John Licata Looks for Natural Gas to Heat Up, Crude to Climb Back Toward Triple Digits
Source: The Energy Report (9/3/09)
Well regarded for his insights and forecasts across the commodity spectrum, Blue Phoenix Chief Investment Strategist John Licata talks about some excellent investment opportunities in both natural gas and oil exclusive in this exclusive interview with The Energy Report. And while acknowledging that he's probably in "a dark room alone on this one," he also sees reason to be bullish about the refining space.
The Energy Report: You weren't too bullish on seeing a recovery in 2009 when we caught up with you in April. We've seen some good Q2 reporting from a variety of companies and some encouraging economic data. The government is starting to claim we're in recovery. What's your take on this?
John Licata: I do think we've seen some better domestic economic data, but it's premature to think we're totally out of the woods. In terms of corporate earnings, a lot of company profits might have surprised to the upside, but they're still down 50% to 70% from quarters before or the prior year.
I've been on plenty of energy companies' earnings calls over the last month or so and many companies have been trying to compare Q1 and Q2. You're still not seeing dramatic differences to the upside. Quite frankly, some companies are still living within cash flow and I think that's one of the reasons why we could have a problem with supply and demand imbalances as we come to the end of 2009 and enter 2010.
Unemployment is likely to keep rising. Although the last numbers were much better than anticipated, I don't think we've seen the green light that will cause people to start hiring again. We could hit 10% unemployment by the end of the year, and that's going to be a precursor to some weaker retail heading into the holiday season. Net-net, you probably could put the word ‘inconsistent' toward most of the economic data coming out of the U.S.
The industrial numbers that came out of China a few weeks ago were actually below expectations as well. While everyone wants to be bullish and the data is somewhat better than many expected, it's still not great. So I think to claim victory right now is definitely premature.
TER: You mentioned a supply-demand imbalance. What do you see on that front?
JL: Companies are not putting money back into infrastructure. For that reason, once demand actually starts to increase, supply levels will be shockingly different from what people might expect. We might have plenty of oil and natural gas right now, but once demand picks up, I really think we will see major spikes in both natural gas and oil prices.
TER: Are you differentiating between the BRIC countries and North America in that regard?
JL: I'm not just looking at the BRIC countries as the barometer for the economic pulse. I don't even think China is the saving grace for commodities. But I do think what is going to be indicative for a recovery is to see demand pick up, to start seeing jobs pick up again, more consistently; not just one month out of six. We need to see consistent job growth.
If we start seeing supplies from the energy side actually start to dwindle, that will help. It would be great if the number continues to build in the Cushing, Oklahoma hub. Then the price of oil, I think, will come down, especially if the products start to come up with builds rather than draws. I just don't expect that to happen any time soon.
TER: When do you think demand might pick up?
JL: Q3, perhaps Q4, is when we probably can start seeing demand start picking up and I think that's when we're going to start to see overall a global economic recovery. I'm skeptical that it can happen before Q4.
TER: Is that worldwide demand pickup you're anticipating?
JL: I'm referring to North America.
TER: Can demand pick up before unemployment abates?
JL: It can happen before, but I think demand and employment will increase in tandem. When you're looking at the energy sector, I think weather will have a lot to do with it as well. El Niño is a dominant factor, so it does not look like we're going to have a very cold winter, which is a great thing for the U.S. economy. But if people are unemployed, even if we get a cold winter, they're going to use more products.
TER: But how would having a mild winter be great for the U.S. economy?
JL: If we have warmer winter and we're not going to be using as much distillate—heating oil—that overbuild in supply should do a great job in containing those prices. Obviously, in an above-average hurricane season or cold winter, the American consumer can suffer because they have to spend what money they have to heat their homes as opposed to buying retail goods. When an El Niño takes effect, the heating bill should be cheaper.
TER: Crude oil prices have increased 40% or 50% since April. Against the backdrop of a mild winter and a fairly mild hurricane season, what do you foresee for oil or natural gas?
JL: As for the price of oil, one of the near-term catalysts will be the OPEC meeting in Vienna on September 9. We've heard commentary from OPEC members that they aren't going to cut any supplies. They seem comfortable with $70 per barrel. Interesting enough, just from historical standards, OPEC members tend to cheat to the upside, such as when Iran produces more than what its top is supposed to be.
As you point out, we've seen a very big move since April, and I think right now a lot of people feel comfortable in that $70 zone. We could pull back a little bit and perhaps trade to the mid $60s for a while, but I still think we can move above $80 by year end. And keep an eye on the fact that because of the Japanese general election last week, where the opposition Democratic Party of Japan (DPJ) defeated the ruling coalition, the new government may not be opposed to a stronger Yen—something that could be supportive for crude this fall.
In terms of natural gas, granted there is a glut, but natural gas prices typically trade around less than 13 times the differential of crude oil. Right now we're trading at around 23 times. Historically speaking, when that differential is greater than 13, the price of natural gas can skyrocket within six months. In 2003 the U.S. was thought to have plentiful natural gas resources, but the price of gas more than doubled within a year. It's my belief that lightning is going to strike twice.
TER: You say the ratio should settle at about 13. What's to say that crude won't be going down rather than natural gas going up?
JL: I don't think crude is going to come down. This is my own theory. Crude has a limited downside. Honestly, I also think that the price of the dollar is going to be very instrumental in this. The Fed won't be touching interest rates domestically for the rest of the year, which will be a catalyst for the Euro to potentially trade to $1.50 by year end. If that's the case, crude oil's going a lot higher. Also as mentioned earlier, we think the Japanese yen is about to strengthen vs. the USD and crude is priced in dollars so that would be supportive of crude oil.
TER: Aside from the historical patterns, what makes you think natural gas prices will increase closer to the ratio?
JL: I've been on plenty of conference calls with natural gas companies in the last few weeks and everyone keeps saying the same thing: the rig count has bottomed and prices will show a dramatic difference to the upside by the end of the year. Natural gas is cleaner than both crude oil and coal and it could potentially be used as an automotive fuel in the future. You can't tell me that the global economy is in recovery mode and crude is at 10-month highs, copper at 11-month highs and natural gas, which is used mainly for industrial purposes, is at 7-year lows. I believe investors have been spooked by upcoming CFTC position limits and much uncertainty regarding the viability of the UNG ETF to play natural gas and this has credited an amazing long opportunity in natural gas. To think that some hedge funds have not been blown up with natural gas below $3 seems foolish—this may have caused further selling pressure that could soon be reversed in a big way.
TER: Some analysts say that with so many incredible finds and such vast improvements in production technology, we'll really have more natural gas than we need. Wouldn't that tilt the supply-demand balance to the point of keeping natural gas prices lower?
JL: I agree that there have been some exceptional finds, not only in the Gulf of Mexico, but in Haynesville and Marcellus and Bakken as well. That said, it will take years for that natural gas to come to the marketplace. So yes, we might have a lot in the ground, but I don't think it's going to come out for a very long time.
There are other factors to consider as well. The fear that the U.S. is going to import more liquefied natural gas has definitely hurt the price of natural gas. I think that fear is exaggerated and that LNG will be shipped more to Europe than to the U.S. If that's the case, there's one major overhang that's going to disappear. This LNG factor has been a major reason why natural gas has been weighed down and we're trading below $4. If that factor goes away and people realize that these major finds of natural gas are still many years away from the marketplace, that's going to be a major boost in natural gas prices. And don't forget that many exploration and production companies have cut budgets back and pushed projects back, not only to 2010, but even to 2012.
TER: All things considered, then, what's the best way to play natural gas?
JL: When I was on the Devon Energy Corporation (NYSE:DVN) earnings call a couple of weeks ago, I was pleasantly surprised to hear that the rise in oil prices has offset weak natural gas prices. That made me think that if natural gas prices rise the way I expect they can, Devon Energy can have substantially surprising earnings. So that's a really good play; I like Devon as a large-cap play in this space.
I still like companies like Berry Petroleum Company (NYSE:BRY) and Bill Barrett Corp. (NYSE:BBG), which we talked about in April, and those are names that I would look to concentrate. I'd probably add a company like St. Mary Land & Exploration Company (NYSE:SM), too. I actually think that money can come out of the oil market and go into natural gas plays.
TER: So even though Berry's and Bill Barrett's share prices have appreciated substantially since spring, you still consider them good opportunities?
JL: Yes, I do. Berry, for instance, has done a great job of raising financing in a pretty dismal marketplace, which goes to show that what they have in their portfolio is quite attractive. So yes, I think they will be rewarded further with natural gas prices moving higher.
TER: Will the big natural gas plays will be in North America versus Europe, considering the issues with Russia?
JL: As an analyst, I happen to like North America just because I see much more upside potential domestically than I do abroad. But while I'm preferential to domestic markets, it doesn't mean that companies abroad won't bring positive results to a portfolio if you add names such as Gazprom (MICEX/RTS/LSE/FRK:GAZP) in Russia and StatoilHyrdo (NYSE:STO) in Norway, which have been very successful on the natural gas side as well.
TER: Are any refineries still in play for you?
JL: I'm probably in a dark room alone on this one, but I still like the refining space. Although some margins have come down in the U.S., I do think that we can see consolidation in this group. Holly Corp. (NYSE:HOC) recently made an amazing acquisition in the Tulsa refinery they purchased from Sunoco Inc. (NYSE:SUN). That's going to help them diversify their own portfolio and I think that company has a lot of upside potential.
I look at some of other names in the space, such as like Alon USA Energy Inc. (NYSE:ALJ). With their exposure to asphalt, I find them extremely intriguing, especially when the United States is looking to put stimulus package money to work and to help build new roads and bridges. Than can only going to help Alon over the next couple of quarters.
I also am a fan of bellwethers like Sunoco and Valero Energy Corp. (NYSE:VLO). I mean VLO pays over a 3% dividend. Keep in mind a lot of companies have been trying to sell off refinery assets, including Valero. There's probably north of 10 refinery assets for sale right now but not many buyers have stepped up to the plate yet. I think that's going to change. We could see more consolidation in a group despite VLO saying they were holding off on acquisitions. I think prices are starting to get very appealing, which will make smaller plays more attractive to companies like Valero, Sunoco, maybe Tesoro Corporation (NYSE:TSO). Plus, it's cheaper to expand capacity by acquiring it. I wouldn't be surprised if you start to see some foreign names, perhaps Total SA. (NYSE:TOT) or Petroplus, look to accumulate some U.S. refinery assets such as Frontier Oil Corporation (NYSE:FTO) or CVR Energy Inc. (NYSE:CVI).
Net-net, I still like the refining sector. It's been very out of favor but especially if you're looking to play an economic rebound, which I think would only foster demand for products such as jet fuel and heating oil. This could be why heat cracks are already trading near par with gas cracks—a possible precursor to better than expected refinery margins for Q3. I think if you're patient you could do very well over time.
TER: What do you mean by "over time"?
JL: These refinery stocks actually could be much higher within 12 months. I think we've already seen the worst in the space. Many people have already factored in a weak U.S. driving season and the fact that some traveling might be lower than original expectations. In terms of some of the refineries' asset plays, those that can produce diverse fuels will do very well. Something that might come back to help the refineries, in the long run anyway, is if new cap and trade legislation imposes more stringent carbon emissions on these refineries. Whether the refineries pass the costs of that action on to consumers or produce less, it will result in higher heating oil prices for the American consumer. Valero is already leading the way with this, cutting back their output, which is something that's ultimately going to make any surprise colder winter very expensive for all of us.
So while this legislation might be great for the environment, I don't think the timing is prudent and, at the end of the day, it will give refineries a better advantage than many people might give them credit for.
TER: Might the cap and trade be voted down because it's not the right time?
JL: I think it will go through but in an adjusted form. I just think that it's the wrong time to do it. There hasn't been a refinery built in the United States in over 30 years and there's a reason for that. It costs a lot to produce a greenfield refinery. To do it now when budgets are already strained, I just think it's the wrong time.
TER: In our previous conversation, you compared the investment opportunities in oil, natural gas and gold to one another. At this point, which of these three sectors do you think offers the greatest return?
JL: Because of the upside that I think could happen over the next 12 months, I would rate natural gas first, gold second and oil third.
TER: When you rate natural gas above gold, does that imply more risk in natural gas?
JL: Yes. Supply and demand is going to come to a head, which I think will come in late Q3 or Q4. I think there is more risk getting into a natural gas space, especially with a lot of new CFTC (Commodity Futures Trading Commission) regulations coming up in November to reduce speculation in the market. So that's a risk that might be associated with natural gas, especially as we approach November.
TER: And oil?
JL: For right now, I'm conservatively optimistic. Although short term we might have a pullback of five or six points, I'm still bullish on the price of oil. I think oil will trade north of $80 by year end. I am looking for the USD to further weaken vs. the JPY and EUR and that could be very supportive for oil prices this fall.
TER: So you're not expecting any big jump?
JL: The only way I think we'd see a "major" jump is if we have some disruption to supplies, whether that comes in the form of a hurricane or some violent action either in South Africa or the Middle East. I think the real push in oil prices will come in late 2010.
TER: And what do you see as the drivers?
JL: Outside of the currency drivers mentioned earlier, a lot of exploration and production companies (E&P) are not producing as much as once thought. Even bellwethers, such as Exxon Mobil Corporation (XOM), just announced that Q2 output dropped to the lowest levels since 1999 when Exxon bought Mobil. If the big boys aren't spending, eventually—when that demand starts to pick up later this year—that supply might be in a major imbalance. That's scary. It's scary to think that Exxon has a war chest of money and yet their output is down so dramatically.
TER: Was that output reduction by choice or because their particular properties are yielding less?
JL: It's both. What boggles my mind is that I think what will build investor confidence is if we start to see a major deal in the space, if you see an Exxon acquire the assets to recover some of that lost production. Even though their second half of the year they admit that they are going to ramp up production for new projects that are coming online in Qatar and Angola, which will be very helpful. I'm just making a reference that, wow, in Q2 it was so bad. Output was not that low from 1999 when Exxon actually bought Mobil. So, to put things in perspective, I just really think that it may be cheaper to consolidate than to go out and go produce assets yourself.
TER: Do you think we're going to be facing the downside of the peak oil before long?
JL: I think we'll again see triple-digit oil within the next two years. I've read all the theories on peak oil and they're fascinating; I think they're very credible when you consider a country like Mexico has said that in 2010 their production is going to drop off from, I believe, 2.6 to 2.5 million barrels a day. Their Cantarell Field in the Gulf of Mexico is drying up and that's one of the largest fields in the world. That should raise some eyebrows; maybe we don't have so much oil in the future.
Just because we hear about gigantic finds such as Petrobras (NYSE:PBR) found Tupi Field off the coast of Brazil doesn't mean that they're going to be so successful in getting that oil out of the ground. A lot of major wells in the world are not as productive as they once were and when it comes to demand increasing because the overall economic health around the world is picking up, we could be in trouble in terms of supplies. That relates to energy and it's also going to relate to the metals.
TER: Any last comments before we meet again?
JL: Only that while it's a difficult marketplace and I do expect tight markets around the world to continue, some of the plays we've talked about have the makings of a pretty successful portfolio.
DISCLOSURE: John Licata
I personally and/or my family own the following companies mentioned in this interview: VLO
I personally and/or my family am paid by the following companies mentioned in this interview: None
After studying economics and graduating from Saint Peter's College in New Jersey (where he received the Wall Street Journal Award for economic excellence), John J. Licata set his sights on Wall Street. During his career, John has held both trading and research positions on the NYMEX, Dow Jones, Smith Barney and Brokerage America. Early in 2006, he founded Blue Phoenix, Inc. an independent energy/metals research and consulting firm based in New York City. John, the company's Chief Investment Strategist, has appeared regularly in the media (CNBC, Bloomberg TV/Radio, Business News Network (BNN), Barron's, The Wall Street Journal, Chicago Sun, Los Angeles Times, etc.) over the years for his insights/forecasts in the commodity spectrum.
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