We Found a Clear Path to Energy Profits, Even in Volatile Markets

It was quickly becoming OPEC's worst nightmare. By the mid-1980s, oil prices had begun to collapse.

What's more, renegade cartel members were selling more oil than their monthly quotas allowed, which merely made a bad situation even worse.

Ordinarily, that was a point when the Saudis usually would step in and cut their own exports.

But by then, the pricing situation had become untenable. Instead, the Saudis embarked on a bold new strategy.

First, they opened up their own spigots and flooded the market with crude. This taught those recalcitrant OPEC members a big lesson about lost revenues.

Second, they also introduced a "netback" pricing strategy that proved to be far more important - both for them and today's energy investors.

This new strategy considered the entire pricing sequence, using refinery margins (the difference in cost between processing and prices on the wholesale level) as a measure of prices upstream and downstream.

Now, 28 years later, the same netback strategy has made a comeback that has handed us a clear path to energy profits - even during periods of high volatility.

Here's how this strategy works...

Don't Believe the Doom-and-Gloomers

For instance, take the bout of volatility we are experiencing right now.

The last three trading sessions have illustrated how global concerns can impact investment prospects just about anywhere in the market. The sell-off in U.S. equities was prompted largely by concerns over Chinese credit markets and the weakness in emerging market stocks.

Unfortunately, energy sector stocks were hardly immune to the rush of lemmings off the cliff. But we have seen a noticeable difference in the way in which certain energy components have responded to the rising volatility.

What you need to know is that the current situation will stabilize in short order. There are simply no triggering factors that would create a prolonged market sell-off. Some are calling this the first wave in a significant market correction. But it isn't.

Meanwhile, others are suggesting this could bring about another credit-induced shortfall. Don't fall for it.

As you know, I always have misgivings about the true intention of talking heads who tout the latest doomsday scenario. They usually give their spiel on TV and rush out to short something they just delivered a eulogy for.

In fact, as many of you remember, this is one of my pet peeves.

As I well know from my many TV appearances, guests are required to disclose whether they own any of the stocks talked about or have any relationship with the company issuing them. However, nobody ever has to disclose whether or not they may be shorting or running derivatives accomplishing the same objective on these stocks.

Often these harbingers of bad tidings are actually hoping you will get on the bandwagon and make them some money by driving the shares down.

But today, I want to focus on what these past few days have actually told us about investing in energy.

Not All Stocks Have Gone Down

Of course, some of what happens in this sector will simply reflect the overall trends in the broad market.

But for the past year or so we've seen something different begin to take place. Different portions of the sector are beginning to exhibit divergent trajectories.

Take natural gas, for example. Certainly the brutal (and recurring) polar blasts have increased its price. The weather has also caused some dramatic drawdowns of gas volume from storage sites, which will bode well for short-term production moving forward.

However, what has escaped nearly everyone's attention is that certain segments have gone up in price while the aggregate markets were swooning. These stocks are examples of either processes or assets that are well-positioned to avoid short-term sector volatility.

These types of companies are becoming more noticeable as the cycles in the energy sector change. These cycles, in turn, reflect a changing dynamic in the sources of energy and way that energy is both transmitted and exchanged.

In the past week, selected limited partnerships (Master Limited Partnerships, or MLPs, and related holdings) have largely withstood what has been happening elsewhere in the energy.

This is not (as one commentator I witnessed yesterday said, spouting the usual pabulum) simply a result of rising natural gas prices.

It's been brought about for two very different reasons. First, these partnerships do not control gas as much as physical assets essential to collect, transport, and process the gas.

Second, new generations of such partnerships are creating unique points of access control - combining selected aspects of upstream (field production), midstream (transport, storage, initial processing, and treatment), and downstream (gas refining and distribution).

How to Invest in the New World of Energy

These "partnership clones" are different from previous attempts to control the transmission of energy. The earlier version had sought to improve corporate bottom lines by replacing market pricing with transfer pricing.

Simply put, the idea was to control all of the elements needed to move energy from production (or generation) through refining (or processing) to wholesale and retail sales. In this case, energy could be exchanged between units of the same company structure less expensively (transfer pricing) than if the exchange took place between separate entities (market pricing).

This resulted in huge vertically integrated oil and gas companies, electricity networks, and consolidated coal providers. Ultimately, in most (although not all) of these experiments - attempts to become more efficient by getting bigger - specialization was found to be a better alternative. Major oil companies spun off retail sales networks and oil fields services as a consequence.

Horizontal acquisitions then emerged as a new direction in corporate planning.

In this perspective, companies are more prone to specialize in a more limited range of stages, while attempting to become more dominant in what they emphasize. This has resulted in a new wave of mergers and acquisitions.

On the other hand, more recent developments have witnessed the collection of a more limited number of processes (usually represented by the control over physical assets) at critical junctures in the larger upstream-midstream-downstream sequence.

What has resulted are a few rising partnerships controlling access to essential points in the entire process. Restricting competition in what goes on at these critical junctures insures both a continuing revenue flow, almost without regard to market conditions, and an ability to make better estimations about the broader production, transmission, and delivery of energy.

These are interesting contemporary versions of the netback pricing strategy first initiated by the Saudis.

These new versions are serving to create profit centers at the intersection of components in the flow of energy. In the process, they are starting to determine a range of prices and the cost for those participants preceding and following the broader process.

As these new junctures solidify, some significant new growth and income plays will develop.

For investors, these new developments will be significant. So stay tuned...

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