Have Energy Stocks Run Out of Steam?
What to do
with bulging energy holdings
Check out
the top mutual fund performers over the past twelve months and you’re likely to
see a list dominated by funds filled with energy stocks. As is always the case
with hot sectors, the big recent returns are often accompanied by continued
optimism for industry fundamentals. The energy sector is no exception, with
many analysts calling for continued strength in energy prices due to high
demand. So, what does that mean for your portfolio? Should you let your
holdings go, or is it time to take some profits?
On a
shorter-term basis, OPEC’s monthly statistical review illustrates their
expectation of crude oil demand to remain relatively flat for the remainder of
this year, while supply is schedule to gradually increase to the point where a
small excess supply can be maintained. This implies steady (perhaps slightly
downward trending) oil prices for the foreseeable future. On the home front,
Natural Resources Canada did a report last year on the domestic energy market.
Here are some of their longer-term projections from the year 2000 to 2010.
On Crude
Oil and Equivalents
ź
Canadian
suppliers are expected to boost production by 24 per cent (2.2 per cent per
year).
ź
Domestic
demand is expected to increase by 10 per cent (0.96 per cent per year).
ź
Canada’s
net exports are expected to expand by 50 per cent (4.1 per cent per year).
On Natural
Gas
ź
Canadian
suppliers are expected to boost production by 20 per cent (1.8 per cent per
year).
ź
Domestic
demand is expected to increase by 17 per cent (1.6 per cent per year).
ź
Canada’s
net exports are expected to expand by 23 per cent (2.1 per cent per year).
This
long-term forecast is generally consistent with the ten and twenty-year
projections prepared by the Energy Information Administration (EIA)’s 2001
industry review. They project world energy demand to rise by just over two per
cent annually over the next twenty years, with demand from emerging markets and
Latin America rising by about three per cent annually over the same period. The
EIA estimates that natural gas will see the strongest demand growth, followed
by crude oil. However, supply (and production capacity) of energy sources is
expected to remain a step or two ahead of the rate of demand growth, thereby
serving to provide some price relief for consumers.
Overall,
supply and demand fundamentals look strong for the world energy market both
short and long term. If projections are even close, energy prices should fall
gradually from today’s levels but remain strong, thus allowing energy producers
to reap financial benefits while giving consumers some relief.
Another
angle on this is to look at current energy prices and assess the feasibility of
current prices. Oil prices, for instance, remain parked in the US$25 to US$30
range. However, George Morgan (manager of Templeton Growth) offered his
thoughts in a conference call last week. (While George is a lead manager he
also retains his analyst responsibilities, which focus on oil stocks.) He
estimates that a more normal price range for oil, given current fundamentals,
is in the US$18 to US$20 range. He said that oil prices that persist much above
that range may draw excess supply and potentially cause a “boom and bust”
effect. He’s been surprised by how long oil prices have been sustained at this
level. If he’s right, revenues, profits and cash flows will fall to some extent
from current levels. That’s part of the risk in this sector.
These days,
buying energy companies is a cheaper expansion strategy than buying energy
properties. Why? Because, quality properties can be had at a discount through a
company, as compared to buying them outright. At least that’s the trend
identified by some of this country’s most astute money managers. That’s a trend
some managers expect to continue among Canadian energy producers, starting with
smaller companies and then escalating to acquiring the industry’s bigger
players. However, the latest deal involves one of Canada’s biggest energy
players – Gulf Canada Resources (“Gulf”). It was recently announced that Gulf
Canada Resources was being acquired by Conoco Ltd. - the fourth largest oil
company in the U.S. The offer was an all-cash US$4.3 billion deal, which
represented a premium of about 34 per cent over Gulf’s pre-announcement share
price.
The TSE Oil
and Gas sub-index is up more than 43 per cent for the twelve months ending
April 30, 2001. Longer-term performance is more “normal” in the 9 to 10 per
cent range. However, the energy sector is deeply cyclical and can move at
dizzying speeds. If returns remain strong for the rest of this year, 2001 will
cap a third straight year of very strong performance for energy stocks – a rare
occurrence for this volatile sector. While fundamentals look strong the
million-dollar question becomes: are
today’s prices reasonable in relation to our expectations?
Cyclical
companies (i.e. automotive, resources, etc.) typically have very volatile
revenues, profits and cash flows. This volatility means uncertainty to
investors, which results in an unwillingness to pay rich prices for these
stocks (extreme conditions excepted of course). Hence, today’s price-earnings
(P/E) ratio of about 10 for the energy sector may not be as attractive it
looks. Just a few months ago, managers had felt that energy stock prices were
behind the industry fundamentals (i.e. energy prices). While recent returns may
have allowed market prices to play “catch up” to some degree, many of today’s
larger energy producers remain priced in historically normal ranges.
Valuation
risk in commodity-sensitive industries is two-fold. Is the commodity over/under
valued? Are stock prices over/under valued? These two questions are crucial to
determining what action to take with your portfolio. In the case of energy,
prices look as if they will strong but slowly trend downward over the next year
or so. The long-term outlook for energy is positive, stock prices aren’t
unrealistic, and consolidation is alive and well. Overall, I remain positive on
the sector and recommend maintaining a weighting in energy for most portfolios
– no more than 10 per cent of the total portfolio or 15 to 20 per cent of the
equity weighting for balanced portfolios.
For those
who did get in early and have made handsome profits, it may be a good time to
take some money off the table and maintain your original energy allocation.
Always remember, when looking at your energy allocation, don’t just focus on
specialty funds. Check diversified funds to keep on top of your exposure.
Dan Hallett, B.Comm.,
CFP is Senior Investment Analyst with Sterling Mutuals Inc. He can be reached
at dhallett@sterlingmutuals.com Sterling Mutuals Inc. is registered as a
mutual fund dealer in Ontario, British Columbia, and Manitoba.