THE STATE OF OIL AND GAS
In our Second Quarterly letter of 2016, we welcomed our friends and intelligent investors to the Exponential Age, a new industrial revolution for the world. While we wrote briefly about the amazing, logarithmic changes coming to automobiles, we thought the topic converged nicely with a large area of investment interest: oil and other fossil fuels. As we began our research work, compiling charts and tables to get a firm grip on this area, we thought the results were compelling enough to share with you in this KnowRisk.
Louisiana has the largest concentration of crude oil refineries (second in total number), is the third largest producer of petroleum, and is a top producer of natural gas in the USA. Many investors local to the gulf south are perhaps more familiar with the oil industry and its volatility than they should be. For those who are not, the chart below shows the price of oil falling dramatically in late 2014 from post Financial Crisis highs. This drop caught many intelligent investors by surprise. Some mistakenly bought into the dip, while others sat cautiously on the sidelines, waiting for a bottom. One tool we use to help sort fact from fiction is Supply and Demand analysis.
Supply and Demand
Starting in the beginning of 2014 (the red box in the picture right), the global supply of oil increased dramatically. Improvements in fracking technology and the expansion of the number of wells in America (from 400 in 2010 to 1,400 in 2014) completely changed the global oil game and the supply of oil sharply increased. This essentially flooded the market with so much oil that demand and even storage could not handle the volume at a price anywhere near the previous +$90/barrel prices of 2015. To compound the issue, many oil exporting nations rely on oil revenues to balance their budgets to supply cheap energy and other necessities to their populations. Thus, in a strange reversal, some producers began to increase production in response to falling prices. This created a negative feedback cycle until businesses and the rigs that were unsustainable at the new lower prices exited the market.
As for the demand side of the equation, usage remained on its relatively slow and stable growth as consumers chose to pocket the savings rather than dramatically increase their usage of oil through transportation or other means. In late 2014, with oil prices falling, the data on increased supply and excess production was available. Accessing and processing this data is vital in telling the difference between a falling knife and a temporarily depressed asset.
While we have covered the current status of oil market dynamics, we need to be continually conscious of the supply/demand environment developing in the future. One of the biggest changes was mentioned in our KnowRisk released after the 2nd Quarter 2016, when we talked about the exponential growth of self-driving and electric cars, as well as the growth of the solar energy industry more broadly. To give specific figures on that growth and its impacts, our research has revealed that between gasoline and low sulfur diesel fuel, almost 70% of our oil use lies in the transportation sector. Germany, a large manufacturer of automobiles, has voted to ban new combustion engines by 2030. We do not think it will take that long. In the US, oil consumption peaked in 2005 and has declined steadily since. All the evidence we have seen paints the picture that the largest uses of oil will be in decline in the near future. Likely in response to viewing the same data, the Rockefeller Family Fund, among many others, has divested from fossil fuels. China has announced a plan to invest $361 billion in renewables by 2020. The future outlook for the demand of oil is not particularly rosy. Our investment committee briefly considered divesting from the somewhat oil-linked Master Limited Partnership (MLP) investments, but research with our industry leading managers revealed a more complex picture.
Implication for MLP’s
For years, Equitas has been covering Master Limited Partnerships (MLPs), which are special vehicles to invest in “toll road” income producing pipelines for fossil fuels. While volatile, the Alerian MLP index (AMZ) returned 18.31% for 2016, and has earned an average annual return of 8.05% over the past decade. As of the beginning of 2017, AMZ is earning an annual yield of 6.91% compared to the yields of the REIT index at 3.85% and for the S&P 500 at 2.13%. Even though valuations might change dramatically the income tends to remain stable and increasing due to the toll-road like nature of the transportation contracts (see: chart on the next page). After the drop in oil, the MLP segment of the sector has rebounded more quickly.
These statistics are great, but they would mean relatively little if they depend on the continued flow of oil throughout the US. Luckily, the pipelines are relatively versatile, and able to adapt to ever changing market forces. Over the past 15 years, natural gas and natural gas liquids has doubled from producing 15.9% of our energy to producing 32.8% of our energy. Natural gas is not only a far cleaner energy than oil (emitting 50% less carbon dioxide), but it’s also more economic. Natural gas usage continues to be on the rise not only for industrial uses, but also as a fuel for fleet transportation including companies like Fedex and UPS among many others.
As our research suggests, the future supply and demand dynamics for oil are not positive. While this is likely to play out over years rather than overnight, we feel safer being ahead of the trend by avoiding concentrated investments in oil. However, with increasing usage of natural gas in the industrial sector, MLP’s are positioned to profit. While any investment comes with its risks and requires ongoing monitoring, our extensive research into the fundamentals of MLPs has given us comfort to invest in managers in this sector.
Equitas Capital Advisors, LLC
Equitas Capital Advisors, LLC was established to be a unique company which blends the resources of a large global corporation with the flexibility of a small firm. The registered service mark of Equitas Capital Advisors is Engineering Financial Solutions (SM) and the purpose of Equitas is to design, build, and deliver investment solutions to meet the goals of our investors. Equitas Capital Advisors, LLC located in New Orleans, has over 200 years of combined investment consulting experience providing professional investment management consulting services to investors.
Disclosures and Disclaimers:
Above information is for illustrative purposes only and has been obtained from reliable sources but no guarantee is made with regard to accuracy or completeness. It is not an offer to sell or solicitation to buy any security. The specific securities used are for illustrative purposes only and not a recommendation or solicitation to purchase or sell any individual security.
Equitas Capital Advisors, LLC is registered as an investment advisor with the Securities and Exchange Commission and only transacts business in states where it is properly registered, or is excluded or exempted from registration requirements. Securities and Exchange Commission registration does not constitute an endorsement of the firm by the commission nor does it indicate that the advisor has attained a particular level of skill or ability.
Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the authors on the date of publication and are subject to change. This publication does not involve the rendering of personalized investment advice.
Charts and references to returns do not represent the performance achieved by Equitas Capital Advisors, LLC, or any of its clients.
Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses.
All investment strategies have the potential for profit or loss. There can be no assurances that an investor’s portfolio will match or outperform any particular benchmark. Past Performance does not guarantee future investment success.