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Equity Perspectives

Abundant supplies of shale gas and oil have lessened America's dependence on foreign energy cartels, transformed industries, created thousands of jobs. Lord Abbett professionals discuss the phenomenal impact.

Abundant supplies of shale gas and oil have lessened America’s dependence on foreign energy cartels, transformed industries, created thousands of jobs, and benefited equity and fixed-income investors alike. Lord Abbett professionals discuss the phenomenal impact.

Slightly more than 40 years ago, a cartel known as the Organization of Arab Petroleum Exporting Countries, in response to U.S. and European support of Israel during the 1973 Yom Kippur war, cut oil production and created an energy crisis that damaged the global economy. The image of long lines of cars waiting to fill their gas tanks—a spectacle that would return in 1979 after the Iranian Revolution—is seared into the memories of those who lived through that period. Saudi Arabia in particular, with some of the world’s largest oil and gas reserves, wielded enormous influence over prices.

Fast-forward to the present and the United States is on track to eclipse both Saudi Arabia and Russia in fossil fuel production thanks to horizontal drilling and hydraulic fracturing (“fracking”) that has penetrated shale-rock formations throughout the country to release massive amounts of oil and gas. (See Chart 1.)


Chart 1. Thanks in Part to the Shale Revolution, the United States Is on Track to Become the World's Largest Producer of Petroleum and Natural Gas
Estimated U.S., Russia, and Saudi Arabia petroleum and natural gas production

Source: U.S. Energy Information Administration. Data as of 12/31/2013.


According to the Energy Information Administration (EIA), shale gas production more than quintupled between 2007 and 2010 (the most recent figures available), with Texas, Louisiana, and Pennsylvania leading the way (and New York banning fracking since July 2008). (See Chart 2.)


Chart 2. With Improved Technology, Shale Gas Production Has Soared
Shale gas production, January 2007–November 2010* in billion cubic feet (bcf)

Source: U.S. Energy Information Administration. * Latest figures available.


“Beneficiaries include shale energy producers and providers of equipment, materials, and services used in the production process,” said F. Thomas O’Halloran, Lord Abbett Partner & Director. “Aside from providing an energy source to help relieve the price pressure from the booming demand for energy, the natural gas extracted from shale is well positioned to meet the demand for clean energy solutions. Internal combustion engines that run on this fuel have become increasingly attractive. Shale producers have been prodigious, benefiting users of natural gas, such as a maker of equipment used to compress and liquefy natural gas.”

Other beneficiaries include the chemical, utility, and engineering and construction sectors. “Lower-cost natural gas has made the U.S. chemical sector one of the strongest in the world, and that benefit could last a long time,” said Jonathan Chung, Lord Abbett Research Analyst. “Over time, you’ll probably see steel companies benefit as attractively priced gas will lead to $100 billion of new chemical plants.”

In the utility sector, cheap, abundant shale gas is fueling a growing share of electricity generation (see Chart 3), lowering fuel costs while also reducing air pollution and carbon emissions. Lower fuel costs have enabled many utilities to undertake major investments in system reliability, new transmission lines, and smart grid technology, while keeping rates at a reasonable level, said Lord Abbett Research Analyst Glenn McIsaac. Shale development also has provided tremendous opportunities for investment in gas gathering and pipeline infrastructure. And a number of companies are investing in plants that convert abundant natural gas to liquid form (i.e., liquid natural gas, or LNG) so it can be exported and sold at much higher prices.


Chart 3. Cheap Natural Gas Is Expected to Transform Power Generation
Electricity generation by fuel type

Source: U.S. Energy Information Administration. Data as of 12/31/2013.
Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.


All of which has created significant stock investment opportunities in the engineering and construction sectors, and several companies Lord Abbett Research Analyst Christopher Wiggins has recommended to the investment team over the last two years have shown strong appreciation in a range of value portfolios.

For Andrew O’Brien, Lord Abbett Partner, Portfolio Manager, energy has been one of the biggest overweight positions in the taxable fixed-income portfolios he leads. And that includes a lot of shale-based credits, ranging from exploration and production to refining, and to infrastructure like pipelines and gas liquefaction plants, where there has been a lot of borrowing for new construction.

From a regional standpoint, the biggest play in recent years has been the Marcellus Shale, which stretches through New York, Pennsylvania, Maryland, Virginia, West Virginia, and Ohio. In Pennsylvania, the Lord Abbett fixed-income investment team has found attractive yields in the debt of two plants that independent power producers are building atop the Marcellus Shale. “Besides having a big cost advantage from ready access to cheap gas, these facilities are reasonably close to population centers and industrial areas, and should benefit from the latest electric-generating and emissions-control technology,” said Lord Abbett Research Analyst Mitchell Moss.

Another big play has been the Eagle Ford Shale, which underlies much of South and East Texas. (See Chart 4.) But Christian O’Neill, Lord Abbett Research Analyst, foresees greater interest in the Utica Shale, which underlies significant portions of the Marcellus in the Appalachian basin.


Chart 4. The Biggest Increase in Gas Production Has Been in the Marcellus Shale Play
Monthly dry gas production from U.S. shale plays, January 2000–December 2013

Source: Calculations based on data from Drillinginfo and EIA’s Drilling Productivity Report.
Note: EIA calculations from Drillinginfo from wells within a geological shale formation are available through November 2013. December 2013 is estimated by multiplying the November 2013 number by the change from November 2013 to December 2013 in each shale play’s aggregated county totals contained in the Drilling Productivity Report.


“While the average investor may be more familiar with the prodigious oil and natural gas production of the Marcellus (where wells continue to get better), the Utica Shale has already demonstrated significant potential in eastern Ohio and western Pennsylvania,” said O’Neill, a former Exxon Mobil analyst who has been following the energy sector for 14 years.

According to geology.com, the Utica Shale is more geographically extensive than the Marcellus, it is thicker than the Marcellus, and it has already proven its ability to yield commercial quantities of natural gas, natural gas liquids, and crude oil.

“Production growth has been so strong out of that region that infrastructure [such as pipelines] hasn’t caught up, which may prevent significant amounts of gas from getting to market in the short term,” O’Neill said. “But if you take a long-term view, we’re likely going to see a pretty healthy demand pull from 2015 to 2018.”

Considering the likelihood of continued low natural gas prices, O’Neill sees demand coming from three distinct areas: power plants (given the number of coal plants slated to be retired in the face of stricter air pollution regulations); industrial expansion (particularly the petrochemicals sector); and exports (once gas liquefaction plants come on stream in a few years and enable producers to sell gas at much higher prices abroad). A significant increase in demand from automotive and mass transportation will probably take longer, although there have been some encouraging moves in that direction.

Pumped on Shale Oil

Shale oil is rapidly emerging as a significant and relatively low-cost, new, and unconventional resource in the United States. There is potential for shale oil production spread globally over the next couple of decades. If it does, it would revolutionize global energy markets, providing greater long-term energy security at lower costs for many countries. —PricewaterhouseCoopers

With the strongest crude oil production in several decades, refiners in the United States have generally benefited, given higher profit margins and the ability to sell gasoline and other refined products on the global market. But getting all that oil to refiners has been a huge challenge, since pipeline construction has failed to keep pace with the shale boom.

As a result, many producers have had to ship oil by rail,1 which has led to a series of highly publicized accidents and closer regulatory scrutiny. At the same time, refiners that processed mostly “sour” crude,2 particularly along the U.S. Gulf Coast, have had to adjust their capacity to process the high-quality “sweet” crude3 from shale plays. But according to O’Neill, those plants are close to a saturation point for all that shale oil. All of which has the potential to widen the spread between U.S. and global oil prices and fuel increased volatility next year—unless Congress allows the exportation of crude oil. With midterm congressional elections in November, the chances of that happening this year appear slim, and some analysts expect that debate over such a controversial measure could drag on much longer.

While the current supply-demand imbalance could put downward pressure on crude oil prices (and therefore hurt earnings for oil and gas producers), O’Neill views that prospect as somewhat transitory. Over the longer term, assuming improved logistics and friendly legislation, O’Neill has a much brighter outlook for shale oil producers operating in the Permian Basin (in West Texas and southeastern New Mexico). One big reason for such optimism is that there are several producing zones, and the combination of advanced drilling technology and improved production techniques makes wells in those regions more economically viable.

“We’re trying to pick companies with good assets and low cost bases,” O’Neill said. “That means looking at land records, going through the state government websites looking at the well results, comparing them to their peers, and seeing which areas actually have the biggest acreage and the best rock, because that’s typically where the most upside comes from. Companies with the strongest assets are best able to withstand all kinds of commodity price cycles because as oil prices fall, the more marginal or highest-cost producers typically have to cut back on their production.”

As for the refining sector, O’Neill said stock picking has been critical in the current stage of the commodity cycle, which helps explain why Lord Abbett has also focused on industry leaders that aren’t shy about “self-help” programs. “That means companies that realize they need to shrink in order to grow by selling off assets that aren’t core to their business,” O’Neill said, “thereby reducing operating costs, then using the proceeds to buy back shares and increase dividends.”

Assessing the Risks
Is the shale revolution a giant crapshoot, as environmentalists and antifracking documentaries like Gasland suggest?

What many people don’t realize is that U.S. companies have been fracking wells for more than 50 years, and those wells may extend between 5,000 to 11,000 feet, well below water tables in the area.

“Fracking is a very safe way to drill for oil and gas, when the well is drilled and securely cased in cement, and tailings ponds (for waste material) are properly set up,” O’Neill said. “If there are cracks in the cement, there’s a chance chemicals and gas will leach into a water system. But if you count the thousands of wells drilled, the industry has a pretty good track record.”

In assessing shale opportunities for Lord Abbett’s taxable fixed-income portfolios, O’Brien asserted that burning gas is still a better alternative to fuels that emit large amounts of carbon into the atmosphere, especially coal, which is still being used at a large number of power plants.

Adds McIsaac, the utility analyst: “We all depend on a world with abundant economical energy, and no form of energy production is completely risk-free. Coal will remain an important part of the mix, but gas production from shale looks like a pretty attractive alternative to fuel future growth.”

The Bottom Line
No matter which Lord Abbett fund you consider, chances are energy (and within that sector, shale oil and gas) will have a significant effect on allocation decisions. Demand continues to grow at a healthy pace, not just in the United States but also globally, especially as consumers in emerging markets buy more and more motor vehicles.

Greater consumption is just one of the reasons Lord Abbett is bullish on the long-term prospects for oil. “It’s going to be much harder for oil to go back to $20 a barrel the way it was in the early 1990s, given current demand trends,” O’Brien said. “The nice thing for the United States is that it has relatively accessible sources of oil compared to, say, Russia, which is trying to drill in the Arctic.” (See Chart 5.)


Chart 5. Shale Oil and Gas Oil Resources Can Be Found All Over the World, but No Country Has Developed Them as Extensively as the United States Has
Map of basins with assessed shale oil and shale gas formations, as of May 2013

Source: U.S. basins from the U.S. Energy Information Administration and the United States Geological Survey; other basins from Advanced Resources International, based on data from various published studies.


Beyond that, O’Brien pointed to a host of geopolitical implications. “The United States used to run a big trade deficit with Nigeria and other oil-producing West African nations; now we don’t anymore,” he said. “We also don’t depend on the Middle East for oil nearly as much as we used to, which raises the question of how the energy security of Europe, Japan, and India would be impacted if regional turmoil interrupted shipments.”

—Reported by Steve Govoni


1 According to the Association of American Railroads, about 400,000 carloads of crude oil traveled by rail last year to the nation's refineries, up from 9,500 in 2008. See, "Accidents Surge as Oil Industry Takes the Train," The New York Times, January 24, 2014.
2 "Sour" crude oil is a type of petroleum that contains higher levels of sulfur, an impurity. This makes sour crude oil more difficult to refine into gasoline. Sour crude oil is often refined into heavy crude oil.
3 "Sweet" crude oil is a type of petroleum that contains a low level of sulfur and is often refined into gasoline.


Risks to Consider: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. Growth stocks are subject to the daily ups and downs of the stock market, and their long-term potential as well as their volatility can be substantial. Value investing involves the risk that the market may not recognize that securities are undervalued and may not appreciate as anticipated. Investing in international securities generally poses greater risk than investing in domestic securities, including greater price fluctuations and higher transaction costs. Special risks are inherent in international investing, including those related to currency fluctuations and foreign, political, and economic events. The securities markets of emerging countries tend to be less liquid, especially subject to greater price volatility; have a smaller market capitalization; have less government regulation; and may not be subject to as extensive and frequent accounting, financial, and other reporting requirements as securities issued in more developed countries. Further, investing in the securities of issuers located in certain emerging countries may present a greater risk of loss resulting from problems in security registration and custody or substantial economic or political disruptions. The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. No investing strategy can overcome all market volatility or guarantee future results.

Each portfolio is actively managed and may change significantly over time.

Dividends are not guaranteed and may be increased, decreased, or suspended altogether at the discretion of the issuing company.

Asset allocation does not guarantee a profit or protect against loss in declining markets.

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