These 6 Oil Plays Are Still Pumping

By  DEC 18, 2012 2:53 PM

With all the talk of natural gas and the ineluctable pull of King Coal, oil still matters and will for a very long time to come


I expect oil prices to rise for years, but natural gas prices are unlikely to hit new highs any time soon.

Why am I bullish on oil? Reason one: no scalable, economically viable replacement for oil exists. Oil became the world's dominant transportation fuel thanks to three key qualities: cost, convenience, and abundance. No alternative fuel meets all three criteria, although some fulfill one or two. That may change someday, but it won't happen quickly.

Reason two: rising demand from developing countries. Note that between 2005 and 2010, oil consumption fell by 1.6 million barrels per day (bpd) in the US, by 1.2 million bpd in the EU, and by 900,000 bpd in Japan.

However, outside of Japan, the rest of the Asia-Pacific region increased its oil consumption by 3.6 million bpd over this period, and other developing regions showed the same trend: consumption rose 1.6 million bpd in the Middle East, 1 million bpd in South America, and 450,000 bpd in Africa. The net result: overall global oil demand increased by more than 3 million bpd over this time period.

Some of this increased consumption occurred because oil-exporting regions, such as the Middle East, were reaping windfall profits and had more to spend. But developing oil-import­ing countries also experienced consumption growth, despite high prices.

Demand growth in developing countries in the face of $100/bbl or higher oil may at first seem counterintuitive. After all, when oil and gasoline prices rise in developed nations, we tend to drive fewer miles, buy more fuel-efficient cars, and make other lifestyle changes-and per-capita oil consumption falls. Wouldn't that be even truer in less affluent areas?

The answer is no, because demand for oil in developing countries is much less elastic. The first barrel that some­one in a developing country consumes might allow him to drive his very first mile or have light or heat for the first time. Such consumers are willing to pay much more for those initial barrels to find and extract. This is a recipe for higher oil prices, regardless of economic cycles.

It certainly won't be a straight climb from $100 to $300/bbl oil, and we may not reach that level until the next decade. In the short term, I expect West Texas Intermediate crude to continue trading in a wide range of $70 to $120/bbl. But when oil prices do break out, the new range has the ultimate potential to go much higher than current prices.

I recommend the following stocks of integrated oil companies as good long-term beneficiaries of higher demand for oil: Chevron (NYSE:CVX), and Eni (NYSE:E), and new Income addition Total (NYSE:TOT). The most direct beneficiaries will be companies for which oil production is their primary business, including Growth Portfolio holdings EOG Resources (NYSE:EOG) and Linn Energy LLC (NASDAQ:LINE).

Naturally Cheap

My outlook for natural gas is less bullish. Gas prices have rebounded strongly of late, and may continue to recover for a while, but I think this trend is unlikely to evolve into a sustained bull market-and extremely unlikely to take gas back to the lofty levels of 2005 to 2008.

The price of any commodity goes through cycles. Simply put, when prices are low, demand starts rising faster than new supply comes online. Prices rise as a result, and companies increase investments into more production capacity and new exploration and production technologies.

After the lag time that is required for new projects to come online, supplies then climb faster than demand grows, and prices crash. Low prices spur demand, and the cycle begins again. With oil, growing global demand has prevented gluts even as supplies continue to expand. But gas is not a global commodity; it can't be easily trans­ported across oceans. Consequently, US production is much less influenced by energy demand from developing countries. And thanks to investments in new technologies, we are experiencing an historic gas glut that will take some time to resolve.

In 2005, the US economy was booming, hydraulic fracturing (fracking) was in its infancy, and experts were expressing concern about potential natural gas shortages. Energy companies began to invest huge sums into drilling for natural gas in formerly inaccessible reservoirs that new technologies such as fracking now allowed producers to access.

The result: Proven natural gas reserves (the amount of gas in the ground that is economically recoverable at current prices) have risen nearly 50% to 300 trillion cubic feet, equivalent to 13 years of US consumption at 2012 consumption rates, versus ten years a decade ago.

This glut, combined with the economic recession, caused prices to plunge to levels not seen in a decade. Now, gas producers are shutting down production and redeploying drilling rigs to continue oil production. In 2008, more than 1,600 rigs were drilling for natural gas; today that number has fallen to about 400.

The natural gas cycle appears to have bottomed out last winter, and gas prices should continue to strengthen, for several reasons. One is that transportation fleets are converting to natural gas. For fleet owners, the economics of switching to natural gas are very attractive, even if natural gas prices climbed as high as $7 per million British thermal units.

At current natural gas prices, oil would have to be priced at around $20/bbl to be as cheap on an en­ergy-equivalent basis as natural gas. That's why natural gas is likely to be a cheaper energy option than oil for years to come.

Demand for natural gas will also continue to increase for environmental and regulatory reasons, as utilities switch from coal to cleaner natural gas. In 2008, natural gas was used to produce 20% of America's electricity; this year, the natural gas share will reach 30%.

Meanwhile, growth in the use of liquefied natural gas (LNG) could increase demand for US natural gas, which would be more transportable around the world. Ambitious LNG export facilities are under construction, and while this market will take years to develop, it may be the next game-changer for gas.

But despite some rising demand, gas rigs can be easily shifted back into natural gas production as prices become more attractive to producers. Combined with the decade-long trend of rising natural gas reserves, that means low to moderate natural gas prices for several years to come. And it means few pure plays on natural gas production will be solid investments at this time.

That's not to say that some companies that produce natural gas aren't attractive -- for example, the aforementioned Linn Energy (which produces oil and gas) continues to thrive, thanks to smart hedging strategies.

Another way to bet on rising gas demand without exposure to low gas prices is to invest in a diversified master limited partnership whose business includes gas as an input, not just a product. One of our favorites is Enterprise Products Partners (NYSE:EPD), which remains a buy.

Editor's Note: This article was written by Robert Rapier of Personal Finance.

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