i don't get it, page-15

Hope this helps...

10 REASONS WHY NOW IS A GREAT TIME
TO INVEST IN THE ENERGY SECTOR
by Bill Powers
Editor, Powers Energy Investor
July 2, 2009

With the general stock market rally stalling out and the economic news getting worse by the day, many investors are left wondering about the future. Despite the difficult economic times, fundamentals of the energy sector have improved over the last six months and will continue to do so. Investors who can find fundamentally solid companies that are growing reserves-per-share and production-per-share will be well rewarded once the general market recognizes the values available in the energy sector today. Below I have listed ten fundamental reasons the energy sector is a great place to invest.

Reason 1: Low Valuations

It is often written that truly great investment returns are closely tied to valuations at the time of investment. For example, many investors who made the plunge into great technology companies such as Cisco Systems over a decade ago still find themselves underwater despite tremendous growth by the company on nearly every front. Meanwhile, investors who chose to allocate funds to the oil and gas sector (or nearly any commodity related investment) when valuations were very cheap have enjoyed nearly a decade of great returns despite the incredible volatility of the past two years.

The 74% drop in the price of crude and a similar drop in the price of natural gas that began in middle of 2008 and continued into early 2009 devastated valuations in the oil and gas sector. Exploration and production companies (E&P), which never traded at valuations that incorporated $100+ oil and double-digit natural gas prices, found themselves caught in the selling tsunami. While there will be many companies who will not be able to make it through today’s lower commodity price environment, the surviving companies are now trading at historically low valuations on nearly every metric. While it is impossible to invest at the bottom, investors who are bullish on the energy sector have not had as an attractive an entry point in nearly a decade.

Reason 2: Peak Oil

Probably one of the most important events of the first decade of the 21st century will be the peaking of worldwide oil production. By no means does this mean that we are running out of oil or that we are on the verge of severe shortages, simply Peak Oil means that the world will no longer be able to grow production on a year-over-year basis irrespective of price or new technology. Much of the seminal work on the study of Peak Oil can be traced back to a Shell Oil researcher named M. King Hubbert who espoused the theory that once half of the reserves of given oil producing field are produced that field will go into an irreversible production decline. Based on this theory, which has become known over the years as “Hubbert’s Peak”, Mr. Hubbert predicted in 1956 that US oil production would peak in 1970. His prediction came true and US oil production has been declining ever since. A number of prominent oil industry experts, based on Hubbert’s work and intense study of the current state of world oil production, believe worldwide production is in the process of peaking or has already peaked. While I do not believe the exact date of Peak Oil is important, I am a firm believer that the peaking or even flattening of world oil supply will lead to higher oil prices and greatly improve the fundamentals of investment in the energy sector.

Reason 3: Peak Natural Gas

Despite television commercials that aired during the summer of 2008 featuring the likes of Chesapeake Energy CEO Aubrey MacClendon and T. Boone Pickens promoting the use of natural gas as a cheap and plentiful alternative to imported oil, the true state of world natural gas supply is far different from the picture painted by these two gentlemen. Examining the production profile of the United States since the start of the decade is very helpful in understanding some of the changes that are occurring but yet to be recognized by most gas market observers. According to the US Department of Energy, domestic natural gas production peaked in 2001 19.61 trillion cubic feet (tcf) from 373,304 producing wells. The following year the US produced only 18.96 tcf from 383,626 producing wells, the most ever. US production continued to drop until 2005 when mass implementation of horizontal drilling and advanced fracture stimulation technology opened up a large number of previously uneconomic unconventional gas plays. Natural gas directed drilling on a scale never seen before caused US production to reach a second peak of 20.57 tcf in 2008. However, this second peak is not only unsustainable, but it has set the stage for an enormous collapse in US gas production and a spike in prices in the second half of 2009 or early 2010.

While many in the energy industry have touted the potential of liquefied natural gas (LNG) as a potential savior for any US natural gas supply shortfall, I do not see LNG as playing a significant role in US supply for at least another decade if ever. It is not for a lack of regassification capacity but for a lack of available supply. It is difficult to overstate the impact the collapse of Russian natural gas production is having on world production and therefore on world LNG demand. According to a March 4, 2009 Wall Street Journal article, Russia’s federal statistics agency reported February 2008 natural gas production fell 16% from a year earlier. The article went on to discuss how some of this drop in output is due to falling demand but it also stated that production is expected to fall further in the balance of 2009.

After Vladamir Putin’s turning off gas supplies to the Ukraine and eventually Europe during one of the continent’s worst cold spells in years in January 2009, many whispers about the true state of gas production in Russia have begun to surface. While Russia is widely recognized as the largest producer of natural gas in the world and the country with the largest natural gas reserves, few have acknowledged that much of the country’s natural gas production is dependent on one aging field in Western Siberia. Julian Darly’s book “High Noon for Natural Gas” published in 2004 had the following to say about the state of affairs of Russia’s largest natural gas field nearly five years ago:

“Russian gas production relies very heavily on western Siberia, particularly its largest gas field, Urengoi. This field is now estimated at 230 Tcf, down from earlier estimates of 350 Tcf, and at least half its gas has been extracted. Furthermore, some analysts believe that despite a large new development, western Siberia faces serious gas depletion problems, and will start to contract by more than 5 percent as soon as 2003 or 2004.”– page 105 High Noon for Natural Gas

It seems increasingly unlikely Russia will continue to supply Europe with 25% of its natural gas via pipelines of which 80% comes via pipeline through the Ukraine. This in turn will set off one of the largest grabs for LNG cargoes by concerned European nations in history. The decline of Russian natural gas production combined with the declining production by several of the world’s largest natural gas producers such as the US, Canada and the United Kingdom, which along with Russia account for 52% of total world production, will eventually cause demand for LNG cargoes to overwhelm supply and drive the price of gas in both North America and worldwide to previously unheard of levels.

Reason 4: Terrible Investor Sentiment

After a cathartic selling of everything energy in the second half of 2008 and into the first quarter of 2009, many industry insiders and investors have reached a level of despair that has rarely been seen before. From fellow Chicago native and market historian/analyst Don Coxe, who also happens to be a big believer that we are in a long term commodity bull market, comes the following saying about bull markets:

“You know that you are in a bull market when those who know it best love it the least because they have been disappointed the most.”

After a couple of visits to Calgary earlier this year and seeing bearishness abound, it has become very clear to me that we are in a period when those who know the oil and gas business the best love it the least because they have been disappointed the most.
Taking the contrarian view on the energy sector is never easy but I believe the values we are seeing today are due in large part to negative investor sentiment among other factors. Investors who are able to go against the grain have the opportunity to generate spectacular returns over the long term.

Reason 5: The Credit Crisis

While it is difficult to quantify the exact impact the tightening of credit has had on the oil and gas industry it is quite obvious that the contraction in credit in the industry is leading to a decline in activity. The cost of capital for nearly every industry participant is much higher than at any time this decade. Companies of all sizes are seeing their revolving lines of credit reduced and many are being forced to live within cash flow. Additionally, lack of access to capital has forced many companies into mergers on unfavorable terms and some of the weaker players into bankruptcy.

More importantly, lack of easy credit or credit on any terms, will not only force companies to massively reduce capital expenditure budgets during periods of weak commodity prices, but it will keep a lid on spending once commodity prices improve.

Reason 6: Industry Consolidation

The consolidation of the oil and gas industry has been proceeding at a rather steady pace in recent years but it is likely to pick up speed as the larger independent companies and majors rush to tie-up the remaining non-OPEC reserves. With many companies with significant reserves in the ground trading well below the net present value of their reserves I believe this situation cannot last for long. Industry consolidation is an excellent thing for small and intermediate sized companies that remain independent for three main reasons. First, the remaining companies will see their valuations trend upwards as their peers are taken over at higher and higher valuations. Second, industry consolidation reduces the competition for attractive farm-in arrangements or tuck-in acquisitions with large independents or majors looking to monetize non-core acreage. Lastly, when investor sentiment turns and money flows into the oil and gas sector there will exist fewer independent oil and gas companies and therefore valuations should move up sharply.

Reason 7: Lower Service Costs

With the cost of drilling and completing wells expected to fall approximately 25% in 2009 it appears the days of oilfield service inflation appear to be over for the foreseeable future. The drop in commodity prices and the tightness of credit has led to large capital expenditure program reductions around the world. After having lived through five years of double digit inflation in the cost of everything related to drilling and completing wells, many of the major oil and gas companies are waging war with their service providers at a time of very low rig utilization rates. The downward pressure applied by the majors and the larger independents has already lowered some rig rates by more than half, lowered the cost of workovers and dropped fracture stimulation costs. With a service capacity glut showing no signs of abating due a rig count that continues to drop, I expect oil and gas producers to be able to significantly increase the rates of return on many projects.

Reason 8: Rampant Money Growth

With the supply of money growing at a never seen before pace in every corner of the globe, investors will increasingly favor hard assets in this new era of negative real interest rates and quantitative easing. With the inability of central banks to create energy supplies out of thin air there should be little doubt that investors will gravitate towards hard assets especially depleting resources such as oil and gas. The depreciation of the world’s reserve currency, the US dollar, despite its recent rise due in large part as a flight to safety will reverse itself in coming months and create a huge rally in the commodity currencies of the world, especially the Canadian dollar. Oil and gas prices should appreciate handsomely in the current world of easy money as many OPEC countries, who already have their fill of dollars, will ratchet down exports of both oil and LNG in an effort to raise prices to make up for a decline in the US dollar.

Reason 9: Relatively Inelastic Demand

While much has been made in the economic press about how the significant economic contraction has led to declines in demand for oil and gas, little has been mentioned that nearly all of the drop demand for oil and refined products has been solely in the OECD. On a worldwide basis, demand for oil has been relatively flat. Countries such as China and India, whose economies continue to grow despite the worldwide slowdown, continue to increase their demand for oil and gas. According the US Department of Energy’s Energy Information Agency Short Term Outlook released March 10th the following figures where provided,

“Average annual world oil consumption is projected to decline by almost 1.4 million barrels per day (bbl/d) in 2009, with consumption in the OECD falling by 1.6 million bbl/d.”

It should be noted that in a world that consumes approximately 85 million barrels a day a drop of 1.4 million barrels is less than 2%. Given severity of the worldwide economic contraction I would consider the demand for oil very inelastic.

Pinpointing demand for natural gas is much more difficult than determining demand for oil since much of the demand for natural gas is based on the weather. However, demand for natural gas, at least here in North America, has become much more inelastic over the last decade. According to the US Energy Information Agency, the consumption of natural gas by producers of electricity has risen from 4.58 tcf in 1998 to 6.65 tcf in 2008. To put the 2008 number into perspective, it represented XX% of total US natural gas consumption of 23.23 tcf. As more large users of natural gas such as chemical plants move overseas, demand for natural gas will become less dependent on economic activity and more dependent on the relatively stable demand as feedstock for natural gas fired power plants. Given the movement towards cleaner burning fuels to power the electricity grid I see natural gas demand continuing to increase in the stable base load electricity generating sector.

Reason 10: Very Elastic Supply

In a world of Peak Oil and Peak Natural Gas and massive cuts in capital expenditures in every link of the oil and gas production chain there is a strong possibility that we are on the verge of an energy shock that will make the shock of the 1970’s look tame. While there are very few in the analyst community that share this view, the facts speak for themselves. There are countless examples of where record spending on development at times of high prices still could not halt production declines in either specific fields or in countries. This indicates a small reduction in spending will likely lead to significant declines in production. With development projects taking longer to come online and few new large discoveries waiting in the wings for development at today’s prices, the decline rates of today’s mature fields will likely be revealed very quickly. For example, few in the analyst community foresee the huge drop in North American gas production we will see in second half of 2009 and in the first half of 2010. With the US natural gas rig count down over 50% from its September 2008 peak and continuing to decline, I see a huge drop in North American natural gas production coming in the second half of this year. With the increased use of horizontal drilling technology and large fracture stimulations in unconventional gas resource plays, the overall rate of decline of many fields is approaching 40%. Production declines in oil fields will not be nearly as dramatic but will become quite significant when the impact of massive capex reductions begin to be felt.

Given the above ten reasons why I believe now is a great time to invest in the energy sector, I cannot overstate the importance of increased knowledge of both the macro outlook for energy and where to invest.