By Baron Funds Portfolio Manager Jamie Stone
As an energy investor, one ignores the outlook for commodity prices at one's own peril. However, while a fundamental under - standing of the macro forces shaping supply/demand and price outlook is an important part of our investment process, we believe that other forces beyond price will be more significant in the next several years and favor investing in energy equities over commodities.
In fact, our energy outlook is really NOT a commodity story, but a story of seeking out those companies best positioned to deliver differentiated growth and returns on investment by cap - italizing on major industry developments driven by changes in technology, trade flows, infrastructure needs, and capital inten - sity. We believe our focus on change, growth, and the long-term differentiates our investment process and investment outlook from those of our competitors.
"Change is the law of life and those who look only to the past or present are certain to miss the future." – John F. Kennedy
This quote from President Kennedy has perhaps never been as true for the energy industry as it is today. We are in the midst of great changes, so much so that the words "revolution" and "renaissance" are frequently used by analysts, politicians and the media to describe these changes and the impacts they are having on the industry, our society and the investment landscape.
Evolutionary developments in the use of horizontal drilling and hydraulic fracturing technologies in recent years are now enabling the production of large quantities of oil and gas from unconventional geologic formations, the most common of which are shales. Shale rock sequences have been well known source rocks for conventional hydrocarbons for over a century, but producing directly from these tight, impermeable rocks has been a huge challenge. With the use of improved technologies, this challenge is now being met, reversing decades of U.S. production declines, rising imports, and competitive disadvan - tages. This major shift has the U.S. on its way to eliminating the need for imported oil from the Middle East and becoming one of the world's lowest cost manufacturers of hydrocarbon based products. Eventually, we believe this shift will lead the U.S. to being a leading exporter of hydrocarbons rather than an importer.
This is a good thing for our economy, our national security, and investors who have focused on the companies driving and cap - turing this growth.
Oil Supplies Rise on Rising Investment
As can be seen from the charts below, U.S. oil production is surg - ing while oil imports are falling, and refined product exports are rising. As a result of these shifts, domestic employment levels in the oil industry have doubled, and the U.S. balance of payments in petroleum products is narrowing.
Although some Wall Street analysts question whether the growth in North American oil production will drive prices sharply lower for a sustainable period of time, we do not believe this will be the case. Instead, we believe the price levels and range of the last several years are likely to persist. Although technology has enabled the growth in production of new resources, without these higher prices, these resources would not be economically viable for the industry writ large. Even as cash flows have risen with the price of oil and gas, the industry has needed higher prices to generate the capital required to exploit the resources (shales, deepwater, oil sands) that are driving production growth and offsetting declining productivity from conventional reservoirs. In fact, in the past 15 years, the global reserve replacement cost per barrel has quadrupled and the annual capital investment to find and replace reserves and grow production has increased six-fold (see chart). Thus, while the industry has figured out how to grow supply, we believe this growth cannot be sustained in a price environment that is materially worse than what we have experienced in the past several years. If anything, we continue to see evidence in project and corporate data that capital intensity remains on the rise.
Finally, in the past five years, most of the growth in global production is from North America and the rest of the world has lagged. This is a change from the previous 20 years, and it can be directly linked to a shift in capi - tal allocation back to the U.S. and Canada and away from the rest of the world, as oil industry investment is something of a zero-sum game.
Demand Growth Makes a Comeback
When thinking about prices, it is always impor - tant to consider demand as well as supply. We believe that the outlook for demand is improv - ing. Following the rise in prices in 2007-2008 and the global recession, oil demand growth slowed materially. However, in the past year or so, it appears that the negative effects of both the price spike and the recession have begun to fade. Despite structural forces that will likely restrict demand growth over the long-term, the rate of growth has shifted from around 0.8% to 1.3-1.4% per annum. Even that small a differ - ence can be meaningful in terms of keeping the market in balance.
Natural Gas – Light at the End of the Tunnel
As for domestic natural gas, we think that prices are going to remain pretty subdued for a couple more years. In the near term, we think demand growth can be readily sated with incremental volumes from certain key shales and associated gas. However, toward the latter half of this decade, we do see a potential sig - nificant upward shift in U.S. gas demand, driven by pending LNG export facilities and proposed increases in petrochemical, fertilizer and other large industrial gas users. Based solely on proj - ects we are tracking with a high probability of being built, U.S. gas demand has the potential to increase by 30-40% more than the average demand level for 2013. However, to bring these facilities on line, the industry will first have to ramp up investment in new drilling and infra - structure to accelerate the growth of domestic production.
Our conclusions on the current outlook for oil & gas prices are as follows:
1. Energy commodities are likely to be relatively non-inflationary in the next several years.
2. Oil prices will remain volatile but within a range of perhaps $80 to $110, which is simi - lar to the range of the past several years.
3. Continuing the trend of recent years, U.S. oil prices will remain structurally below global prices for the next several years, due to improved local supplies and a reduction in light oil imports. However, this could change if the U.S. lifts the 40-year-old crude oil export ban, allowing the free trade of crude oil.
4. U.S. natural gas prices will also remain seasonally volatile, but constrained by the industry's ability to grow supply at the current price point until there is at least a significant change in domestic demand.
5. Since most of our valuation work already incorporates the forward prices embedded in the futures strip – which is pricing in a sharp decline in the forward price of oil — our long- term views incorporate pricing at the lower end of our expected range.
6. Current global exploration and development economics necessitate that prices remain around the current level. Over time, this level is likely biased higher in contrast to the futures curve's direction.