August 16, 2005On August 8, 2005, President Bush signed “The Energy Policy Act of 2005,” a 1700 page bill guaranteed to make anyone’s head spin. You’ve all heard the media accounts of what is in the bill, so we will focus on its impact to various industries and our portfolios.
Creators of this $12.3 billion “sweeping legislation” hope it will be a key first step to solving our energy problems, and it is the first legislation in many years to address the need to strengthen our electrical infrastructure, provide for less dependence on foreign oil, and increase the use of renewable energy. We would love to say that it will reduce gas prices at the pump next week, but unfortunately, the short-term impact is limited. The bill does allow for energy companies to benefit through the use of tax breaks and loan guarantees for new nuclear power plants and clean coal technology, making the long-term impact of the bill much more promising. With incentives to encourage investment and efficiency across many energy areas, the bill ultimately could lead to not only lower energy prices but also more profitable and highly valued energy companies for investors. Below we outline the impact to various industries and the investment implications:
Crude Oil
Today, the majority of our oil comes from foreign sources since we do not currently have the capacity to meet our demand (see chart next page). As we have outlined in previous strategy pieces, oil is a non-renewable resource and supply is currently limited because the major producers have significantly curtailed investment in new production over the past several years. After years of making investments based on volatile crude prices that were difficult to forecast, oil companies discontinued investing their cash flow in new crude production and instead allocated cash to more shareholder friendly uses, such as debt reduction and dividend increases. In addition, although we may be a long way from running low on the supply of crude, a case can be made that we are closer than many believe; thus, the urgent need for the key tenets of the Energy Bill. The average production per giant field (i.e. those that produce over 100,000 barrels per day) is significantly lower for newer fields than it is for older fields. Up to 70% of the current daily supply of oil from these fields was discovered before 1970, and disciples of geologist M. King Hubbert (who correctly predicted the peak in crude oil discovery that occurred in 1971) believe that oil production will peak later in this decade. Lastly, potential terrorist activity in Iraq and Saudi Arabia could also impact the availability of oil while continued political instability in places such as Russia, Venezuela, and Nigeria threatens to remove even more of the available supply. Couple the dwindling supply story with the insatiable demand for crude coming from emerging markets such as China and India, and you can make a strong case for a need for new sources of energy. Through subsidies granted to oil companies, the bill hopes to provide incentives to companies to increase refining capacity within the U.S. as well as increase exploration and drilling in the Gulf of Mexico. The major producers have not built a refinery in decades; so adding new capacity could pose a challenge as companies attempt to grapple with the new technology and regulation changes from the last 30 years. This is an important point, as the lack of refining capacity has played a large role in the increased prices paid at the pump.
Pipelines (Natural Gas Utilities)
The price of natural gas has reached new highs this summer, and January futures prices crossed the frightening $10/mcf mark, both of which have serious implications for our heating bills come winter. While the Energy Bill includes several provisions, which should stimulate natural gas production and aid gas utilities, the positive effects will not be enough to provide relief in the short-run. However, the tax-incentives provided by the newly gained ability to accelerate depreciation for natural gas distribution lines will prove positive for pipeline intensive companies in the long-run, as this “tax shield” will increase cash flows for these companies and provide incentive for re-investment in various new and existing pipeline systems. In addition, the repeal of the Public Utility Holding Company Act (PUHCA) allows for less stringent regulations on merger and acquisition activity. This creates an opportunity for price appreciation in the stocks of small to mid-sized natural gas utilities, as large companies look for ways to exploit under-utilized gas fields that have already been discovered by acquiring these smaller firms.
Alternative Fuels
With the Energy Bill, creators hope to provide subsidies for the increased development of various types of alternative fuels. The bill calls for a doubling of corn-based Ethanol production, which currently accounts for 12-13% of corn produced in the U.S., by 2012. Doubling production takes us to 25% of the U.S.’s corn production being put into our gas tanks. This is a big positive that could lead to a long-term, non-subsidized demand for ethanol. With ethanol prices currently at a historically low price of approximately $1.25/gallon, the lower cost of filling up our cars should encourage increased usage and, ultimately, decrease our dependence on foreign oil.
Coal
Providers of clean coal technologies will see large benefits, as the bill has allocated $1.6 billion in tax-credits for the initiation of several coal projects, such as the development of several clean coal power plants, and for integrated gasification combined cycle (IGCC) development, which is one of the most environmentally friendly types of coal power generation. IGCC plants will be able to burn higher sulfur coals, which will benefit Northern Appalachian (NAPP) and Illinois Basin coal producers. Traditional coal-burning companies won $1.1 billion for accelerated amortization of pollution control facilities and for producing fuel from other alternative sources. Additionally, the development of pulverized coal plants and other advanced goal generation incentives will target low levels of emissions and other efforts to control pollution, which will benefit NAPP, Illinois Basin, Powder River Basin, and Western coal producers. Coal can often be used, as a substitute for natural gas, to power utility plants, leading to potentially lower electricity bills.
Utilities (Electric)
Utility companies received numerous incentives. As mentioned earlier, the bill repeals PUHCA and provides for accelerated depreciation of new transmission and pollution control facilities, which lowers the overall tax-bill for these companies. In recent years, due to the lack of standardization and reliability of power grids, there have been numerous blackouts, including ones in the Midwest, the Northeast and in California. In fact, one could say that the primary long-term goal of the bill is to provide more affordable and reliable sources of energy with its call for federal reliability standards to regulate the electrical grid across the country. While improving the infrastructure and transitioning to common national transmission grids could be costly in the short-run, in the long run, it will increase reliability and efficiency at utility companies, which leads to a healthier bottom-line.
Construction Materials, Engineering and Construction
For the first time in 30 years, the Energy Bill calls for financial support to build up to six nuclear plants, including a “next-generation” nuclear power plant capable of producing electricity and hydrogen, in order to provide a cheaper energy source. Under this plan the first new reactor should be ready by 2013. Construction of these plants will likely be controversial, but they may ultimately lead to opportunities for the few construction companies left in this small field.
Additionally, building or expanding refineries and updating the infrastructure for utilities and highways will require a great deal of construction and building products. As such, long-term, construction and building material companies should benefit from new levels of sustained demand growth. While these projects have not yet begun, the Bill provides funding initiatives and tax incentives for these projects to begin sooner rather than later.
Lastly, consumers will receive new tax credits for making improvements to their homes that help to conserve energy. These improvements can range from installing solar-powered hot water heating systems to new, more efficient air-conditioning units as well as new exterior windows and improved insulation. Similarly, contractors who participate in building energy-efficient homes and manufacturers who manufacture energy-efficient appliances could benefit from tax credits, as well. This could not only mean lower energy bills for consumers, and therefore, provide more incentives to make home improvements, but also could contribute to the bottom line of companies who provide the goods and services that may be in demand.
Industrials
There are also some less obvious beneficiaries of the Energy Bill. Corn acreage was up 3% this year, but most of that increase is being wiped out by drought. The large level of corn stored from last year’s bumper crop has been an overhang on corn prices, but the drought has materially eroded the outlook for corn yields. (see chart below) Lower yields and an outlook for a substantial increase in the production of ethanol may lead to higher corn prices going into 2006 and longer term. As a result, farmers and farm equipment makers are having a difficult time this year. However, the longer-term picture for corn and the agricultural equipment makers, especially those leveraged to the U.S., is increasingly positive as higher average corn prices provide financial benefits to farmers and, eventually, to the companies that supply them.
With high energy prices, more and more automakers are responding to the call by consumers to manufacture more fuel-efficient cars and SUVs, as several have introduced prototypes and plan to produce these cars in the near future. As consumers become eligible to receive tax credits for buying a hybrid, the demand for these vehicles, coupled with the high price of gas, will likely increase. We saw a similar situation a few years ago with the tax-breaks on SUVs, which increased demand for them tremendously.
How are we positioned to take advantage of this?
Our portfolios are positioned to take advantage of the long-term growth we foresee in many of these industries. The high price of oil benefits companies in the Energy sector (crude oil, natural gas and coal) in a very direct way in the short-term, but our holdings across several industries, including pipelines, Industrials, Utilities, Materials & Processing and Autos & Transportation will also benefit in the long run, as refineries, nuclear plants, hybrid cars, and improved, expanded and uniform infrastructures are built in many different industries. We will continue to look for high-quality, undervalued companies, and we believe that one can find many truly high-quality companies in a variety of economic segments today.
It may be hard to believe, but despite the sky-high prices of crude oil, we continue to find value in the Energy sector. Over the near term, due to higher than expected energy prices, limited investment, and continued robust demand, these companies should continue to produce solid earnings and cash flow growth. For example, energy companies are trading today as if the price of crude oil was $40/barrel, instead of in the mid $60s, and are priced at multiples of cash flow that are significantly lower than historical norms. Free cash flow generation remains very strong for such companies, balance sheets are healthy and investors are now placing a premium on companies that generate strong cash flow through unit volume and return cash through shareholder friendly actions.
We also remain convinced that the global industrial cycle will last longer than the consensus expects, leading to gains for firms operating in the Energy, Materials, and Producer Durable segments of the market. Most importantly, valuations remain attractive in all these industries.
The structural supply/demand imbalance that exists today is a problem that the authors of The Energy Policy Act of 2005 hope we can solve longer term. In the meantime, however, investors should brace for continued high energy costs and insulate their portfolios by owning fundamentally sound companies that can benefit from the high cost of crude oil, natural gas, and other commodities.
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