Wednesday, January 21, 2009

Opportunity in Energy Investments

As discussed in my previous post, significant events are in play in the energy world. The cost of both electricity and gasoline seems set for serious increases as a result of Obama energy policies. Both the timing and the implementation details are outstanding questions, and many other factors are at work. But, with so many changes apparently on the horizon, it makes sense to consider the implications and opportunities.

Let's review. Democratic leaders seem strongly inclined to reduce use of coal and gasoline. While the demand and cost for both is relatively low right now as a result of economic conditions, the coming of peak oil would normally increase cost of both coal and oil if demand returns to growth rates of the past 80 years, since a large majority of world energy supply is from these two sources.

However, substantially increased taxes on gasoline will reduce demand for oil, thereby depressing oil prices, relatively speaking. Transportation demand, coupled with high gasoline prices, will substantially increase demand for the two practical alternatives, electricity and natural gas.

Meanwhile, decreased use of coal, or alternatively, use of carbon sequestration, will depress demand and prices for coal. At the same time, carbon sequestration and/or substitution of higher cost alternatives will drive up the cost of electricity, which could already be stretched by transportation demand.

So, what will be the replacement for coal and the source of this increased electricity demand? Solar and wind supplies will be increased, but even dramatic growth in these resources will fall far short of demand for many years. Nuclear appears to be gaining ground, but substantial increases will be at least 10-15 years away due to plant permitting and construction times. Natural gas is clearly the only viable solution for the next decade. Substantial supplies are available, although largely at higher prices. It is relatively cheap. It is relatively green. Combine its role as a viable alternative for both electricity and transportation, and higher demand and prices seem to be a slam dunk for natural gas.

So, where to put your money? Conservation will be a great investment, with both higher gasoline and electricity costs. Unless you have a relatively well insulated and efficient home, conservation investments there will return in excess of 10% annually, even based on current prices. This would be enhanced if I'm right about the direction of electricity and natural gas prices. Transportation is a bit more tricky, since many current efficiency alternatives are not currently viable and the winner of the technology race for transportation efficiency is not yet clear.

But, let's say you want to look at more conventional energy investments. Coal, oil and natural gas are all relatively cheap right now and are essentially the only alternatives available in the near term for the majority of energy supply. So, I'd expect somewhat higher prices for all over the next year or so, as demand returns . But, over time, both coal and oil will be at a disadvantage. Meanwhile, natural gas will see substantial increases in demand and price.

To play the above in conventional energy companies, I'd favor natural gas producing companies over those who focus on coal or oil. Electricity generating companies are not as cheap as resource companies and are still largely regulated. Meanwhile they will need to deal with the complexities of shifting resources while highly dependent on difficult capital markets. As a result, I expect utilities to continue to be the relatively low return, conservative business they've traditionally been.

Manufacturers of solar panels will likely grow, but huge growth already seems to be priced into their prices. Meanwhile, their products are not currently competitive and the technology winner is still unclear, making investments there risky.

Another alternative is to invest in oil and gas exchange traded funds such as USO(oil) or UNG(natural gas). When natural gas is below $5/mmbtu and oil is below $40/ bbl, the downside of USO and UNG seems limited, and I expect both will rise over the next year or two, although as noted above I would lean toward UNG in the longer term.

Related to USO, you should also be aware of an extreme contango (oil futures selling for significantly more than current prices). As a result, many are storing oil while selling it on the futures market. This results in somewhat higher prices today, while putting downward pressure on near term future prices for oil, although the volumes are small relative to the overall oil markets. This situation, as well as robust prices for call options reflects a prevailing wisdom that oil prices will be higher in the near future. As a result, opportunities exist in these funds if you would like to lower the risk involved with being long in them. I've recently been buying these funds and selling 6 month calls with strike prices near current prices for about 15% of current price. With this method I am able to lock in about 30% annualized returns if prices remain the same, while breaking even when prices fall by 15%. I consider this a good alternative to virtually nonexistent yields on CDs or money market funds for cash I may need over the next year or two.