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Economic Insights

The United States is on a path to become a net exporter of energy. Lord Abbett experts discuss the investment implications.

 

In Brief

  • President Trump’s goal of U.S. “energy dominance” seeks to make the United States a net exporter of energy as a vehicle for economic growth.
  • Technological advancements in hydraulic fracturing and horizontal drilling have given the United States a cost advantage in the extraction of oil and natural gas.
  • The United States is likely to achieve energy dominance in most exportable resources by the middle of the next decade. 
  • Because the United States is today producing more than 50% of the incremental crude oil supply to the markets, high oil prices are not the negative factor they used to be for the U.S. economy.
  • Lord Abbett equity analysts prefer U.S. exploration and production (E&P) companies that will see secular growth from U.S. shale, but that are exhibiting capital discipline. 
  • International energy companies no longer offer growth equity opportunities because of the U.S. competition that is producing “more for less.”
  • Credit fundamentals are improving for U.S. oil E&P in particular, increasing the upside potential.
  • Credit analysts are more cautious about oil-service providers, many of which are in the high-yield sector, as rig count growth is slowing. 

 

For decades, U.S. presidents have promoted the idea of American “energy independence” as a solution to the geopolitical issues that historically have led to volatile energy prices and domestic vulnerability of supply. The goal of energy independence means that the United States would produce enough energy to supply itself without having to rely on foreign imports.  

The Trump administration has shifted that goal to focus on what President Trump has called “energy dominance”—meaning that the United States should become a net exporter of energy as a vehicle for economic growth. 

Is that achievable? Yes it is, according to Lord Abbett equity energy analyst Yoginder Kak—and by the middle of the next decade. In this article, Lord Abbett energy analysts examine the U.S. energy markets, and offer their perspective on the investment opportunities created by a reach for energy dominance.

Three Factors Supporting the Push for Dominance 
While the goal of energy independence is largely a matter of national security—ensuring supply and reasonable affordability in times of geopolitical volatility—the goal of energy dominance is primarily an economic one. 

For the current administration, increasing energy production and becoming a net exporter are part of a broader effort to create new jobs and grow the U.S. economy. Therefore, the energy focus of this administration is based almost exclusively on easily exportable resources—oil, natural gas, and coal—and less on alternative energy sources, such as wind and solar.   

There are three factors, some of them controversial, that make the goal of energy dominance in exportable resources not only realistic but also desirable. These include the nation’s vast energy resources, the technological developments that have enabled the United States to access those resources, and the need of U.S. allies around the globe for energy security, in particular those who are heavy importers of energy. 

Tapping into U.S. energy resources—The administration has introduced a number of policy initiatives aimed at speeding up production of oil, natural gas, and coal, including the reassessment, streamlining, and, in some cases, elimination of regulations and the lifting of moratoriums on new coal leasing on federal lands. 

On January 7, 2018, the Department of the Interior also proposed the most sweeping offshore drilling plan in history, according to oilprice.com, that calls for opening up the Arctic, Atlantic, and Pacific oceans to oil and gas drilling, while also opening up parts of the Gulf of Mexico that have been off limits. The proposal is unprecedented with regards to the geographical extent—more than 90% of the entire U.S. outer continental shelf—and in the number of proposed lease sales, at 47. 

The Department of the Interior believes the proposed territory holds some 90 billion barrels of oil and 319 trillion cubic feet of natural gas, or reserves that are about 80% larger than is currently available.

But the plan includes areas that have either never seen drilling or haven’t experienced drilling in decades.  So, it remains to be seen if oil companies will gamble large sums of money in areas where the resource potential is far from clear. Low oil prices also could deter exploration. And the exploration process itself is likely to encounter legal challenges.  Pushback from environmental groups and political challenges from governors in coastal states are inevitable. The Department of the Interior already has granted Florida an exemption from the plan after objections from Republican governor Rick Scott.

Advancements in technology—The United States currently is in the midst of an energy renaissance, thanks chiefly to an oil and gas boom that followed technological advances in hydraulic fracturing (better known as “fracking”) and horizontal drilling. (Fracking involves using water, sand, and chemicals to break up rock deep underground to release oil and natural gas.)  Fracking and horizontal drilling have been combined in recent years to make previously unprofitable deposits profitable.  

Much of the oil and natural gas that drillers are after is sandwiched deep underground in layers of rock.  A vertical well going through a 100-foot-thick gas shale, like the Marcellus formation in eastern North America, contacts that geological structure for 100 feet. That means a driller would be able to extract oil or gas from only that 100-foot section. But with horizontal drilling, the drill bit makes a turn and extends the well out—horizontally—through the layer of petroleum-rich shale. Now a driller can, instead of extracting gas from only a 100-foot section, extract it from a section that extends a mile or more. As a result of the breakthrough technologies of fracking and horizontal drilling, the United States today has a more than 100-year supply of natural gas, according to industry estimates.  

Here again, legal and environmental challenges remain a factor in terms of being able to reach the full potential of this technology.  

Foreign policy considerations—The administration also wants to use the country’s energy resources—particularly liquefied natural gas (LNG)—as a bargaining chip in the international arena to provide energy security to U.S. allies. For example, on June 8, 2017, the United States exported LNG to the Netherlands and Poland—the first American LNG exports into Northern and Central Europe. This relieves Poland, in particular, from being entirely beholden to natural gas or oil sourced via pipelines from Russia. 

Dominance in Some, Not All
How close, then, is the United States to energy dominance?

“The United States is already energy independent in both coal and natural gas,” said Thomas Daniels, Lord Abbett energy equity analyst, “and is also now an exporter of both.” According to the Department of the Interior, the United States has a 500-year supply of coal. Historically, the United States has always been a net exporter of coal, and thus dominant in that sector. Over the past decade, as a result of advancements in fracking technology, the United States has experienced rapid growth in natural gas production and has started to export that as well, although it has not yet become a net exporter, according to Kak. 

“The United States is still importing natural gas from Canada,” Kak said. “But the United States is also an exporter to Mexico and recently internationally. And there are a large number of LNG export facilities that have recently come online or are in the construction phase, which will add to U.S. net export numbers.”

Pavan Hoskote, Lord Abbett international energy equity analyst, agreed. “When it comes to natural gas, the United States definitely has a cost advantage. Going forward, with the new LNG capacity, the United States will be exporting even more.”

 

Chart 1. Exports of Coal, Natural Gas, and Petroleum Are All Trending Higher
Annual imports/exports, December 31, 1980–October 31, 2017 

Source: U.S. Energy Information Administration. The information shown is for illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.

 

Over the past decade, U.S. crude oil output has roughly doubled, reflecting the increasing ability of U.S. producers to extract oil from shale formations through the use of horizontal drilling and fracking techniques. In fact, U.S. oil production surpassed 10 million barrels a day in November 2017 for the first time in 50 years, according to the U.S. Energy Information Administration (EIA), putting the United States on pace to pull ahead of Saudi Arabia, which produced just shy of 10 million barrels a day in 2017, and vie with Russia, with output of 11 million barrels a day, to become the world’s top oil producer within the next two years. With the EIA forecasting the trend to continue—recently predicting that U.S. output will average more than 10 million barrels a day in 2018—the United States may be producing more oil than Saudi Arabia this year.    

As U.S. producers pump more oil, oil imports from foreign countries are shrinking to new lows and American crude exports are rising. Nonetheless, the United States is still not a net exporter of oil. America imports eight million barrels of pure crude daily, against exports of 1.1 million barrels, according to Daniels. “However, closing the import/export gap in crude,” he said, “may be only six or seven years away. Given a price in the $40–70 range, U.S. production is expected to grow an additional 1.0 million barrels annually.” 

Even if those projected growth rates are too rosy, there is, according to Hoskote, an increasing need for the United States to export crude oil, because of the current limitations of U.S. refineries in terms of being able to process U.S. light crude. “That’s ironic, to be sure,” Hoskote said, “but the fact is that U.S. refineries have been configured to ideally process the heavier crude produced internationally. For decades, they have been refining the heavier crude from OPEC and Canada—a process that takes a highly sophisticated and expensive system.” Besides, heavy crude is cheaper, adding to the profitability of the U.S. refineries. “Simple refineries in Europe and elsewhere prefer to use light crude as a feedstock,” said Hoskote, “and will be the likely targets for U.S. crude exports.” (The difference between heavy and light crude oil is the level of viscosity.)

In terms of refined oil products, the United States is a net exporter, at a rate of about 2.9 million barrels a day, according to Andrew Bernstein, Lord Abbett energy fixed-income analyst. U.S. refineries import as much as eight million barrels daily of heavy crude, which they then refine to create gasoline, diesel, and jet fuel products for export. 

Energy Economics
Another aspect of energy dominance is the effect of rising oil prices on the U.S. economy. Oil prices rose more than 7% in January 2018 and have posted monthly gains for five straight months—their longest streak since 2011, according to The Wall Street Journal.  During the first week of January 2018, Brent futures contracts were priced at $68.27 and U.S. Texas Intermediate at $62.61, as political concerns in some OPEC nations offset projections for higher U.S. oil production.

High oil prices used to be a “bad” thing. And they’re certainly not welcomed by consumers when they appear at the gas pump. But the United States today is producing more than 50% of the incremental oil supply to the market, according to Daniels. “So, in terms of the industry itself, today it’s a different dynamic,” Daniels said. “Now that the United States is the primary producer of the next incremental barrel, stronger global demand for oil is positive. Higher oil prices are less of a drag on the economy than in prior economic cycles. U.S. domestic producers have been the first to respond and have increased drilling activity far in excess of any other country globally since oil bottomed in early 2016. This is positive for domestic jobs and has led to particularly low unemployment in states with oil and gas assets.”

Middle East turmoil will remain a key focus for oil markets, and will have the potential to send oil prices higher.  But U.S. production is strong, and will remain stronger as prices rise. 

Russia aligned with OPEC in November 2016 to cut output in an attempt to support prices in the world market. The pact runs through 2018. Russia’s cooperation with OPEC indicates the political and economic shift caused by U.S. energy dominance, according to Kak. “The growth of U.S. shale, in particular, has been the key driver for the down-cycle in oil prices since 2014,” he said, “and that has put enormous economic pressure on Russia.”

“Russia is also threatened by U.S. exports of LNG, which put Russia in a weaker negotiating position in Eastern Europe,” Kak continued. “Most of Russia’s gas is exported to Europe through pipelines, which is still cheaper than overseas shipments of LNG from the United States.  But the fact that the United States is an alternate supplier makes it less likely that Russia can threaten to turn off the spigot on a cold winter’s night.”

What about a potential spike in oil prices? Daniels doesn’t believe that oil will be going back to a $140 per barrel—a level it reached in June 2008—anytime soon. “U.S. shale caps the relative upside compared to the 2002–2008 cycle,” he said, “because shale production has the ability to quickly respond to price signals. With a goal of energy dominance, we’re going to be producing a lot more. Oil prices spike when there is a shortage (that is, when supply can’t meet demand), but this is a low probability event today, given the extensive resources of the United States.”

Investment Challenges and Opportunities
What does all of this mean in terms of investment opportunities? 

Daniels believes that investors should consider allocating a portion of their equity portfolio to U.S. shale-levered energy stocks—that is, “among those firms that don’t need $100 oil prices to win,” he said. 

“We are looking to invest in companies that benefit from consistent production and revenue growth at $40–$70 oil and that are disciplined on capital allocation,” Daniels said. “In this market, we prefer U.S. exploration and production [E&P] companies, as well as select oil services and midstream companies that will see secular growth from U.S. shale. We have a quality bias and are avoiding companies with a “growth at any cost” mentality.”  

Kak agreed. “From a 12- to 18-month perspective, we are constructive on this sector and are positive on energy equities in general. It is a cyclical and volatile sector, however. We look for companies with improving cost position and capital discipline relative to the industry. Shale breakthroughs have improved the cost position of U.S. E&P companies on the global cost curve. Recovery of oil prices from cyclical lows of the last two years should allow the E&P companies to better execute their development plans and earn more reasonable returns.”

On the international side, Hoskote believes that international energy companies are no longer going to offer growth opportunities, because of the U.S. competition, which is “producing more for less.” Hoskote is looking at firms that are focusing on cutting costs, strengthening their balance sheets by selling assets no longer needed, and rewarding stockholders—“doing all the things that good stewards of capital do,” he said. Those companies that did those things got rewarded in 2017, he continued. 

What about fixed-income investments in the U.S. energy space? On the fixed-income side, Bernstein said his team is “looking for more beta and upside potential, based upon our expectation that credit fundamentals will be, and already are, improving for U.S. oil E&P companies specifically.” As for energy-service providers, many of which are in the high-yield sector, “we’re still a bit cautious,” he continued, “because, according to EIA reports, the rig count in the United States, after increasing pretty aggressively early in 2017, has shown minimal growth since mid-2017.”

Bernstein believes the rig count will increase only modestly going forward because of the huge pushback in the investment community in recent years on E&P firms to put less of an emphasis on growth and more on corporate returns. Returns at the corporate level, as opposed to the individual project level, have been weak, Bernstein said. “The E&P firms are now articulating that they’re going to focus on getting a good return on the acreage they already have, and fund drilling programs with organic cash flow, rather than seeking more cash via debt or equity funding. That refocus on capital allocation has trickled down to the service provider level, which is beginning to realize the pace of growth will be slowing and they too need to be capital disciplined.” 

In Summary
After decades of focusing on energy independence as a matter of national security, the United States today is on a path to achieving energy dominance as a net exporter of coal, natural gas, and oil—a goal that may be achievable by the middle of the next decade thanks to technological breakthroughs that are increasing production. 

For the Trump administration, achieving energy dominance is part of a broader effort to create new jobs and grow the U.S. economy.  The focus of energy policy, therefore, is based almost exclusively on easily exportable resources—oil, natural gas, and coal—and less on alternative energy sources, such as wind and solar. 

Shale technology breakthroughs have improved the cost position of U.S. E&P companies relative to their global competitors. Investment opportunities overseas, therefore, are likely to be in firms that are focusing on strengthening their balance sheets and cutting costs rather than on pursuing growth at any cost.  On the fixed-income side, Lord Abbett analysts expect credit fundamentals to continue to improve for U.S. oil E&P companies in particular. They are less enthusiastic about the U.S. service sector where they expect rig counts to increase only modestly in 2018.  

 

IMPORTANT INFORMATION
Keep in mind that all investments carry a certain amount of risk including possible loss of the principal amount invested. No investment strategy, including diversification and asset allocation, guarantees a profit or protects against a loss. Stock markets, especially international markets, and investments in individual stocks are volatile and can decline significantly in response to issuer, market, economic, industry, political, regulatory, geopolitical, currency fluctuations, and other conditions. These risks are magnified in emerging markets.

This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in this article are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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