What's Next for the Energy Sector?

August 31, 2009

Charles Ober, who manages the T. Rowe Price New Era Fund and other portfolios of natural resource stocks, looks back at how the energy sector fared in the first half of the year and offers an outlook for the future.

Energy and natural resource stocks have rallied strongly since the stock market’s early March lows, in anticipation of stronger global economic growth and demand for various commodities. While many commodities have risen sharply from their lowest levels of the year, most are now fairly listless, given that only a weak recovery is anticipated for the second half of this year.

• Oil was the first commodity to recover strongly, rising from the low $30s per barrel in December 2008 to the low $70s recently.
• Although this strength was anticipated, it happened more rapidly than would generally be expected given high global inventories and limited evidence of demand recovery. In fact, demand is expected to fall nearly 1.7 million barrels per day this year.

• The domestic natural gas market has been slow to recover. Domestic natural gas prices collapsed over the last year due to a number of factors—including the economic downturn, which caused industrial and utility demand to weaken while the previously high natural gas prices induced conservation by consumers.
• In addition, a new technique has allowed significant new sources of natural gas to be recovered in basins prone to shale formations at great depths that are saturated with gas. Application of the new technology spread from the Texas/Oklahoma/Arkansas region to the Northeast and even to areas in western Canada. As a surplus developed in the face of declining demand, gas exploration and development activity dropped precipitously.

• The oil service and oil and gas drilling industries have lost pricing power with the decline in domestic natural gas drilling and the reduction in global expenditures. But the stocks reacted very positively to rising oil prices, with expectations that it would lead to a recovery in capital spending.
• It may be years, however, before the high pricing levels reached in early 2008 will once again be achieved, and, in our view, earnings comparisons for most of those companies will be tough for the next several quarters.

• While the Obama administration has sought to restore funds to develop clean coal technologies, the domestic thermal coal market has languished. Utility stockpiles have grown as economics favored substituting power derived from natural gas, and power demand has weakened in the face of the recession.
• Furthermore, it now appears that some form of carbon regulation, perhaps in the form of “cap and trade,” is unlikely to pass until after the congressional elections of November 2010. This legislation is vital to establishing the economic framework for building new power plants, whether coal-fired, natural gas-fired, or nuclear.
• Such legislation will further encourage the development of technology to retrofit existing coal-fired plants to reduce carbon dioxide emissions. Demand for imported coal from India and China is increasing and will gradually tighten up world markets.

• While utilities are being forced to use a greater proportion of green technologies such as wind and solar to produce power, the decline in energy prices has made the economics of these technologies marginal unless there are significant tax breaks.
• Adoption of solar power in some European markets has waned, and residential and commercial adoption in the U.S. has been quite slow, aggravated by the weak economy.

• We believe that the long-term outlook for natural resource stocks is robust. Demand from recovering economies is likely to increase, and government stimulus packages, which have targeted infrastructure as a means of boosting growth, should also prove positive. In addition, emerging economies, which have accounted for more than 80% of the incremental growth in demand over the last decade, are poised to grow at a faster rate than developed economies.
• With consumers saving more and spending less while corporations are generally rebuilding their balance sheets, government spending will be key to any economic growth in the intermediate term. A sustainable recovery in China is increasingly important as that nation now accounts for virtually all of the growth in resource demand.
• However, easy monetary policy and deficit spending will likely debase or weaken the U.S. currency relative to others. Given resource capacity constraints, this means that any global economic growth, particularly from emerging markets, will force prices of constrained resource commodities to rise in U.S. dollar terms.
• We are attempting to identify those commodities that are likely to be most positively affected, and we are investing in the companies that we believe are best positioned to exploit those resources.

The New Era Fund may underperform when economic growth is slowing and the level of inflation is low. Because of the cyclical nature of natural resource companies, their stock prices and rates of earnings growth may follow an irregular path. Factors such as natural disasters, declining economies, market illiquidity, or political instability in commodity-rich nations could also have a negative impact on various portfolio holdings and cause a drop in share prices.