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Markets: It's Heating Up!
New York: January 08, 2006
By John R. Stephenson

North America has been basking in unseasonably warm weather of late. While this is a welcome change for most of us, it isn't quite so attractive if you operate a ski resort in, say, Vermont. But the unseasonably warm weather isn't just a problem for ski resort operators and winter apparel retailers, it is also a problem for investors in oil and natural gas stocks. That's because weather has a very dramatic impact on the value of these stocks — particularly for those stocks linked to the price of natural gas.

And the problem could be getting worse because we are heating up. Eight of the warmest years ever recorded in North America have occurred in the last ten years. While opinions on global warming differ widely, it is getting harder and harder to argue that our weather has not been a casualty.

The warm weather has wrecked havoc in investment land. Natural gas prices that stood at US$11/Mcf at the beginning of last year tumbled as low as US$4.20/Mcf this past September only to rebound to the low US$6.00/Mcf range of late. The fall in natural gas prices has helped to drag down the shares of natural gas-weighted stocks, as well as those of the drillers and service companies.

Figure 1: Backward Adjusted Natural Gas Prices -2006

Source: Report on

For natural gas prices, the story is not only one of warm weather curbing winter heating demand (some 30% of total seasonal demand) but it is also a story of demand destruction. The northeastern United States has been basking in warm weather of late. With some 80 percent of heating load in the U.S. being attributable to this region, this is a big problem indeed. Forget about Denver, New York is where the action is — at least from the perspective of winter natural gas prices.

As well, many industrial (petrochemical and plastics) companies have started to relocate their operations offshore. That's because natural gas is not a world commodity, like oil, but rather a regional commodity. For many companies, the price for North American natural gas is just too steep. With some forty percent of total North American demand for natural gas being derived from industrial demand, this demand destruction coupled with the warmer weather is a very big deal.

If natural gas is an important feedstock for your plastics plant, does it make sense to use $6/Mcf natural gas here in North America if your facility could just as easily be relocated to the Middle East where the cost of this important feedstock is closer to $1/Mcf? For many producers of plastics and other petrochemical products, the answer is no .

For drillers and service companies, particularly those who are Canadian based, this pullback in natural gas prices has hit them very hard. With exploration and production companies ("E&P") postponing or curtailing drilling activities, these companies have been taking it on the chin. Already, utilization rates for Canadian drillers during the month of November has clocked in at a meager 66 percent which is down substantially from the November 2005 utilization rate of 92%. For drillers this is a potent cocktail of lower activity and lower rates, cutting dramatically into revenues and margins for these firms.

Not only is the weather warm, meaning that demand is down for natural gas, but storage caverns are overflowing. The likelihood of a cold snap being prolonged enough to send natural gas prices rocketing back to the $11/Mcf level seems pretty remote.

For oil, the story is a global story rather than a local story. While warm weather has lowered the heating load and therefore destroyed some demand here at home, the rapid industrialization of Asia has continued to pressure worldwide demand ever higher.

A flood of capital into the world's commodity and other asset markets has caused risk to be mispriced. One good example of this mispricing is in the price of oil. Investors seem to be putting more emphasis on short-term indicators such as the amount of crude and refined products in inventory. Absent from the current thinking, is a longer-term view of the role of risk in the world's oil market. Commodity investors seem to believe that OPEC has unlimited supplies of crude oil, despite recent reports that Iran has been struggling to meet their OPEC quotas for years. To believe that oil prices are heading lower and staying there, you have to believe that places such as Russia, Venezuela and Nigeria are hospitable to western investment and expertise. But that's just not the case. Most of the world is following a state funded model of oil and gas exploration. And it's not just garden spots such as the former Soviet Union where this is the case, countries such as Norway and Mexico are also following a similar path. While Norway may not be expropriating assets, it isn't open to foreign investment. In fact, 90 percent of the world's oil production is in state rather than the public's hands.

Look no further than Royal Dutch Shell, which is rapidly becoming the poster boy for what ails Big Oil. Already besieged by a massive 22 percent write-down in their reserves, their largest project, Shakhalin, a massive 800-kilometer pipeline and liquefied natural gas ("LNG") terminal in Russia, has just been effectively nationalized. Shakhalin, was the largest oil and gas project in the world, with Royal Dutch Shell investing some $10 billion in its development. Not only that, but this project was one that Shell was counting on to increase its reserves and extend its flagging reserve life index ("RLI").

While oil prices may be subdued for the first quarter of 2007, a fresh round of geopolitical tensions or the start of the U.S. summer driving season in a few more months could send prices climbing. For our money, the recent pullback in oil prices may be an outstanding time to build a position in mid-tier oil companies that aren't exposed to some of the world's trouble spots.

According to CIBC World Markets research, one such area for investors to consider is the Canadian oil sands of Alberta. While the valuations are high and cost over-runs are the norm, this is the single largest reserve base of hydrocarbons in the world. In addition, it is geographically proximate and contracts and the rule of law are the norm, not the exception. According to CIBC, this region alone accounts for some 60% of the world's investable hydrocarbons.

Investors looking to profit from the warm weather, could take this opportunity to use the pullback in commodities, particularly crude oil, to build core positions in the great oil sands stocks. While Royal Dutch Shell may be battered, they still had the presence of mind to vote with their feet by using an earlier pullback in commodity prices to tender a bid not for only Blackrock Ventures but also for the shares of Shell Canada, both of which have valuable stakes in the Canadian oil sands.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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