Energy in the Financial Sector: Life “In the Bubble”

When the surging tide unleashed by Hurricane Katrina into New Orleans crested and began to wane, it was apparent that New Orleans was not, in fact, completely ruined. Older neighborhoods and the commercial district sustained only minor damage, and life continues – businesses operate, restaurants compete, and tourists savor good times. New Orleanians have christened this area “The Bubble.”

The energy sector also lived in such a Bubble in 2007. While the credit crunch led to carnage in the financial sector, the energy sector provided an island of outperformance and stability:

• Oil prices actually benefited from the credit crunch, as portfolio diversification and the dollar slide drove funds into oil markets.

• The personnel crunch in the financial services sector accelerated the hiring of traders and analysts, with several players “ring-fencing” their energy divisions.

• While the subprime crisis wreaked havoc on asset-backed bonds in general, bonds secured by oil reserves have been relatively unscathed.

• Most importantly, energy was the top performing equity sector, climbing by 15%, while the S&P was essentially flat. This marks the fifth straight year that energy outpaced other sectors.

Even within the Bubble, however, the market showed 8 important trends and changes:

1. Oil markets continued to financialize and commodity traders created more depth and complexity as liquidity and interest continued to grow. Gone are the days of simply investing in an index to ride the commodity cycle up. Now, players have developed a taste for playing time spreads and the option market has gained liquidity. By the end of 2007, the concept of oil as a pure new asset class had gained great momentum, particularly to hedge the falling dollar.

   Key message: It is critical to understand where, why, and how funds are flowing into the market and migrating along the curve.

2. Publicly listed national oil companies (NOCs) attracted strong investment in 2007, easily outperforming most IOCs. The market recognizes the promise of the NOC business model: all the synergies, scale, and scope of the supermajors, but with the access needed to sustain growth. This is the space to watch again in 2008.

   Key message: Understanding the NOCs adds entirely new dimensions to traditional equity valuation. Investors need to be very savvy about politics, prospects and hype.

3. Gas-weighted players are suffering as oil and gas prices diverge. This was extremely apparent in the latter part of the year. Investors will have to develop more nuanced strategies.

   Key message: Gas valuations are likely to continue to lag oil, for some very good reasons.

4. Investors resurrected the E&P MLP model. Although enthusiasm waned as liquidity dried up during the year, the driving forces are still in place – relatively high profits, low interest rates, tax efficiency, and players that will fail without aggressive acquisitions. We expect a re-emergence of these players in 2008 and beyond.

   Key message: In the long-run, MLPs may not always make sense, but we believe the trend will create opportunities in a number of niches.

5. The service sector began to show much more differentiation. PFC’s clients are increasingly keen to understand the dynamics and outlook for the service sector. The reality is that the service sector is a complex collection of products and services, and market conditions can vary substantially from one to the next. 2007 performance demonstrated that there is no single cycle. Rather, each niche experiences unique factors and while some markets can experience pricing pressures (e.g. N. American and Cone), others can be generating large margins.

   Key message: Investors can create opportunities by dividing the service sector into sectors and understanding key drivers.

6. Refocus on Technology: As finding and accessing oil becomes more difficult, technology becomes increasingly key. The market is coming to this realization, as the paucity of R&D investments in the sector in the last ten years plays out. The migration of R&D to the service sector has created new challenges to IOCs who are responding but lack the innovation of SMEs and niche start-ups.

   Key message: The market will have a tough time sorting out the long term winners and losers without a clear understanding of new technologies and patent holders.

7. Petro-States Recycling Petro-Dollars Into Energy Assets: Sovereign Wealth Funds have become aggressive bidders for assets worldwide, and their appetite has extended to energy assets. This trend is unlikely to slow in 2008 as the accumulation of wealth in these funds continues.

   Key message: Asset prices are unlikely to collapse as eager buyers with deep pockets abound.

8. Alternative Energy: The bloom left the ethanol rose, but solar grasped the baton. The whole alternative energy space is in rapid transformation. Finding winners and losers this early in the cycle will require nerves of steel, and insight.

   Key message: Investors should expect growing pains and tough competition from oil and gas as alternatives ramp up to world scale.

As important as what we saw in 2007 was what we did not see, namely consolidation. While the service sector inked a number of large deals, investors waiting for large-scale buyouts and mergers were generally disappointed. PFC Energy’s work on the strategies and portfolios of the companies leads us to believe that pressure will intensify in 2008 particularly in the service industry.

Overall Key Message:

The bottom line, then, is that energy extended its bull run in 2007. Given the structural drivers in place globally, PFC Energy believes that energy will continue to live in “The Bubble” in 2008, offering another robust year to those who understand how the game is changing. As they say in New Orleans: Laissez les bons temps rouler!

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Roger Diwan is a Partner and Head of the Financial Advisory Practice. Raoul LeBlanc is a Senior Director within the Financial Advisory Practice. For further information on this article contact Enews_rdiwan@pfcenergy.com.