Recommended Energy Portfolio Positioning-Overview

Energy Positions

If no current exposure, start with an underweight position, and expect to add dollars over time. This based upon my belief we have not yet seen the slowdown in demand for energy from a weakening economy. Stock valuations are down, but overall not cheap enough yet.
Given current stock prices though, I would not be a net seller of existing positions, but would trade around to arrange them as follows.

Long only funds should be very defensive. Hedge funds can be more aggressive (not much) and should be mostly/fully hedged (market neutral).
General composition would be long oily E+P and short gassy E+P; long offshore drillers and short OFS companies and JU’s.

Rationale for Long Oily E+P/Short gassy E+Ps
Rationale is my belief in a natural gas surplus that may last 12-24 months. The oversupply period depends upon the extent of drilling curtailments, weather and LNG imports overcoming the high US shale gas production growth. Natgas production, through September 2008 is up 6.7% vs year ago, while 2007 production increased 3.6% over 2006. This on a demand of around 1-2%. These past two years represent the first time this decade and longer that US nags production increased y/y driven by the highly productive Shale wells. It will take some time to reverse this growth, which means that natgas will be dead money until that occurs, absent M+A activity.

Investors not paying enough attention to LNG risk
I believe investors are overlooking the potential for harm to natgas prices from LNG, given recent benign impact. In 2008, LNG imports decreased a full 2/3 less than 2007 imports, to 0.9bdfe/d for the first 9 months of 2008 vs. 2.9bcfe/d imported in the same period in 2007. Volumes fell due to an increased shortage in UK (leading to higher prices there) and unique events in Spain and Asia, which created higher than normal demand. With a moderation in these one-time demand surges and significant new LNG capacity coming on stream in 2009-10, the risk and uncertainty over natgas prices increases. This higher risk/uncertainty requires greater valuation discounts in the stocks to compensate.

Conversely, while Oil’s price has been clipped pretty hard (as has natgas), It has a supplies regulator in OPEC. While further OPEC cuts will not necessarily cause oil to rally (demand will be weak for a time), cuts will help to place a floor on prices. There is no comparable mechanism for natgas, which increases relative confidence levels for oil prices vs. natgas.