Energy
Industry Outlook
June 22, 2005
When we started Thunder Energy in October 2001 the investment climate
at the time for the energy industry could best be described as utter
contempt. The near-term outlook for the industry was overwhelmed by
the short-term negative implications of the US natural gas market which
went drastically out of balance. A huge spike in natural gas prices
in early 2001 led to a surge in domestic drilling just as the spike
began to have a dramatic impact on domestic industrial demand for natural
gas. Much of this industrial demand destruction could be classified
as final in nature as it became more apparent that foreign gas supplies
were more abundant and better positioned to produce end products such
as ammonia and others that are big users of natural gas. As we expected,
the supply response from the increase in drilling was much more disappointing
than generally perceived at the time by the industry and the excesses
were worked off in much shorter order than previous imbalances. Meanwhile,
the punishing stock market response strengthened the resolve of oil
companies to only commit capital to find or produce new reserves with
much lower price expectations in mind. This resulted in the industry
setting higher than disclosed hurdle rates to ensure profitability of
capital projects.
In every facet since the genesis of tighter energy markets, the response
has been an underestimation of the actual supply-demand situation. The
reluctance of the public to forego their gas guzzling SUV’s is
a typical response to higher energy prices seen to date. There seems
to be a lackadaisical attitude toward the sustainability of higher energy
prices and that alone is a sign that the trend of higher energy prices
will sustain longer than currently expected. This fact alone convinces
us that we are very early in the energy bull market of the next decade.
This general disbelief of the attractiveness of energy for investment
was reflected in a total lack of interest in the energy fund until mid-2004
where we first saw some mild interest. Interest is currently running
very high so this cautions us to a near-term pullback. An important
lesson learned is that investors that have similarly identified the
long-term trends at hand would best be discovered by their willingness
to make investments during sharp pullbacks. This eliminates the counter-productive
experience of the typical fund of fund approach to jump on the latest
hot trend and bail on price corrections that would otherwise be most
beneficial.
The sentiment of analysts and Wall Street has changed 180 degrees since
2001. The best example of this can be seen from commentary by Goldman
Sachs. In September 2001, after the downing of the towers of the World
Trade Center which has been attributed to Middle Eastern terrorists,
and continual altercations between Israel and Palestine, their call
was that energy prices may well spike but the spike would be short-lived
due to its effects on the economy which would almost immediately lead
to lower prices. These statements caused crude prices to plunge to around
$18 per barrel. Contrast that today with Goldman’s current call
that prices may spike to $105 per barrel and you have a sense of the
optimism that has built. While these changes in perception are important
to monitor, it is most important to stay focused on the attractive long
term fundamentals. Among the most obvious is the long period of underinvestment
in the industry; for example, there has not been one elephant oil well
found in the last 35 years. This glaring lack of response by both the
industry and no visible efforts toward conservation by consumers despite
a doubling in prices, leaves the country dangerously exposed to an oil
shock as suggested by Goldman. There are multiple supply disruption
threats around the globe not the least of which is Venezuela led by
its rebellious leader Hugo Chavez.
The global scramble to procure long-term energy supply as well as many
other commodities has clearly gathered a head of steam. The rapid industrializations
of China, as well as India, are in the forefront of this quest for scarce
resources. While per capita consumption of oil in China and India are
among the lowest in the world at 1.7 and 0.7 barrels of oil per year,
respectively; these rates are poised to explode higher as these countries
rapidly modernize. Compared with America’s 27 barrels per capita,
their growth is much more likely to be understated rather than overestimated.
A good example of this was the rapid development of South Korea beginning
in the 1970’s. At that time South Korea’s per capita oil
usage was 1.9 barrels a year. By 1985, this rate more than doubled to
4.5 barrels a year and by 1994 per capita usage reached 14 barrels a
year! With China and India the main targets of economic outsourcing,
trends are rapidly accelerating as labor cost advantages are arbitraged.
When you combine the political risk of oil supply disruptions with
rapidly industrializing economies, you have a backdrop for potentially
wild volatility. A sharp spike in the oil price as suggested by Goldman
could result in longer run implications such as a new awareness and
movement toward conservation bringing into play the old adage, “the
best cure for high energy prices is high energy prices”. These
risks can be minimized by identifying the sectors of the energy industry
that would not be as influenced by such an occurrence and this is how
we plan to navigate the excellent opportunities in energy over the next
decade.
While prices can change dramatically when a long-term opportunity becomes
better known, we believe there are certain sub-sectors of energy that
are still very under-exploited compared with the opportunity. Three
of our favorite areas currently are: uranium, coal, and drilling contractors.
While the drillers have had the best recent performance we will just
mention a few key points since we expect better entry points will be
forthcoming. Utilization rates are currently extremely high both on
land and offshore, at levels that provide excellent pricing leverage.
Deepwater specialists such as Transocean and Diamond Offshore are seeing
the biggest dayrate increases. This is an especially good sign since
such rigs are extremely expensive and represent a strong long-term commitment
on the part of the big money players such as Exxon and Chevron to commit
capital in search of big new reserves. Recently, Transocean announced
a contract that will see the dayrate of a rig more than double from
a rate of $145k per day to $320k per day.
The uranium area is by far our favorite area and represents our highest
weighting due to its obvious choice as a solution to the lack of sufficient
resources in the electricity generation area. For years, the 103 US
and 404 worldwide nuclear power plants have depended on the conversion
of uranium from nuclear warheads to supplement production. Global uranium
production only amounts to 102 million pounds annually while consumption
was 173 million pounds last year. Going forward, production requirements
will go up as stockpiles go down and new nuclear power reactors are
built. China, India, Japan, and South Korea alone currently have 24
reactors under construction. China and India already have plans for
40 more. While 20 years ago there were 26 uranium mills operating, there
are now only 4 mills remaining. One of the most exciting factors for
the future of uranium is that a sharp rise in the price to even $100
per pound would not detract from the economics. It would, however, be
tremendous for the stocks we are invested in. The objections to nuclear
power are in rapid decline, surprisingly, for environmental reasons.
Fossil fuel is causing increasing amounts of pollution while new technologies,
namely the pebble bed modular reactors, have sharply increased safety
and lowered expense.
While the long-term outlook for energy is solid, near-term inventories
of oil and gas appear adequate with few shortages. With the political
outlook of the world, however, this could change in a flash. The uranium
group appears to be finishing up on a sharp correction that makes our
strategy for energy particularly attractive at the current moment. There
are a few stocks in the sector we recently began building positions
in and would sharply accelerate that process with any new funds at this
time.
Richard J. Greene
June 22, 2005