few years. And the company has a strong portfolio of exploration-and-production opportunities in Africa. Two other areas of interest for Eni include the deepwater Gulf of Mexico and offshore Brazil. Eni also offers among the most attractive dividend yields of any major integrated oil in my coverage universe; the stock’s indicated yield is over 5.5 percent. Eni is another conservative play that rates a Buy under USD60. (Investors should note that the symbol for Eni on the New York Stock Exchange is “E”, not “ENI”).
ExxonMobile (NYSE: XOM) – My recommended play on ExxonMobil isn’t an outright Buy, but rather a covered call. I explain the concept of a covered call in the December 24, 2008, installment of TES, Buy Income, Super Oils and Gas, and update this specific covered call recommendation in the February 24, 2009, Flash Alert, S&P 500 Contagion. This covered call was a play on the extreme volatility in the options market in early 2009 and the defensive nature of ExxonMobil’s stock, a product of the company’s low production costs. Covered calls allow investors to earn an ongoing stream of income, even from stocks that don’t pay actual dividends.
The stock is trading roughly 8 percent higher than my recommended price once you factor in the sale of the October 80 calls that expire in the middle of next month. When those calls expire, we will likely still own the stock in Exxon; at that time, I will likely recommend selling another call in Exxon to produce additional income. I would not recommend buying Exxon outright; it’s likely to be a laggard in any advance because of its relatively weak production growth prospects. I will issue a Flash Alert next month to update my advice once these calls expire. For now, the ExxonMobil covered calls rate a Hold.
Anadarko Petroleum (NYSE: APC) – As I mentioned earlier, I rate exploration-and-production firms Hess and Tullow a Hold at this time and recommend that investors take some profits off the table in both positions. Don’t interpret this advice as an outright call to Sell; instead, consider cutting your stake in these plays by a third to one-half and cashing in the remainder when I issue an outright Sell recommendation.
To offset these partial sales, I’m adding Anadarko Petroleum (NYSE: APC), an exciting new production story, to the Wildcatters Portfolio. Anadarko offers exposure to two themes I follow: the end of easy oil and the potential that natural gas prices will recover in 2010.
In my write-up of Tullow Oil, I noted that Anadarko in the operator on the Venus project off the coast of Sierra Leone and has a 40 percent stake in the field. I also noted that the littoral region of Sierra Leone and neighboring Liberia, Core D’Ivoire and Ghana appears to have exciting exploration potential.
In this area, Anadarko has a total of 8.8 million acres that it has leases or shares in joint ventures. The company is performing seismic surveys on much of this acreage to identify drilling opportunities and found as many as 30 plays offer likely drilling targets. When Anadarko reported second0quarter earnings, management noted it has plans to drill six more “high-impact” deepwater wells in the region by year-end; it appears the Venus well is among those planned high-impact finds.
And the Venus well is only the latest in a number of successes for Anadarko off the cost of West Africa. The company has made a series of large discoveries off the cost of Ghana, including the massive Jubilee field–Africa’s largest deepwater play–which is slated see first production at the end of next year. The Odum, Tweneboa and Mahogany fields are some of the firm’s smaller holdings.
Given the firm’s prior success in this region, the potential is high for Anadarko to announce some other major, high-impact wells between now and year-end–a meaningful upside catalyst for the stock.
In addition to offshore Africa, Anadarko has significant exposure to wells in Brazil and the deepwater Gulf of Mexico, two of the hottest regions for oil and gas exploration. In fact, Anadarko announced two additional deepwater Gulf discoveries in August.
Worldwide, Anadarko has plans for roughly a dozen new wells by early 2010, any or all of which could be major upside catalysts.
And remember, not all of Anadarko’s wells have to be blockbusters. The more the company drills and identifies targets in existing plays, the more value the market assigns to its remaining acreage; each successful well is a sort of “proof of concept” for the rest of the play. If Anadarko drills just a few more blockbuster finds, analysts would significantly discount the risk of its remaining wells, increasing the valuation of its remaining acreage. One way or the other, Anadarko appears to be on a path to actually exceed its long-term production growth targets of 5 to 9 percent annualized over the next few years.
Anadarko does have significant exposure to the US gas market via some legacy acreage in the Rockies. Fortunately, the company doesn’t have a great deal of exposure to near-term gas prices and has hedged about 75 percent of its production through 2010 at attractive prices.
Nevertheless, as I noted in the last issue of TES, I’m bullish on gas prices into 2010–and Anadarko has exposure to this upside through its joint venture with Chesapeake Energy (NYSE: CHK) in the Marcellus play–one of the most promising unconventional gas plays in the US). Anadarko also has interests in the East Texas side of the Haynesville Shale play and the Eagleford, a relatively new play.
With more than USD3.5 billion in cash and over USD1 billion in undrawn credit facilities, Anadarko has plenty of cash on hand to fund its aggressive drilling plans. Anadarko rates a Buy under USD70 in the Wildcatters Portfolio with a stop at USD47.50.
Oil Services and Equipment Companies – Oil services and equipment stocks, which I covered in the June 17 installment of TES, The Drilling Dozen, and the August 19 issue, Mapping the Cycle, should also benefit from the end of easy oil. As I’ve reiterated in previous issues, this group remains my favorite play for investors seeking long-term growth in the energy patch.
I currently recommend two pure-play oil services firms, Schlumberger (NYSE: SLB) and Weatherford International (NYSE: WFT). As I highlighted both stocks at great length in the August 19 issue, I won’t belabor the point here. Suffice it to say that I believe that spending has bottomed, and global exploration and production companies are likely to boost their budgets now that oil prices are hovering around USD70 a barrel.
North American E&P spending remains ultra-weak but should begin to bounce back as gas prices improve into 2010. Spending on deepwater remains robust and services firms benefit disproportionally from deepwater plays–these fields require just the sort of high-tech techniques offered by the big services companies. I rate Schlumberger a Buy under USD75, and I’m raising my Buy target on Weatherford from USD22 to USD26.
Dril-Quip (NYSE: DRQ) – Dril-Quip has been among our more successful holdings this year, up more than 55 percent since I added it to the Portfolio in the April 1 issue, Islands of Growth. Dril-Quip has two divisions: Drilling Equipment and Services. The former accounts for about 85 percent of revenues and is the basis of our investment. The company’s drilling equipment segment manufactures subsea products used primarily in deepwater offshore field developments.
Many investors seem to believe that in a deepwater field, all the equipment used to control a well is located on a floating production platform. But that’s just not the case–producers install equipment directly on the seafloor, and this equipment is aptly named subsea equipment.
Subsea trees are key pieces of equipment used in all deepwater oil and gas developments. The term “tree” is short for Christmas tree. When onshore wells are completed and ready for production, producers install a network of valves and pipes on top of each well. The general shape of this equipment is vaguely reminiscent of a Christmas tree, hence the term.
Subsea trees are infinitely more complex. Such installations include equipment that allows producers to control the flow of oil and natural gas remotely from the surface. In addition, subsea trees have to be able to handle the extremes of pressure, temperature and other harsh environmental conditions endemic to deepwater oil and gas plays.
As the name suggests, subsea risers are a sort of pipe that acts as a conduit between subsea wells and surface production and drilling equipment. Obviously, risers are required during the drilling process and to actually bring produced oil and gas to the surface.
Dril-Quip primarily operates as a backlog business, booking orders for new subsea equipment and then filling those orders over time. Therefore, one widely watched metric of the stock’s fundamental health is the size of its backlog, which had continued to rise despite the slump in exploration-and-production spending late in 2008 and early in 2009. At the end of 2008, Dril-Quip’s backlog stood at USD603 million. Although it fell slightly to USD573 million at the end of the first quarter, it had jumped to USD618 million by the end of June.
Dril-Quip is trading above my Buy target once again, even though I’ve raised this Buy target three times since my initial recommendation. On a price-to-sales basis, the stock trades at around 3.5 times, well above the lows recorded in 2008 but still not much above its five-year average valuation of about 3 times sales. And extremely depressed valuations at the end of 2008 don’t represent a meaningful benchmark. On a price-to-forward earnings basis, Dril-Quip trades at a slight discount to both FMC Technologies (NYSE: FTI) and Cooper Cameron (NYSE: CAM), two other widely watched subsea equipment manufacturers. The potential catalyst for the stock would be a series of new subsea equipment orders over the next few months and continued positive news on deepwater finds.
Deepwater-leveraged stocks are among the strongest in my coverage universe, and I see more upside for Dril-Quip. I’m raising my Buy target to USD50; I can see the stock trading into the USD60 to USD65 range by year-end.
Offshore Contract Drillers – I discussed this industry at great depth in the June 17 issue of TES, The Drilling Dozen. I recommend two plays in the group: Seadrill (OTC: SDRLF) and Noble (NYSE: NE). I’m raising my Buy targets on these two recommendations to USD22 and USD43, respectively.
My investment thesis for both stocks remains relatively unchanged. Noble has relatively modest exposure to deepwater day-rates in the near term–most of its rigs are already booked on contracts–but it should see upside in coming years as an uptick in deepwater projects spells strong demand for rigs. The next rig the company has coming up for re-contracting is the Noble Paul Romano, a 6,000-foot capable semisubmersible rig currently contracted to Marathon Oil (NYSE: MRO) at a day-rate of USD482,000 per day.
Marathon has indicated that it would be interested in extending its contract on the rig for another 120 days from its current expiration date in February 2010. Day-rates have fallen since then for rigs of this class since then, but I suspect the rig will be re-contracted at a reasonable rate in the neighborhood ofUSD400,000 per day. That would be an upside catalyst, as it will demonstrate that the market isn’t collapsing but has simply slowed from sky-high levels.
A turn in the international jackup market would represent an even bigger upside catalyst. Based on second quarter earnings reports, it appears that there has been an uptick in interest in these shallow-water rigs. And with oil prices remaining healthy going forward, I expect to see this market stabilize and bottom moving into 2010. Further evidence of such a turn during upcoming earnings season would provide upside for the stock. Noble also remains the cheapest of the offshore drillers, with the exception of those focused entirely on the Gulf of Mexico jackup business, a market I’ll discuss later in today’s issue.
Seadrill (OTC: SDRLF) has a large fleet of highly advanced deepwater rigs but the real story here, as noted in the June 17 issue, is the normalization of credit markets. Seadrill has considerable debt and was trading at distressed valuations at the height of last year’s credit crunch. With the supply overhang from margin-driven sales out of the way, a solid backlog position with existing deepwater rigs, and leverage to a turn in international jackup rates Seadrill’s stock has upside to the upper 20s.
The potential for a major rally in natural gas prices and related stocks into early 2010 was the subject of the most recent issue of TES, The Gas Puzzle. As I recently devoted an entire issue to this theme, there’s no need to repeat my case for natural gas in its entirety, especially after I followed up that issue with last week’s Flash Alert, Natural Gas Rally. Nevertheless, it’s worth noting that the production drop-off and pick-up in demand I discussed is showing up in gas storage statistics. Check out the graph below.
Source: EIA
This chart compares the change in natural gas storage over the past few months to the same period in 2008. Positive numbers indicate that gas in storage built up faster in 2009 than in 2008; negative numbers indicate the opposite. In April and May of this year, gas in storage rose a good deal faster than in 2008. In July, the difference was less profound and in August, gas in storage actually increased by about 100 billion cubic feet less than it did in 2008. This doesn’t make much sense when you consider that summer 2008 was hotter than this year’s relatively mild summer–under normal conditions a hotter summer translates into higher gas consumption to generate electricity.
My basic estimate of storage levels in September the 11th of the month (the most recent EIA data) suggests that storage levels rose at a slightly faster pace this year. But consider that in early September of last year, US gas production was already feeling the impact of adverse weather in the Atlantic–hurricanes shut in significant production in the Gulf of Mexico, skewing the figures. I expect that the finalized data will indicate that adjusted for storm activity, gas in storage built up at a slower pace than one year ago.
I believe this reflects two basic facts: US gas production is dropping this year, and demand is beginning to recover. Although storage remains elevated by any historical norm, signs suggest that inventories will begin to normalize moving into 2010. Natural gas prices likely will remain volatile between now and early November (the beginning of winter heating season) as traders fret over the potential for US storage to reach its physical limits. But as gas draw-downs resume, the ramifications of the massive drop-off in drilling activity will become increasingly apparent in storage statistics.
The plays I highlighted in the last issue were: Linn Energy (NSDQ: LINE), XTO Energy (NYSE: XTO) and Chesapeake Preferred D (NYSE: CHK D). Note that I adjusted the Buy targets in last week’s Flash Alert.
In addition to these plays, land contract driller Nabors Industries (NYSE: NBR) remains among my top services plays on natural gas. I highlighted the company in the August 5 issue, Buying Coal and Natural Gas. Nabors leases land rigs to producers in exchange for a daily fee known as a day-rate. Over the past year, the number of rigs actively drilling for gas in the US has fallen over 50 percent; literally hundreds of rigs are idle. As you can imagine, falling demand and a glut of unutilized rigs has weighed on day rates and hit Nabors’ business hard.
A number of factors offset these negatives. First, Nabors fleet of land rigs is relatively modern; it has a large number of rigs that are ideal for drilling in unconventional plays with low costs of production–for example, the Haynesville and Marcellus Shale. Day-rates and demand for these so-called high-specification rigs have held up far better than for less-capable land rigs.
Second, Nabors has a number of rigs committed to producers under longer-term contracts. These rigs were primarily built for a specific producer with a particular drilling project in mind. By signing a contract of 1 to 2 years in duration, Nabors was able to lock in guaranteed cash flows to help it finance the construction of the rigs. Although these rigs will gradually roll off contracts, these longer-term deals helped soften the blow of the big drop in day-rates over the past year.
Finally, Nabors has a growing international business. Demand for rigs internationally has also fallen with commodity prices, but many of these rigs target oil–not natural gas. With oil prices recovering, there’s room for demand to rise.
The US gas-directed rig count appears to have bottomed and, as is usually the case, Nabors stock bottomed out months before that low. As gas prices recover into 2010, I expect the US rig count to gradually rise off recent lows, which should support day-rates. I also suspect that many less-capable rigs will be permanently idled, further alleviating the glut of rigs. Buy Nabors under USD23.
One of the longest-standing fallacies among investors is that coal is a dying fuel, destined to be replaced by alternative energies or other conventional fuels. But as I explained in the July 22 issue, Improving Tone, and the August 5 issue, Buying Coal and Natural Gas, coal still accounts for nearly half of all electricity generated globally, 70 percent of electricity generated in India and closer to 80 percent of China’s electricity. Coal also has been the fastest growing fossil fuel over the past five years.
The media has made much of China’s decision to build a 2GW solar power plant, the largest and most ambitious plant ever built anywhere in the world. China signed a memorandum of understanding with First Solar (NSDQ: FSLR), a component of the TES Alternatives Field Bet, to build the plant in Mongolia. The first stage, slated to get underway next June, would be for a 30 megawatt demonstration plant. Phase two would add another 100 megawatts of capacity, while the third stage would further expand this capacity by 870 megawatts. The first three stages of the project are expected to be completed around 2014. The final stage of the project would be completed in 2019 and would add another gigawatt of capacity.
This is an impressive project that will generate significant revenues for First Solar and could provide a useful proof of concept for China and other countries looking to build out solar capacity. But let’s slice through the hype and take a look at what it all really means. According to the EIA, China’s total generating capacity in 2007 exceeded 623 million kilowatts, or 623,000 gigawatts. In the year 2007 alone, China added more than 105,000 gigawatts to its power capacity. In light of those figures, a 2 GW solar plant that will take a decade to complete sounds somewhat less impressive.
The truth is that alternatives, natural gas and nuclear power will all play a role in meeting fast-growing energy demand in emerging markets, but coal is the real workhorse. Of the 105,000 gigawatts added to China’s capacity in 2007, conventional thermal power plants accounted for 96,000 gigawatts and about 90 percent of that capacity was coal-fired. Coal isn’t dead, and it’s ridiculous to assume it can be replaced by alternatives in any reasonable time frame.
I explained the shorter-term dynamics in the coal market in previous issues. But a few recent news items demand comment. First, on Tuesday the CEO of Wildcatters recommendation Peabody Energy (NYSE: BTU) reiterated that demand for coal, especially metallurgical coal used to make steel, is strong in the Asia-Pacific markets.
On Wednesday morning, the CEO of one of Peabody’s biggest US competitors, Arch Coal (NYSE: ACI), noted that the economic recovery is also pushing up US demand for coal. In particular, a number of US steel mills that severely cut back output last year and in early 2009 are now ramping up again–a positive for metallurgical coal.
Demand for thermal coal in the US remains due to lower electricity demand and some generators switching to natural gas thanks to ultra-low pricing. But rising industrial demand for power, coupled with a resurging gas prices, should help reverse that weak demand into 2010 and reduce current high inventories of coal at utilities. And the picture couldn’t be more different in Asia. India, in particular, is expected to become increasingly dependent on thermal coal imports over the next few years.
I look for three key traits in my coal plays: exposure to the Asia-Pacific markets, low mining costs and exposure to metallurgical coal markets. Peabody Energy fits the bill. I offered a detailed look at Peabody’s operations in the July 22 issue, so I won’t rehash those arguments here. Suffice it to say I’m most bullish about the company’s Australian operations, which now account for nearly half of profits. Australia is the world’s largest metallurgical coal exporter and, alongside Indonesia, is the world’s largest thermal coal exporter.
I expect Peabody grow its share of the international market. It’s already making investments in emerging coal producing nations such as Mongolia, and I wouldn’t be surprised if the company made additional acquisitions in Australia as well. I originally recommended playing Peabody using a covered call, which I explained in the May 6 issue, A Turn for the Better. If Peabody closes above USD40 in mid-January, this covered call offers a total return of 68 percent from my original recommendation. For now, I am rating this covered call a Hold; Peabody’s shares recently surged over USD40–much of the profit potential of this position is already realized.
Investors who didn’t participate in the Peabody covered call trade should buy the stock outright under USD45.
I also recommended Australia’s Felix Resources (Australia: FLX), a producer with the potential to rapidly ramp up its production and export potential in coming years to take advantage of higher demand. But as I explained in the August 11 Flash Alert and the August 19 issue of TES, I wasn’t the only one to see the value of Felix’s assets; China’s Yanzhou Coal (NYSE: YZC) is acquiring the company for a total valuation of roughly AUD17.95 per share.
The deal would hand us a total gain of around 35 percent in local currency and more than 40 percent in US dollar terms. Nonetheless, I continue to see this offer as rather low; it’s still quite possible a rival bidder could emerge with an offer over AUD20. And I see little chance that Yanzhou will walk away from the deal. I am recommending subscribers give the stock a few more weeks to see if a rival offer materializes; Felix rates a Hold for now.
I’m adding Bucyrus (NSDQ: BUCY) to the Wildcatters Portfolio as another play on coal. Bucyrus manufactures mining equipment used to produce all sorts of metals and minerals; however, far and away its top end-market is coal, which accounts for more than three-quarters of the firm’s business. Another important end-market for Bucyrus is equipment used to produce oil sands; last year this machinery accounted for about 7 percent of new equipment sales.
Coal mining equipment includes draglines, a sort of giant scoop used to scrape away the overburden (rocks and dirt) that covers coal. Draglines are primarily used in surface mining operations where the coal is located relatively close to the surface of the earth–the Powder River Basin (PRB) in the western US would be an example. Draglines are truly enormous pieces of equipment that can cost as much as USD200 million for the largest models.
Other products include longwall systems. In longwall mining, large shears are used to cut coal from underground mines. Longwall systems also include ancillary products such as roof supports that prevent mine collapse as coal is removed. And Bucyrus also makes belt systems used to move coal mined deep underground to the mouth of the mine for loading and removal.
The company sells new equipment, and provides after-market parts and services; roughly half of its revenues come from new equipment and the other half comes from after-market services. Sales of new equipment grew rapidly through mid-2008, as high commodity prices prompted mining companies to upgrade from older systems. The combination of falling commodity prices and troubled credit markets conspired to squelch this boom. But several positive trends have helped to offset the decline in new sales.
Because miners have cut back on new equipment orders, they’ve been running their existing machines harder and spending more on maintenance and parts–a boon for Bucyrus’ after-market parts and services business. Better yet, thanks to strong sales and market share gains, the installed base of Bucyrus’ equipment has tripled since 2004; higher penetration translates into more parts and service contracts. Bucyrus has built and commissioned a total of 35 draglines in the past 5 years alone.
Second, Bucyrus still has a $2 billion backlog of orders left over from the recent boom. Although the company has allowed some customers to push back orders, it’s minimized outright cancellations. The backlog has dropped only USD500 million since the end of 2008, despite the drop-off in mining activity at the beginning of 2009. Bigger mining outfits should continue to fulfill their contractual obligations, providing a cushion in these lean quarters.
Third, Bucyrus has systematically cut its expenses to shore up margins. The company reduced headcount, shuttered underperforming factories and reduced costs by installing more-efficient manufacturing equipment.
With commodity prices recovering and Chinese demand for coal picking up once again, Bucyrus has likely seen the trough in its new equipment business. In fact, the company’s guidance is that revenues will drop only slightly in 2009 while profits will actually increase thanks to lower costs. I’m looking for a return to revenue growth late this year as new orders surge again. Buy Bucyrus International under USD42.
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