Saturday, October 4, 2014

Is it different this time for the energy sector? Yes and No...

Oil prices are down, and that's a wonderful thing for the consumer. So the following is in no way a complaint about the present price of a gallon of gas. It's just my stab at explaining what's going on and why it might be a bit frustrating for investors in the energy sector...

Boy, and alas, was I bullish on energy at the beginning of this year! Not, mind you, to the point of recommending an aggressive overweight, but a 10-15% allocation on the equity side of a portfolio made good sense to me. And by mid-year the energy sector exchange traded index fund we use was up nearly 15%, while the S&P 500 was up about half that. All the while the sector traded at a multiple (price to earnings ratio) noticeably below the broader market. Plus, the U.S. economy was heating up, as was geopolitical turmoil. And if you check past business cycles you want to own energy as an expansion expands.

And here we sit today with my chosen ETF up a paltry 1.29% on the year. So what gives? Well, lots of experts would tell you it's different this time for the energy sector. And they'd be referring to North American production: Technology has made pulling from underground reservoirs a virtual snap (relatively speaking). Simply put, we can get to the stuff, big time! And, at least for the moment, competition has kept foreign producers (the Saudis) from their usual practice---during times of plummeting prices---of cutting production to support the price. And other countries, such as Libya have stepped up their production markedly as well. And, lastly, much of the rest of the world economy is not doing so hot (demand?? --- and a strong dollar). So yeah, some things---utilizing technology and OPEC's approach in particular---are different this go-round.

But one thing will never change: Companies gotta turn profits. And a plummeting price of what they produce makes for ever-thinning margins. Therefore, make no mistake, there's a point where it no longer pays to produce at a breakneck pace. And that's when production will wane, inventories will get used, and prices will rebound.

So why, amid plunging prices, haven't we already heard about cutbacks in production? Good question. Apparently, at the present price, it still pays to sign paychecks for all those happily employed folks in the big oil and gas producing states. Plus, I strongly suspect that producers expect to see export routes really open up, allowing them to sell their stuff to the rest of the world---inspiring them to keep on expanding...

The scary thing is---as I've complained here before---there are politically-connected interests here at home who lobby heavily to keep those trade routes blocked. Under the guise the lie that U.S. energy producers exporting freely to the rest of the world would ultimately harm the U.S. consumer. Their story goes that opening up the global market would push prices higher and, therefore, hit the consumer's pocketbook in a big way. Makes sense, right? Sure... But here's the thing, if Washington shuts the door on the prospects for exports, I promise you prices are going up anyway. For, as I already suggested, producers will absolutely not produce if it's not substantially profitable:

They'll cut production, prices will rise, the U.S. consumer will take the hit, the foreign consumer will not enjoy lower energy prices, the U.S. exporters of myriad goods and services (and all the folks they would've hired) will not benefit from the foreign consumer's new-found discretionary income, many of today's employees of energy producers will become tomorrow's unemployed, and on and on.

Here's a snippet from that earlier post:
So what would make trading natural gas any different? Unequivocally nothing!! There is no legitimate case, economic or otherwise, for restricting the sale of natural gas to other markets. Any attempts at such, as convincing as they may seem (“higher demand means a higher price”), are led by those (like America’s Energy Alliance, a group formed by Dow Chemical, Alcoa and Nucor) whose execs believe, erroneously, that their companies benefit by restricting global opportunities for U.S. energy producers (I wonder how loud they’d scream if new export limits were placed on them). They don’t seem to understand basic economics: that restricting the export of natural gas can only result in the industry, which is counting on the opening of trade routes, restricting production—which results in what? You got it; a higher price. That is, a higher price without all the economic growth (think jobs) that would result from free trade. Although I suspect that they clearly understand (and would trumpet if need be) that most basic concept when applied to the export of their respective commodities.

And, for now, we'll maintain our energy sector exposure...


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