Energy Stocks Undervalued as Crude Oil Targets Beyond $100 During 2008

By: Roger_Conrad

Is energy cheap or dear? Oil prices cut above the once-unthinkable level of $100 a barrel for the first time ever this week. One of the biggest questions as we move into 2008 is what kind of impact that will have on the wider markets and the US economy.

Since oil bottomed in the late 1990s, both market and economy have survived successive milestones in its rise, despite forecasts of disaster every time a new one was reached. Last year, however, crude prices reached new territory by breaking past their '70s highs in inflation-adjusted terms. At the same time, the collapse of the US housing industry and mortgage market began to stoke US recession worries in earnest.

The move to $100 in the early days of 2008 has further intensified worries that recession will indeed hit this time around. Ironically, this has also raised serious questions about whether oil is headed for a steep plunge, as a slowdown here spreads abroad and slows currently torrid global demand growth.

It's this later concern that has held back performance of most energy producers' stocks in recent months, as well as those of energy services companies. The ability of energy stocks to post gains has been further inhibited by continued lagging of natural gas prices.

CHEAP GAS

Based on a rough conversion rate of 6-to-1 for barrels of oil equivalent (boe), the price of gas is less than half oil on a boe basis. That's a historically wide differential that would ordinarily be a harbinger of either a major bounce up in gas prices or a drop in oil to bring the price relationship back into balance.

Gas and oil are perfect substitutes in many areas of industry, as well as home heating. When one fuel is significantly pricier than the other, consumers have historically shifted back to the other. That's what happened in the months following hurricanes Katrina and Rita in 2005, when gas prices spiked in the wake of severe supply interruptions from the Gulf of Mexico.

The result that time was reduced demand for natural gas and higher demand for oil. Coupled with higher production from other regions, the restoration of output from the Gulf and historically mild weather over the past two years, that's driven down natural gas prices to current levels. In contrast, oil has continued to move upward and onward.

As my colleague Elliott Gue, editor of The Energy Letter ( http://www.energyletter.com ) points out, there are plenty of signs that oil is overbought at these levels and, therefore, vulnerable to a steep pullback, particularly if the US economy does slow sharply. In contrast, gas has scant few friends, despite very clear signs that demand is firing up.

The clearest sign that gas use is headed higher in coming years is the large number of new gas-fired power plants either under construction or on the drawing boards around the electric industry. To date, the biggest announced is a 1,750-megawatt facility proposed by FPL Group for its fast-growing South Florida territory. But there are scores of other projects in the works, particularly in areas that are now very reliant on coal.

Coal-fired power plants are still the source of more than half of America's electric power, but they also produce more than 80 percent of the carbon dioxide from power generation. The new generation of integrated gasification combined cycle plants (IGCC) promises to dramatically improve efficiency. And IGCC plants basically eliminate other traditional pollutants such as mercury, sulfur and nitrogen oxides (SOX and NOX) and particulate matter.

IGCC plants also effectively cut carbon emissions by reducing the output per megawatt hour produced. And there's promising carbon-capture technology that could be attached to IGCC plants, as projects by DUKE ENERGY in Indiana and the FutureGen consortium (including AMERICAN ELECTRIC POWER, SOUTHERN COMPANY and PEABODY COAL) in Illinois.

On the other hand, IGCC plants are highly complex; they basically combine the attributes of a chemical plant with those of a power generation facility. Furthermore, there still aren't any commercial-sized IGCC plants operating, so costs and time to build are still works in progress, though builders have made great progress narrowing the range. 

Finally, IGCCs' advances over conventional coal-fired plants still aren't enough to satisfy many environmental purists. The “No Coal Plants” movement, for example, has made opposing them a priority. And as I've pointed out in Utility & Income, they've succeeded in halting or at least stalling scores of projects, including most recently a Southern Company project in Florida.

If the Duke Energy and/or FutureGen projects prove to be successful, more utility companies may elect to build IGCC plants. But with the political uncertainty of an election year upon us, few are likely to take on development, financial and regulatory risks until there's compelling evidence that IGCC plants do work commercially and that costs can be anticipated and controlled.

Only then will they brave the regulatory challenges, which are likely to become steeper as energy policy discussions turn from the rational to the political. And that won't happen until we get closer to these plants' anticipated completion dates in the neighborhood of 2012.

What is virtually certain is that we'll see tighter regulation of carbon dioxide, with legislation likely as early as 2009. Utilities have certainly seen the handwriting on the wall, and that's what's behind the “rush to natural gas” as announced by industry executives in various forums last year.

Simply, gas-fired power plants can be erected far more quickly than IGCC, nuclear or and other traditional baseload power plants. In fact, there are a large number of already permitted sites and projects—many owned by independent power producers who bet wrong on gas growth in the '90s—that utilities can buy and shorten the normal 12 to 18 month construction time significantly. That's in fact what DOMINION RESOURCES did recently in its newly re-regulated home state of Virginia.

Every megawatt that can be generated from gas rather than coal reduces a utility's total carbon-dioxide output by half. The price of gas is low now as well, which opens the door to locking down supplies at low prices.

Even supply bottlenecks to certain regions are being overcome. For example, FPL Group's mega-project in South Florida is possible because of major new pipelines coming into service between the Sunshine State and the energy producer states further west along the Gulf.

Rising gas demand for generating power is the most important factor that drove gas from a price range of $1 to $2 per million British Thermal Units (MMBtu) to mid-single digits, with an apparent absolute floor at $5 per MMBtu. The new wave of gas-fired power plants promises to ultimately send the fuel to a new range in the upper single digits in the next few years.

On the other hand, gas prices in the near term are still governed by the same factors that rule oil: namely inventories, which are in large part determined by mercury. Even as oil inventories have shrunk this winter, raising supply concerns, supplies of natural gas have remained relatively flush. That, more than anything else, has kept oil prices strong and gas weak.

At this point, the curious relationship between oil and gas prices has taken on an aura of quasi-permanence. And it's persisted despite clear signs that production is tightening.

Canadian natural gas production, for example, has slowed dramatically over the past year, clearly evidenced by the dire straits in which its energy services industry has found itself. Major US producers EOG RESOURCES and CHESAPEAKE ENERGY have also announced major cutbacks.

Finally, liquid natural gas (LNG) imports—the source of 3 percent of North American supply over the past year—are finding a more profitable home on other continents, where the weather is colder and the price of gas higher. Unlike domestic supply, which comes via pipelines, LNG shippers have the luxury of always selling in the globe's most profitable market. If the price differential is great enough, it's not unheard of for an LNG tanker to turn around even a few days from port and head for greener pastures.

The rise of LNG use in North America and around the world may eventually make natural gas as much of a global market as oil is now. That, too, is an exceptionally bullish development for the fuel over the long haul.

But again, it won't show up in prices before it does in all-important inventory numbers. And until it does, slack numbers mean low prices for gas.

ENERGY'S IMPACT

According to utility industry data, natural gas heating prices to consumers will average about 7 percent lower this winter than they did the prior year. And winter 2006-07 marked a lower level in most areas from the year before that, as utilities brought the runaway costs of the post-Katrina and Rita period under control and filtered them through.

Those lower gas prices don't get a lot of press with oil pushing toward $100 a barrel. They could have a significant impact on lowering consumers' expenses, particularly if the winter overall turns out to be mild in heating-intensive regions such as the Northeast and Midwest.

On the other hand, if the weather is particularly cold around the nation, bills will rise no matter where gas prices go as more of the fuel is used. A particularly sharp rise in demand could actually lift the cost of gas to consumers as well as utilities are forced to buy outside of previously contracted supplies for which the price is already locked in.

I don't claim to be a weather prophet. And, unfortunately, anticipating what's going to happen to natural gas prices in the next couple months will take just that.

On the other hand, no one else—including Wall Street analysts—can do it either. That's why the market for gas continues to be extremely chaotic and volatile in the near term, despite the fact that all market participants can clearly see rising demand in the longer haul.

Although gas is cheap and uncertain, high oil prices are a reality every time consumers fill up. That leaves electricity prices as the key to whether energy is cheap or dear.

Since its invention and adoption for mass use in the early 20th century, electricity use has risen virtually every year in the country. In fact, America's electrification has accelerated in recent years as we've moved to electric heating, bought more appliances, built bigger houses and turned on to the broadband Internet.

Projections based on very conservative assumptions of annual growth between 1 and 2 percent call for a 40 percent increase in electricity use in this country by 2030. That's at the same time voters are demanding new controls on carbon-dioxide emissions from power plants, raw material and labor costs are rising, and older generation and transmission infrastructure is starting to demand renovation, retirement or at least repair.

All this adds up to significant future capital expenditures for utility companies. And getting adequate rate increases to pay for them will be the difference between prosperity and financial disaster for individual utes.

We're starting to see a growing number of utilities ask for rate increases. Most are working with regulators to find ways to pass them on without rate shock for their customers. But some of the hikes have been quite hefty, such as those passed onto Illinois ratepayers after the state's recent unregulated power auction, even after a compromise between utilities and the legislature to phase in the boosts.

Even in states like Illinois, however, electricity rates are generally coming from a pretty low baseline. In fact, many areas haven't seen a significant increase in decades for what they pay for power. Illinois, for example, had enjoyed a 10-year rate freeze before last year's rate increase because of a deal worked out under deregulation.

Power bills have risen in recent years. But the reason has been demand as homes have filled up with electronics and other appliances. Power prices are on track to rise in coming years. But the actual price of power at this juncture is still quite low in historical terms.

The bottom line: Some energy is expensive as we enter 2008 but not all. That may be one reason the economy has been able to shrug off the relentless increases in the price of oil over the past nine years or so. And it may offer some hope that crude oil's well-publicized rise won't spell doomsday for the overall economy and broad market after all.

Over the next few weeks, we should be able to get a pretty good read on how the US economy is holding up. Today's headline news was the employment number, which came in far worse than consensus expectations.

Specifically, an estimated 18,000 new nonfarm jobs were created. That was down considerably from last month's 115,000 estimate and well off the consensus expectation for December of 70,000. The unemployment rate, a further derivative measurement from those estimates, rose to 5 percent of the workforce, up from a projection of 4.8 percent.

Those are heady numbers indeed. But they're tempered by a relatively benign reading this week in the only wholly reliable measurement of the employment situation, unemployment insurance claims (UIC).

Unlike the payroll numbers—which are based on estimates that are frequently revised wildly— the number of people filing to get real money for unemployment is a hard number that doesn't change. The fact that UIC and payroll data diverge isn't that unusual, but it should be cause for pause to anyone who's reading in too much economic weakness here.

In my view, the more interesting number posted today was a better-than-expected number in the ISM Services national nonmanufacturing survey, which came in at 53.9 percent. More than 50 percent indicates a growing economy.

But that hasn't deterred the sellers today (Friday), who've been in command pretty much since New Year's Day. On the whole, the stock market is off to one of its worst starts in many years, as investors have renewed their race to the safest of the safe havens.

The benchmark 10-year Treasury note yield is again well below 4 percent and some 30 to 35 basis points below where it opened this week. That's a dramatic drop for any market. And the benchmark is certain to sink further still if there are more signs of economic and market weakness in coming days as speculation rises that the Federal Reserve will again cut interest rates despite signs of accelerating inflation.

KEEPING FOCUS

If there's a lesson to be drawn from the first trading week of 2008, it's that fear is still the market's dominant emotion. As long as that's the case, we're going to see roughly the same winners and losers we did in the latter half of 2007.

In the winners' camp are clearly Treasury securities and other highly rated bonds. Utility stocks and other traditional safe havens will also generally hold their own and could continue to wend their way higher, though even they aren't immune from the really bad days.

Super Oil and Big Telecom stocks also ended the year strong and should continue to be winners. The former are winning big from soaring oil prices but are sitting on huge piles of cash that ensure they can survive even a very steep drop in crude. In fact, that would be an opportunity for them to increase their global dominance by snapping up new reserves at cheaper prices.

Big Telecom, meanwhile, is poised to post very robust numbers for the fourth quarter as investments in fiber networks start to pay off.

In the at-risk category, unfortunately, is virtually every other type of income investment. Canadian income trusts have made a strong case that they may prove to be an exception.

The S&P/Toronto Stock Exchange Trust Composite Index was up a little more than 6 percent for 2007, including distributions. That was good enough to beat most income investments, except for the safest far like utilities. But a number of trusts outside the energy production business threw off truly remarkable returns, including YELLOW PAGES INCOME FUND.

In the first two trading days after Jan. 1, we saw a strong rally even in some of the trusts that had been particularly weak in 2007. That included BORALEX POWER INCOME FUND, which has again become the focus of takeover rumors.

Two days, of course, don't make a trend. But this is an encouraging sign that at least one corner of the high-yielding market may be near a bottom.

In my view, diversification and relentlessly focusing on high quality are the keys to making money in 2008, just as they were in 2007. Strategically, that means it's best to own strong companies paying high dividends even in the sectors that were weak last year, as well as those from strong ones.

Eventually, we'll see a clear bottom for the US economy and investors will begin to head back to the high-yielding fare they've been dumping of late. This is still an income investing world, just as it was a growth world in the late '90s.

And just as investors came rushing back to the darlings of that market—technology—when the 1997-98 credit crunch eased—they'll pour back into Canadian trusts, limited partnerships, REITs, rural telecoms, high-yield bonds, closed-end bond funds, income deposit securities and other super-yielding investments that have been so hot for most of this decade.

Even now, anything that demonstrates clear business weakness should be dumped. The longer this goes on, the more potential for blowups, and there's nothing like a stock backed by a weakening business to blow a major hole in your portfolio.

Equally, I remain staunchly opposed to the idea that you can lower risk or reliably improve your returns by doubling down on a falling stock or investment. There's no better way to stack the deck against yourself to make emotional rather than rational decisions. And that's how the real money is lost in any difficult market.

But if you've been buying good businesses all along, there's no cause to do anything else but hang in there. As long as the business is producing the cash, the distribution will keep being paid, no matter how bad the market sentiment gets. And sooner or later—very likely by the second half of 2008—sentiment will indeed turn for the better.

As for energy stocks in 2008, they haven't come anywhere close to reflecting oil prices near $100 an ounce. They've risen in recent years. But valuations remain very low, including Super Oils such as Chevron Corp that trade at barely one times sales.

In other words, they're priced to lower energy prices already. You're not taking a lot of risk by sticking with them. And if the economy and energy prices do surprise to the upside in coming months, there's a lot of upside potential for just sticking around.

By Roger Conrad
KCI Communications

Copyright © 2007 Roger Conrad
Roger Conrad is regularly featured on television, radio and at investment seminars. He has been the editor of Utiliy Forecaster for 15 years and is also the editor of Canadian Edge and Utility & Income . In addition, he's associate editor of Personal Finance , where his regular beat is the Income Report. Uniquely qualified to provide advice on income-producing equity securities, he founded the newsletter, Utility Forecaster in 1989. Since then, it's become the nation's leading advisory on electric, natural gas, telecommunications, water and foreign utility stocks, bonds and preferred stocks.

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