US in the Catbird Seat on Energy

10/04/2012 12:14 pm EST

Focus: STOCKS

Elliott Gue

Editor and Publisher, Energy and Income Advisor and Capitalist Times

The US has come a long way in a short time when it comes to our energy sector, notes Elliott Gue of Energy and Income Advisor.

Gregg Early: I’m here today with Elliott Gue, editor of Energy and Income Advisor. Elliott, oil prices seem to be moving lower, yet there’s a lot of talk that they should be moving higher. What is your view of oil prices, say in the next three months, the next six months, and beyond?

Elliott Gue: Oil prices have been on a rollercoaster ride over the course of the last year or so. We’ve seen a couple of big spikes, often precipitated by geopolitical events such as concerns about some sort of attack on Iran.

Lately, oil prices have been moving a little bit lower. However, I think that’s really more of a temporary dip than anything to be concerned about. I do think oil prices are going to be trading in a rather wide range over the next six to twelve months.

As far as West Texas Intermediate, which is the benchmark grade of crude in the US, I would expect prices not to fall much below the mid–$80s and probably hit highs around $100 to $105. For Brent crude oil, which is the key global benchmark, I would expect oil prices to generally average over $100 a barrel.

Just to give you some idea about what some of the forces at work are, lately the main concern has been on the demand side. Out of the US, we’ve had a series of weaker than expected economic data. In particular, we’ve seen the employment data be very, very disappointing. Initial jobless claims have come off their lows, meaning that more people are filing for first–time unemployment benefits. We’ve also seen some weakness in manufacturing data, such as the durable goods orders in September. It’s really a concern about the US economy.

More broadly, we’re also seeing obvious concerns about global demand for oil and global economic growth. Europe is in a recession. Even though the European Central Bank is willing to intervene in bond markets there, that doesn’t really change the real economic situation in the short term.

Looking into Asia and to emerging markets, clearly the Chinese economy has slowed down. The Chinese government’s now taking steps to simulate growth there, but clearly Chinese growth has slowed down.

I think that’s what’s really causing these current minor bouts of downside in oil prices, and I think that’s really the concern about oil that some people are expressing.

However, I think it’s very important to keep an eye on supply as well. The reality is that outside of OPEC, most countries—with the exception of the United States—are seeing declining production and a lot of project delays and production shortfalls this year. Supplies are actually quite tight globally.

Looking a little further into the future on the demand side, the Chinese government is pretty aggressively cutting interest rates, cutting bank reserve requirements…and I actually think Chinese demand is going to come roaring back as we enter 2013.

I see a floor being put under oil prices due to concerns about very tight supply that’s out there and sort of a feeling due to concerns that as oil prices rise, that could actually negatively affect what looks like already pretty weak global economic growth.

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Gregg Early: You were saying that it was in the US that actually the supply side was different than it is in other parts of the world. Could you elaborate on that?

Elliott Gue: Yes, absolutely. In the US over the last ten years, we’ve seen a real revolution, which is the shale oil and gas fields, plays like the Bakken oil shale in North Dakota. And on the natural gas side, of course, plays like the Haynesville shale down in Louisiana and the Marcellus shale in Appalachia.

These unconventional plays were thought unproductive for many, many years. Everybody knew there were oil and gas there, but nobody thought that it was economical to produce.

Through the commercialization of horizontal drilling and fracturing—basically pumping a fluid into the reservoir to aid production flow or crack the actual reservoir rock to allow oil and gas to more easily flow through the rock—we’ve really unlocked lots and lots of reserves…huge amounts of reserves in these plays.

As a result, for the first time since the late '70s and early '80s, US oil production has actually risen for the past three years in a row. A lot of that oil is finding its way to the Cushing, Oklahoma terminal.

For example, the Bakken oil shale is located in North Dakota. A lot of that crude finds its way via pipeline to Cushing, Oklahoma, which also happens to be the delivery point for West Texas intermediate crude oil. The result is a real glut of crude oil in that area of the county, in the mid–continent of the United States.

Also, the amount of natural gas in storage in the United States is way above average for this time of year, and we actually have the lowest natural gas prices in the world. Right now in the US, natural gas is trading around $3 per million BTUs or a little bit over. In the UK and parts of northern Europe, it’s more like $9 to $12 per million BTUs. We have a tremendous cost advantage when it comes to natural gas prices.

On the oil side, the US oil plays are generating a lot more oil. Internationally, a lot of the focus is on exploration in places like the deepwater. When you look at the number of plays that are being talked about internationally, places like offshore West Africa, offshore Ghana, and places like that. Also, offshore East Africa in places like Kenya and Mozambique and then also up in the Norwegian Bering Sea, up in the Arctic.

You are seeing producers outside the United States really have to target a lot of these kinds of expensive to produce deepwater and offshore fields in pretty harsh environments. While the US producers are actually having a pretty easy time growing production from shale plays, international producers have to rely on these massive deepwater projects, which are prone to delays.

I think that’s one of the reasons you’re seeing supply weakness in non–OPEC countries outside the United States and Canada, and actually pretty decent supply growth in the US and Canada.

If you look at the cost of leasing a deepwater rig in global markets or even in the deepwater Gulf of Mexico, it is well above $600,000 per day. That’s actually one of the reasons that I think that the deepwater contractors like SeaDrill (SDRL) are a great way to play the global oil market right now.

These companies are able to lease their rigs at near–record day rates. In SeaDrill’s case, they pass through most of those cash flows as a very high dividend, which is currently around 8%.

Gregg Early: Are there any other companies that you like at this point?

Elliott Gue: Ironically, even though I think that natural gas prices aren’t going to see a whole lot of upside in the United States over the next couple of years, because of all the storage of gas coming from shale fields, I actually think there is a huge opportunity in natural gas in the United States right now.

The reason is that even though gas prices are very low, companies that have gas acreage or acres of land in gas–producing areas of the country are desperate to sell those properties to kind of monetize that asset, just to try to generate some cash. In many cases, they’re using that cash to fund drilling in oil plays.

What that means is that companies that are out there with cash can actually purchase that acreage at fire–sale prices or prices less than one–third of what they would have paid just three years ago for the same land. If you are able to buy gas–producing land at very, very low prices, you can still make money, even at current gas prices.

Even better than that, if you look at the futures curve for gas—in other words, the prices that you’re able to lock in two or three years in the future—they’re considerably higher. About three years in the future, you can already lock in prices well above $4 per million BTUs.

As a result, companies like Linn Energy (LINE), which is a master limited partnership, this company has gone out and made two major transactions this year purchasing gas–producing property from BP (BP), which used to be called British Petroleum. They're and actually purchasing at such low prices that they’re able to still make money, even with $3 gas.

More importantly, they’ve hedged all their future output for five years into the future, and they’re even looking to hedge a little farther out than that. Which means they’re locking in some very, very attractive margins, just because they were able to purchase that property at such a low, low price.

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