Zaks Investment Advisory Service

Energy Price Forecasts and Investment Considerations

Today, we will complete our series of programs devoted to energy. I would like to remind you that in previous programs, we discussed the changes to the price of oil, natural gas and coal, how much energy we get from differed sources, and how much more energy-efficient our economy has become. We also described alternative energy sources: the oil sands of Canada, the shale deposits of Colorado and Utah, and the process of producing liquid fuel from coal. In the Market Notes section of our site, www.zaksinvest.com, we have posted charts reflecting the price fluctuations of the various energy sources, in a historical perspective. You may also read our previous programs in the Radio section of the site.

We have mentioned on several occasions that the use of alternative energy sources depends on the future price of oil: if it remains relatively low, no one will be investing billions of dollars into the development of complex technologies, and if it stays above a certain threshold, then many alternative sources become economically viable. Unfortunately, we have no crystal ball to tell us future oil prices. Still, we all have access to a very interesting resource: a forecast prepared by the Energy Information Administration (EIA), called Energy Trends to 2030. In the process of developing various scenarios, Department of Energy experts work hand-in-hand with industry representatives, so that the released forecasts represent the sum total of the information available to us today. Of course, these forecasts may not prove true, but we have none that are more precise – and, most importantly, major energy companies use them to develop their own plans. So what do the EIA experts believe will happen to the future price of oil?

Their forecasts may come as something of a surprise: in their opinion, over the coming few years, oil prices will gradually fall. In 2005-dollar terms, the price of light sweet crude in 2010 will be about $57.50 per barrel. For comparison: in the current (2007) year, the average oil price between January 1 and mid-July was nearly $62. In 2006, the average price for the year was $65.70. In 2005, it was $56.50. In other words, the Energy Information Administration believes that the current oil price has temporary deviated from an equilibrium, which they believe is lower than the current price. Moreover, according to their forecasts, oil prices will continue to fall until 2015, dropping to about $49 per barrel. Then it will gradually start to rise, reaching $52 by 2020 and $59 by 2030. So oil prices will gradually drop by one-fourth, and in 2030 oil will cost 10 percent less than it did on average in 2007. The EIA predicts that prices of natural gas and coal will undergo quite similar changes: a slow decline until 2015, and then gradual growth.

Of course, these are only forecasts, and a multitude of events – both political and economic in nature – could change them. What we just described is the baseline, main forecast scenario. The EIA also issues other scenarios, with higher and lower prices. Nevertheless, we may still draw a number of conclusions.

First of all, it seems that the world has a lot of oil, and will have plenty of it for a long time to come. Second, the price of oil price will remain at a fairly low level, which will put the breaks on the development of alternative energy sources. We have talked about how the development of oil sands and slates is economically viable only if the price of oil remains high over the long term. According to EIA forecasts, oil prices will be lower than those required for high cost efficiency of alternative energy projects. People making decisions about whether or not to invest money in alternative energy are forced to rely on the oil price forecasts. The energy industry has no more precise forecasts than the ones we described. It seems that alternative energy sources will not see quick development in the coming years.

What are the prospects for us, investors? As I have mentioned, in recent years, shares of integrated energy companies (such as ExxonMobil, Chevron, etc.) have outperformed the market indexes like the S&P 500. And what about the future? Should investors be reallocating their portfolios to make more room for energy companies? After all, such portfolios had better returns in the past five years that the market average. We can offer the following hypotheses. On the one hand, forecasts say that oil prices will be gradually falling. On the other, even if they do, they will do so slowly – and at the moment they are relatively high, bringing energy companies enormous returns. Still, this does not mean that the rise in energy company shares will necessarily continue to outpace the market average: all of these factors have already been priced in by investors, who were the ones to lift the oil companies’ share prices in the first place. Which is why, if we count previous years, their return was so high. But it is far from evident that such growth will continue into the future. Interestingly, investors already believe that future oil prices will be gradually falling: the ratio of the market price and oil companies’ earnings, the so-called P/E coefficient, is fairly low. ExxonMobil’s, for example, is 12 while the average for the 500 largest companies is near 20. This means that investors believe that ExxonMobil’s future returns may drop. However, this does not mean that its share price will necessarily fall. My advice – not to redistribute your portfolio at the moment, but to keep it close to the proportions of the various sectors in the economy. Thanks to the rise in energy companies’ share prices, their proportional portfolio weight is up as it is. You should not, in my opinion, overweigh the portfolio with their stocks even further.

And with this, we will close our program for the day. Next time, we will return to the financial markets and talk about bonds. This was Sergey Zaks. Thank you for your attention and until next time.