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Portfolio > Mutual Funds

Energy Outlook for 2007

By Staff Writer

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While S&P projects real U.S. GDP (gross domestic product) growth will slow to 2.3% in 2007 from 3.3% in 2006, the world economy looks solid. S&P Economics is calling for global GDP growth of 3.2% in 2007 vs. 3.8% in 2006, driven by growth in emerging countries, particularly China. This global economic growth is increasing the consumption of energy. As such, energy demand in developing countries is expected to account for 75% of the increase in energy usage over the next 25 years.

S&P Economics is forecasting a soft landing for the U.S. economy, and believes the Fed may lower interest rates by the second half of 2007. Given that a soft landing is most likely and a recession may not materialize – investors are likely to turn to sectors that do well early in an expansion. Thus, we believe that the energy sector may soon be on investors’ horizons.

While S&P expects that operating EPS growth for the S&P 500 energy sector will slow to 6% in 2007, from 26% in 2006, using data from S&P Index Services, we estimate that the energy sector is the most attractively valued sector within the S&P 500 with a P/E-to-growth ratio of about 0.7 vs. 1.2 for the S&P 500. We believe attractive valuations will continue to drive investor interest in the Energy Sector. S&P forecasts a year-end P/E of 9.3 for the energy sector in 2007 vs. 14.7 for the S&P 500.

S&P and Global Insight project global oil demand will increase about 1.8% in 2007, from 1.1% in 2006 – with demand from China the largest single source. While there are a large number of non-OPEC (Organization of Petroleum Exporting Countries) projects slated to come on stream through 2007, as well as sizeable light sweet OPEC projects, we estimate that worldwide demand for oil will exceed non-OPEC supply growth in 2007 by about 1.5 million barrels per day, once we factor in field declines and project delays. We thus believe that West Texas Intermediate (WTI) oil prices will average $64.44 per barrel in 2007 and $64.75 in 2008 vs. $66.04 per barrel in 2006.

While weather patterns remain uncertain, OPEC actions are likely to prevent WTI oil prices from falling much below $55-60 per barrel – and escalated geopolitical tensions could cause prices to rise above expected mid-$60 range. On the U.S. natural gas front, we believe that North American natural gas production peaked in 2001 and is now declining, with near-term incremental power generation dependent on natural gas.

U.S. natural gas supply has declined by 6% since 2001 despite an increase in drilling activity, which has expanded to add more than 30,000 gas wells per year. With U.S. natural gas production on the decline, reduced imports from Canada and increased exports to Mexico, U.S. natural gas demand continues to be constrained by available supplies. S&P and Global Insight expects U.S. Henry Hub bid week (blend of spot and contract) prices will average about $7.20 per million btu in 2007 and $8.30 in 2008, compared to $7.23 in 2006.

We have seen refining capacity tighten significantly since 2003, and global upgrading capacity (ability to process heavy sour crude) now appears fully utilized – which is a bottleneck for refining additional amounts of lower quality crudes. With labor and equipment constraints delaying refinery projects, we expect 2010 or 2011 is the most realistic timeframe for the start-up of new refineries. Until these new and complex refineries come on stream, we expect that global refining margins and crude differentials will remain strong.

While M&A activity has enhanced the positions of major oil companies over the past few years, there appears to be reduced opportunity for consolidation going forward due to lack of access to large upstream reserves and increased competition from state-owned, or national oil companies. And despite increased cash flows to oil producers from high oil prices, we are seeing increased monies being returned to shareholders through dividends and share buybacks.

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