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The Return of Fossil Fuels

06/14/13 at 01:57 PM

Enormous new oil and gas discoveries under American soil are having a game-changing impact on the entire economy. How to play the new energy boom.

For pharmaceutical executive Abe Abuchowski and his wife, Mary Nucci, going solar meant a little pain for what they hoped would be years of gain. The couple decided in 2011 to convert their 3,500-square-foot colonial home in Hunterdon County, N.J., to solar power, and they endured a barrage of banging hammers and droning electric drills on their roof as a crew installed the photovoltaic panels. The total price tag: a daunting $120,000. Still, by the couple's calculations, the ruckus and money would be worth it; with energy prices climbing toward the stratosphere, they'd recoup their costs in five years.

Less than a year later, Abuchowski is second-guessing the decision. Since his panels went up, New Jersey's home-energy rates have bucked a decade-long trend and started to dip, and local utilities no longer pay top dollar for the electricity from his home grid. One culprit behind the unexpected reversal, experts say: natural gas, which is driving down power prices all over the Garden State and undercutting the alternative-energy business just about everywhere. Now, Abuchowski says, the money math looks a lot different: "It could take 25 to 30 years to recover what we paid."

It used to rank up there with death and taxes -- the certainty of the rising price and eventual disappearance of fossil fuels. For a generation and beyond, images of oil dependency were drummed into the American psyche -- in the form of long lines at gas stations, secretive overseas oil barons and screaming headlines about $100-a-barrel crude. And our spending and investing alike have reflected our energy anxiety. Americans have bought 1.6 million hybrid cars since 2007, putting up with higher sticker prices in order to cut back on trips to the pump. Almost every community has a few homes that sport shiny solar panels. And most of us have hedged our portfolios to cope with fuel fear: ExxonMobil is one of the most widely owned stocks in America, but in 2008, shares in alternative-energy darling First Solar cost three times as much as the petroleum giant's.

So what's different now? To put it crudely, our economy has been fracked up. Fracking is the extraction technique that has enabled drillers to tap enormous new reserves of natural gas across the country -- a 75-year supply, by some estimates, with the potential to change the economics of everything from the electricity that runs our iPads to the trucks that deliver them to our doors. And natural gas isn't the only historical fossil that's resurfacing; North American oil production is also bouncing back, driven by technological breakthroughs that have brought hard-to-reach sand and shale deposits into the fuel fold. "The shale revolution could transform our economy," says Sarah Emerson, president of research and forecasting firm Energy Security Analysis, who has been covering the industry for 25 years. "The potential here is phenomenal."

Those game-changing ripples are being stirred up, appropriately enough, by water -- specifically, the millions of gallons that engineers pump underground as part of the fracking process. First widely implemented in the 1980s, fracking technology now enables energy companies to tap deposits that they once regarded as too costly to extract. In the past few years, the Marcellus Shale in the Northeast has emerged as what could be the U.S.'s largest natural gas field, while oil drillers have descended on North Dakota and Montana to tap the enormous Bakken Formation, which geologists estimate may hold as much as 10 billion barrels of recoverable oil. The impact on the energy industry has been immediate: In the first four months of this year, the U.S. imported only 42 percent of the oil it consumed, the lowest level in nearly two decades, and the country is producing more natural gas than ever. In fact, says Michael Avery, a portfolio manager at the $27 billion Ivy Asset Strategy fund, "the U.S. is the only energy-producing country with significant, sustainable production growth."

As revolutionary as these new fuel sources may be, their impact won't hit home immediately for most people. Most notably, rising oil production is a long way from making a big dent in prices at the gas pump. Still, the new energy boom is already creating upheaval in a host of other sectors, producing some unexpected new winners and losers. Cheap natural gas, for example, has been a bonanza for companies that burn a boatload of it, like utilities and chemical giants. And nowhere has the impact of cheaper fuel been more stark than in the alternative-energy industry, which has had the green rug pulled out from under it. Solar-, wind- and even some nuclear-power providers all saw their share prices soar when $8-a-gallon gas seemed inevitable; now they're struggling to compete.

Amid this turmoil, the savviest investors are quietly shifting gears, trying to anticipate which companies could benefit from more domestic gas and oil, and which could be hurt the most. Those calls aren't as slam-dunk obvious as they may appear from a distance, of course, and even for Main Street types who wouldn't know a refinery from a Ferris wheel, the implications are big. Is it too soon, or too late, to add more energy stocks to a retirement portfolio? Is it still worth paying a premium for a car that sips at the gas pump -- or skips it altogether? The only certainty, economists and analysts say, is that these decisions will remain tricky as the energy dice continue to roll.

It may sound contradictory, but investors say it's true: You can thank high oil prices for breakthroughs that might someday make prices lower. When prices are high, energy companies have the incentive (and cash) to figure out how to tap hard-to-reach reserves. The past decade proves the point. Fueled by demand from the developing world, oil prices have risen 265 percent in 10 years. The industry, in turn, put more resources into fracking and horizontal drilling -- techniques that opened up huge North American finds like the Bakken and the oil sands of Alberta. Before the oil-price boom, says Brian Hicks, comanager of the $500 million U.S. Global Investors Global Resources fund, these reserves would have been unprofitable; now they're anchoring "a gold rush."

Some companies have already seen a big payoff from the new finds. Oil producer Continental Resources has the biggest stake in the Bakken field, leasing nearly a million acres. Jeff Hume, Continental's vice chairman of strategic growth initiatives, says the company is on track to triple its production from 2009 levels by the end of 2013. And he says a slew of other businesses are benefiting from its shale plays -- from makers of memory chips used in pumping equipment to the restaurant and hotel operators flocking to serve oil-field workers. Indeed, some investors see bigger opportunities in those smaller hangers-on. Donald Coxe, whose Chicago-based investing firm specializes in commodities, favors companies that make specialized equipment for extracting oil from the Alberta sand fields. Such processes present technical challenges and, as environmentalists note, major pollution problems. But Coxe says the payoff is 50 to 75 years' worth of oil reserves: "Your grandchildren can get dividends."

Of course, many consumers are painfully aware that they haven't seen dividends yet, at least not in the form of lower gasoline prices. That's partly a result of high global demand -- the fuel burned by a Buick owner in Beijing drives up prices for a minivan-driving mom in Memphis. But analysts say the U.S. also has a distribution problem, in the form of a pipeline shortage, which could mean an opportunity for master limited partnerships, or MLPs, that specialize in operating such pipelines. MLPs have soared in popularity and price, as investors have flocked to their high yields. But Hicks thinks these MLPs will continue their strong run, and his fund is committing about 8 percent of its assets to MLPs, up from zilch five years ago.

Handicapping energy stocks could be a first step on the road to something bigger. If U.S. oil production does eventually help cut oil prices, it could boost any company for which fuel is a major expense -- think major shipping firms, or the nation's airlines, which burn 47 million gallons of jet fuel a day. The price of oil will still be determined by global forces, says Emerson, the energy analyst, but the U.S. "will influence it in ways it hasn't in decades."
Back in the late 1970s, energy consultant and regulator Branko Terzic appeared before Congress to deliver some bad news. The U.S. was facing a natural gas shortage, he told lawmakers -- one so bad that he was advising clients and regulators to write off their natural gas plants as worthless. The U.S. was shutting off gaslights on little old ladies' porches and even dousing the flame in the John F. Kennedy Memorial to make sure there was enough gas left to heat homes, Terzic recalls. "It was one absurdity after another."

Today, Terzic -- now a chatty 65-year-old -- heads the energy center at accounting and consulting giant Deloitte. These days, he's helping clients deal with a different issue: How to play a U.S. gas-production boom. And his job isn't about handing out congratulatory cigars. All those recent domestic strikes have helped create a short-term gas glut, and U.S. prices have dropped to a stunning 86 percent below their highs from the middle of the last decade; this spring gas from many shale fields sold for less than it cost to take it out of the ground. Those falling prices have hurt the stocks of companies with big gas stakes -- including ExxonMobil, whose shares trade at 15 to 20 percent below prerecession peaks.

Exxon's executives have said they're confident that natural gas bets will pay off, and many investors agree with them. Dan Rice, comanager of the $950 million BlackRock Energy & Resources fund, calls today's ultralow prices an unforeseeable "black swan" event, triggered by one of the mildest winters on record, which led consumers to use much less gas than expected for heating. But many analysts think that the electricity that runs laptops and DVRs will help push natural gas prices steadily upward. Driven by concern about pollution (and pressure from regulators), utility companies have switched from coal to gas to run their power-generating plants, and most new plants under construction will rely on gas. Atlanta-based Southern Co., the largest electricity generator in the country, now gets 47 percent of its electricity from gas, up from 16 percent five years ago, and it's planning more gas-conversion projects.
Plentiful gas is having an even bigger impact on manufacturers that compete with rivals outside the Americas. Natural gas in the U.S. currently costs as little as one-quarter of what it does in Europe and Asia, and that's been a boon to U.S. chemical companies that use gas as a component in their products. Dow Chemical decided to invest more than $4 billion in a range of new projects in the Gulf Coast that are set to be completed between now and 2018; the plants make ethylene and propylene, which appear in all kinds of plastics and other products. Until the recent gas boom, an investment of that magnitude in the States wasn't even on the radar, says Jim Fitterling, a Dow executive vice president, but now it could be profitable for many years: "People here still pinch themselves every day to see if it really is real."

A few firms are looking toward the next frontier -- sending gas abroad. The country exports only about 6 percent of its natural gas, in part because shipping gas is technically challenging (it requires either a pipeline or a plant that can liquefy gas for shipment). Right now, only a few such plants are even being contemplated; but if the spread between prices here and abroad remains wide, more U.S. companies might gamble on this move, says Paul Christopher, chief international strategist at Wells Fargo Advisors.

Ann Minnium, a financial planner in Scotch Plains, N.J., runs the all-female Athena Investment Club. Each month, the
12 members come together to vote on which stocks to buy and which ones to drop. Minnium says the group's returns have averaged 14 percent a year, but they'd be doing even better if it weren't for one stock: First Solar. The club bought the Tempe, Ariz., solar-equipment maker in November 2009 for $117 a share; now a victim of falling demand and competition from companies that make cheaper gear, it trades at $13. Minnium calls the stock "our biggest loser -- and that's saying a lot, considering we own a Greek shipping company."

Despite the ecological arguments in their favor, solar and wind power have almost always been more expensive than fossil fuels, and recent trends have widened that gap. What's more, government budget problems in Europe and the U.S. have begun to erode or threaten tax breaks and subsidies that encouraged consumers to go solar or put windmills in their backyards. Making matters worse for solar companies, analysts say, is a simmering tariff war between the U.S. and China that could drive up the price of solar panels. All these headwinds are chilling investors: According to Lipper, assets held in alternative-energy mutual funds have fallen by two-thirds since 2009.

In response, green money managers are scrambling to redefine their approach. In one bleak six-month stretch in 2011, David Kurzman, manager of the Leuthold Global Clean Technology fund, sweated through a 40 percent loss; for the year, he saw more than half of his $26 million portfolio disappear. Today, he has less than 20 percent of his assets in alternative-energy companies, down from 50 percent before the slump.
His holdings now include firms like American Water Works -- a utility that supplies water to, yes, fracking enterprises. Kurzman says that when fracking is performed in an environmentally conscious way, natural gas is a cleaner source of energy.

Other green investors are buying shares in companies that follow green practices, even if they aren't green-centric. Brian Salerno, manager of the Huntington Strategy Shares EcoLogical ETF, says he's done well with NextEra Energy, a Florida company that uses more renewable sources than any other big energy distributor, and BorgWarner, which makes auto parts that improve fuel efficiency. Salerno says he likes these businesses because they're "not just waiting around for that next subsidy check."

Indeed, the best of the green-energy companies are also avoiding that waiting game. Edward Guinness, comanager of the $18 million Guinness Atkinson Alternative Energy fund, says renewable-energy manufacturers are becoming more efficient and producing their equipment more cheaply, so they can better compete with fossil fuels. Guinness likes Silicon Valley-based SunPower, which brought in $2.3 billion in revenue in 2011, even as its stock fell to an all-time low. As for First Solar, the company says it plans to move its operations away from smaller projects and focus on building major power installations for utilities. And the Athena Investment Club has decided it will hang on to the stock. After all, Minnium says, fossil fuels like natural gas are finite resources, and "they can't stay cheap forever."
Green products like solar panels and hybrid cars have caught on with only a small minority. Could cheap oil turn green consumer tech into an endangered species?

As enormous and influential as the energy industry is, it's still a consumer-driven business -- with hundreds of companies competing to see who can convince customers that their fuel is the cheapest and most convenient. In one sense, economists say, the battles of the energy revolution are being fought house by house and car by car. On the home front, natural gas has been looking like a better heating option to many owners. Last winter, according to government estimates, the average resident in a gas-heated home spent 31 percent less for heat than his electric-heat neighbors, and a whopping 72 percent less than those who use heating oil. While exact numbers of home conversions aren't disclosed, gas executives say the numbers are up, especially in the oil-dependent Northeast.

Still, the economics of converting a home to gas heat aren't necessarily a slam dunk. A conversion typically costs between $5,000 and $10,000; while that's less expensive than the $23,000 spent on the average single-family-home solar installation, the savings are also proportionally smaller. (After all, a solar-powered-home owner can theoretically reduce her heating bills to zero.) Based on last winter's prices, an oil-to-gas conversion might pay for itself in as little as three years, but an electricity-to-gas switch might take as many as 11 years. And the natural gas industry's own trade group says it's unlikely that gas will keep its current price edge indefinitely. Meanwhile, a solar installation can look attractive even today in states where gas hasn't had as big an impact on electricity rates, including California and Nevada.

There's also a bit of an energy muddle in the garage. Some 3.3 million new hybrids, diesels and electric cars have been registered since 2007. A closer look, however, shows an industry that's uncertain about the best future "alternative." With manufacturers racing to meet stricter government fuel-efficiency standards, some gas-only cars now get 40 miles per gallon or better. "Forty has become the new 30," says David Whiston, the senior automotive equity analyst at Morningstar. So car buyers are thinking twice about paying, on average, $6,000 more per car for hybrid technology.

But no other green alternative is exactly muscling hybrids aside. Electric cars have been supported by generous tax breaks, and Mike Omotoso, an analyst at research firm LMC Automotive, points out that electric-car-battery prices have been dropping by 8 to 10 percent a year. But he adds that it'll be at least a decade before the U.S. has an infrastructure to support plug-in cars -- right now, the country has more than 10,000 electric charging stations, or one for every 16 gas stations. Natural gas faces a similar problem.

If it's any consolation, drivers who have already bought hybrids won't see them going the way of the rumble seat. Tom McCarthy, chief engineer for engine research at Ford Motor, says his company and other automakers are likely to keep investing in all the alternative "power trains" -- hybrid, electric and the like -- because "it's too early to be betting on just one." And for now, the industry's green efforts won't offer stock investors much to cheer about. Sized up against the industry's $450 billion in annual revenue, Whiston says, sales of hybrids and electric cars "aren't even a rounding error."

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