Rob Fraim’s Energy Call

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The decline in the oil price over the past two months might not have surprised everyone but the severity thereof was certainly not widely expected. One analyst who got it right was Rob Fraim of Mid-Atlantic Securities. With crude down by almost 40%, a new report on energy has just been published by Rob.

This report is worth perusing for two reasons: (1) Rob’s good long-term track record in this sphere, and (2) his common-sense approach and findings with which I mostly concur. The paragraphs below are extracts from his excellent report.

Today I will tackle one of the (many) issues with which market participants are grappling. And I will have a sector recommendation that has “hero or a goat” implications for the writer of this missive.

I am cogitating on the disruptions and disasters in the financial sector – and the implications for the broad market. At some point you will hear from me on that subject as this mess unfolds and I feel that I have actionable thoughts to share.

Today though – we talk energy.

I’ll probably get tons of e-mail taking exception to my conclusions and citing multitudinous arcane bits of Economist World data. And I will gladly receive these and will appreciate the input. But that doesn’t have to mean that I will necessarily agree or find reason to change my conclusions.

I am approaching this … and I don’t want to use the word “gut feeling” – given that I believe that I have sound reasons for my opinion on this – but there is a certain amount of “feeling” involved in the process and conclusions. What I see in market action, what I hear from clients, what I sense in the mood of market participants, what I observe in the market’s reaction to events. And with all due respect to economists, the market is often more art than science. So I don my proverbial beret, pick up my figurative brushes and paint, and present my art project. Some fact, some feel, lots of opinion.

What a bleak mood in the energy patch. What a sickening slide. What the h*** happened? What an … opportunity?

Back on June 10, in a piece I wrote entitled “Oil – Whither Goest Thou?” I gave the opinion that crude oil – then at $136 a barrel was overextended and due for a correction. I said that the $100 or so area looked about right. Of course oil promptly rallied to $147 or whatever it was and I was a stoopie-head for a little while. But since then, well … hey, hey what a genius, huh?

You don’t believe that I actually got something right? OK, you force me to quote/copy/paste. Here is an excerpt from the June 10 flash in which I recommended lightening up on energy stocks:

“Do I think that oil is going to $50? Not a chance? Not $50, not $60, not $80. But I do think that there is a better than average chance that we are going to revisit $100-ish and stabilize there for a while.

“This being the case I am suggesting that reaping some profits and reducing energy positions a bit might be a wise move – at least on a trading basis. Keep a core holding for the long-term, but lighten up. Sell some stuff. Write some covered calls. Hedge a bit. Maintain the core but trade with part of your energy investments. Do something other than get whipsawed.

“… It would not surprise me to see $100-105 oil by the end of the year. That probably equates to gasoline in the $3.50-ish area.”

Of course after that I went on to elaborate brilliantly (oh all right it wasn’t that brilliant, but I did elaborate) on the reasons why I was – at that time, in June – becoming cautious on energy. Recapping (sans the details) the reasons for the selling recommendation were:

a) Demand destruction resulting from changing consumer and transportation industry driving habits and vehicle choices

b) The potential for a rise in the US dollar

c) Slowing demand for China with the Olympics build-out winding down

d) Modest production growth – specifically from Russia

e) Comments from the Saudis saying that there was no justification for the rise in oil prices that had occurred.

Hmm … not too shabby on those points if I do say so myself.

And then I stated the following:

“When the crowd is virtually all leaning in one direction on a sector, you have to take advantage of it at some point. You just have to. Right now everybody says that financials are garbage and energy is gold, and we of course know all of the reasons for both. But just you wait and see… 12 months, 18 months out – when quality banks have risen 30% in price – the analysts will fall in love with them again. And if energy stocks go down 20% the cries to sell will erupt. We have to take the opposite side of the masses sometimes. We. Just. Have. To.”

So as it turns out I was reasonably on target with those comments and the call to reduce energy holdings for a while. (You know what they say about even a blind squirrel finding an acorn every now and then.) Now the burning question on the minds of my readers is this: “What now, Rob?” Well, again, I don’t know how many minds are burning and hearts yearning to hear the answer, but I’ll take a crack anyway.

I don’t expect a huge rally in oil in the near term, but I do believe the correction has just about run its course. Recently when crude approached $100 on the way down, OPEC began the “defending” process by announcing some production cutbacks – hoping to maintain $100 as floor of sorts. But now with the disruptions across all segments of the market, oil prices have moved right through that level – particularly yesterday as panic hit all markets, trading below $92 as I write this. I would not be surprised to see OPEC coming back with more production curtailments.

I am somewhat more bullish on natural gas prices than many analysts I have read, more based on seasonality, but also because of increased focus on natural gas use. (We’ve all seen the Boone Pickens/Aubrey McClendon ads. And we are approaching an election – what politician is going to badmouth natural gas? Heck, Nancy Pelosi said that it isn’t even a fossil fuel. As to the seasonality play, I have had some success through the years in buying natural gas stocks in the fall prior to our entering the heating season for a trade out as spring approaches.

So, I’m kind of reasonably positive on oil itself – the commodity – for the short term. I’m growing more bullish on natural gas – against the opinion of some smart people who feel otherwise.

The key point though is that I am getting significantly more interested in the stocks of the energy companies. Why? Because it doesn’t take $140 oil for the energy companies to make a lot of money. They do very nicely at $100 and the resultant decline in gasoline prices (once we get past this hurricane pricing anomaly) will calm down some of the finger-pointing and windfall profit-espousing by the politicians.

And the prices of the energy company stocks – oil and gas producers, drillers, coal companies, energy trusts, MLPs, alternative energy … the whole bunch of them – have just absolutely plummeted over the last couple of months and it (again I hate to use the word but here I go) feels like a bit of a selling crescendo taking place.

I have made the comment to a number of people the last few days that it seems that we have margin clerks running billion dollar portfolios. We know there was a liquidation of a large energy-focused hedge fund recently. The sector action of late feels/smells/acts like there is more forced selling taking place. And as one astute observer pointed out to me, in addition to the margin clerks, you have to factor in the risk management people at the funds. Forced selling of another sort. On top of that there seem to have been some significant fund redemption requests at hedge funds – particularly by fund-of-fund groups, which are notoriously fickle and prone to pull out.

So now that everything energy-related has been hammered we hear all of the after-the-fact cautionary/bearish thoughts: China doesn’t want any energy anymore … all commodities are going to fall another 50% they say … the economy is going to totally destroy energy demand … we’re all going to bike to work and cook on campfires … we’re going to be awash in cheap oil … blah, blah, yadda, yadda.

We’ve heard it all lately. I’m just not totally buying it. I’m not convinced that the big picture has shifted totally.

I believe that the stocks of energy companies have more than discounted the decline we have seen and then some. 50% declines in stock prices have not been out of the ordinary. I don’t think you have to be a raging, snorting bull on the commodities themselves to believe that the producers of energy products and services will be very nicely profitable – even at today’s lower-than-before prices for oil and gas.

And my very astute friend Jeffrey Saut at Raymond James (who has been spot on about energy and who has become more bullish of late) pointed out something very interesting yesterday. Evidently China – the previous “buyer at the margin,” the force that kept sopping up all supply for so long, which contributed to the big rise in energy before – has been pretty much out of the energy markets for a couple of months. The reason: pollution concerns during the Olympics and the Paralympics (the games for those with disabilities.) Many factories and industries were shut down and idled during that period so as to improve air quality during a time of so many visitors and so much world attention being focused on China. (We know China is image-conscious. Just ask the little girl who was not considered pretty enough to sign the anthem live and was replaced by a more attractive lip-syncher.)

The Paralympics end on September 17, and this means that China may very soon reopen manufacturing and transport – particularly so since there is a massive earthquake rebuilding to be done. And they could well be back in the energy market as buyers almost immediately – like on the 18th. The implications for the energy commodities are positive and a psychology shift in those markets could quickly spill over to the beaten up stocks of the energy companies.

Big picture, let’s not forget a few key energy points:

1. Production in many places is peaking or has peaked. Mexico appears to have peaked and Russia – a recent source of supply and the currently the 2nd largest oil producer – is doing things in a way that is short-term profitable for them, but long-term counterproductive. They are investing very, very little in new exploration (the capital intensive part of the business) – opting instead to try to squeeze out production from existing fields. That’s cheaper production for them in the short run, output has peaked and they are depleting those fields. Ultimately, they stand to be left with played out reserves and few new prospects – since they are skimping horribly on cap-ex and exploration now. It’s like the landlord who spends all the rent and doesn’t maintain the building. Eventually it catches up to him as the structure falls apart. Or the pharmaceutical company that does no R&D even though patents are expiring. Russia is milking the cow but not feeding it.

2. The low-lying fruit in the oil business has been picked. The potential “super giants” being explored and developed now – Brazil’s Carioca/Sugarloaf and the Bakken formation in the US for example, while exciting are also challenging and very expensive to produce on a per barrel basis. Same with the huge Canadian tar sands projects. Tar sand fields have been known of for years, but until oil reached high prices it was economically impractical to extract oil there.

There is still plenty of oil out there, but it is not the cheaply available, “poke a stick in the ground and watch it flow” type of oil. Prices will have to remain high to justify development.

3. While the world got a bit “China and India crazy” there for a while as regards energy consumption, the basic premise remains valid. As these huge populations become more urban and industrialized in nature – with cars, the need for electricity, etc. – there will be growing demand for the foreseeable future. Oh there will be the month-to-month ups and downs of course and everybody will obsess about that. But big picture – demand grows.

4. Alternative energy sources – and look, I’m a big believer that we have to develop new ways to provide power – are a long way from meeting our energy needs. And while they may do so one day, for now those needs must be met from both traditional (fossil) and progressive (alternative) sources. I believe that we need to break the oil addiction via new sources. But that is a process over a generation of time, not an immediate reality. For now, to quote Mr. Pickens, we have to drill, drill, drill.

5. We need more electrical power. Badly. Some experts say as many as 30 new power plants are needed ASAP. We might be oil addicted, but we are electricity junkies of the first magnitude. Computers, multiple TV sets, cell phones, iPods, recessed lighting all over the house, floodlights in the yard, plug-in cars on the way, so many appliances and gadgets in every home that it would have seemed like The Jetsons to a 1960s observer. And what runs power plants? While it might be alternative sources as time goes on, right now and for a good while to come, it’s fuel of the old-style. Natural gas and coal mostly.

6. And speaking of natural gas, I like Pickens’ idea of automobile conversion. We have lots of natural gas produced domestically and it is comparatively clean and certainly readily available. And what does that mean for the future price of natural gas? The same natural gas that runs the power plants being used to run our cars? Not too hard to figure out.

7. If this financial system mess puts pressure on the US dollar that has the obvious effect of causing oil prices to rise, all other things being equal, as it will take more dollars to exchange for one barrel.

By the way, I recently talked to a coal industry contact – a coal broker – who said that although the stock market doesn’t indicate it, the coal business is not bad at all. Pricing is off of the peaks, but still pretty strong and holding. He said that a lot of buyers – utilities in particular – have been playing a waiting game, looking for lower prices. But with winter approaching they don’t have much time left to get their supplies locked in. Some of the buyers have tried to play hardball with him – saying that they would just buy cheaper from someone else. But there isn’t much of “someone else” out their. Demand season is coming up and there’s not a lot of excess.

Additionally, people forget that most coal is sold under long-term contracts, not in the spot market. So the stock market got spooked about falling oil and gas prices and extrapolated that to coal – when in fact these short-term energy market gyrations have less impact on earnings than they do in other energy areas. Heck, lower fuel prices actually kind of help the coal companies in one regard since they are big fuel users for their equipment.

Coal got nutty a few months back and stock prices were way overdone to the upside as hot money chased the relatively small market cap of the whole sector. But after 50% to 60% declines across the board for the coal stocks over the last little bit? Getting very interesting I think.

Oil, coal, natural gas, alternative energy sources, E&P companies, drillers and service companies, energy trusts, MLPs…all have their own particular appeal in a portfolio. I cannot discuss specific companies here, but if you would like to know which stocks I like in which areas, drop me a note or give me a call.

I thought about finishing up this little blurb and sending it out earlier today, but it has been busy – for obvious reasons with the whole Lehman/Bank of America/Merrill Lynch/AIG/Washington Mutual/etc. etc. mess today. And as it turns out it was just as well, since the energy sector (using oil as a proxy) and the market in general have clearly been weak. Some will attribute the $4 drop in crude today to economic weakness and upcoming lower demand. I tend to believe that it is more a function of forced selling, an aversion to risk in the markets, and the old “sell what you can not what you want to” phenomenon. I don’t know exactly where oil bottoms, nor would I be likely to be correct in pronouncing an exact moment for the general market decline.

But I am intrigued enough by energy sector valuations and energy sector prospects to recommend “re-loading” positions starting right now.

As always, I hope that I’m right in the first minutes and days after such a call. But I probably won’t be. However for the weeks and months ahead … I have a good level of confidence in the ultimate success of the idea.

Source: Rob Fraim, Mid-Atlantic Securities, September 16, 2008.

 

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3 comments to Rob Fraim’s Energy Call

  • marilyn kim

    well written overview … thank you

  • Frank Wordick

    Those are the fundamentals. The CEOs of Exxon Mobil and Chevron say they would be happy with an oil price of $50 a barrel. But in the shorter term they may not be all that happy. Sedacca has done a short article based on technicals. He has illustrated what happened to the price of four goods that just experienced a parabolic peak — that is termination of a bubble. Based on these four cases, which are near mirror images of each other, the target price of West Texas Intermediate is around $15 (no, NOT $50) a barrel. From there, expect a rebound. Eventually, I would expect the price to gradually achieve $25 a barrel. The large majority of energy analysts have said crude oil won’t break $100 a barrel. That we are stuck with astronomically high prices forever. Now they say it won’t break $80. When it does that, they’ll say it won’t break $50 ever following the price down till it finally achieves its downside target. Then they will pat themselves on the back and declare that they have been right all along.

  • Ian Nunn

    I’m sold on the oversold aspect and on the list of 7 fundamental drivers for oil price.

    My concern has been the larger market. While oil stocks in a year or two may be seen as incredibly cheap at this price, the issue is how much more downside there might be.

    Since the credit crisis surfaced 14 months ago, this past weekend has been perhaps the most critical in its unwinding. And George Soros says he believes we’re not half way there yet.

    We’re sitting on close to a nominal $500 trillion US derivative market. Is it safe? Can it implode? How do you support or unwind something this big if you have to?

    Central banks just threw another $180 billion in short-term liquidity into the marketplace to staunch the latest hemorrhage. The US Fed in particular must be running out of bullets.

    At some point, I think they have only their helicopter fleet left. Then watch the price of oil.

    On the other side, Kevin O’leary speaking on BNN, noted that while company stocks are down in price, most companies outside the financials have strong balance sheets. Donald Coxe notes potash is still selling for $1000 a ton if you can buy any, while the ag stocks have been trashed.

    So the Fed has signaled it will do anything necessary to support markets. Commodity stocks are a screaming buy. Major financial institutions will survive whatever happens. There will be a stock market next year.

    I just don’t know how much worse it can or will get before the sunrise on tomorrow. My fear is we are on the brink of something we have never seen before (how do you unwind $500 trillion?). Oh where is my security blanket!?!?

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