Tuesday, December 29, 2009

Energy Investing Guide for 2010

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.

As has been the case for many years now, oil was once again one of the best investments in 2009. While oil has a leadership position in energy, it is only one part of a very large and complex sector that includes natural gas, coal, nuclear power, biofuels and renewables. Ultimately, the price of everything else in the sector will be influenced by the price of oil. All sources also have an easy to determine cost per unit of energy generated and these at least in theory should be somewhat similar across the sector. In reality, that price can become significantly different from one energy commodity to another and this can indicate severe over or under pricing. Price moves in oil and the other commodities in the sector don't necesarily take place at the same time, but can be considerably lagged.

While oil and coal (both the commodity and their stocks) and wind energy and natural gas stocks had significant rallies from their respective price bottoms in February and March 2009 , the natural gas commodity, uranium and nuclear-related stocks, and many solar stocks remained depressed throughout the year. While almost every commodity rallied strongly in 2009, natural gas and uranium were the two glaring exceptions. Natural gas prices literally collapsed and at the low were trading at price levels that were seen earlier in the decade and in the later 1990s. Natural gas futures fell to around $2.40 and spot prices were even lower. Uranium had a strong rally from 2003 to 2007 when it rose from around $10 to over $130. It fell to around $40 at its low in 2009 and hovered just above that price throughout the rest of the year. The solar industry is a more complex story. It is only an economically viable source of energy when oil prices are high. At lower oil prices, government subsidies are key. While a few solar stocks have rallied nicely from their lows, most had not gone up much by the end of the year.

In 2009, prices for both natural gas and uranium fell below estimates for their production costs. No commodity can trade in that range for long since production closes down to bring supply and demand back into balance. By the spring, 50% of natural gas rigs in the U.S. had already closed down. In must be kept in mind that prices in both the natural gas and nuclear industries are influenced by the government. The CFTC (Commodities Futures Trading Commission) held hearings this summer about trading in the oil and natural gas markets. Along with the SEC, the CFTC interfered with access to trading vehicles in these markets that were used by the small investor. Natural gas ETF, UNG was effectively turned into a closed-end fund because of the actions of these two government bodies. Leveraged oil ETF, DXO, closed down as a consequence of their interference. As for the nuclear market, the U.S. Department of Energy has a stockpile of 158 million pounds of uranium and it occasionally sells some of this on the open market and depresses prices, just as central bank selling of gold occasionally depresses gold prices.

While prices were down for natural gas and uranium, they are not likely to go lower in 2010, at least for any extended period of time. They will be supported because they are too close to their production cost levels. This does not mean a major rally is imminent however. Prices can get low and stay low for a long time, as was the case in the 1990s. A number of commentators claim that this will be the what happens now because oil, natural gas, uranium and solar stocks were in a bubble that lasted into the 2007 and 2008 period and once the price goes down it will not recover again for many years. Similar arguments were made in 1974 when oil hit $12 a barrel. It's ultimate high was still several years off and several times higher. Energy was in a bullish period back then just as it is now.

Oil looks like it will be strong again in 2010, based on its price behavior in the fall of 2009. Oil prices, like many commodities, have a strong seasonal component. For oil, the bottom tends to be in the winter between January and March and the yearly peak between June and September. Light sweet crude rallied 9% in October 2009, at a time of the year when it should have been selling off. This indicated unusual strength. Crude ended the year near its yearly high, which was somewhat above $80. While seasonal selling pressure will exist for the first couple of months of 2010, buying pressure will then cause the price of oil to rise. It would not be unreasonable to assume that it will get above $100 a barrel during the year. It is not likely however that price will go up enough in 2010 to break the old high of $147. That will have to wait until the following year. Oil and many oil stocks should continue to be good investments in 2010.

ETFs/ETNs, exchange traded funds and exchange traded notes, are the easiest way for investors to get oil and oil stock exposure in their portfolios. The ETF/ETNs: OIL, DBO, USO and USL can be used to invest in oil as a commodity. For those who are more aggressive and want as much as 200% long exposure through leverage, UCO, HOU or LOIL, which trade in the U.S., Canada, and the UK respectively, can be bought. For ETFs that hold stocks of oil and gas companies, XLE, IYE, and IXC are possible choices. Investors bullish on oil stocks can get leverage on them by purchasing DIG and ERX.

While oil should be doing well in 2010, natural gas does not look as promising. There is an incredible glut in the market and new supplies are coming online through the global shipping of compressed natural gas. Still the price of natural gas is relatively low compared to oil on a historical basis. It will take some time to work out the excesses however and fully restore balance between these two commodities. Natural gas tends to have sharp price rises every four to five years and the last peak was 2008, so another really big move up shouldn't be expected until around 2012. Trading opportunities will of course exist in 2010 and low prices will be available for those who want to slowly accumulate and hold their positions for a while. A good ETF for the natural gas commodity is GAZ. Leveraged natural gas ETFs HNU and LNGA trade in Canada and the UK. The leveraged ETFs are a better choice for shorter-term investors.

The supply demand picture of uranium is bullish in the intermediate term. A number of new reactors will be coming online in Asia over the next several years. Growth in the use of uranium usage is expected to be over 2% a year until 2030 according to the World Nuclear Association. The market is thought to be in deficit of 60 million pounds a year. It is estimated that uranium prices would have to move up to around $75/$80 to improve supply. Miners in particular will benefit when this happens. ETFs for nuclear power include NLR, NUCL and PKN. Only NLR has any significant trading volume however.

As for solar power, a few of the leaders had good rallies in the second half of 2009. This is an indication the whole sector is in the beginning stages of a market recovery. Investors should keep in mind though that this is a new industry and there will be a period of consolidation. Some companies will not last. Longer-term investors should avoid stocks with bad financials. The two solar ETFs are TAN and KWT, but these have partially rallied already in 2009 because the leaders in the sector started moving up. Individual stocks which have not rallied too much yet and which investors might want to consider are ENER, JASO, SPWRA, and WFR.

Commodities have been in a longer-term secular bull market since around 2000. This type of bull market tends to last around 20 years. So, there is still a lot of time left and good investments to be made. Buying stocks and commodities on intermediate term drops is the correct strategy in such markets. Buying oil in the spring of 2009 produced quick and substantial profits. Prices in other parts of the energy sector haven't moved as fast as oil did in 2009 and this is giving investors another chance to profit in 2010.

Disclosure: Long ENER, WFR, natural gas.

NEXT: Conmodities Versus Stocks: A Decade Performance Review

Daryl Montgomery
Organizer,New York Investing meetup

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.