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Wilf Gobert

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More boom than bust

Wilf Gobert

CALGARY (GlobeinvestorGOLD) Crude oil prices plunged by nearly $14 (U.S.) per barrel in November and December, after hitting a peak in late October. Most energy-related stocks listed on the Toronto Stock Exchange followed suit, slumping after driving the TSX energy sub-index to an all-time high in late November, registering a gain of 29 per cent in 2004 and 57 per cent since the beginning of 2003.

The question now facing retail investors, portfolio managers and oil-patch workers is whether we are witnessing the beginning of an energy bear market, or is this a buying opportunity for the next leg up?

Time will tell, eventually, but in the mean time, evidence is mounting that a downturn should not last very long.

Crude oil prices based on the benchmark near-month contract for West Texas Intermediate crude traded on the New York Mercantile Exchange traded at their all-time high of $55.17 per barrel this past October. Prior to 2004, the all-time high was set at $40.42 in 1990. WTI will have averaged over $41 in 2004, up 29 per cent from its 2003 record annual high of $30.99, and this compares to a five-year average of $26.53. February 2005 will mark six years since the cyclical low in crude oil prices was set at $11.37, in 1999. This represents the longest period of sustained high world oil prices since the end of the 1970s.

Many powerful energy analysts, including those at the International Energy Agency (Paris) and the U.S. Department of Energy's Energy Information Administration, have predicted that crude oil prices will be sustained at higher levels than those seen in the 1980s and 1990s, using terms such as "Paradigm Shift" or "Structural Change."

In a sentence, they argue that energy has been too cheap, for too long, and the world has run out of inexpensive, abundant crude oil (OPEC's unused capacity to produce more has never been smaller). In the future, higher prices will be required to finance higher-cost supplies, such as Alberta's oil sands deposits.

At this point, the critical factors for 2005 performance are OPEC's price band, geopolitical conditions in oil exporting countries, and demand growth in reaction to 2004's high crude prices.

OPEC's price band (target), was set in 2000 and currently sits in a range of $22 to $28 per barrel for the OPEC basket of crude oil, which equates to a WTI price range of $25 to $31. Since then, the price has been below the minimum for only a handful of months. Some OPEC members have suggested that the cartel should raise the price band to $30 to $35. If this happened, it could set the price floor for the future of world oil prices.

At its December meeting, OPEC members agreed to cut production by one million barrels per day in January, to avoid crude oil inventories growing to a level that would undermine prices.

Reliving the past

When we look back at crude oil prices over the past two years, geopolitical events have had an enormous impact, including the civil strike in Venezuela, the Iraq War, and the threat of disruptions in Nigeria, Indonesia, and Russia.

At the same time, crude consumption has grown at a brisk pace of 2 per cent to 3 per cent per annum, led by China. If crude prices are sustained at $40, will it have a major impact on consumption? Probably only in the United States, as the decline in the U.S. dollar against most major currencies and the Canadian dollar means that the cost of crude oil in many countries has not risen nearly as much as it has in the U.S. Furthermore, when the price of crude is adjusted for inflation, the real price would have to approach $80 to reach the peak prices of 1981.

Finally, conservation has caused the unit consumption of energy in the U.S., to generate a unit of GDP, to drop by 40 per cent since 1980.

The supply and demand balance for natural gas in North America is even more precarious as Canada's production stopped growing in 2002. During the 1990s, Canada supplied 50 per cent of the U.S.'s incremental demand growth. Shipments of liquefied natural gas, or LNG, have grown from 5 per cent of U.S. supply to 14 per cent recently but they are near the full capacity of the existing infrastructure.

Future growth plans have come up against strong community opposition, slowing down the timetable for substantial new supplies. Thus, natural gas prices appear destined to remain high (approximately 1/6th of the BTU heating value of crude), with price weakness occurring due to short term, seasonal factors.

So what does the crystal ball say? Traders sold in December, while the aggressive funds went short. After the huge gains of the past five years, including in 2004, and given the steep retreat in crude prices, the fundamentalists will likely require some base building in commodities and energy stocks (i.e., sideways movement), before they can feel confident that we have seen the lows. Crude prices should hold at around $40, otherwise the chart support comes at $35.

Picks and pans

Our picks and pans for 2005? Look to Suncor Energy among integrated oils, as it lost over $500-million (Canadian) in crude hedging in 2004 but, discontinued hedging for the future. Thus, if crude prices were to be flat in 2005 versus 2004, Suncor's cash flow would rise $500-million before tax.

Among large cap producers, our favorite stock continues to be Canadian Natural Resources. The company has had one of the best track records among its peers and yet, it trades at the lowest multiple. In addition, the company should soon give the green light to a three-phase development of the Horizon Oil Sands Project. Phase One would see oil sands mining and upgrading of 110,000 barrels per day by 2008, and expansion through Phase Three to 232,000 barrels per day. The discounted present value of the project represents between $10.00 and $20.00 per share.

Junior and smaller producers are attributed high price valuations by the market because they are able to grow more rapidly, and because there is a strong probability that they can sell themselves to an income trust. Among a large group of worthy stocks, we would highlight Duvernay Oil Corp., Fairborne Energy Ltd., NuVista Energy Ltd., and Resolute Energy.

The oil field services industry is recording record activity levels, as record oil and natural gas prices generate record cash flow, and record capital spending. This means the services companies are running at capacity, with 24,500 wells expected to be drilled in 2005. Our favorites in this sector are companies that supply services to the growth areas, such as coiled tubing drilling, gas well stimulation (fracturing), and coal bed methane exploitation. Our picks are Calfrac Well Services, Savanna Energy Services, Technicoil Corp. and Trican Well Service.

The writer is a shareholder of Duvernay, Fairborne, NuVista, Resolute, Savanna, and Trican.

Wilf Gobert is a managing Director for Peters & Co., a Calgary-based full-service investment dealer.

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