Every February I look forward to the Orlando Money Show. It was heartening to see just how well attended all of the presentations were this year despite the ongoing market turmoil and the big selloff in energy commodities after mid-2008.
In fact, energy was one of the hottest topics at the show. Investors were particularly focused on two main points: energy subsectors best placed to recover first in the next up-cycle and high-yield plays.
In last Saturday's issue of my free e-zine Pay Me Weekly , I covered some questions I was asked frequently at the show, some related to energy and some focused on broader market themes. In this week's issue of The Energy Letter , I focus on some of the more common energy-related questions at the show and my responses to these queries.
Question: What's the outlook for crude oil prices this year?
Answer: Short term, the main driver for crude oil has been and will remain demand.
Demand for crude has been shrinking rapidly in the US and other developed countries. And while demand in developing countries has remained somewhat resilient, there's been a clear slowdown in growth from countries such as India and China.
This demand slump is a symptom of the weak global economy. In the last issue of PMW I dissected my favorite gauge of health for the US economy, the Index of Leading Economic Indicators (LEI).
There's very little cause for cheer on this front; the only components of LEI that are showing signs of life are those primarily controlled by the Federal government, such as money supply growth. In a healthy recovery, we'll see some of the other main LEI indicators turn positive as well.
But the US accounts for roughly a quarter of global crude demand. We can no longer afford to analyze the global oil markets without factoring in economic conditions outside the US.
Here there are also signs for concern; check out the charts below, which I ran in the Feb. 4 issue of The Energy Strategist .
Source: Bloomberg , The Energy Strategist
Source: Bloomberg , The Energy Strategist
The first chart shows the 12-month percent change in LEI for the Eurozone, the countries in the European Union that have signed on to use the common currency. The second chart is the 12-month change in Chinese LEI. Investors can interpret these indicators in much the same way as the US LEI year-over-year percent change.
As you can see, the picture for the EU looks every bit as negative, if not more so, than for the US. The 12-month change in LEI has rapidly deteriorated over the past year and now stands at the lowest level on record; this is consistent with a severe recession similar to the contractions witnessed in Europe in the '70s and early '80s. This is not good news for European oil demand.
What's even scarier is China's LEI. China, India and other emerging markets have been the key driver of global oil demand over the past five years. One could argue, in fact, that growth and development in the emerging markets has been the main driver of the energy bull market since the late '90s. Chinese LEI hasn't turned negative year-over-year, but it is hovering around the lowest level since the Organization for Economic Cooperation and Development (OECD) began publishing the index.
Bottom line: Weak economic conditions will put a ceiling over oil prices in the $55-to-$60 a barrel range. We won't see real cracks in this ceiling until there's clearer evidence of a turn in the global economy. My expectation remains this will happen in the latter half of 2009 as an unprecedented wave of global stimulus begins to filter through economies and as credit markets revive.
That said, a bigger long-term issue is oil supply. Oil exploration and production firms of all sizes are slashing their capital spending budgets to cope with rapidly deteriorating oil and natural gas prices. Lower spending spells fewer projects and lower production in coming years. Moreover, some of the most exciting markets for oil exploration and development--including oil sands, deepwater Brazil and enhanced oil recovery--aren't economic at prices under $70 a barrel.
At under $30, most firms outside the supermajor integrated oil names just can't make money. At those prices, for example, as much as 0.50 to 1 million barrels a day of production could come offline in the US alone. These supply headwinds will maintain a floor under crude in the $30-to-$35 a barrel range.
Over the next six to nine months, I see oil stuck in a range between $35 and $55. When demand does return to global oil markets, the loss of oil supply due to spending cutbacks will soon put the squeeze on prices--I'm looking for oil to touch $100 a barrel again in 2010.
Question: Should I own master limited partnerships (MLP) in my IRA?
Answer: No, I recommend you avoid buying MLPs in your IRAs and other tax-advantaged accounts. In a recent Personal Finance On the Money article, Peter Staas explains at some depth the reason for this.
Briefly, payments made by MLPs, limited liability corporations (LLC) and other similar publicly traded partnerships (PTPs) aren't regular dividends but are known as distributions. Unlike dividends, distributions made by MLPs are subject to unrelated business taxable income (UBTI). In most cases, only a fraction of the distributions you receive from an MLP are subject to UBTI; this information is reported on the K-1 form you receive at tax time.
If your total UBTI payments from all MLPs and LLCs you own exceed $1,000 per year you'd become subject to increased filing requirements and would have to pay tax on part of your distributions. This is hardly an attractive proposition for a tax-advantaged account.
There are two ways out of this: buy closed-end funds that hold MLPs or buy one of the two publicly traded i-units. I-units are NOT iShares or exchange-traded funds. Rather, these are MLPs that pay out their distributions in the form of additional units (MLP parlance for shares). Such payouts aren't subject to UBTI.
Question: Why should I buy MLPs when the price-to-earnings (P/E) ratios are so high?
Answer: Standard earnings measures are essentially meaningless for MLPs. The reason is that earnings include a large number of non-cash charges such as depreciation and amortization. Because these charges don't involve the exchange of cash, they have precious little to do with the underlying fundamental business or the MLP's prospects.
MLPs tend to own physical infrastructure and assets that generate a large slug of depreciation charges each year. In fact, one of the reasons that MLPs are able to pass along distributions to unitholders in a tax-advantaged way is that these firms are simply passing along their depreciation charges. Thus, high depreciation charges are actually good for unitholders.
However, since these non-cash charges reduce earnings, MLPs' earnings figures are quite often underreported. This, in turn, inflates the P/E ratio.
To combat this problem, I look at distributable cash flow (dcf) for MLPs instead of conventional earnings. DCF backs out non-cash charges from earnings figures and then adds an additional charge known as maintenance CAPEX. Maintenance CAPEX is simply an estimate of how much money an MLP needs to spend in a given year to keep their assets functioning properly.
In short, dcf is how much cash an MLP needs to pay all its bills and maintain its assets in working order. On this basis, the MLP sector looks undervalued rather than overvalued.
Question: Why hasn't cold winter weather pushed up natural gas prices?
Answer: The short answer is that while the US winter is on track to be the coldest since 1978, inventories of natural gas in storage haven't fallen as sharply as most analysts expected. There are two reasons for this phenomenon.
First, stronger-than-projected gas production from onshore unconventional gas fields in the US such as the Barnett Shale of Texas and the Haynesville Shale of Louisiana has pushed up supply faster than demand. This situation is beginning to reverse, as US producers have responded to weak gas prices by cutting their drilling activity. But there's usually a lag of three to four months between producers cutting back on drilling and supply actually falling.
Second, weakening industrial demand. About a third of the gas used in the US is used by industrial customers such as chemical producers. A weak US economy has caused many of these companies to scale back their operations; the result is lower gas demand.
I see a floor for gas near current prices. Strong drawdowns over the past two weeks suggest recent drilling cutbacks may finally be hitting supply. And a recovery in the US economy by the back half of 2009 would help stabilize demand.
Question: What's your outlook for uranium prices and related stocks?
Answer: Nuclear power has two major benefits over other sources of power: It reduces dependence on imported energy commodities and produces far less pollution than plants powered by fossil fuels.
I try to avoid getting embroiled in the global warming debate. I'm not a climate scientist, and I'm not here to save the world but to make money. What I can say is that carbon dioxide regulations are coming to the US and are already in force in many markets around the world. Investors simply can't afford to ignore the impact of this regulation on the companies they own.
Accounting for about 12 percent of global power generation, nuclear is the world's most important source of carbon-free and, for that matter, pollution-free electricity generation. Producing electricity in nuclear power plants emits nothing but steam; there are no direct emissions of any pollutant.
The central role for nuclear power in any plan to reduce global carbon dioxide emissions is gaining recognition. During the 2007 Climate Change Conference in Bali, the director of the International Energy Agency, Nobuo Tanaka, stated that the world needs to build as many as 30 new nuclear reactors per year to stem climate change.
The simple fact is that many nations are pursuing nuclear power. The US has several proposed new reactors in various stages of permitting. And China, India and Russia are all building plants or have outlined plans to massively increase their reliance on nuclear power.
Uranium is the key fuel for nuclear power plants. Amid nuclear capacity growth in the developed and developing world, the key question is whether existing global uranium supplies are sufficient to meet growing demand.
In my view the answer is yes. There are plenty of large deposits of uranium located all over the world. Many of the largest are located in quite stable nations such as Canada, Australia and the US; that's a major advantage over crude oil and other key energy commodities.
There are two important points to watch. First, global uranium mine production will need to rise rapidly to meet growing demand and offset a moderation of so-called secondary sources of uranium. And second, just as with oil and other commodities, uranium prices will need to remain high enough to justify those investments.
Primary mined uranium production in 2007 was around 115 million pounds, while the world's reactors used over 180 million pounds--mined supply represented about 65 percent of total demand.
At first blush, these numbers just don't add up; surely supply must equal demand. The difference with uranium is that there are massive secondary sources out there. The list includes inventory held by utilities, government stockpiles, recycled spent fuel rods, and recycled nuclear warheads. These secondary sources fill the gap left by insufficient mine production.
But these secondary sources are beginning to run out. Uranium prices have been on a rollercoaster ride for the past several years, rising from around $10 per pound at the beginning of the decade to a high of over $130 a pound in 2007 to a current price in the $50 per pound range. The obvious question is what accounted for these gyrations, and how does this fit in with the long-term bullish case for uranium demand and prices.
The main reason for the big run-up in prices to the 2007 highs was that uranium consumers (the utilities) began to run short of uranium supplies and became concerned about the decline in secondary sources. They began buying uranium both on the spot market and in the contract market.
The spot market for uranium is tiny; turnover is perhaps only 10 to 20 percent of the total market, with the rest of the world's needed supply locked under long-term contracts. Because volumes are quite thin in the spot market, it doesn't take much to move prices markedly.
On top of real buying in the uranium market, speculators began to enter the space after 2006. Basically, speculators consisted of hedge funds and some exchange-traded companies that bought and stockpiled physical uranium in a bet on higher prices. In the crude oil market, I believe that the effect of speculators is consistently overplayed. However, the uranium market is so small that speculators can certainly have a much larger impact on prices.
Speculation and utilities' buying panic reached a fever pitch when Cameco (NYSE: CCJ), the world's largest uranium miner, announced a flood at its massive Cigar Lake mine in Canada. This mine is expected to reach peak production of 18 million pounds of uranium per year, equivalent to about 10 percent of world supply. As a result of the flood, production from the mine was delayed by several years; another flood that occurred last year will delay production yet again.
In 2007, a number of factors brought uranium prices back to Earth. First and foremost, the utilities reached a position where they did not need to secure any immediate additional supplies of uranium; their needs were covered and most decided to step away from the market rather than pay sky-high prices. Many assumed, quite correctly, that prices would fall and they could lock in supplies at a lower cost.
To make matters worse, the financial crisis and credit crunch hit the market. The result was that many hedge funds were forced to delver and exit the uranium market. This added yet more selling pressure.
But we've now reached a turning point in the uranium market. Uranium prices bottomed out last fall and have rallied significantly since then. According to participants in the uranium spot market, much of the buying is coming from actual utilities rather than speculators--the utilities now need to cover future needs and are taking advantage of lower prices.
To meet growing global demand for uranium from new plants and offset a decline in secondary sources, mined uranium production will need to rise sharply. But that's unlikely to happen with uranium at $40 or $50 per pound; this is below marginal costs for many new mines around the world. I suspect prices will need to recover above $70 to $80 to balance the market in the intermediate term.
Question: What's the outlook for coal in light of the Obama administration's policies on global warming?
Answer: Coal accounts for 50 percent of global electricity supply, 80 percent of supply in China and more than 70 percent in India. There's absolutely no way the world is going to be able to replace all that capacity within any reasonable time frame. The idea that wind or solar could replace these plants is naïve at best; these power sources still account for less than 2 percent of global electricity supply even after decades of government subsidies.
And remember, short-term gyrations aside, the long-term trend in demand for electricity in China is sharply higher. There's no readily available power source to meet this demand other than coal.
Near term, I don't see Obama attacking coal in the US. For one thing, taking steps to control carbon would undoubtedly raise electricity prices, a move that's unlikely to be politically popular during a recession.
And second, remember that Obama was elected as a Senator in the coal state of Illinois. It's quite likely that subsidies for clean coal and carbon sequestration will be included in the current stimulus bill or in a future energy bill.
But even if the US never builds another coal fired plant, strong demand growth from the developing world will make coal the world's fastest-growing fossil fuel for at least the next 20 years.
Question: How sensitive are MLPs to commodity prices?
Answer: That really depends on the MLP. Traditionally, most MLPs have been involved in the midstream energy business--pipelines are the most commonly owned assets.
This business has little or no exposure to commodity prices. Pipeline owners don't take ownership of the oil and gas that travels through their pipes but are simply paid based on volumes transported. In many cases, pipeline owners also exact capacity reservation fees; in other words, they're paid a fixed fee whether their pipelines are being fully utilized or not.
One business that does have commodity exposure is a business line known as gathering and processing (G&P).
Gathering lines are small-diameter pipelines that collect oil and natural gas from individual wells. Before it's suitable for injection into the nation's pipeline network, gas requires processing. Processors remove impurities from the gas and separate natural gas liquids (NGL) from the gas stream. NGLs include valuable saleable hydrocarbons such as propane.
Not all companies involved in G&P have real exposure to commodity prices; it depends entirely on the types of contracts they've signed and their service territories.
Gathering can provide some sensitivity to oil and gas prices because gatherers get paid based on the volumes of gas they collect from wells; when gas prices fall, companies cut back on drilling, and that spells lower volumes.
That said, the prices firms pay for gathering services isn't directly related to commodity prices, and the dropoff in volumes of gas produced has been far less than the fall in the price of gas--gathering has only modest exposure to commodity prices. Further, gatherers operating in promising regions near unconventional gas plays are unlikely to see a significant falloff in volumes.
Processing is a different story. Some processors chart a simple fee for processing gas that's based largely on the volumes processed--these are stable, commodity-insensitive deals.
The problem comes from a contract type known as percent of proceeds (POP). Some POP contracts are written in such a way that the processor actually buys the natural gas at the wellhead from producers and then processes and sells the gas and NGLs. A prearranged percentage of the proceeds from those sales is then paid to the producers.
Obviously this business isn't as sensitive to commodity prices as actual production. The reason is that when oil and gas prices fall, the processor earns less revenue from selling gas and NGLs; however, the cost of the gas it buys also falls, helping to offset some of that headwind.
The problem right now is that NGLs typically trade somewhat in line with crude. Natural gas prices have been outperforming crude over the couple of months; for companies with POP contracts, the cost of buying natural gas from producers has gone down by less than the value of the NGLs they sell. This depressed margins.
We've already seen distribution cuts from some MLPs involved in G&P such as Hiland Holdings (NSDQ: HLND). There could well be more.
One other area to watch: MLPs and limited liability companies (LLC) involved in actual oil and gas production. Obviously, when the prices of commodities fall, companies that produce those commodities earn less money.
However, most MLPs heavily hedge their production using the futures market. Some MLPs, such as Linn Energy (NSDQ: LINE), completely hedge their production for years into the future. Even if commodity prices fall further, Linn is unlikely to see any need to cut its payout.
Other upstream MLPs and LLCs however aren't fully hedged. These can be excellent speculations for investors interested in playing a rebound in energy prices. But don't expect them to maintain their distributions if energy prices remain depressed for months.
In closing today's issue, I'd like to extend a special invitation to all Pay Me Weekly subscribers to attend the Atlanta Wealth Conference, hosted in a beautiful mountain setting in northern Georgia. This conference has always been a personal favorite of mine, as it's smaller than most with only 175 attendees.
Even better, proceeds from the conference all benefit a worthy cause, Friends for Autism. The conference lasts from Thursday, April 23, through Saturday, April 25. Meals are included for the special discounted price of $459 for a single and $599 per couple.