To catch a falling knife: sharp investing in energy markets
No one, as the saying goes, wants to catch a falling knife.
It’s sound advice for those investors who would love nothing more than to buy oil at its bottom and then ride it back up to its 2014 price above $114/barrel — an investment strategy grounded in the reasonable assumption that oil prices will eventually rebound to former levels. Investors base this assumption on the historical importance of oil to our modern-day civilization and on the fact that just a privileged few have made billions off of its extraction and sale in the past. Thus it goes without saying that nearly every active or passive investor is watching oil prices waiting for the right moment to grab the knife.
In light of recent volatility in our energy markets, investors can make two observations. The first is that oil right now is still wildly undervalued, in spite of its recent recovery. The evidence is incontrovertible: Oil’s current price, just above $36/barrel for West Texas Crude, is well below its inflation-adjusted price for the past 16-, 36- and even 70-year averages. Major oil companies are slashing all nonessential investments in order to maintain their history of paying consistent dividends. Smaller oil companies are just trying to keep up with their interest payments.
The second observation is that oil prices are currently extremely volatile, as made apparent by the recent plunge and recovery. The secondary impacts of this volatility, such as the drop in U.S. operating rigs from more than a 1,000 a year ago to just under 550 in February, makes it clear that no matter the price, investors should be wary. Oil production remains at an all-time high — but that could, and probably will, change.
Figure 1. Global liquid fuels production and consumption
Source: EIA Short-Term Energy Outlook, February 2016
The world has experienced production in excess of demand at least one other time in the past five years: over the first and second quarters of 2012 (see figure 1, above). Investors should note that during these two quarters, production curtailed sharply as the oil market regained a new equilibrium between supply and demand. The situation today, however, is a historical anomaly, driven in part by certain members of OPEC and their unique geopolitical ambitions. Global oil production is topping 96 million barrels per day. Production levels have exceeded demand for eight consecutive quarters. This situation simply cannot continue endlessly, given our understanding of economics and, more important, our limited storage capacity.
We at Entelligent agree: Soon there will be nowhere else to store the excess oil, and producers will be — finally — forced to turn off the spigot and reduce their normal CAPEX on new development to just shy of zero. Such a scenario, with the market burning through supply inventories and capital markets reacting slowly, uncertain of future pricing, raises the prospect of significant supply insecurity as early as 2017.
So we set out to discover why this is happening, beyond geopolitical considerations, and to apply our modeling in order to glimpse the future — that is, to forecast both energy demand and price (see Lori Siegel’s article “The implications of oil price volatility”) as well as profitability by fuel source, including renewable energy resources.
We ran 11 different scenarios using our modeling to test the impact on varying prices of extracted oil. This meant overriding our model for projections on the price of extracted oil, varying the frequency and amplitude, to not only measure the impact on energy demand of competing fuels but also determine demand for competing fuel sources. Our forecast of the impact on returns (both internal rate of return and net present value) for three different investment horizons (2017, 2027 and 2037) comprises oil versus coal, versus natural gas and versus renewable energy, looking through our non-electric versus electric windows (i.e., fuels used for transportation and industrial production versus those used for electricity generation).
All of our scenarios assume no efforts to cap fossil fuel development — no carbon tax or advancement of energy policies — beyond the status quo. Such policies to reduce greenhouse gas emissions, it should be noted, would be likely to adversely impact or provide downward pressure on demand for traditional fuels, including potentially natural gas.
Overall, we came up with some interesting results.
For electric generation, we see renewable energy coming from behind in 2017 and taking the lead dramatically by 2037.
Despite the hype over the “war on coal,” we still see global electric generation from coal as profitable and stable. That is not to say that coal fuel suppliers are doing well. Obviously, given recent bankruptcies in the industry, the decline in coal demand in the United States has devastated many of these suppliers as utilities switch coal for more competitive natural gas (see Hutch Hutchinson’s compendium article “What can the U.S. oil and gas business learn from the coal bust?”). For electric generators, however, lower fuel prices have meant greater profitability.
Figure 2. End of Lifetime Electric NPV (Billions $)
For non-electric generation, we see investing in coal as only marginally profitable and below our applied discount rate, leading to a negative NPV for all three investment-year snapshots.
Figure 3. End of Lifetime Non Electric NPV (Billions $)
The real surprise, though, is the difference in the attractiveness of investing in natural gas for electric generation when looking at NPV versus IRR (see figures 2 and 4). Based on NPV, and compared with its short-term high internal rate of return, gas has a long-term marginal profitability relative to both coal and renewable energy supplies. Such a forecast might indicate that while investing in natural gas the electric sector is hot now, it will cool off eventually.
Figure 4. Electric IRR
Another point of interest is the expected, continued profitability and high rates of return from oil investing in the non-electric sector. Oil isn’t going away under any scenario, even given increased volatility in oil prices. Money will indeed be made, over the short and the long term. Entelligent must warn, however, that oil’s extreme volatility does have a high cost for suppliers. Couple this cost with the potential for stranded assets and lost reserves due to regulatory influence in placing a price on carbon, and it’s clear that investors in oil should proceed cautiously. Yes, unfortunately there will be losers.
Figure 5. Non-Electric IRR
Entelligent is designed to help investors size up the companies that operate in and are shaped by energy markets, and separate the leaders from the followers. In a world where leaders win and followers lose, we hope this service can help investors successfully manage their holdings.
Tom Stoner, a 30-year veteran of the energy services and power industry, has led two companies through venture funding to successful exits, selling one to a publicly traded utility holding company and leading another through a successful IPO on the London AIM Exchange. He has raised more than $300 million in venture capital and public equity and has invested proceeds into dozens of energy efficiency and renewable energy projects.