GAM’s Woodard: Can energy stocks withstand their rising valuations?


Few commodities capture investor attention the way energy does. Price changes have far-reaching economic impacts, playing a vital role in the costs of numerous products and services. The prevailing view is that falling energy demand in the developed world, coupled with supply increases in the U.S., will continue to drive prices lower.

While this idea has merit, it neglects several important factors such as depletion rates and emerging market demand growth. Emerging markets should continue to offset weak developed market demand. Furthermore, alternative energy sources are not yet ubiquitous enough to replace traditional options in satisfying the world’s energy needs.

Recent moderation in economic growth in emerging economies has contributed to investor expectations for lower future oil demand. However, forecasts seem to disregard that transportation remains a primary source of oil demand. As consumers in developing economies continue to move into the middle class, transportation demand has expected dramatic increases.

The surge in oil and natural gas production from shale in the U.S. has garnered a lot of attention in recent years, causing some to speculate about prospects for U.S. energy independence. While technological advances have brought new supply to market, the reality is that global oil supply has been “running to stand still” for some time.

The ongoing battle against depletion, coupled with global supply constraints, should ensure that capacity remains tight. If views prove correct, for future prices to remain stable, it will take either a massive new round of capital expenditures in new and existing fields to lower the marginal cost of oil, or increased use of cheaper substitutes. This backdrop sets up very well for natural gas exploration and production companies to provide a cheaper oil substitute. For the oil services industry, this is a major beneficiary of increased investment from the world’s oil producers.

The Hurdle Rate strategy, a conditions-based investment strategy for capital-intensive cyclical industries, focuses on industries where capacity is leaving because returns on investment are currently unattractive. The key is identifying leaders positioned to withstand difficult circumstances and benefit from conditions as the industry recovers. As a cycle progresses, investment opportunities may develop in companies exposed to different aspects of the value chain.

EOG Resources engages in exploration and production of natural gas and crude oil, primarily in North America; with excellent natural gas assets, including liquids resources and low-cost natural gas. During the intermediate-term, we expect to see increased industrial gas demand and coal-to-gas switching, due to mandated coal-fired electric plant retirements. We also expect to see increased demand for gas as a transportation fuel. Over the longer-term, U.S. companies may begin to export natural gas in the form of liquefied natural gas (LNG), which would compete globally against higher cost natural gas.

Baker Hughes is a market leader in important early cycle service markets within natural gas and oil, including directional drilling, well completions, and fluid controls. All of these business lines may be early beneficiaries of an upturn in drilling rig activity. U.S. natural gas prices have begun to rebound, but are not yet high enough to incentivise companies to drill. However, the market is anticipating during the next 12-18 months we will see natural gas rigs put back to work. Additionally, oil prices are now at a level that should compel producers to spend.

We haven’t reached the later stage of the natural gas cycle, with prices high enough to add late-cycle beneficiaries. However, UPS would be an example of a well-positioned ‘consumer’ of both oil and natural gas. Although we currently have no investments in energy ‘consumers’, we applied the Hurdle Rate strategy to transportation companies such as UPS, FedEx Corporation, and several well-positioned railroad companies in 2008 during the latter stages of the oil cycle. At the time, elevated oil prices were cutting into profits of most global freight and transportation companies. These companies could withstand the higher prices much better than weaker competitors and benefitted when the cycle turned.

Greg Woodard is manager of the GAM Star US All Cap Equity fund