Energy Tribune

Arthur L. Smith has been an energy analyst for more than three decades. In 1984 after spending nine years on Wall Street doing institutional equity research, he acquired control of John S. Herold, Inc., a research-only firm focused on the energy sector.

In February 2001, Smith and two fellow energy analysts at Herold became the first to publish a report critical of Enron, saying its stock was overvalued and that it lacked the hard assets needed to make money on an ongoing basis. In 2007, Smith sold Herold to IHS Inc. for $48 million. A chartered financial analyst, he now works as an investment advisor with his new firm, Triple Double Advisors.

ET: What are the key macro trends in the energy industry?

AS: For petroleum – oil and NGLs – it’s the same mega-trend: unrelenting global demand growth constantly bumping up against anemic supply gains. Notwithstanding record upstream investment by the large public IOCs, oil production gains in the non-OPEC regions continue to disappoint. That leaves all the heavy lifting – read: incremental capacity gains – to the NOCs and OPEC, while world surplus production capacity remains razor-thin.

Meanwhile, most energy economists have been amazed by the relativelymodest evidence of price elasticity for oil products globally – $100 per barrel oil may make headlines, but so-called expensive oil does not appear to affect consumer spending patterns appreciably. To be honest, we have long been of the opinion that “oil is cheap” and natural gas ridiculously inexpensive. And, despite a flood of interest (and investment) in alternative energy, it can be said that another meaning for the acronym “AE” is “awful economics.” The politicians who triggered the great Ethanol Boom and Bust over the past five years must have been drinking the substance in the Capitol during lawmaking sessions.

For oil, fundamentals remain robust, with world inventories lean going into the peak demand months for the Northern Hemisphere. Only the onset of a global recession is likely to derail petroleum demand enough to trigger a significant ($25 per barrel) price retreat: we look [for] the world economies to sputter along with $85 oil for 2008.

Natural gas has dramatically decoupled from oil in North America, anyhow. Looking ahead we have a number of moving pieces: 1) Demand is a function of Heating Degree Days and Cooling Degree Days and no one can predict the weather, so we focus on 2) Supply, where onshore U.S. gas production is growing strongly while Canadian gas production falls steeply.

Gulf of Mexico shelf production [is] continuing to wither but deepwater production is surging to more than offset [it]; and finally, LNG imports could accelerate rapidly as new regasification facilities are completed; LNG is truly the wild card. As a global LNG market races forward, Atlantic basin trade of LNG cargoes zig and zag to the daily spot market fluctuations…

In recent months, energy analysts and investors have become increasingly concerned about natural gas – harboring the dread of $3 to 4 per MMBtu natural gas wellhead values in a supply and inventory glutted market in North America. In some ways, the energy bull market appears overdue for a respite. We agree – and we seldom agree with conventional wisdom – that the upstream sector and drilling and services market could be in for “a good sweating” in 2008. But then again, we caution investors to focus on long-term fundamentals, which are decidedly positive for North American gas.

ET: Why are the economics for alternative energy “awful”? Will anything change that in the foreseeable future?

AS: Let’s face it: we already are benefiting from several sources of Alternate Energy that are providing significant new petroleum supply: Canadian oil sands, Venezuelan Orinoco belt heavy oil, and unconventional natural gas.

These sources are economic in today’s market without subsidies.
Wind power is great but it still needs subsidies (nearly 20 percent of its retail value in tax credits) to be competitive. Ethanol does not provide any energy return on investment….I concede that there will be technology and economic breakthroughs that will aid the development of alternate energy sources. But, there is more hype than substance in most AE investments. I would steer clear of the AE sector; however, many energy conservation options exist – e.g., LED and fluorescent lighting – that are sure winners today and in the years ahead, when we will be living with higher-cost Btus.

ET: How you see the NOCs vs. IOCs issue playing out?

AS: It is not a level playing field: the NOCs will win hands-down.

ET: Given your belief the NOCs will win, what should investors be doing? Should they ignore the IOCs? Invest in the service sector?

AS: I have been dead wrong by avoiding investments in the NOCs like PetroChina and Sinopec, but I think they deserve valuation discounts, not premiums. IOCs offer reasonable valuations but are just too boring, have no volume growth potential, have terrible reinvestment challenges. It’s hard to get excited about billion-dollar share buybacks and dividend boosts. E&P and oil service are each much more exciting and interesting.

ET: What stocks do you like now?

AS: A good portfolio manager never reveals his picks to anyone other than his investors. (Or unless forced to disclosure through a 13-D filing when his position exceeds 4.9 percent.)

That warning aside, here are some of Triple Double Advisors, LLC’s Top 10 themes for 2008 energy investing:

1) Deepwater is very, very good.
2) We love the Canadian oil sands – I would be whispering into Ben’s ear (The Graduate), “Oil sands, my son.”
3) Acreage and resource plays are expensive.
4) North America onshore drilling and services are out of favor and may stay that way, but long-term patient investors will be rewarded.
5) Brazil has more than nice beaches and the best South American Mardi Gras.
6) Winston Churchill aptly remarked in 1939 that “Russia is a riddle wrapped in a mystery inside an enigma.” In our view at TDA, Canada is a better bet at current depressed prices for the oil and gas sector – and despite the currency imbalance favoring loonies over the greenback, Calgarians are most receptive to analysts and investors.
7) Winning E&P companies build net worth per share by focusing on free cashflow, share repurchases, and operational excellence.
8) [Look for] exceptional managers who “eat their own cooking” by owning and maintaining large shareholdings in their companies.
9) [Also look for] technology-heavy oil service companies which help the upstream battle “expense creep.”
10) Avoid most “white knuckle” exploration companies on London’s AIM exchange.