Quarterly Report – September 30, 2003
October 20, 2003
The major event in the quarter was the August 14, 2003 electricity blackout in the Northeast and Midwest states. The near-term investment implication of this transmission grid breakdown is a refocusing of the Bush’s Administration’s energy bill. Although comprehensive legislation is not likely because of sharp political differences, there is bi-partisan pressure to deliver a bill that will enhance electric transmission reliability. Importantly, both the Senate and House of Representatives versions include repeal of the PUHCA (Public Utility Holding Company Act), which should encourage consolidation and aid in attracting much needed capital to the industry.
Overview
Oil prices continue to trade around $30.00 per barrel and natural gas prices $ 5 per million cubic feet (mcf). Based on consensus earnings models, valuations of both the exploration and production and oil service sectors currently discount oil and gas prices to approximately $20/bbl and $3.20 to $3.30/mcf, respectively. Investors apparently still lack confidence that present energy prices are sustainable. However, we look for an improving environment, particularly if the U.S. economy continues to strengthen as we close out 2003 and move into 2004.
With respect to electricity, average prices in the third quarter were lower than last year, while production was up 3.1% for the latest 52-week period through September 30, 2003. Our strategy in power has been to recommend utilities that have some or all of the following attributes:
- strengthening balance sheets;
- diversified generation assets that include low cost coal and nuclear;
- distressed securities where there is a particularly attractive risk-reward profile and;
- offer above average dividend yield.
Outlook
Recently, on September 25, 2003, the National Petroleum Council (NPC), an independent advisory group to the Department of Energy presented its North American natural gas outlook to Energy Secretary Spencer Abraham. The following observations support our long-standing strategy of suggesting investing in selected companies that are significant beneficiaries of the expanding use of this preferred fuel. Our conclusions in this regard include the following:
- Natural gas markets on average, will stay “tight” until the arrival of additional imports (2007/2008)
- Demand growth will continue to reflect a shift in the mix toward power. Current U.S. total gas demand of 23 trillion cubic feet (tcf) will grow to 30 tcf by 2005 driven largely by electric power generation and commercial and residential consumption. Industrial usage is expected to decline by 6% during the 2005-2015 period—reflecting its price sensitivity compared with other fuels.
- Current supply sources are not sufficient. Conventional gas resources will not be able to meet projected demand growth. Annual production declines are running at 25%-30% from the existing resource base. Increasingly, new supplies will have to be obtained from non-conventional sources and imported Liquefied Natural Gas (LNG).
- Increased LNG use should be considered inevitable with imports increasing from 2.5 bcf/day to 12.5 –15 bcf/day by 2025. This will cost $90 -$115 billion and begin to impact the market by 2007 and beyond.
- Gas prices will be trading between $4.00 and $5.75 until 2005, and $3-$4.00 /mcf over the longer term.
In our judgment, a large financial investment will be necessary to cover infrastructure to maintain the existing US system while incorporating increased imports and production from non-conventional resources. Industry sources have projected $1.5 Trillion in capital expenditures will have to be spent for energy infrastructure, and exploration and production activities alone, excluding LNG. We conservatively believe this total could double over the next ten to twenty years when electricity expenditures are included.
Conclusion
The important take aways for our sector are: a) higher gas prices are here to stay; b) electricity reliability must be strengthened and c) trillions of dollars will have to be spent over the next few years. This, coupled with energy only accounting for about 6% of the S&P 500 Index, down from as high as 20%, implies continued opportunities for investos to make money. Again, we cannot over emphasize the importance of individual stock selection in managing a portfolio.
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About ELCO Management, LLC
Established in 1995 and based in New York, ELCO Management (www.elcomanagement.com) offers investment solutions to high net worth individuals and institutions. ELCO also manages two highly specialized energy funds: the ELCO Energy Fund, L.P. and the ELCO Select Fund L.P.
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