For investors in the oil and gas sector, the first quarter of 2012 has certainly provided an interesting ride. Rising prices, crimped refining margins and historic capital spending budgets among other things marked the quarter’s highlights and have set the tone for the next period.
While slowing Chinese demand has taken some of the wind out of natural resources’ sails as of late, the energy sector promises to deliver the goods long term.
For investors, it’s important to see where we’ve been in order to know where we’re going. Here are some highlights from the oil patch’s first quarter and some potential outcomes for the second.
Mideast Troubles and Higher Prices
If there was one overarching theme for energy investors during the first quarter, it could be the tensions with Iran. Anxiety in the West about Tehran’s nuclear program continues to put pressure on Brent crude prices. Since the end of 2011, the key European benchmark has risen from around $107 a barrel to about $127 as sanctions threaten to choke off Iran’s exports. That’s just $20 short of Brent’s all time high reached in 2008.
These sanctions have certainly put a dent in world oil supply. Geneva-based oil industry consultant Petrologistics estimates that Iranian exports may have shrunk to nearly 1.9 million barrels per day in March. That’s down from about 2.2 million bpd in February. The majority of this oil flows into emerging Asia, Japan and Europe.
European sanctions stemming from last July have caused major purchasers of Iranian oil like France’s Total (NYSE:TOT) and Royal Dutch Shell (NYSE: RDS-A, RDS-B) to scale back their buying. Total is Europe’s largest refiner by volume.
While energy analysts predict that Iran won’t take military action, the odds are rising that it will. Iran’s repeated threats to close the Persian Gulf’s vital Strait of Hormuz are without doubt a cause for concern. Likewise, are Israeli threats to strike at Iran’s nuclear facilities at any time it deems appropriate. With no easy fix in sight, the continued tensions will remain a major catalyst for oil prices into the next quarter.
Woes Flow Downstream
That rising cost per barrel also had its way with refining margins. While many of the major oil and gas giants reported booming exploration and production (E&P) revenues, poor showings from their downstream refinery operations hurt earnings. With crack spreads (the price difference between crude oil and refined products) under constant pressure, the refiners, especially those on the East Coast, are seriously hurting.
Already, a gaggle of integrated firms including Marathon (NYSE:MPC), ConocoPhillips (NYSE:COP) and Sunoco (NYSE:SUN) have either decided to close their operations or spin them off in order to focus on more profitable midstream assets. With Brent remaining high for the next few months, analysts predict that more energy firms will engage in these sorts of transactions. This will definitely hit bottom lines as well as investors’ portfolios (as well as pump prices, as more gasoline refining capacity gets shuttered).
No Lack of Natural Gas
While oil keeps rising, natural gas keeps plunging. The boom in unconventional drilling and hydraulic fracturing has unearthed a record amount of the fuel. So much, that natural gas inventories are currently more than 50% above the five-year averages for this time of year.
Prices have hit a 10-year low of $2.18 per 1,000 cubic feet. That low price makes a variety of dry-gas wells unprofitable for E&P firms. To that end, producers like Chesapeake (NYSE:CHK) and Canada’s EnCana (NYSE:ECA) have been reducing production and shifting toward more profitable natural gas liquids (NGLs). Prices for these fuels generally track the U.S. benchmark West Texas Intermediate crude standard and generally sell for about 50% of the price of a barrel of oil.
Despite production cutbacks and moves to NGL-rich fields like the Mississippi Lime, analysts expect that record amounts of natural gas in storage may not be absorbed by summertime. That’ll keep prices low for some time.
The first quarter was also marked by a series of historically large capital spending budgets by the major producers. Starting with Chevron (NYSE:CVX) and its $33 billion capital plan, the recent spending projections highlight the sheer dollar amounts needed to produce hydrocarbons these days. As demand grows and traditional sources of supply dwindle, the capital requirements needed to tap unconventional assets will undoubtedly continue to rise.
Exxon Mobil’s (NYSE: XOM) five-year $185 billion budget is a testament to these rising costs. Ultimately, higher capital spending amounts will become even more prevalent and necessary in the future.
Finally, the first quarter also marked a turning point for beleaguered BP (NYSE:BP). The company released better-than-expected earnings, and it reached a settlement with some of the victims of its Deepwater Horizon disaster. While the British energy major still has plenty of legal woes to deal with, these major milestones could be a step in the right direction.
Another Doozy Is in Store
So, after an interesting first three months to the year, investors should be ready for more of the same. While nothing is for sure, oil prices should continue to remain high on both Mideast tensions as well as a strengthening global demand. That’ll be bullish for E&P sector, though not so much for the refiners that don’t have access to cheaper WTI crude readily available in the U.S. Midwest.
For investors, focusing on the producers with strong capex budgets will be key to long-term success. Likewise, those producers that focus more on NGL and shale oil will get the nod as natural gas inventories remain high. Overall, the second quarter should another doozy for energy investors. At least, there’s plenty to like about the sector.
As of this writing Aaron Levitt doesn’t own any the stocks mentioned here.