Oilpatch Bull Market Moves Into 6th Year
During the 1980s and 1990s, the duration of bull markets in energy equities (an uptrend in the energy index of 25% or more) lasted 18 to 20 months on average before world oil price volatility caused a bear market, which typically lasted 12 to 14 months. The current bull market in energy began in March 1999, nearly 60 months ago. What changed and can it last?
The supply/demand fundamentals for world crude oil and for North American natural gas have changed dramatically over the past five years in contrast to the situation in the 1980s and 1990s. While the current high price level of crude oil and natural gas may weaken, the sustainable price level will continue to be much higher than in the past. This suggests that in 2004, the energy stock market and oilfield activity in Western Canada should continue to avoid the bust (bear market) that occurred so often over the previous twenty years.
In 1980, which marked the end of the roaring 1970s (for energy), the world had just witnessed the overthrow of the Shah of Iran by Islamic fundamentalists, was reeling from a second oil price shock (over US$30, up from US$12-14 in 1978), and world economies were fighting hyper inflation. By 1982, interest rates approached 20% and a world wide recession was the worst of the post-World War II era.
In 1980, OPEC was producing nearly 30 million barrels per day compared to world consumption of 60 million barrels per day. By 1985, demand for OPEC crude had fallen to 16.5 million barrels per day. Saudi Arabia reduced its production from 10 million barrels per day to less than 4 million barrels per day, in an effort to sustain OPEC’s high oil price. Finally, in late 1985 Saudi Arabia opened the taps. Oil prices crashed in 1986 to a low of US$10.00 per barrel, before other OPEC members agreed to rein in their production.
From 1986 through 1998, the price of U.S. oil averaged US$19.00 per barrel, with most fluctuations within a range of US$15.00 to US$23.00 per barrel. However, world crude consumption grew from 60 million barrels per day, to about 78 million barrels per day in 2003. Boosting demand growth was the fall of communism in 1990 in the Former Soviet Union and satellite countries, and the emergence of southeast Asia and China as economic powerhouses. In addition, political instability in many OPEC countries (including Indonesia, Venezuela, Nigeria, and Iraq) has caused many OPEC countries’ crude production capability to stagnate or decline.
In Canada, natural gas producers were suffering from thirty years of gas supply when markets were deregulated in 1986 and prices averaged C$1.65 per thousand cubic feet (US$1.10) during 1986-1998. In the United States, production growth from the Gulf of Mexico and rising supply from Canada, also kept natural gas prices low.
Over the past five years, the fundamentals of oil and natural gas have changed dramatically. OPEC is once again producing over 25 million barrels per day. World demand for crude is growing by 2% per annum (77 million barrels per day in 2003) and China’s demand grew by 10% last year.
With supply continuing to be disrupted in Iraq, Nigeria and Venezuela, with the weakness of the US dollar against the Euro (resulting in lower crude costs in Europe), and world wide recovery from weak growth in 2003, the outlook is for oil prices to stay strong.
The North American natural gas situation has changed even more dramatically. From 1986 through 2001, Canada’s natural gas production more than doubled, to about 6.4 trillion cubic feet, and its exports to the United States nearly quadrupled, from 1.0 TCF in 1986, to 3.6 TCF in 2001. The U.S. gas industry managed more modest increases in production, primarily from the Gulf of Mexico.
The relatively low level of wellhead natural gas prices in Canada and the United States through the 1990s had created an impression that cheap, abundant natural gas would always be available in North America. This resulted in strong demand growth, led by independently-owned, natural gas-powered electricity generation.
In 2001, a little-noticed, but major change in the gas supply picture occurred: Canada’s natural gas production stopped growing. Despite record levels of industry cash flow and capital spending in the 2002-2003 period, Canada’s natural gas production has declined marginally. Along with the highest sustained oil prices over the 2000-2003 period since the end of the 1970s, natural gas prices have soared in three of the past four winters, and average prices have been double the average of the 1986-1999 period.
As the supply/demand situation has changed, so has the face of the Canadian industry. Mergers and acquisitions and the rapid growth of energy trusts have changed the rankings of Canada’s largest oil companies and the allocation of capital investing.
As recent as 1997, the market value of Canada’s top 100 public oil and gas companies measured $100 billion as measured by the Peters Energy 100 Index and the top 50 companies, which were included in the Toronto Stock Exchange (TSX) Oil index, represented $80 billion of the total value of the PE 100. At the end of 2003, the market value of the PE 100 exceeded $150 billion. The TSX Oil index has seen the number of oil stocks shrink to 27, but the market value has grown to $115 billion.
A major structural change in the Canadian industry has been the emergence of the energy trusts (a trust is non-taxable, distributing its available cash flow on a pre-tax basis to its unitholders). Compared to a handful of income trusts in the mid-1990s, the sector has ballooned to over twenty firms today, with a stock market value of over $25 billion, and annual distributions to unitholders of over $3.0 billion.
This phenomenon has had two major impacts on the oil industry. One is that energy trusts do not invest in exploration, avoiding the high-risk end of the business, to maximize cash distributions. This strategy has reduced the level of reinvestment of cash flow, in particular for exploration of new reserves.
Secondly, the trusts offset their depletion of reserves and distribution of cash flow by aggressively purchasing oil and gas reserves and production from other (taxable) companies. This activity has reduced the flow of assets to small, independent companies which have been historically the most aggressive growth oriented sector of the industry.
What are the risks that another bust is just around the corner? Watch the growth rate of Russian oil production. Watch OPEC and world oil inventories. Watch the stories about China’s economic growth. World oil prices crash when supply exceeds demand, which translates into excess inventory.
In the meantime, the Western Canada economy should see robust growth and investors should enjoy the benefits.
Oh, and for the consumer? Yes, the cost of energy is high. But, Canadians need to improve their conservation efforts. We enjoy the lowest energy prices in the world, along with the Americans, and it shows in our energy consumption patterns, SUVs and all. Lastly, the western provincial governments generate substantial revenues from a healthy oil industry and that reduces the need for tax revenues.
About the Author(s)
Wilf Gobert is Vice Chairman of Peters & Co. Limited, an integrated investment dealer headquartered in Calgary, Alberta. The company focuses primarily on the analysis, underwriting and trading of oil and gas securities.
Wilf Gobert has been a stock market, investment analyst since 1974 and an oil industry analyst since 1976. He joined Peters & Co. in 1979 from Wood Gundy.
Wilf Gobert holds a Mathematics degree from the University of Windsor, Ontario, an M.B.A. in Finance from McMaster University, Hamilton, Ontario and a Chartered Financial Analyst designation from the Institute of Chartered Financial Analysts. He has been married to Marg since 1971 and has two adult children.