We are currently in a brief period between crises. Nothing was resolved in the eleventh (and a half) hour compromise.
The truth is there are still three huge fights on the horizon – revisiting the sequestration (automatic spending cuts) portion of the fiscal cliff, spending versus taxation in the budget, and raising the debt ceiling.
All will hit by early March.
So the reprieve gained on New Year's Eve will be brief.
The spike after the accord was huge. Unfortunately, as we witnessed late last week, the market rally has no legs. VIX (volatility) has been abnormally low, but that will be drifting up, to accelerate as we get closer to the next round of legislative paralysis.
We cannot predict how protracted this next round will be, but early indications are hardly encouraging.
That's why investors need to be more defensive and identify energy components that are more likely to withstand the gridlock and even profit from it.
Overall, you should divide the energy sector into four segments:
- Processors/Distributors; and,
Most members in each of these groups are likely to be vulnerable as we move closer to the end of February. But not all of them.
Here's what you need to know…
Each of these segments is going to come under some demand-side pressure.
As an impasse approaches inside the Beltway, hints of a new recession will place renewed constraints on the energy market.
Now most of these concerns are overblown. They rely on emotional reactions and lack significant statistical support in swings of less than a quarter in length.
But it will be happening again nonetheless.
We also have the unknown of natural gas price levels. While the overall volume in storage is lower than last year (tending to improve prices), the production levels remain in surplus territory (reducing prices). The great unknown here is how bad the winter will play out and over what extent of the country.
It will certainly be colder than last year, but even the recent bout with a series of storms in the East indicated the changing nature of the gas market. We know there is additional production easily available and, while lower than last year, storage is still at the upper level of five-year averages.
Market position will be a staple element in each of the suggestions I am about to give.
And if you correctly position your energy holdings, you can avoid the next Washington crisis.
Breaking Down the Four Energy Segments
With gas, we have two positioning elements to consider. The first is basin-based, while the second involves the ability of a company to bridge between oil and gas. Both will provide a premium for specific midstream service providers.
Recall that midstream companies provide gathering, pipeline, initial processing and fracturing (especially with heavy concentration "wet" gas containing value added product streams), terminal and storage. With the reduction in gas in storage, those midstream companies with developed feeder and transit pipeline networks will benefit from the ongoing production. Remember, much of the pipeline capacity nationwide is used for storage instead of transit.
And midstreams are paid whether a pipeline stores or moves gas.
But this will hit all sectors of the country evenly. We need to consider infrastructure already in place, new networks nearing completion and proximity to main end users (power generation, concentrations of commercial, and industrial consumers). Over the next year, companies are going to ramp up for export of liquefied natural gas (LNG). As a result, midstream providers serving the Marcellus basin in the Northeast, Eagle Ford in south Texas, and the Denver-Julesburg basin in Colorado have better leverage.
The prospects for short-term oil price rises remain better than for gas, but the demand concerns will be hitting both. Here, midstream and well-positioned, well-focused midrange producers will fare better. The ability to move from gas to oil provides enhanced flexibility in a market where the demand levels for both are subject to different sets of market and political (or in the case of oil geopolitical) constraints.
The processing segment, especially certain oil refineries, will tend to be a stronger player over the next two months. This will hardly be a straight line, but there are several important factors to keep in mind.
The Impact on Refineries in 2013
Refining profits are determined by refinery margins. Those margins are the difference between what it costs to process products versus what can be commanded on the wholesale market.
Provided there is not a major collapse in demand cheaper costs for crude oil actually improve refinery profitability. A collapse is very unlikely, since we are approaching March, which is when we see increased refining activity for the rising driving season.
Refining companies servicing large markets and providing a range of distillates – light (mainly high-octane gasoline and naphtha primarily), middle (especially diesel and high-end kerosene, and jet fuel) and heavy (of primary concern here is the ongoing regional shortages of asphalt) and able to service the specialty products markets in lubricant, fuel stock, and petrochemicals will fare best.
On the gas processing side, propane demand will increase if the winter grows colder, especially in the rural U.S. where propane is the primary source of energy. Propane usage will also increase as we move into the growing season. Similarly, the fertilizer market will boost gas-processing facilities, specifically those in areas impacted by the ongoing drought. A point to keep in mind as we move forward in the decade – there is a transition under way from oil to gas as feeder stock for a range of petrochemicals. That is having an impact on the fertilizer market, as well as other usages (plastics and related components, for example).
In alternative energies, the improvement in wind and solar remains largely dependent upon the return of government subsidy programs, hardly a guarantee in the current political climate. If one plays these at all in the short-term, broad-based exchange-traded funds (ETFs) are the best move. However, an ETF selected must have a heavy foreign component, given the Chinese lead in solar on the one hand and the European position in wind.
Coal Continues its Struggles
Coal production has been under very heavy pressure over the past year. The entire market segment has experienced cuts in share value of 50% or more. This is a combination of cheaper natural gas prices (and expanding competition in generating electricity) and rising government oversight. Some regions of the country will still favor coal given a remaining favorable pricing differential, but those smaller companies are already under intense profit constraints.
Plays here are dictated by rumors of acquisitions and further consolidation.
Coal companies providing high-grade metallurgical coal – needed for steel production – may be in a better position. Yet this market remains determined by global trading trends and that translates largely into two elements largely beyond the control of American-based coal producers: Australian production and Chinese demand.
All of the above involves admittedly fluid energy sectors with considerable movement expected over the next six to eight weeks. That means as matters develop, I will focus on specific strategies in response, as well as in anticipation of the next cycle.
Related Articles and Links:
- Money Morning:
The Brewing Shale Gas Energy Boom That Nobody is Talking About
- Money Morning:
Fiscal Cliff 2013: For Energy Investors It's Going to Be Like Fishing in a Barrel
- Money Morning:
Where Oil Prices Are Headed In the Face of the Fiscal Cliff
- Money Morning:
Are the Russians on the Verge of a Major Arctic Oil Coup?
About the Author
Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk assessment, and emerging market economic development. He serves as an advisor to many U.S. governors and foreign governments. Kent details his latest global travels in his free Oil & Energy Investor e-letter. He makes specific investment recommendations in his newsletter, the Energy Advantage. For more active investors, he issues shorter-term trades in his Energy Inner Circle.