The experts are wrong on energy – here’s how you can profit
Matthew Partridge Sep 13, 2012
Energy experts tend to fall into two camps.
There are those who think we are about to enter an era of abundant, cheap energy, as the US and other nations exploit vast reserves of shale gas and oil.
Others argue that conventional oil supplies have peaked, while demand is still growing, and that we face a major shortage. At the very least, they argue, the days of cheap energy are over.
For example, Citigroup recently suggested that Saudi Arabia, which currently provides one in every eight barrels of oil in the world, may be consuming more than it produces by 2030.
Who’s got it right? And how can you profit from it?
Peak oil – or shale gas bonanza?
Do we face an energy drought or energy glut? Markets aren’t sure which outcome is more likely. The price of natural gas in the US has tumbled. But at the same time, a barrel of Brent crude oil will still set you back more than $100.
There’s some truth in both arguments. We’ve talked about the exciting potential shale gas holds for the US economy (most recently in our MoneyWeek magazine cover story on automation).
And back in the early years of this century, when oil was much cheaper than it is now, we also regularly wrote about the case for ‘peak oil’.
However, we suspect that both trends have been over-exaggerated. Oil is likely to get cheaper, and the price of gas is likely to go up. Here’s why.
The big problem with both the bull story on oil and the bear story on gas is that they both assume that current trends will continue. This is a natural human tendency – you see it played out in markets across the globe, every day. We all think that today will be much the same as yesterday was, and then get shocked on the days when it isn’t.
This is why, for instance, peak oil theorists tend to take current reserves as given. In other words, they assume that no more oil – or not enough - will be discovered. At the same time, they assume that demand for oil will keep growing at existing or higher rates.
However, history shows that reserve levels are anything but static. The oil industry has consistently managed to find new oil at a pace that keeps up with demand.
In March, the Saudi state oil company, Saudi Aramco, said that it was launching an exploration drive, which it claims could expand known reserves by up to 40%. There is also renewed interest in other parts of the Middle East, such as Kurdistan. And as we’ve pointed out in the past, given the right conditions, Venezuela has the potential to massively increase both reserves and production.
Demand for oil is also more elastic than many people recognise (that’s an economic jargon term which just means how easily demand adjusts to changes in price). While people won’t change their habits overnight, they are willing to do so over time.
For example, the US transport system is far more car-centric than that of any other major country. However, while nearly 40% of 21-34 year old Americans owned a car in 1985, the proportion is now barely over a quarter. Several members of oil cartel Opec have also warned that high crude prices may speed up a move away from oil.
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Shale gas is promising – but it’s overhyped too
The same tendency to extrapolate applies to the visions of a shale gas utopia. It is true that technology and production levels have both progressed greatly in recent years. Gas clearly has the long-term potential to reduce the US’s dependence on imported energy.
However, it is hard to see how it can live up to the hype that has been generated. As we’ve pointed out, attempts to find major reserves that can be drilled outside the US have met with only very limited success.
Similarly, the rise in shale gas production is partly to do with how the industry operates. Most firms operate by buying land-use options. This forces them to sell as much gas as quickly as possible, even if they make little or no money. Much of this supply is clearly not sustainable.
Already the cycle is starting to turn. Companies are rushing to cancel projects, sell land and cut down the number of rigs. Firms have also cut back on conventional gas fields. In a sign of the new pessimism, Russia is delaying a major project to drill gas in the Arctic.
How to profit from the future of energy
Taking advantage of the high price of oil is straightforward. Most spread betting firms allow you to short the oil price. However, do bear in mind that spread betting itself is extremely risky – you can lose far more than your original stake.
We’d also be wary about making any short-term trades on oil ahead of the US election. Iran’s nuclear ambitions have slipped out of the headlines in recent months, but the Israelis clearly remain very concerned. If an airstrike or other attack on Iran takes place, the price of oil would certainly spike, and that would wipe out anyone taking short-term punts on oil’s direction.
A better bet is to investigate companies in the shale gas sector, which should benefit from any recovery in price. Two that look interesting are Devon Energy (NYSE: DVN) and Chesapeake Energy (NYSE: CHK).
Devon is down nearly 20% from its peak in March. It trades at 10.3x earnings. It is worth less than the value of next year’s projected net assets.
Chesapeake looks even cheaper. Not only is it 38% lower than its peak last year, it has a price/earnings ratio of only 6.55x. It is also trading below its book value. While the company is still dealing with the investor backlash over its ‘colourful’ chief executive Aubrey McClendon, it has a new chairman: Archie W Dunham. Dunham is both experienced and respected within the industry. My colleague Phil Oakley looked at Chesapeake a few months ago.
• This article is taken from the free investment email Money Morning.
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