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Markets: Time to Jump In?
New York: November 14, 2005
By John R. Stephenson

For energy investors, the last month and a half has been one to forget. Over a three-day window, North American oil and gas equities plunged by 12%. The oilfield services index posted a 14% decline over the month as the market focused on the prospect of lower commodity prices. The combination of lower commodity prices, profit taking and the October effect seemed to crush what had been an incredible run for energy stocks through September. Now, we have the strange spectacle of watching senior energy executives testifying on Capitol Hill about a proposed windfall profits tax on their industry. Is now the time to jump back into energy?

Throughout August and September, we witnessed a tremendous rally in the oil stocks. Many a professional portfolio manager loaded up on oil stocks to show by quarter-end (September 30th) that they were overweight in the hottest sector of the market. Not only that, but throughout the summer, we witnessed bullish call after bullish call on the commodity from Wall Street with Goldman Sachs calling for oil to hit $105 per barrel. With that kind of enthusiasm, who wouldn't load up? With the release of massive supplies of crude oil from the U.S. and European strategic petroleum reserves in the wake of hurricane Katrina, the stage was set for both lower U.S. imports of crude oil in October and the lower spot (current) market prices that followed.

With lower crude oil imports but higher U.S. inventories, traders focused on the improving short-term fundamentals (supply and demand) and sold crude contracts sending the price of the commodity down. With lower crude oil prices and a tremendous rally in August and September behind them, investors focused on profit taking rather than position building. Professional investors who didn't believe in the long-term fundamentals for the oil and gas industry, sold their positions after the quarter end to consolidate gains and because they had achieved their goal — a short-term improvement in portfolio optics. The result? A massive sell-off ensued in the equities of North American energy companies. Finally, we witnessed capitulation in the stock market when a 24.5 million-share block of Exxon Mobil Corp (XOM — NYSE) crossed the New York Stock exchange down a full 95 cents from the previous trade.

But in spite of the carnage out there, the energy sector is still the best performer around. The Toronto Stock Exchange capped energy index is up 44 percent year to date. In the U.S., the Standard & Poors 500 ("S&P 500") index is up 16 percent this year but without the strong performance of energy (a ten percent weighting in the index) it would be up just 11 percent. The reason for such strong performance? The industry is coming out of a twenty-year slump. Throughout most of the 1980s and 1990s, the place to invest was in technology, not energy. Not only that, but for most of the past thirty years, the energy exploration companies have been facing commodity prices well below their cost for finding and developing (now just under $9.00 per barrel) crude oil reserves. In fact, with production volumes declining rather than rising, energy companies are facing a declining reserve life (proved reserves divided by current production rates) across the board. While oil prices may be high now, they need to remain high for some time to come for the industry to invest the enormous sums it takes to locate and develop needed energy resources. Of course, this investment reality is lost on the bureaucrats on the hill who seem more interested in scoring points with the electorate than in addressing the complexities of the energy crisis we may be facing.

Figure 1: Low Commodity Prices Are the Norm not the Exception in the Energy Industry

Source: FrontPoint Partners

While the politicians jockey for airtime and try to blame the oil companies for higher prices at the pump, the fundamentals of strong demand and struggling supply continue to build. China, India and strong demand from the U.S. continue to push available supply to the limit while politicians bicker about taxing an industry that should be investing in future energy supplies. Refiners, once known as the commodities commodity, are suddenly on fire as investments and with good reason as most North American refiners are capable of processing only the light sweet grades of crude oil. With the incremental barrel supplied being the less desirable light crude oil, the stage is set for higher prices and higher margins for the refiners in the years to come.

Figure 2: China Demands More Oil on a Per Capita Basis

Source: FrontPoint Partners

But the producers, especially the ones with leverage to the Canadian oil sands, are in for a pleasant surprise by year-end. Why? Because one of the most persistent problems for the energy industry is the declining reserve lives (asset bases) of major oil companies. But with the U.S. Securities and Exchange Commission (SEC) set to reclassify the oil sands (because barrels are economic to mine at current prices), the reserve bases and the reserve lives of producers in the Canadian oil sands are likely to explode upward at year end as billions of barrels of crude oil get added to proven reserves of companies active in the area. This should help support the stock price of companies active in the region and oil companies in general.

Not only are prices for crude oil and the stocks of oil companies likely to head higher because of strong fundamentals for the commodity and the possible upward revisions to the reserves of leading oil companies by year end but also because of a strong funds flow into the sector. The reason? The world is awash in capital, with most other sectors offering little or no room for growth.

Throughout the world, inflation (ex. energy) is on the wane, meaning that interest rates are likely to remain subdued and returns on bonds and stocks are likely to remain low for the foreseeable future. Japan has been in a deflationary spiral for decades. Inflation in the U.S. (ex. energy) has been cruising along at 2 percent this year. This represents a forty year low. Countries such as Mexico (3 percent) and Brazil (5 percent) which have historically witnessed run-away inflation are seeing extremely low rates of inflation. All this spells trouble for pension funds that are using inflated assumptions for the discount rate (7 and 8 percent) for their future liabilities (pension obligations to retirees).

But things are changing and the U.S. Securities and Exchange Commission ("SEC"), the government watchdog, is starting to challenge the assumptions underlying many of the large corporate pension plans in the U.S. When the other shoe drops, and it will, it will be ugly. Companies such as Ford and General Motors, who already have pension problems, will look a whole lot worse when the reality of low interest rates and low returns gets filtered in.

Not only is the low inflation, low return environment problematic for pension plans and their administrators, but corporations are also struggling to find assets in which to invest their surplus cash. Today, U.S. corporations are sitting on some $2 trillion in cash which needs to find a home. The problem? It's hard to find an asset class which is offering much more than 5 percent returns.

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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