Quarterly Report – December 31, 2004
January 21, 2005
We remain positive on the long-term outlook for most major sub-sectors for the total energy chain, namely; oil and gas exploration and development, oil service, infrastructure (Master Limited Partnerships) and utilities, but have become more selective given the capital appreciation performance last year. Although oil and natural gas prices have fallen from recent highs, in our judgment, exploration and production and oil service prices still generally reflect commodity projections below the current market. Importantly, we continue to believe that tightening supply and demand fundamentals will translate into strong cash flow and earnings improvement for most of the sub sectors along the energy chain over the next 12 months.
Noteworthy, is that the International Energy Agency (IEA) recently raised its 2005 global crude demand growth forecast by 60,000 bbl/d following 2004, a year when North America's demand was at its highest in 20+ years. Also the IEA stated that the tsunami in Southeast Asia appears to have had minimal negative impact on demand.
Additionally, company managements have increasingly aligned themselves with shareholders by using the free cash flow to strengthen balance sheets through debt pay down and initiating and raising cash dividends and common stock buybacks, as overall liquidity is at a historical high.
Outlook
Crude Oil – The consensus 2005 crude oil price forecasts approximates $38.24/bbl, versus $41.33/bbl actual for the full year 2004, and $47.83/bbl for the fourth quarter of 2004. Following the experience of the last two years, the forecast could once again be too low as demand was stronger than forecasted. As an example, it is estimated that China 's incremental demand for oil grew by approximately 736,000 bbls/d to 6.3 million bbls/d in 2004, which is attributable to the country's robust expansion of its transportation and electric power sectors, which accounts for about 43% of the country's oil consumption. China has accounted for over 30% of incremental demand over the past few years and, while it is expected to slow down in 2005, the increase will remain impressive.
Natural Gas – While weather remains an important factor impacting short-term price swings, we believe that over the longer-term, challenges related to declining North American production and Canadian imports and the limitations of securing alternative supply such as liquefied natural gas (LNG), should continue to result in higher natural gas prices. Industry sources indicate that U.S. supply is not likely to increase meaningfully over the 2005-2010 period. Restrictions on expanding drilling activity, the lack of profitable new prospects, coupled with declining production, support our confidence that gas supply will remain tight over the foreseeable future. We expect domestic production to decline 1%-2% annually, while Canadian imports, after peaking at 10 bcf/d in 2002, which equated to 17% of total U.S. supply, also could shrink by at least 1% a year. LNG is projected to increase and make up some of the shortfall, but not enough to keep supply flat. Realistically, the declines could be even more severe. Under a tight industry price scenario, LNG becomes a critical supply source.
Coal – The outlook for coal remains positive as increased usage in Asia helps support prices. China burns coal to fuel the world's largest steel manufacturing industry and roughly 80% of the country's electricity generation. China 's power consumption has increased over 40% since year-end 2000. Steel making and electricity demand has translated into over 350 million combined incremental tons of steam and metallurgical coal. Despite the growth of natural gas for new power plants, domestically, coal has consistently remained the dominant fuel for electricity generation accounting for over 50% of the market and is expected to grow 1%-1.5% annually.
Oil Service – Onshore and offshore drilling day rates continue their upward momentum as contracts expire and are rolled over into longer-term agreements at significantly higher rates. We expect this trend to accelerate. As such, we continue to be optimistic about prospects for the oil service industry. Macro fundamentals remain positive as worldwide demand rises. OPEC has been more disciplined in managing oil supply. Most rigs now have an expanding backlog of work while service companies are also benefiting from price increases that began in 2004, and are expanding further in 2005. The combination of positive E&P profitability and macro industry fundamentals enhances the outlook. Rig capacity is more constrained than in 2004, with utilization now above 90% for many segments of the industry including land, jackup, and ultra deepwater contract drilling. This translates into pricing leverage and expanding margins. The result is that earnings and cash flow of oil service stocks are generally under estimated. Therefore, in our opinion, the average company's forecasts and valuations are too low which increases our confidence that this sub sector will continue to outperform the overall stock market in 2005.
Energy Infrastructure (Master Limited Partnerships) – Most of the pipeline and midstream (gas gathering and processing) companies have been restructured into energy master limited partnerships (MLPs). MLPs are limited partnerships whose interests (limited partner units) trade on the New York Stock Exchange. Under the partnership structure, they typically do not pay income taxes. Therefore, in contrast to corporations, MLP investors are not exposed to double taxation. Also MLPs usually receive a tax shield that equates to 80%-90% of cash distributions (dividends) in a given year and pay income taxes on the residual 10%-20%. The tax-deferred portion of the distribution is not taxable until the equity is sold. Select has been an early investor in MLPs and our record has benefited given the compounded annual total return of 25.5% (Wachovia MLP Composite Index) delivered over the past five years. Unit average trading volume increased about 30% in 2004, and we expect further improvement in liquidity as institutional investment expands in the sector with public offerings of new closed-end funds. Also beginning in 2005, for the first time, mutual funds can own MLPs without incurring an income tax penalty.
It was our opinion that we were in a long-term cycle of relatively high energy prices tied to an overall tightening of commodity supplies, particularly oil, gas and coal coupled with increasing demand. We have not changed this position and are encouraged to see bullish momentum in the various sectors accelerate. At the same time, despite the rise in interest rates, utilities were up about 12% in 2004, and the “street” consensus is that the group will have another good year in 2005, as managements also utilize record free cash flow to increase dividends, buy back stock and reduce debt. One major firm recently forecasted that utility earnings growth in 2005 will actually exceed the technology industry profit increase and strongly recommended the sector.
In our judgment, several fundamental factors are expected to continue to drive investment in energy. As such we repeat our positive rationale which was noted in the year-end 2003 letter, namely:
- The strengthening economy is positive for energy stocks
- Oil and gas prices should remain tight
- Energy stocks typically outperform the overall stock market during periods of rising interest rates
- Natural gas is now the fuel of choice for U.S. residential and industrial usage, which is translating into expanding demand growth
- There is under investment in energy stocks with the sector accounting for about 7% of the S&P 500 market capitalization versus over 20% in the past
- A strong earnings outlook with improving visibility as many companies benefit from rising oil and gas production and the hedging of increasing prices.
In summary, while we see exciting opportunities in many of the energy sub sectors, individual stock selection, as always, is key to successful performance.
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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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