Big-picture Case for Energy Stocks is Pretty Bullish

Maj chongqu’ tI nguv bey’vetlh!

That’s Klingon for, “Ooooh, that flower arrangement is soooo fabulous.”

Actually, we don’t really know if that’s an accurate translation (not speaking Klingon ourselves). But it’s been such a week of passion and debate here at the Old Hat Factory that we felt compelled to bring some levity back to the discussion.

There’s certain world-weariness to the tone of the letters we’ve been getting this week. So in an effort to reinvigorate your animal spirits, we turned to our friends the Klingons, who came to our mind after watching the new Star Trek movie last night. More on the human imperative to act in a moment.

How about a little market analysis for a change? After touching $60 earlier in the week, crude oil closed just above $57 in New York trading. The International Energy Agency said that global oil demand would decline in 2009 by 2.56 million barrels per day. It would be the largest annual decline in world oil demand since 1981 (just before the stock market’s 18-year run to glory).

Oil has risen despite OPEC production cuts, despite large inventories, and despite downward adjustments by the IEA to demand. Why would that be? Well maybe oil traders know that the supply side of the picture is the more important story. Demand is going to recover eventually. But the capital spending collapse in the oil industry beginning in 2008 has massively affected the industry’s ability to supply future demand.

That’s our take on it anyway. You can read the full explanation in our “Long Aftershock” report. If we’re wrong it wouldn’t be the first time. But building positions in Aussie energy producers and explorers is part of our investment strategy in Diggers and Drillers. Despite the yo-yoing of IEA oil demand forecasts, we think the big-picture case for energy stocks is pretty bullish.

Kris Sayce has been banging on the LNG drum, meanwhile, over at the Australian Small Cap Investigator. If you’re wondering what the difference is between his energy stock coverage and ours at D&D, we’d say it’s risk. Kris has been researching and recommending LNG plays in Queensland’s budding coal-seam-gas industry.

The industry is brand new. It’s trying to catch up with conventional off-shore LNG production in the Northern Territories and Western Australia. There are some big foreign partners with deep pockets who want to make it work. Earlier this week the China National Offshore Oil Corporation (CNOOC) signed an agreement with BG group to buy 3.6 million tonnes of LNG per year for twenty years from BG Group’s Curtis LNG Project.

Source: Queensland Curtis LNG Project

The whole project is designed to turn coal seams from Queensland’s Bowen and Surat basins into exportable energy. The Curtis project would export 7.4 million tonnes per year by 2014. Under the terms of the off-take, CNOOC also gets 5% of the reserves and 10% of the equity in one of the two LNG trains planned.

So there you have it, Chinese capital again coming to the table to secure access to strategically vital energy and mineral deposits in Australia. If anything is surprising about this it’s how the coal-seam-gas industry has gone from a fringe energy experiment to something major international companies are sinking billions of dollars in. Recall that BG got into the game by paying $5.5 billion for Queensland Gas last year.

What does this mean for small cap investors? It means the other four LNG projects in Queensland (with Aussie firms Origin, Santos, and Arrow Energy partnering up with foreign capital) are likely to move ahead as well. The industry is capital intensive and in its infancy. That’s what we think makes it riskier than conventional off-shore LNG plays in WA and the NT.

But the CNOOC off-take agreement confirms that global energy players think energy prices are going higher (no matter what the IEA says from month to month). A portfolio of different energy stocks (oil, LNG, uranium, and coal-seam-gas) is one way to take advantage of this. If you want producers, that’s what we’re recommending in D&D. If you want project developers with promising resources but new business models, you’d go the small-cap route at ASI.

By the way, we missed this story, but in late April the Australian reported that China’s National Nuclear Corporation is talking with Australian firms about “large scale investments in Australia’s uranium miners.” CNNC vice president Jiangang Qin told Dow Jones Newswires his firm was definitely interested, “But we need to verify the feasibility of certain projects before making any more details public…”We want to focus on our own production but we’d also like to make investments similar to Japan, to plug any shortage in Chinese uranium supply.”

Rare earths, iron ore, bauxite, LNG, uranium. Are you sensing a pattern here? The only word of caution we’d throw out is to avoid euphoria and over optimism about what real Chinese demand will do to energy stocks. Like all commodities, energy is cyclical. We confess to getting caught up in the base metals boom that peaked in 2007 and not being prepared for the downside of the cycle when it came. And come it did.

But for now, there is a nice little trade going on in energy stocks. And we think it will keep rolling along at least through this year. Low commodity prices are attracting foreign capital to come and make bargain deals. Shareholders of Aussie junior energy stocks may benefit from this now, or later when energy prices rise if the world economy ever starts growing again.

And now to the animal spirits of entrepreneurship. In the The General Theory of Employment, Interest and Money, John Maynard Keynes wrote that economic decisions are not made based on rational calculation but can, “only be taken as a result of animal spirits, of a spontaneous urge to action rather than inaction.”

Where are those spirits now? Are they dispirited? Has the GFC crushed them? Will they ever come back?

Who knows? A new book by economists Robert Shiller and George Akerlof argues that there are actually five “animal forces” which animate investors. They are: confidence, fairness, corruption, anti-social behaviour, and money illusion. We haven’t read the book, so we don’t really know what exactly they mean.

However, after watching the new Star Trek movie last night, we think we know what’s missing from the current spirit of the age. What’s missing is an ambition to take a risk in order to achieve something great or good. That probably sounds silly, given the consequences of excessive risk taking over the last ten years in the financial industry.

But there’s a qualitative difference between pioneering the field of credit derivatives and say, boldly going where no one has gone before. For some reason, there’s a under-current in the modern Western world (driven, we suspect, by post-modern humanities professors) that there is nothing worth achieving, nothing worth effort, and a lot of history for which we ought to be ashamed (and apologise for).

The great thing about the Star Trek franchise is its unbridled passion for the ability of human beings to literally expand their horizons. The passion of the franchise is that human beings need to take risks in order to survive and feel alive. Without risks and challenges, we are just animals struggling to survive.

We’re not sure Gene Roddenberry, the creator of the Star Trek franchise, was an Austrian economist. But the Austrians recognise that the passion of the entrepreneur to take risks is what animates the spirit of capitalism. They celebrate that passion, while realising that the creation of new wealth from new businesses can’t take place without the destruction of old or obsolete ideas.

What’s interesting about today, especially politically, is how a great many people in government and finance are clinging to obsolete and established economic arrangements. They are doing so because it’s comfortable and it’s not clear what would replace them. They are also doing so because they have a vested economic interest in preserving the status quo.

But fundamentally, we are optimistic here at the Old Hat Factory that the genetic and even spiritual desire to take risks and create is stronger than the defensive and suffocating instinct to suppress risk and impose order on chaos. Mind you, we are not taking off our skeptics hat when observing financial markets. It wouldn’t do to ignore economic and fiscal reality based on idealism about human nature (which is a two-sided beast).

But yes, someday this Depression is going to end. Some problems will find solutions. New economic arrangements will be made when other problems can’t be solved (the dollar as reserve currency, peak oil, etc.) But the world will keep turning, including this weekend. In that spirit, live long and prosper.

Dan Denning
for Markets and Money

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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2 Comments on "Big-picture Case for Energy Stocks is Pretty Bullish"

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Oils aint oils, the appeal of gold seems to be on the wane, now oil is the darling of the Daily Reckoners! They could be right though! Then again……..

Greg Atkinson
“Oil has risen despite OPEC production cuts”…actually the aim of OPEC cutting production is to drive up oil prices so I am not sure what the author’s point is here. But before people get too excited about oil demand they should also look into “Peak Demand” theory as well. Remember oil traders were the people who were talking up oil to $200 a barrel not long ago. I also find this comment interesting from Dan Denning: “But fundamentally, we are optimistic here at the Old Hat Factory that the genetic and even spiritual desire to take risks and create is… Read more »
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