Musings: Will Energy Be as Important in the Next Decade as Last?
We awoke last Friday morning to the start of a new decade. We had been noticing for several weeks before that many articles were appearing in the media reviewing the prior decade's most important events -- whether they were in politics, business, entertainment or sports. One theme that emerged was the difficulty reviewers had in deciding what to call the past decade. We saw references in the Financial Times and The Houston Chronicle to terms such as "Noughties" and "Aughties." On a web site seeking names for the decade, people suggested all sorts of ideas including "00's," "Zeros" and "Forgetful."
A year-end stock market wrap-up column on CNN Money.com suggested that names such as "Naughty Aughties" or "Awful Aughts" or even "Zilches" were appropriate given the amount of wealth destroyed during the decade. The writer seemed to settle on the "Uh-Ohs" as they labeled their charts with that term. Paul Krugman of The New York Times wrote a column last week on the decade in which he called it the "Big Zero." While we haven't come up with a catchy monocle for the decade, we tend to think it will be known as the "00's" in keeping with the conventional description of the 60s, 70s, and so forth. Regardless of what we call it, we are certain about one fact -- energy played a significant role in the last decade.
A chart showing the performance of the broad stock market averages over 2000-2009 reminds us how bad the last 10 years were for the nation's investors. During that time the Dow Jones Industrial Average fell 8%, but that was considerably better performance than either the broad-based S&P 500 Index that declined 23% or the tech-heavy Nasdaq that dropped 44%. The near-by chart documents these performances.
As the reviewer pointed out, the last decade was marked by recessions at either end, including one that rivaled the Great Depression, along with accounting scandals, poor business decisions and greed running wild. The energy business was involved in some of those events as a timeline for the decade shows. But what stood out to us when we started examining the period in greater depth was just how well energy investments performed. We need to point out, however, how important it is to have the trend as your friend: In this case, that trend was generally rising oil and gas prices.
As shown in the accompanying chart, crude oil and natural gas prices started out the decade at lower levels then they ended. During the decade, however, there were extended periods when prices seemed to be stagnant. For crude oil that seemed to be from the beginning of the decade until mid 2004 when the Chinese economy's need for oil not only escalated but it became a central focus for both that government's economic planning efforts and the global media's attention. As global oil consumption climbed during the decade, the world's ability to satisfy that growth was continually under pressure. As in all free markets, the rationing mechanism of price is how we balanced demand and supply. As the oil supply/demand balance tightened in the middle of the decade, and forecasts called for continued growth in demand, oil prices slowly started on an upward course that would eventually take them to an all-time peak of $147 per barrel in mid 2008 just before the collapse of global economies. The subsequent fall to lows last seen before the emergence of Chinese oil demand shocked the industry, for it only to be whip-sawed by a recovery that took oil prices back to near $80 a barrel by the end of 2009.
For natural gas, which started 2000 at around $2 per thousand cubic feet (Mcf), the volatility of prices during the first three years of the decade would fail to convey how much gas markets would eventually change. From the $2 lows of 2000 and 2002, gas prices would quickly climb by over threefold to the $6 to $7/Mcf range where they traded from 2003 to nearly 2008. Then, taking their lead from the upward trend in crude oil prices, natural gas prices soared to nearly $14/Mcf before collapsing along with oil prices as the global recession and credit crisis undercut demand and energy company access to capital. As opposed to the recovery in crude oil prices in the early months of 2009, natural gas became a victim of the industry's drilling and technological success in exploiting gas shale resources that saw gas production continue to grow in the face of falling prices and curtailed drilling. An increase in gas demand heading into the 2009-2010 winter has given gas markets some hope that the recent recovery in prices will be sustained, but the latest production data for October casts some doubt over that view.
Given the decade's upward trend in oil and gas prices despite periods of stagnation, energy equities were favored by many investors. As the nearby chart shows, three broad indices of energy sector stocks showed strong outperformance versus the broad stock market over the entire decade. Interestingly, energy stocks almost always outperformed the overall stock market throughout the decade.
Indices representing three of the broad energy sector segments are displayed in the chart in Exhibit 3. The Philadelphia Oil Service Stock Index (OSX) represents the oilfield service companies while the XOI (Amex Oil Index) and the XNG (Amex Natural Gas Index) are representative of the larger oil and gas companies and the smaller exploration and production (E&P) companies, respectively. For the entire decade, the OSX and XOI indices generated nearly the same performance for investors. The XNG index considerably outperformed the other two energy stock indices reflecting the greater ability of smaller E&P companies to grow both their asset
values through successful exploration and development results and their production as they are usually starting from small bases. With the help of rising oil and gas prices and optimistic expectations for future commodity prices, E&P companies seem to have the best of both worlds in the stock market.
While all of this appears intuitively rational in hindsight, there were many times during the last decade when one seriously questioned the ownership of any of these energy stocks. Those questioning times arose when investors became focused on potential problems with the health of the future economy. One of those first questions came as we started the decade with fear of what the Y2K event might do to global economies and thus their energy demand and even the ability of energy companies to operate in the future. January 2, 2000, proved that we had little to fear -- either because we had anticipated and corrected all the potential problems or Y2K was over-blown. But as the energy saga of the decade got off to a good start, we soon found ourselves dealing with the issue of deregulation in the California energy market, which most thought would be a good thing. Few saw the restructuring of California's energy business as a potential triggering event that would create havoc for years. The year also brought us a hard-fought presidential election whose outcome would continue to influence the energy business for the balance of the decade. Little did we understand that outcome as we anxiously watched the hanging chads in the Florida vote re-count.
By the next year, with a new president from Texas with an oil industry background installed in office, energy executives looked forward to better days for their business. But that summer California began to experience power supply disruptions as electricity demand appeared to be outstripping the industry's ability to satisfy it. A major beneficiary of this power market turmoil was a Houston-based company, Enron, which saw its stock price soar to a peak of $90 a share that year. But as California dealt with rolling brownouts and isolated blackouts, the trading of electricity fell under intense regulatory and political scrutiny. With this scrutiny came questions about the accounting behind Enron. Before the year was over, Enron was gone. The bankruptcy of Enron, one of the largest in the history of the country, despite a desperate last-ditch call to the White House for help that was never answered, opened up a new chapter for energy markets, especially the electricity sector. It was a chapter marked by public scorn for energy companies and glee over the perp-walks of energy company executives.
But the events in early 2001 rapidly faded into the background when the U.S. was attacked on 9-11. The event and its immediate aftermath triggered a global recession and a fall in worldwide energy demand. While the specters of political unrest and economic distress became dominant themes, another event with seemingly less ominous implications happened. Economists at the investment banking firm of Goldman Sachs (GS-NYSE) coined the term "BRIC" as shorthand for designating the significant role that four developing/recovering economies would play in the world's future. Brazil, Russia, India and China were identified by these economists for the first time as all having similar forces at work that would promote high growth rates for their economies that would begin to pressure global commodity markets.
For the energy business, the geopolitical events spawned by the 9-11 attacks were played out during 2002 in Venezuela where the nation's oil industry executives went on strike to challenge the power of the country's socialistic and charismatic ruler, Hugo Chavez. Mr. Chavez wanted to make various changes to how the oil company worked, and especially how its money was controlled. Venezuela's oil production and oil exports fell rapidly reducing the government's flow of income. At the end of the day, Mr. Chavez won and Petroleos de Venezuela SA (PdVSA) was broken. Competent management and technical talent were exiled and replaced by people with less operational skills but highly loyal to the country's leader. The defeat of PdVSA emboldened Mr. Chavez who looked for other sources of income to support his socialist government. The operations of western oil companies in Venezuela became an easy target and the first steps on the road toward their nationalization were taken.
In 2003, Operation Iraqi Freedom began as the United States set out to seek retribution against the source of the power behind the 9-11 attack and to influence the Middle East's tolerance for sponsoring terrorist activity. For the energy industry, the war did little to disrupt markets, although it did add slightly to global oil demand as the troops needed fuel to prosecute the war and to sustain them in the region. But some thought the war was all about oil.
A series of events in 2004 set the tone for energy markets for the balance of the decade. That was the year that China's oil demand growth exploded onto the public's radar screen. China's oil demand made it onto the front pages of global newspapers because the International Energy Agency (IEA), the body charged with projecting energy demand and helping western country governments manage their energy markets, totally missed anticipating the increase.
The pressure on China to construct facilities for the upcoming Olympics and for the Chinese government to build infrastructure throughout the country in anticipation of showing it off to the crowds coming for the event boosted oil consumption well beyond any prior increase China had ever experienced. It is important to note that China had only recently become an oil importer so the surge in oil demand put unusual pressures on the global oil industry and its ability to deliver supplies to the country on a timely basis. The shortage of electric power nationally was offset by the use of portable power generators burning diesel and swelling China's need to import more fuel. This added to China's energy problems as the country was short of refining capacity thus needing to import refined product, not just more crude oil.
This was also the year that Hurricane Ivan roared through the Gulf of Mexico doing damage to offshore drilling and production facilities and heightening concerns about how vulnerable the U.S. energy industry was to severe storms. And 2004 marked the first time that Goldman Sachs' energy analysts discussed the potential of a "super spike" in oil prices. They suggested that a spike driven by demand and supply issues could boost global oil prices to a high of $95 a barrel sometime within the next few years, although they were officially only predicting an oil price in the $40 a barrel range for 2005.
If the events of 2004 did not get everyone's attention, 2005's events certainly did. The fallout from the explosion in global oil demand growth the prior year, driven by China's need for more oil, resulted in a growing focus on the ability of the petroleum industry to meet this accelerating oil consumption growth coming from the developing economies led by the BRIC countries. Matt Simmons took on the world's largest oil supplier, Saudi Arabia, with claims that "the sheiks had no robes" as his analysis of published papers by Aramco (the state-owned oil company) engineers pointed up serious production problems within the country's bedrock oil supply sources. The thesis underlying Twilight In The Desert engendered a fierce debate within the world petroleum industry, eliciting a determined publicity campaign by the Kingdom to discredit the book and to ease energy consumer concerns about the Kingdom's ability to meet the global oil needs of the future. The idea of Peak Oil when we can't meet growing oil demand became firmly implanted in the minds of citizens around the world with, for many, scary scenarios of a world heading back to caves and clubs.
The Peak Oil debate was further fueled by a revised Goldman Sachs super spike forecast that oil prices could reach $105 a barrel. Support for both positions was provided by the efforts of the CNOOC Ltd. (CEO-NYSE) to buy U.S.-based Union Oil of California. While it seemed that the Chinese really coveted Union Oil's Southeast Asian oil and gas assets, the bid produced a nationalistic uproar in Washington that ultimately led to domestic giant Chevron (CVX-NYSE) buying the company. People wondered, if China was willing to risk political repercussions in battling the U.S. government in order to buy an oil company with actual crude oil and natural gas assets, could Peak Oil and rapidly escalating oil prices be far off?
While industry players contemplated these geopolitical trends, nature created its own challenges with back-to-back major hurricanes -- Katrina and Rita. Between them they devastated New Orleans and much of the Upper Texas, Mississippi and Alabama Gulf Coasts. But more importantly, these two storms devastated the Gulf of Mexico and coastal oil and gas infrastructure including a large part of the nation's refining capacity. As the nation recovered from these events, the vulnerability of Gulf of Mexico petroleum operations to hurricanes became a focal point in industry efforts to rebuild. New standards for operating drilling rigs offshore were instituted. But the greatest challenge was the reconstruction of the offshore gas pipeline network.
The underlying oil and gas market dynamics set in place by events of 2004 and 2005 were slowly lifting commodity prices and providing encouragement for producers to step up spending. In 2006 there were several general events along with some specific petroleum industry events in the news. On the broader scale, the bird flu cut energy usage in Asia as economic and transportation activity suffered. In the Americas, Mr. Chavez was re-elected despite a concerted effort by opponents. In the United States, we welcomed our 300-millionth citizen. At Prudhoe Bay in Alaska, the 400,000 barrel per day oil flow was shut down as minor spills appeared due to holes created by corrosion in the Alaskan Pipeline. In Europe, the
first of what would become an almost annual event occurred when Russia shut off the flow of natural gas moving through the Ukraine destined for Western European countries. While the cutoff was nominally over the transit fee paid by Ukraine, the issue was largely about preventing a small country from having control over its larger and more powerful neighbor’s energy business and its income. Another major event in 2006, at least locally, was the trial of Enron executives including its chairman and ceo, Ken Lay and Jeff Skilling, who were ultimately convicted. In one of the more bizarre twists of the Enron story was that while awaiting sentencing, Mr. Lay died at his vacation home in Colorado, erasing his conviction.
The subprime mortgage crisis emerged in 2007, which would eventually lead to the recession of 2008 and the global credit crisis that undercut energy demand growth. But before that happened we were treated to the UN's Intergovernmental Panel on Climate Change's report on the dangers of global warming and the need to control carbon emissions. The UN report was followed by former vice president Al Gore's movie, "An Inconvenient Truth," presenting visual images, some computer generated as we learned later, of the environmental horrors awaiting Planet Earth caused by global warming due to human burning of carbon fuels. The IPCC and Mr. Gore were awarded the Nobel Prize that year for their efforts to alert the world to the dangers of man-caused global warming. While the world was watching the emerging debate over global warming, climate change was renamed to enable the inclusion of any "abnormal" weather event as support drastic civic action. Concern elicited about Peak Oil and the growing acceptance of commodities as a legitimate investment asset class for investors began to alter the energy landscape. Oil prices had risen steadily throughout 2007 and the trend was drawing greater media attention.
As we moved into 2008, rising oil prices were being driven by growing demand, but they were also being lifted by hedge funds and other investors betting on the growing shortage of future oil supplies in the face of relentlessly rising consumption. Government investigations of commodity speculators became a frequent scene in Washington. Were they the ones driving oil prices higher? Or was it Goldman Sachs' latest prognostication that crude oil prices could hit $200 a barrel in the foreseeable future? Others, including Mr. Simmons offered suggestions that oil at $400 or even $500 a barrel would be cheap in the future world of limited oil resources they foresaw. A positive development from high oil prices was a growing recognition that the U.S. possessed significant potential hydrocarbon resources off its coasts that have been off-limits for exploration and development. For the first time since the Santa Barbara oil spill in 1969, Americans were in favor of opening up these offshore resources for the oil and gas industry to explore. This public sentiment switch may have resulted from the jump in gasoline pump prices. Americans, however, were also attacking the high gas prices by changing their driving habits and after years of steadily increasing, mileage driven began to fall.
The IEA contributed to the oil price rise when it released the results of its detailed study of the world's 400 largest oil fields showing that their average production decline rate was 9.1% per year rather than the approximately 4% decline the agency had been using previously when forecasting future oil supplies. The IEA study clashed with the 4.5% decline rate that Cambridge Energy Research Associates (CERA) claimed. In general the industry and forecasters accept the IEA's higher decline rate. Spring and summer brought significant economic news as one of the larger investment banks, Bear Sterns, failed and then the global insurer, AIG, had to be bailed out by the Federal government. These events highlighted the growing scope of the systemic problems in the U.S. economy and global credit markets. In one weekend in mid September, the entire financial and energy worlds changed. Hurricane Ike roared ashore over Galveston, Texas nearly wiping the entire city off the island as the storm of 1900 had done. Ike caused additional damage to the Gulf Coast petroleum infrastructure adding to the unrepaired damage from hurricanes Katrina and Rita in 2005. The same weekend that Galveston was hit, the world watched the failure of Lehman Brothers and the near total breakdown of global credit markets. Combined these events hastened the slowing in economic activity that had been underway and forced companies across the spectrum of industry to curtail spending and implement survival strategies further constraining economic activity.
As the recession of 2008 transitioned into 2009 and deepened in the first half of the year, comparisons with prior recessions became the norm. Trying to fathom just how bad this recession could be and then how it might end and an economic recovery commence became the focus of government efforts. For energy markets, investors seized on oil as a commodity that would always have value regardless of the value of the U.S. dollar, or any other currency, in which it was priced. However, as the value of the U.S. dollar fell, oil prices rose as investors bought futures contracts to help preserve the value of their money. Additionally, many investors and speculators began betting that oil demand would eventually recover -- it was only a matter of time -- and with reduced investment in finding and developing new oil resources, the current surplus productive capacity would be wiped out sending oil prices higher. So based on these hopes, oil prices started their remarkable climb from the low $30 a barrel range in March to slightly over $80 in a matter of seven to eight months.
The story for natural gas was quite different as the demise of the U.S. auto industry and the depression in new home construction, two large consumers of natural gas, created a falling demand scenario. At the same time, the unlocking of gas shale resources saw the industry begin to grow its annual production for the first time in years. Growing production and falling demand became a recipe for falling natural gas prices. For the first time since the 1950s, America witnessed the natural gas industry out trying to create demand for its product. The use of gas as a transportation fuel and greater use as a cleaner substitute fuel for power generation were loudly touted with mixed results.
When looking back over the past decade, we can see significant changes to the energy market in the United States. While domestic oil production has steadily declined since it peaked in 1971, the impact of high oil prices during much of 2008 and part of 2009 has led to increased production. Energy executives are optimistic they can continue to boost oil production, or at least hold the volume steady. Natural gas represents another positive trend as the ability of the industry to solve how to produce gas from the shale resources has lead to increased production after years of steady declines. Can that trend be continued? The gas shale resource base suggests we can if we assume that economic conditions for natural gas remain positive -- reasonably high prices and few restrictions on the use of hydraulic fracturing to open up the shale formations. The significance of this trend was confirmed by ExxonMobil's (XOM-NYSE) agreement to purchase XTO Energy (XTO-NYSE) for $41 billion in stock and debt assumption. So after kicking off the decade with its purchase of Mobil Oil in 1999, ExxonMobil closes the decade with another transformational move. If crude oil was the story of the 00’s, then natural gas is destined to be the story of the next decade.
As the decade ended, the energy landscape had shifted dramatically once again. In our estimation, the future for energy will more likely be dictated by regulation than free markets. Profitability in the energy industry is and will remain under attack as the industry's "robber baron" identity makes it an easy target for higher taxation. Energy companies will be forced to take steps to fight that increased taxation such as done by Ensco (ESV-NYSE) that elected to relocate its operations and incorporation outside of the United States. While energy stocks proved to be outstanding investments over the last ten years, we wonder if they are now entering a period of increased regulation, slowing demand and lower profitability that will reduce future stock market valuations. As we have often pointed out, energy stocks were great investments in the 1970s, only to be pounded by the industry collapse of the 1980s. Could history repeat? Yes. But then again there is no certainty it will. Check back with us in January 2020.
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