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Energy Sector Poised for Growth: New Regulations and Political Unrest

Conflict in Iran

At market-opening on Jan. 3, oil prices spiked 4% on the news that U.S. airstrikes killed Major General Qassim Soleimani, a powerful Iranian military leader. Following the Pentagon's announcement that President Trump had authorized the airstrike, the price of Brent oil surged to $70 per barrel, while West Texas Intermediate increased to approximately $61 per barrel. Ayatollah Ali Khamenei, Iran's supreme leader, has promised "harsh retribution."


"The game has changed, and we're prepared to do what is necessary to defend our personnel and our interests and our partners in the region," U.S. Secretary of Defense Mark Esper said on Thursday.

The airstrikes came days after an Iranian-backed militia attacked a U.S. embassy in Iran. With instability in the major oil-producing Iran/Iraq region expected to worsen, gas prices are likely to continue facing upward pressure. Additionally, analysts and politicians alike speculate that said "harsh retribution" will include further attacks on oil infrastructure, particularly in Saudi Arabia and shipments travelling through the Persian Gulf.

Pantheon Macroeconomics' chief economist, Ian Shepherdson, said full-scale war between the U.S. and Iran is "unlikely," and that, "Iran will turn to oil infrastructure if it looks to retaliate against the U.S."

IMO 2020

Further upward price pressure for oil, particularly lighter gasoline products, comes from the official beginning of the International Maritime Organization's new regulations on sulfur emissions going into effect. As of Jan. 1, all marine vessels must limit sulfur emissions from fuel burning to 0.5% or less, which is being achieved primarily through the burning of more refined fuels and the use of scrubbers to clean up emissions from heavier bunker fuels.

However, there is the question of how many ships and ports will fully comply with the new rules, especially in its early months, making the exact effect on price difficult to predict. Sarah Emerson, the president of Energy Security Analysis Inc., said the following:


"The big unknown is just how compliant the market will be. Seventy percent? Eighty percent? Ninety percent? How many waivers will shippers get? I don't think anyone will get 100-percent compliance. There's a whole bunch involved with execution of the plan. Along the way, will there be additional new refining capacity?"



Analysts expect to see high volatility as the price difference between light and heavy fuels widens. Oil companies with high refining capacity and responsive supply chains stand to gain the most ground against competitors under such circumstances.

Valero Energy Corp. (NYSE:VLO), for example, saw its share price increase approximately 13% during the fourth quarter of 2019, more than any of its main U.S. light-fuel-producing competitors (see chart below). The key to the independent refiner's business strategy has long relied on upgrading and expanding its refining operations. It does not produce its own oil, instead sourcing crude fuels from U.S. oil trading centers as well as foreign cargo. This has the potential to provide a greater advantage to Valero if IMO 2020 pushes the price of heavier oils down far enough, though this edge could be reversed if the price of crude is driven up by reduced global oil output.

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Growing demand for Natural Gas despite warm temperatures

"Demand for oil is expected to increase approximately 20% from 2016 to 2040 and will remain the primary source of energy for commercial transportation and continue to serve as a critical feedstock for chemical products. Natural gas demand is expected to grow nearly 40 percent over the same period, largely from expanding industrial activity and increasing use in power generation as utilities look to switch to lower-emission fuels," reads the Exxon Mobil Corp. (NYSE:XOM) website. The forward-looking data comes from the International Energy Agency's 2017 flagship World Energy Outlook.

A large portion of this expected growth will likely occur in the marine sector as companies and governments look for newer, cheaper and more environmentally friendly ways to keep their ships compliant with the 0.5% sulfur emissions limit.

Caterpillar Inc. (NYSE:CAT), a leader in dual-fuel technology (engines that burn both oil and natural gas), has begun development of liquid natural gas propulsion and fuel gas systems for next-generation marine vessels. The development of these cleaner-burning engines has the potential to become even more profitable if stricter emissions regulations are enforced in the future.

While the same forces are driving up demand for both oil and natural gas, however, oil stands to provide more value to shareholders in the short term while natural gas stands to provide more in the long term.

Additionally, a higher percentage of those gains will be among producers that have an established market in countries like China and Russia, which lack the heavy oil infrastructure of the U.S. and the Middle East and are thus expected to grow their natural gas consumption at higher rates. For example, Enterprise Products Partners (NYSE:EPD) sent 55% of its exports to Asia, while 18% went to North America and the Caribbean, 13% to Central America and South America, 12% to Europe and Africa and 2% to other destinations in third-quarter 2019.

In the U.S., natural gas production rose approximately 10% in 2019 following a 12% increase in 2018, according to data from the U.S. Energy Administration. The growth in production was faster than growth in demand for 2019 as the U.S. experienced record-breaking high temperatures throughout the end of autumn and the beginning of winter, decreasing the need for gas-powered heating systems.

This increases the export capacity for U.S. natural gas even further. The U.S. has been a net exporter of gas since 2017 and is set to become the world's largest LNG exporter by mid-2020. Companies that stand to benefit from increasing natural gas demand include ConocoPhillips (NYSE:COP), Exxon Mobil and Enterprise Products Partners, whose strong exports are well-placed to benefit from global energy demand.

Conclusion

While new international marine regulations and escalating tensions between the U.S. and Iran are expected to drive up demand for oil and natural gas as these factors cut into the production capacity of necessary fuels, oil faces the pricing pressure of being the commodity that is short on supply and high in infrastructure utilization capacity, which is why oil prices spiked at the news of the U.S. airstrikes in Iran while natural gas prices did not.

Natural gas, on the other hand, is in plentiful supply, contributing to the downward price pressure of the comparative lack of infrastructure in place to utilize this cleaner-burning fuel. Efforts to increase utilization of natural gas are underway, especially in certain developing economies and in the marine sector, though the growth that this commodity can provide to shareholders is more likely to occur in the long term and not the short term.

Disclosure: Author owns no shares in any of the stocks mentioned.

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This article first appeared on GuruFocus.