Crude Realities

In the premiere issue of 2011, my forecast called for oil prices to exceed $100 per barrel in the first quarter, top $120 per barrel at some point during the year and average more than $95 per barrel. Although my outlook for oil prices was more bullish than Wall Street’s consensus estimate, each of these predictions came to fruition.

Both West Texas Intermediate (WTI) crude oil and Brent crude oil eclipsed $100 per barrel in the first quarter of 2011 and later reached highs of about $115 per barrel and $126 per barrel, respectively.

My bullish outlook for oil prices was rooted in a tightening supply-demand balance. Some pundits blame geopolitical risks for oil’s resilience in 2011, but these critics overlook a key point: When the loss of Libya’s 1.5 million barrels per day of oil production produces a supply shortage in a market of 90 million barrels per day, the supply-demand balance is exceedingly tight. With oil demand on the rise in China and other emerging markets and non-OPEC supply growth likely to remain constrained, the 40 percent surge in oil prices that occurred in early 2011 provided investors with a temporary preview of the future.

According to the International Energy Agency (IEA), global oil demand grew by 700,000 barrels per day in 2011, while non-OPEC oil supply expanded by only 60,000 barrels day because of project delays and disruptions to Libyan production. This imbalance forced oil-consuming nations to tap their existing inventories. Fortunately, OPEC also brought some of its spare capacity online to prevent oil prices from reaching levels that would destroy demand.

My outlook for 2012 calls for more of the same in the oil market. The price of WTI should rise in the short term and average about $100 per barrel over the course of the year. Meanwhile, Brent crude oil should command a premium of about $10 per barrel relative to WTI. Both benchmarks should retest their 2011 highs at some point in 2012. Once again, my outlook for oil prices is above Wall Street’s consensus expectations.

Bearish commentators often argue that growth in oil demand will weaken in 2012 because of slowing economic growth in emerging markets, a recession in Europe and a potential contraction in the US economy. My outlook for the global economy isn’t as dour.

Although Europe will likely lapse into this a recession this year, the region accounts for less than 16 percent of global oil demand. Europe’s oil consumption has declined steadily for years and hasn’t driven demand growth for some time; a moderate recession in the eurozone shouldn’t have an outsize affect on the global oil market.

If the US economy manages to grow 2 percent to 3 percent in 2012, the nation’s oil demand should remain relatively flat. Don’t believe the hype about a decline in US consumption of oil and refined products. Although demand plummeted during the Great Recession, US oil consumption has recovered and held up reasonably well.

Source: Energy Information Administration

The IEA estimates that total North American crude oil demand will fall by about 250,000 barrels per day (0.8 percent) in 2011 and 135,000 barrels per day (0.5 percent) in 2012. Much of this potential downside would stem from conservation in the face of high prices. US oil demand could also surprise to the upside; auto sales reached 13.52 million units annualized in December 2011, the second highest total since Cash for Clunkers was in full swing.

Emerging markets will continue to drive global oil demand in 2012. Since the beginning of the decade, China and other emerging markets have accounted for about 95 percent of the surge in oil consumption. With China’s Purchasing Managers Index climbing above 50 in December and Beijing likely to ease fiscal and monetary policies in 2012, the nation should be able to match this year’s GDP growth of about 8.5 percent in 2012.

Developments on the supply side could also tighten the balance in global oil markets, particularly if non-OPEC production falls short of expectations once again. At the end of 2010, the IEA projected that oil production outside OPEC would increase by 600,000 barrels per day in 2011; in reality, project delays worldwide limited output growth to a tenth of the forecasted amount.

The IEA’s current outlook calls for non-OPEC production to grow by roughly 1 million barrels of oil per day, led by an uptick of 150,000 barrels per day in the US, 160,000 barrels per day of incremental supply from Canada and almost 250,000 barrels per day from Latin America. Setbacks to deepwater developments offshore Brazil or in the Gulf of Mexico could prompt the IEA to lower its forecast. For more color on long-term trends in oil supply and demand, check out the Oct. 19, 2011, issue, Supply and Demand Revisited.

Investors shouldn’t heed overblown concerns about Iran’s threat to disrupt the global oil market by closing the Strait of Hormuz, a strategically important waterway between Iran and Oman, at the mouth of the Persian Gulf. About 15.5 barrels of oil per day are transported through the straight annually.

This latest proclamation isn’t the first time Iran has threatened to disrupt the global oil trade; for all its rhetoric, the nation is unlikely to pursue such a course. Although the financial media continues to attribute rising oil prices to Iran’s threats, it’s telling that the price of WTI, a North American benchmark, has rallied more than Brent crude oil, an international bechmark that would be more sensitive to such a disruption. Meanwhile, with the market for oil futures still in backwardation, a near-term rally in crude prices could have legs. (See A Short-Term Trade on WTI for more details).

Oil-services names remain my top bets on rising oil prices, as well as select equipment providers and producers that have the scope to grow their output meaningfully. Although shares of oil-services stocks have underperformed in the past year, valuations in this industry are completely incongruous with prevailing oil prices and rising drilling activity. These stocks should take off whenever investors shift their focus from macro-level concerns to stock- and industry-specific stories.

My favorite oil-service plays include Schlumberger (NYSE: SLB), the industry’s largest player and leading innovator, as well as Weatherford International (NYSE: WFT), a deeply undervalued name and the smallest of the Big Four service providers. Fourth-quarter earnings could act as a near-term upside catalyst for the stocks; investors should take advantage of depressed valuations and buy Schlumberger under 100 and Weatherford International under 17.50.

Aggressive Portfolio holding Petroleum Geo-Services (Oslo: PGS, OTC: PGSVY) collects and sells high-end seismic data describing oil and gas formations to exploration and production firms. With producers likely to step up offshore exploration and development in 2012, the seismic market should tighten in 2011, enabling Petroleum Geo-Services and others to raise prices. Buy Petroleum Geo-Services’ American depositary receipt up to USD17.50.

Growth Portfolio holding Core Laboratories (NYSE: CLB), which specializes in reservoir description and a host of services that maximize oil and gas recovery rates throughout a field’s life cycle, generates about 70 percent of its revenue from international oil companies. The company enjoyed a strong 2011, and more upside is in store for 2012. Buy Core Laboratories when the stock dips below 105.

Contract driller SeaDrill (NYSE: SDRL) boasts the most modern fleet of offshore drilling rigs in the industry, sports a dividend yield of almost 9 percent and continues to add high-specification rigs that command the highest day-rates. Buy SeaDrill up to 38.

Among the producers in the model Portfolios, I continue to favor Aggressive Portfolio holding Oasis Petroleum, a small-cap name that continues to ramp up production in the oil-rich Bakken Shale and could be a takeover target. EOG Resources (NYSE: EOG), which boasts leading positions in the nation’s most exciting shale oil plays, also offers plenty of near-term upside. Buy Oasis Petroleum up to 36 and EOG Resources up to 125.

We’ve Got Gas

My 2011 outlook for natural gas prices in North America generated a fair amount of negative email from some readers, but a persistent oversupply ensured that the commodity traded for less than $5 per million British thermal units for much of 2011.

I revisited this outlook in Step Off the Gas, predicting that natural gas prices would remain depressed for the next few years and highlighted the likelihood that the commodity would trend even lower in late 2011–which is exactly what happened.

My outlook for the North American gas prices hasn’t changed one iota since I penned Step Off the Gas; please consult that issue for an in-depth analysis of supply and demand trends in this market. 

In contrast, supply and demand conditions for liquefied natural gas (LNG) remains sanguine in international markets.

The Asia-Pacific market tightened substantially in 2011, as China brought two new import terminals online. China’s monthly LNG intake increased an average of 30.7 percent through the end of August 2011, a remarkable feat after the country’s LNG demand surged 67 percent in 2010. 

Meanwhile, as we forecast in March 24, 2011, issue, The Fallout, Japan’s demand for LNG has spiked after the magnitude-9.0 earthquake permanently damaged the Fukushima Daiichi nuclear power plant and forced the government to shut down many of the country’s nuclear reactors for stress tests. As of the end of December 2011, only six of Japan’s 54 nuclear reactors were operating. Legislation requires that these reactors undergo maintenance every 13 months; unless idled capacity is brought online, the nation could find itself with a severe power shortage in May.

Accordingly, we expect Japanese demand for LNG cargos to remain robust, particularly during the summer cooling season and winter heating season, which should keep prices elevated in 2012. 

European demand for natural gas will likely moderate in the coming year because of economic weakness, but elevated oil prices should continue to incentivize utilities to reduce purchases of oil-indexed pipeline gas to the lowest levels allowed by contract, replacing these volumes with lower-priced LNG.

One of the biggest winners from increasing demand for LNG cargos will be Conservative Portfolio holding Teekay LNG Partners, which owns a fleet of 20 LNG carriers, five vessels that transport liquefied petroleum gas and 11 conventional tankers. The surge in demand for LNG has produced resulted in a severe shortage of shipping capacity, sending day-rates to new highs and enabling operators with excess capacity to ink favorable long-term contracts. Teekay LNG Partners LP rates a buy up to 41.

King Coal

Last year was the best of times and the worst of times for Peabody Energy Corp, our top play on rising demand for seaborne thermal and metallurgical (met) coal.

The company began the year with promise: Severe flooding in eastern Australia disrupted mining output, sending the price of seaborne coal through the roof. Robust demand in Asian emerging markets, particularly for met coal used in steelmaking, tightened the market even further. In the first half of the year, Peabody Energy and other producers benefited from skyrocketing prices that more than made up for any reduction in volume.

But as macro fears mounted, investors began to price in a rapid decline in thermal and met coal prices. The shift in sentiment made coal-related equities one of the worst-performing energy groups in the second half.

Fortunately, this selloff reflects a shift in sentiment more than a shift in fundamentals. In fact, Chinese coal imports hit an all-time high of 22.14 million metric tons in November 2011. At this point, investors have focused more on the worst-case scenario than conditions on the ground.

Peabody Energy, which gave up 47.9 percent on the year, was the worst performer among the coal-related stocks in the model Portfolios. Not taking some of our profits off the table in the first half of the year was my biggest mistake in 2011. At this point, Peabody Energy remains one of the most undervalued stocks in my coverage universe; once investors focus on fundamentals rather than an unlkely worst-case scenario, the stock price should take off.

Some investors have expressed concerns that Peabody Energy overpaid when it acquired Australian miner MacArthur Coal in December and that the company took on too much debt to finance the deal. But the deal dramatically increases Peabody Energy ability to grow its production over next few years; management has outlined a compelling case as to why the deal will be accretive to earnings in the second year of combined operations.

Although management lowered its full-year earnings guidance in the fall, this revision reflected one-off production issues, not poor geology at the company’s mines. In some cases, worse-than-expected output was due to supply shortages of equipment from Japan, a headwind that should fade in 2012.

At current levels, the stock has little downside and represents a compelling play on China’s solid economic growth in 2012. Buy Peabody Energy Corp up to 45.