The best bet in the energy sector
By
Associate Editor
David Stevenson Feb 12, 2010
Print this article
Last week wasn't great for big oil. Neither BP nor Royal Dutch Shell impressed with their latest results – Shell's profits were down 76% on last year. Both stocks are down more than 10% from their early-January peaks. Indeed, given both offer 6% yields, they now look cheap. So what's upsetting the oil market and are these stocks still a good way to make money?
Global crude oil volumes dropped by 1.5% last year, the largest fall since the 1980s, according to the International Energy Agency (IEA). And although the key West Texas Intermediate (WTI) benchmark recovered from 2009's average of $62/barrel to around $82/barrel at the start of this year, it has since dipped to around $70/barrel.
In part this is due to fears about global growth when government stimulus schemes wind down, prompting demand worries. Market jitters over Greece and big downward revisions to American job numbers haven't helped either. As oil is quoted in dollars, recent strength in the US currency has automatically lowered crude prices.
Meanwhile oil price forecasts, as ever, vary widely. The US Energy Information Administration (EIA) sees WTI averaging almost $80/barrel in 2010 and predicts $83.50/barrel for 2011. But that's based on an upbeat economic growth forecast of 2.7% in 2011 for Organisation for Economic Cooperation and Development (OECD) countries, which "should begin to show significant oil demand growth in 2011 in response to improving conditions".
And there are several other caveats. "Compliance with cuts announced by the Organisation of the Petroleum Exporting Countries (Opec) has weakened," warns the EIA. Meanwhile, "global oil inventories and spare production capacity remain very high by historical standards". In other words, there's still lots of oil around – and plenty of scope for prices to drop if economic growth doesn't come through.
Also, greater fuel efficiency and the use of alternatives mean OECD countries' oil use – likely to be 53% of world demand in 2010 – will never return to 2006 and 2007 levels, the IEA's Dr Fatih Birol tells Reuters. World demand for 2010 is forecast to be 86.3 million barrels per day (mbpd), up from 84.9 mbpd in 2009, but that will be due to Asian growth. "None of us will sell more gasoline than we sold in 2007," says BP boss Tony Hayward.
He says that's "being offset by very strong... markets of the East, and particularly China". But petrol is actually the main problem for BP and Shell. Both were hit by large losses in their downstream (oil refining) divisions. That's because "there are too many oil refineries in North America and Europe", says Nils Pratley in The Guardian. This "is killing everybody's profit margins". Nor is a near-term upturn likely. The downstream and chemical areas will be particularly tough in 2010, says Shell CEO Peter Voser. Add in the need to maintain capital spending to secure future crude supplies, and the oil giants' cash flows will be squeezed further. Both firms are now having to borrow to fund their dividends. That's raising questions about how safe their high dividend payouts are.
Yet, for all these worries, while oil prices stay above $60/barrel, we don't see too much danger of a dividend cut from either firm. Last year, with banks no longer paying out what they used to, BP's and Shell's dividends accounted for 25% of the overall distribution by UK-listed companies. Shareholder pressure to maintain payments will be intense. But if you want a way of making money from the oil business – with the prospect of an even better yield than big oil – take a look below.
The best bet in the energy sector
Natural gas is a mixture of carbon and hydrogen, both components of crude oil. It's found in similar places and is extracted by the same businesses. It also meets 25% of total US energy demand. Better still, it's currently cheap compared to crude (see chart). No wonder the global oil giants have been snapping up extra gas supplies. But rather than buying oil stocks, there's another way of tapping directly into natural gas.
The San Juan Royalty Trust (NYSE: SJT) has zero debt. It also has a 75% 'overriding' royalty interest carved out of Burlington Resources' oil and gas leasehold and royalty interests in the San Juan Basin of north-western New Mexico. "The beautiful thing about these businesses is there's really nothing to understand about them", says Porter Stansberry in Investment Advisory. "They take the royalties owed on the drilling leases and pay them to shareholders. Because this is an income trust, any natural gas price increase translates into higher dividends."
Sure, lower gas prices mean lower dividends. But with the shares at $20.65, the latest yield is 8%. And distributions are paid monthly. Besides, "natural gas will surely move higher", says Stansberry, so investors should "make plenty of money".
• This article was originally published in MoneyWeek magazine issue number 473 on 11 Februrary 2009. To read more articles like this, ensure you don't miss a thing, and get instant access to all our premium content, subscribe to MoneyWeek magazine now and get your first three issues free.
Published in
Commodities
| More
articles
by
David Stevenson
FREE - MoneyWeek's daily investment email
Our free daily email, Money Morning, is an informative and enjoyable analysis of what's going on in the markets. Written by our Editor, John Stepek, and guest contributors.
Sign up FREE to Money Morning here.