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Interview with Judith Dwarkin of Ross Smith Energy Group

Judith Dwarkin Chief Economist at Ross Smith Energy Group

Judith Dwarkin Chief Economist at Ross Smith Energy Group

Biography: Judith is Chief Economist for the Ross Smith Energy Group. Judith’s vast expertise includes energy market operations and regulation, transportation issues and energy policy. Before joining Ross Smith, Judith was Senior Vice President, Global Energy with the Canadian Energy Research Institute (CERI), where she managed the domestic and international research program pertaining to crude oil markets and prices, as well as the Institute’s Conference and Training divisions. Prior to joining CERI, Judith was a Managing Director with the Alberta Petroleum Marketing Commission, where she was responsible for oil and gas market analysis and energy regulatory interventions on behalf of the Alberta Government. All of Judith’s degrees are in economics.

I reckon it must be confounding for an economist to reconcile the rising stock markets with the shaky recovery that the U.S. economic statistics are foretelling. However, for Judith Dwarkin, Chief Economist at Ross Smith Energy Group, the crux of the matter lies in whether private sector investment can pick up the slack when the government stimulus is removed. Ms. Dwarkin points to falling personal incomes in the third quarter of 2009 and rising unemployment which she thinks will likely not peak till next year and could take several months to fall back to pre-recession levels as reasons for further stimulus to come. Furthermore, she adds that the share of personal income coming from transfer payments hit 8% in Q2/09, compared to around 2% during the boom. With the total federal package designed to be spread over 2009 and 2010with a tad left over for 2011, Ms. Dwarkin is still fearful for potentially scary developments at the state level in the coming months. Several states face falling taxes, leading to losses in public sector employment with the huge care packages still to come from Uncle Sam. Given this backdrop, Ms. Dwarkin doesn’t sound too optimistic about the economic health of the United States. She cites a persistently large output gap as little incentive for businesses to re-invest anytime soon. Along the same lines, larger companies that are able to raise money and earn profits are hoarding the cash to shore up balance sheets. It remains to be seen whether the United States can reinvent itself as salesman to the rest of the world because in case you missed it, the world has changed, says Ms. Dwarkin.

Q: Given the widespread pessimism regarding natural gas and the glut in inventory, what are your thoughts going forward for this commodity?

A: My colleagues and I have long thought the required correction in near-term market balances has to come from the supply side. We still think so. In this light, the good news is the collapse in gas-directed drilling in the Lower 48 this year has translated into a slow-down in production and probably a contraction, measured year/year. I say “probably” because the EIA data that everyone uses to gauge reality appear to be deteriorating in quality, adding more uncertainty to the mix. The bad news is the supply-side adjustment is too little, and coming too late to thwart a large bulge in Lower 48 gas storage remaining at the end of the current winter. This will continue to put a damper on price recovery. To compound the problem, we’re now seeing gas producers ramping up their spending and drilling programs. The practical effect of this could be to prolong the market imbalance. Low-cost and price-hedged producers with production close to market will be best-positioned to weather the continuing storm.

With respect to the longer-term fares of the industry, capturing a greater share of the electricity generating load would seem to be a no-brainer for natural gas in a carbon-constrained world. But gas is not the preferred alternative to coal for the US administration at present, so the industry needs to do a better job of explaining the merits. In addition, although a renaissance in US industrial activity isn’t likely anytime soon, the sector will be helped by a lower dollar, which in turn should be positive for gas demand.

Q: With crude oil hovering at approximately $80/barrel, do you think these price levels are sustainable for the next 1-2 years, especially in light of the IEA saying that they only expect a marginal increases of 1.5% per annum in oil demand between 2007 and 2030 in their most recent world energy outlook, why or why not?

A: $80 is somewhat fluffy relative to current and likely market balances over the near term, in my opinion. This price is signaling there’s a supply issue when there isn’t one.

However, this isn’t the first time, and won’t be the last time where prices are at odds with the fundamentals. There are many different players in the oil market with different interests, strategies, time horizons, information, and perceptions, all of which can combine to trump the basics of supply and demand, sometimes for surprisingly long periods of time. But ultimately, the fundamentals re-assert themselves, as we have seen many times in the past. Layered onto this is the fact that the global oil market isn’t competitive (although regional/local markets are). Rather, the world’s least-cost producers manage their production levels to keep stocks low and maintain upwards pressure on prices. The higher-cost producers supply as much as they can at the prevailing price, and costs tend to follow prices.

The IEA projection actually anticipates global oil demand growth returning to its long-term trend, which isn’t a provocative supposition. However, the next 20 years will see the locus of demand growth continuing to shift towards emerging economies, while consumption in the advanced economies continues to shrink. The data for emerging-economy oil demand are much less transparent, plus some of these countries regulate retail prices, making it more tricky to understand the behavior of oil demand in these places. This spells greater uncertainty for prognosticators, more uncertainty about price direction and likely greater volatility in prices.

Since late last winter, oil prices have doubled, alongside surging equities – in anticipation of economic and oil demand recovery - and a falling dollar. If equities correct and/or the dollar pauses in its descent, oil prices are vulnerable.

Q: With the oil/gas ratio sitting at approximately 20 and the average over the last 2 years being around the 12 to 13 mark, would you short oil at the moment or go long natural gas?

A: There are structural reasons to expect the oil/gas price ratio to remain elevated relative to its historical average, albeit not to the degree currently. On the gas side, the supply curve has shifted upwards because of the shales plus improvements in drilling and completion technology across the board. This means more gas can be supplied at a given price, compared to previously. And unlike oil prices, North American natural gas prices are much more fundamentals-based. And as I’ve already noted, calling the timing of a turnaround in the near-term gas market is a tough one, particularly if producers get ahead of themselves and start supplying more gas into a market that doesn’t yet need it.

In addition, growing global spot trade in LNG makes the US market more vulnerable to offshore suppliers diverting cargoes to the US to maintain netbacks from markets in Europe and Asia which will have a chronically dampening effect on gas prices.

On the oil side, the transportation sector will likely remain in thrall to oil for some time to come, meaning a continued premium on this fuel relative to potential, but still very imperfect substitutes such as compressed natural gas or fuel cells. In addition, world oil prices will continue to have a habit of becoming somewhat (or very!) detached from the fundamentals from time to time, causing the oil/gas price ratio to scoot up. While the fundamentals in oil eventually reassert themselves when prices get out of whack, timing the corrections is a guess. Certainly, the further oil prices diverge from the actual costs of finding and producing the stuff, the greater the likelihood a correction is in the works.

Q: What is your outlook for M&A activity in the energy sector? Do you have any plays (as in the bakken, montney, cardium etc.) or particular stocks that may be particularly susceptible to M&A activity?

A: As always, companies with good land positions but lacking the capital or technical skills to exploit them are targets for takeover or acquisition by companies with the financial wherewithal and good operating teams.

As well, a number of large players in Canada currently are shedding non-core assets, presenting smaller players with a smorgasbord of opportunities, provided they have the financial backing, can acquire these properties at the right price, have the know-how to exploit them efficiently, and can tolerate a volatile price environment.

Thank you Ms. Dwarkin!

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