The future of energy – eight stocks to buy now

Four professional investors talk to John Stepek about profiting from energy production, and pick eight energy stocks to buy now.

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In this month's Roundtable, our panel of experts talk to John Stepek about profiting from energy production, and pick eight energy stocks to buy now.

John Stepek: At $70 a barrel, oil is a lot cheaper than in mid-2008, but it's a lot more expensive than at the start of the decade. Why is it still so high, given the fragile economic backdrop?

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Tim Guinness: I can tell you why in very simple terms. At $75, it might be three times what it was in the past, but it was very, very cheap then. We think it will trade somewhere between $65 and $85 for two to three years.

Angelos Damaskos: I agree that oil will probably be range-bound for the next couple of years it depends largely on whether the economy double dips or we see some sort of recovery.

But Asia's industrialisation story is not over. The mere fact that ten million people move from the rural areas to the city every year means huge demand for energy and raw materials. Once the developed economy stabilises, global demand will begin to outstrip supply. On-land production is dropping. The only new sources of oil are from deeper offshore areas, and BP's problems are going to result in higher exploration and development costs for those fields, due to increased regulation. So it is not unlikely we will see the old highs in the next five years or so.

Clare Brook: One also has to take into account the overall cost of oil whether it's the environmental hazards associated with its extraction or the cost of what happens when you burn it. Proposals for putting a price on carbon have been delayed. But assuming they come alive again, we can expect this to put upward pressure on the oil price.

John: So oil is bound to become more expensive if you include the environmental costs?

Clare: Yes. And I suspect that over the next decade or so, the impacts of climate change will become more obvious. So the pressure on policy-makers to do something about it will increase.

Jonathan Waghorn: I actually find it very difficult to explain why crude prices should be as high as they are today. But the most obvious explanation is it's because oil cartel Opec is keeping three million barrels a day off the market. And even though they are keeping prices high, the world economy, surprisingly, is recovering and coping with that oil price, so demand has a lot to do with it. But as we start to see interest rates moving up and personal disposable income ebb away, we're going to see complaints about gasoline and petrol prices.

Our Roundtable panelClare BrookFund manager, IM WHEB Sustainability FundAngelos DamaskosChief executive, Sector Investment ManagersTim GuinnessFounder and chief investment officer, Guinness Asset ManagementJonathan WaghornPortfolio manager, Investec Global Energy Fund

So I would probably be a little more bearish in the near term on the crude price. Longer term, $80-$85 is what we need for Canadian tar sands, and as long as we all keep driving petrol-powered cars, we'll need synthetic crude oil. But we've got to get through an overhang of Opec spare capacity first.

Tim: Like Jonathan, I analyse the market and worry about why is it so high when I can that see stock levels in the OECD are plentiful. But we must remember, we can't see stock levels in the emerging markets. This year, oil demand will be back at peak levels because the emerging economies are screaming for it. So Opec is being helped by the fact that the demand dip has really been pretty modest 1.8% I think, compared to 8% to 10% for some previous recessions.

Clare: I remember seeing an oil analyst speaking in 1990 and projecting that oil would get to $78 a barrel, which seemed amazing back then. He made the point that the average Indian was then consuming, as it were, half a cup of oil per capita per year. So obviously that's been a huge factor in driving up oil prices.

But as neither China nor India are oil-producing nations, their governments must be brutally aware of the need to shift their energy demands to a different source. China has a huge portion of the world's rare-earth metals which go into both hybrid electric vehicles and batteries and wind turbines as well. My pet theory is that the Chinese will push alternative energy because that would suit them so much better.

Angelos: Chinese companies have been buying oil assets around the world, particularly in countries where they can do so more freely, such as those in Africa. But small measures such as the introduction of electric cars will have no major impact on oil demand. After all, an electric car needs to be powered up. Electricity comes from a power plant that uses either oil or nuclear energy

Clare: Or coal, or natural gas, or wind. There are lots of ways of producing electricity but there is only one way of making petrol.

Tim: I'm interested in alternative energy. But it's going to be very hard for wind and solar to make a dent in oil demand. We've modelled the growth in the electric car, or for that matter the gas car in America, and it's very hard to see it having a significant impact within the next 20 years.

John: Could energy-efficiency measures have any impact?

Jonathan: Yes, a massive one. The US consumes 22.5 barrels of oil per head of population. In Europe that figure is about 12, China two, and India one. The argument is that China and India's figure will rise, and the US's will come down. And it will. Look what Obama is saying, he's going to do it somehow he has to. The US can't export billions of dollars a month to regimes it doesn't trust. And BP's spill has made that point even clearer. So something's got to change. We had a US refiner see us last week who told us that the US is starting to go to diesel. We did that in Europe 25 years ago diesel is a damn sight more efficient. BMW/Audi diesel engines are phenomenally efficient relative to petrol. So that's one thing. There is a move to electric too, but it's starting from a tiny, tiny base.

Clare: But you are just looking at transportation. If you take energy requirements as a whole

Jonathan: Then for electricity generation, there will have to be a move towards natural gas.

Clare: But what about the smart grid, for example? Introducing one is estimated to cut overall energy demand not including transport by 25% to 30%.

Jonathan: I'm all for it, but it's years away. But what about in the meantime? If we have $100 crude and $4 gasoline in the US, then it becomes efficient to switch your car today to compressed natural gas. I'm not saying that consumers will make the switch because the infrastructure isn't there. But it'd make sense for school buses, taxis, local buses any type of fleet transport.

Angelos: But the capital expenditure for alternative energy technologies is massive. Without subsidies, it doesn't make economic sense.

Clare: Subsidies are coming through. Of the $177bn pledged towards investment in renewable energy and energy efficiency measures by governments worldwide, only 14% was used in 2009.

Angelos: I'm not sure that will be sustained though, not now that governments are trying to cut expenses across the board.

Clare: Well, we are seeing reductions in feed-in tariffs in Germany, Spain, Italy although not in the UK so far. But technological advances are also narrowing the gap between the cost of alternative energy and more traditional methods. In certain parts of California, for example, you are pretty much talking parity in other words, alternatives are as cost-effective as anything else. So if you're talking about oil potentially going to $100 a barrel, then it gets very interesting.

John: Of all the renewable energies, which would you back most strongly as the 'energy of the future'?

Jonathan: Nuclear. No one wants to have a nuclear plant in their backyard. And it's going to take 15 years to build one. But in terms of the economics of producing electricity in a relatively clean way, it's got to be that.

Angelos: Also, uranium is in plentiful supply. I am very bullish on nuclear power, but very bearish on uranium prices. There are some massive deposits and projects due to come to production over the next two to five years. Take Extract Resources in Namibia it has one of the biggest deposits, which could come to production in three or four years' time. That could potentially supply something like 20% of the world's needs. There is enough uranium to run all the power stations the world can build.

Tim: Nuclear is going to be big. But I think wind will produce let's say 10% of global electricity to begin with, and that solar will get to 5%, then maybe 10%. In terms of investment, I think that's where the potential lies. It's very hard to invest in nuclear, particularly if you're ruling out uranium miners.

Angelos: There are technology providers that could do well in a nuclear-power-station construction boom (for more, see page 8). And some alternative energy companies are interesting. But I think the difficulty is that most use some sort of proprietary technology. If the technology does well, then it could be a massive winner. But many fail abysmally.

Clare: But that's typical of the early days of new technologies isn't it? The same must have happened with oil drilling in the 19th century.

Angelos: Yes, but that's exploration risk and development risk. You can differentiate between the two. If you back a company that has found reserves in the ground, then you can roughly assess its value and commercial viability. But if you're looking at the technology of a new solar-power panel, unless you have a technical consultant who knows it inside out, there is very little way for non-specialists to assess the company's prospects.

Jonathan: I've got a masters degree in semiconductor physics and I don't understand it. It moves so quickly.

Clare: Clearly there won't be any single answer. Different things suit different climates. So for the UK, wind makes a lot of sense we're a very windy island and we've got a lot of suitable offshore locations. But in many parts of the world, solar would be a better alternative. I heard an amazing statistic the other day: that with all the right equipment installed, obviously at hideous expense, 3% of the Sahara could supply the entire world's energy needs. Clearly that's not going to happen. But I think it could play a bigger role than people who are wedded to conventional forms of energy can imagine at the moment. We always think that the status quo will go on forever.

Jonathan: It's controversial, but how about natural gas as a renewable energy source? With the shale gas breakthroughs, the resources could be phenomenal.

John: Explain how the shale gas process works.

Jonathan: In a perfect world you would produce gas from sandstone. Sandstone is nice and clean and it is easy to extract the gas. But the US has done that and it's all finished. With shale, the only way of making it produce is to 'frack' it: you pump massive pressure into the mine using water and blow the rock apart. You then take the fluid away, and collect the gas. It's like taking a bottle of champagne, shaking it up and flipping the cork off. You get a sudden gush of bubbles and you get an 85% decline rate in the first year. So there's a hyperbolic decline rate, and then very low production levels thereafter. The difference is the volume.

The resource potential is absolutely enormous. The break-even price is $6 per thousand cubic feet (MCF). Six dollars for gas is the equivalent of $36 for oil that's the difference. With crude at $80, and the equivalent gas price of $36, demand will change. And suddenly the US has got a huge resource base within its own borders.

Clare: It's alternative, maybe, but you can't really argue it's renewable once you've used it up, it's gone.

Tim: But it's a halfway house to achieving lower carbon emissions.

John: This all sounds relatively optimistic. How easy do you think the transition from oil will be in practice?

Tim: Worrying about carbon emissions is one thing. But what really worries me is the idea of using up our fossil fuels too quickly and here I'm talking in the next 100 or 200 years. In the medieval period, there would be maybe one or two horses per village. I sometimes wonder, are we going to go back to a world where only one or two people can afford to have a car? I don't think so. But in the long run, we'll have to move to gas and eventually, although it could take 100 years, to electric cars.

Jonathan: Yes, putting climate change to one side, we should be more efficient

full stop, and save resources for the future. I think you will see big demand changes to gas in the next ten years.

Clare: There is a lot of worrying and apocalyptic scenarios for our children and grandchildren being drawn up. But I don't think it's as serious as everyone seems to fear it might be. It's not the end of the world to change from a petrol car to a gas one, is it? Or to ride your bicycle a bit more, or have a meter in your house?

Angelos: But on electric cars I mean, the Tesla an electric sports car currently on the market is a mockery of electric cars, isn't it? It's essentially a car people buy for fun. It's not really the answer to our future transportation problems.

Clare: Well, as investors we haven't backed the electric car industry at all. Yes, there is definitely urban demand, because the vast majority of journeys are short ones. But I think that the industry has a few convulsions to go through before it

takes off.

John: So what stocks would you buy now from either old or new energy sectors?

Tim: My tip is a little company called Helix (NYSE: HLX), which is involved in offshore work including deep-sea support in the Gulf of Mexico. My view is that in the medium term we will continue to see the development of offshore oil reserves, despite BP. This company will be a beneficiary.

John: Would you buy BP just now?

Our Roundtable tips

Swipe to scroll horizontally
SMA SolarDax: S92
American SuperconductorNasdaq: AMSC
CreeNasdaq: CREE
Premier OilLSE: PMO
Dana PetroleumLSE: DNX
Encore OilLSE: EO/
Ultra PetroleumNYSE: UPL

Tim: I haven't done the maths on where we are after the recent bounce. But if you are rational about the clean-up costs, the litigation and the fines, you get to $20bn. You double it to factor in the uncertainty and the political sensitivity you get to $40bn. So when the market cap had fallen by $80bn, it was cheap. Also, I'd argue that BP is the most competent operator out there. BP is good and it is going to crack this.

John: What are your tips, Clare?

Clare: We were talking earlier about solar power. We are worried that the solar industry will have to go through convulsions as the price approaches grid parity. There's a huge amount of growth there, but it'll come at the expense of profit margins. But companies that feed off the industry should do well. SMA Solar (Dax: S92) makes solar inverters, which are crucial for producing electricity that is compatible with the grid. I also like energy-efficiency group American Superconductor (Nasdaq: AMSC). Its weakness, but also its strength, is that it has one huge customer who accounts for about 70% of its business Sinovel, China's largest wind-turbine manufacturer.

As the wind industry grows and competition does too, prices will come down. That's not good if you are an established player facing competition from China. But if the Chinese have to use the same widgets in their turbines as everyone else, you just buy the widget-makers. American Superconductor's particular widget normalises the flow of electricity generation in other words, the turbine functions at both much lower and higher wind speeds than it would otherwise.

Today, 10% of the global electricity generated from wind turbines goes via American Superconductors. So it is big. Also, the company has produced a high-temperature superconductor wire, which could convert all the wires that have to be transported overhead in pylons into a small wire that could go underground. This could transform our landscape and hugely improve the efficiency of the grid.

My third pick is Cree (Nasdaq: CREE), which makes LED lights. Lighting is a huge use and waste of energy at the moment. LED lights are 80% more efficient than old-style lights. I think in ten years' time, a light bulb will seem as quaint as a penny farthing bicycle.

There is a huge potential demand for LEDs in things like fridge and car lighting, and anything where you've got a manufactured unit that can install the LED direct. But what we particularly like about Cree is that it has just signed an agreement with Philips, which had looked like being a dangerous, huge competitor. To us, this deal has changed the landscape for Cree.

Angelos: At this stage of the economic cycle, I am particularly concerned about valuations. I think there is a considerable risk of another potentially quite severe correction in the markets.

So I back real assets value that minimises the downside risk. The top holding in my fund just now is Premier Oil (LSE: PMO). It has significant reserves in the ground, and very strong production. It's growing a very active exploration programme that should add to reserves and to production over time, plus it is a potential takeover target.

The second is Dana Petroleum (LSE: DNX), which has seen an approach by the Koreans. But if it changes hands, it will do so at a much higher price than its current one because again it has a lot of reserves, a lot of production and a very active exploration programme.

And the third is a smaller company, Encore Oil (LSE: EO), which has had a phenomenal discovery recently in the central North Sea one of the largest finds in the last 20 years. I believe that the market still does not appreciate the value that could be found here.

Jonathan: I will go for something gassy Ultra Petroleum (NYSE: UPL). It has grown in the last few years at 20% per year and will maintain that rate for the next few years. It will increase its reserves by two and a half times over the next two or three years. Its return on capital employed has never fallen below 18% and it is currently trading at $10 per barrel of proved gas reserves in the ground.

That means that, in a couple of years' time, it will be trading at less than $5 per proven barrel of gas in the ground. Given that it costs the oil majors $20 a barrel to find and develop, it makes a lot more sense to buy on Wall Street than it does to actually go ahead and develop themselves. And given that Ultra shares all of its operations with Shell, I can't believe it won't be a target one day.

This article was originally published in MoneyWeek magazine issue number 496 on 23 July 2010, and was available exclusively to magazine subscribers. To read more articles like this, ensure you don't miss a thing, and get instant access to all our premium content, subscribe to MoneyWeek magazine now and get your first three issues free.

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.