When it comes to the energy sector, 2012’s first quarter clearly was a hot time for energy. The second quarter was anything but.
Lawsuits, slowing global growth, record-low natural gas prices and corporate scandals cooled off many of the largest names in energy in the past three months. In almost a repeat of last year, the overall market drifted lower, and broad energy sector measures — like the Energy Select Sector SPDR (NYSE:XLE) — sank hard.
However, it wasn’t all doom and gloom. New unconventional assets were tapped, and the U.S. moved closer to becoming energy independent. Overall, the quarter serves to underscore the challenges and long-term potential facing the energy sector.
Here are some highlights from the oil patch’s second quarter and some potential outcomes for the next 90 days.
Perhaps most detrimental to the energy sector has been crude oil’s dramatic price collapse. For most of this year, the threat of tough international sanctions against Iran, the world’s third-largest oil exporter, pushed prices higher and higher. Countries in the West believe Tehran is working on building nuclear weapons, while the Iranian government insists its nuclear program is strictly for civilian purposes. Sanctions and embargoes have been imposed, amid Iran’s threats to close the critical Straits of Hormuz. That caused global benchmark Brent crude to peak at $113 per barrel in February.
However, on the eve of tougher new sanctions and an EU embargo that forces Iran’s energy customers to seek alternatives, crude prices have tumbled. Both the U.S. benchmark West Texas Intermediate (WTI) and European standard Brent have fallen around 26% from their respective peaks. Brent crude can now be had for around $90 a barrel, while WTI flirts with the high $70s.
The main culprit: slowing economic growth stemming from Europe. As the eurozone continues to grapple with its debt problems, austerity and social imbalances, estimates for the continent’s economic activity continue to drift lower. At the same time, the U.S. economy has been slowing, and now emerging-markets leaders like China and India are also struggling to keep up their past growth stories.
Plus, in an effort to make up for Iran’s dwindling exports, Saudi Arabia has increased its pumping capacity and boosted exports. The world is now flooded with oil relative to current demand.
Overall, analysts predict that the energy sector will see a 12.6% decline in second-quarter sales as firms begin reporting earnings.
Low Natural Gas Prices at Home
While slowing growth in Europe and key emerging markets take the oomph out of global oil prices, the fracking boom here at home is still wreaking havoc on natural gas. A host of firms from EnCana (NYSE:ECA) to Quicksilver Resources (NYSE:KWK) have cut dry gas production because current prices are below the marginal cost of production. Market prices for natural gas have averaged about $2.20 per million British thermal units throughout second quarter. That’s 50 cents lower than during the first and way less than 2011’s $3.50 average.
Those prices are even affecting the big guys. ExxonMobil (NYSE:XOM) — who’s forward-thinking purchase of XTO Energy in 2010 made it one of the largest natural gas producers in the nation — recently highlighted its struggle. Speaking before the Council on Foreign Relations in New York City, Exxon CEO Rex Tillerson remarked that “We’re making no money. It’s all in the red. We are all losing our shirts today.”
These comments mark a stark departure from speeches he made earlier on how widespread lower natural gas prices had not yet hurt Exxon’s bottom line due its operational efficiency, low production costs and size. While natural gas prices have rebounded from their absolute lows, Exxon’s troubles underscore the fact that the current market is not sustainable.
Scandal Made Things Worse
Any quarterly energy sector recap would be incomplete without talking about Chesapeake’s (NYSE:CHK) continued drama. As if falling natural gas prices weren’t enough, revelations about the firm’s finances and inner dealings of CEO Aubrey McClendon have caused CHK’s value to plummet.
Starting with the company’s controversial Founder Well Participation Program (WPP) and McClendon’s $1.1 billion in personal loans and mortgages tied to his ownership stakes in those wells, Chesapeake’s problems continued to intensify over the quarter. Reuters later reported that McClendon partially owned and helped run a $200 million private hedge fund from within Chesapeake’s Oklahoma headquarters between 2004 and 2008.
Then came the company’s unexpected first-quarter loss of $71 million and a warning that it could run short of cash next year without enough divestitures. Chesapeake then began selling assets in earnest, including its controlling stake in pipeline firm Chesapeake Midstream (NASDAQ:CHKM) for $4 billion. 
While Chesapeake may eventually get over its problems, especially now that Carl Icahn is involved and the board is getting a total revamp, Anadarko’s (NYSE:APC) problems may just be beginning. A massive $25 billion lawsuit over its 2006 acquisition of Kerr-McGee and that company’s toxic legacy is finally “oozing” into court. That lawsuit plus any other environmental legislation stemming from fracking could set the tone for future investment in the oil and gas industry.
It Wasn’t All Bad News
Despite all the negative press, some good occurred. First, the U.S. made some serious strides regarding natural gas exports. After receiving a license from the Department of Energy in May of 2011, Cheniere Energy’s (NYSE:LNG) Sabine Pass LNG export facility got final government approval in April. The go-ahead could be a watershed as a multitude of firms, including Sempra (NYSE:SRE) and Energy Transfer Equity (NYSE:ETE), have announced plans to build LNG facilities.
Also, on the bright side, falling oil prices have benefited one sector of the economy: consumers. Gasoline prices continue to drop, and have broken the critical $3 mark in some places. July 4 travelers will welcome that as AAA predicts the holiday will see a decade-high number of them — nearly 42.3 million.
The chief concern going forward will be sustained lower prices for crude oil and natural gas. It’ll be interesting to see how current prices affect earnings announcements in coming months. For investors, that means staying the course and doubling down on any long-term bargains that may arise during earnings season. Focusing on exploration and production companies with strong cash flow and low relative debt will be key. Those companies will be able to survive even if low prices persist.
Hopefully, the third quarter will see more positives than negatives.
Aaron Levitt doesn’t own any securities mentioned here.