July 2014

“If you think you are too small to make a difference, try sleeping with a mosquito.”

- Dali Lama

Like the mosquito, fracking started out as a small thing.  A few pesky oil men were believers in hydraulic fracturing, or fracking as far back as the 1940’s to extract otherwise inaccessible pockets of oil—but with conventional oil fields plentiful in the US and especially in the Middle East, there was little need for fracking.  Fracking adherents buzzed around, but were mostly seen as irrelevant noise at best… and kind of quirky at worst. 

Times have certainly changed.

Fracking has emerged an energy game-changer, and the US has been the primary beneficiary of the new energy revolution.  To illustrate the point, let’s first look at some numbers from British Petroleum’s (BP) 2014 Statistical Review.

  • Global conventional oil production peaked in 2009.
  • Of the top 10 oil producers (accounting for 66% of world’s total) 4 are in decline.  Only 1 is increasing production.
  • OPEC production is down 600,000 barrels/day from its peak.
  • Post Arab-Spring Libya is producing 10% of the oil it produced at its peak.
  • Meanwhile, global oil consumption grew by 1.4 million barrels/day in 2013 and continues to grow.

In short, OPEC production is down and global consumption up.

Knowing this, you would think that gas would be $6.00/gallon, or more, a recession would be entrenched, and another “energy-crisis” had arrived.  Yet, energy prices have been relatively stable, because what has compensated for the drop in conventional (loose) oil production has been made up for by startling increases in fracking (tight) oil production.  Here are more facts:

  • In 2013, the US increased oil production by 1.2 million barrels/day.
  • Since 2008, the US has gone from producing 5 million barrels/day to 8.5 million barrels/day today.
  • The US imports only half (!) the oil it did in 2005.
  • At the current pace, the US will soon be producing at levels not seen in 50 years.
  • According to Bloomberg, the US will remain as the world’s biggest oil producer this year after overtaking Saudi Arabia and Russia due to shale extraction.

The implications of this structural change in world energy supplies shouldn’t be underestimated.  Cheaper land-based drilling is making deep water projects less viable.   This is pleasing to environmentalists (and those who suffered as a result of the Gulf oil spill) and has temporarily taken some political pressure off big oil companies. 

Investments in infrastructure such as pipelines, storage facilities, processing plants and gathering facilities have boosted local economies and offer well-paying (no pun intended) wages to the workers.  Small and mid-sized oil companies have seen their balance sheets swell and cash flows are the healthiest they have been in decades.

These technologies and techniques are spreading worldwide.  Canada is already well ahead of the curve and emerging markets are seeing hope for energy independence and positive and sustainable economic growth. 

This paradigm shift is hard for many people to fathom.

The generation that had crushes on Jan Brady and Donny Osmond still remembers the oil shocks of the 1970’s….and the economic damage that resulted.  It therefore seems natural today to predict catastrophe when the Middle East explodes with the ever-present military/social/political/religious (pick one….or more) turmoil.  Yet, this is exactly what is happening today in the Middle East.  ISIS is storming across Iraq.  The Kurds are about to declare independence and the Turks are not happy.  Yet, prices at the pump are only slightly higher. 

According to Francisco Blanch, Bank of America’s head of commodities research, “The U.S. increase in supply is a very meaningful chunk of oil.  The shale boom is playing a key role in the U.S. recovery. If the U.S. didn’t have this energy supply, prices at the pump would be completely unaffordable.”

The world’s energy posture has clearly changed, but our perceptions are often a few beats behind.

This is generally good news for investors.  Rapidly rising energy prices and unreliable energy supplies have historically been harbingers of recessions and stock market corrections.  And while many analysts focus on the correlation between interest rates and the economy, the fact is energy prices and economic growth are more closely correlated. 

Additionally, owning oil stocks can be a hedge against destabilizing one-off events, if “something goes wrong.” In the case of increased instability in the Middle East, it is more than likely than not that oil prices will move up rather than down. 

Drilling down a little deeper (again, pun intended) into the energy sector brings some surprising results.  PE ratios of big oil companies like Exxon and Chevron are in the 12-14 range with dividend yields between 2.7%-3.3%.  By historical measures, these are not high PEs---and the dividend yield is higher than 10-year Treasury Notes. 

Institutional investors seem to be making this comparison and deciding to swap out a portion of bonds in exchange for stocks with high dividend yields.  Many oil companies fit this profile and it may help explain why the energy sector was one of the best performing sectors for the first half of 2014.

What is clear to us is that big oil companies with heavy investment in U.S. and Canadian properties are in a good position for years to come.  The small “mosquito” called fracking has generated a very large change in domestic and global energy costs, creating hundreds of thousands of jobs and becoming the driving factor behind manufacturing moving back to our own shores from other parts of the world.  We like that too as stable energy is a huge contributor to a stable US economy.

Happy Investing. 


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