Few things in life are certain, but Encompass Fund managers Malcolm Gissen and Marshall Berol are convinced that the world needs much more energy, and that this is great news for oil and gas companies and their investors. In this interview with The Energy Report, Gissen and Berol highlight eight oil and gas producers with potential for dynamic expansion, and two premium companies in the burgeoning sector of oil and gas services.
The Energy Report: In your May 31 annual report, you wrote: "The most important change we have made to improve performance has been to increase the [Encompass] Fund's exposure to the energy sector, while reducing exposure to metals." Why have you done this?
Malcolm Gissen: We believe that we are now living in a golden era of oil and gas. We believe that demand for oil and gas will continue to grow faster than supply. This provides a unique opportunity to invest in companies that do not have a great deal of risk, yet boast many attractive characteristics. They are expanding production. They are expanding cash flows. They are improving exploration technology. They are reducing expenses. Internal rates of return (IRRs) often go over 100%.
TER: How are the investments in the Encompass Fund allocated by sector?
MG: Oil and gas companies comprise about 20–25%. Oil and gas field services are 2.5–4%, and natural gas processing companies are about 2.7%. Precious metals are a little under 20%. We're not solely a commodity fund, however. We've also got technology and biotech companies, as well as homebuilding, healthcare, and real estate investment trust (REIT) companies, among other sectors, represented.
TER: How much must oil and gas supply grow to meet demand?
MG: In "The Outlook for Energy: A View to 2040," Exxon Mobil Corp. (XOM:NYSE), in its annual report for 2013, predicted that global energy demand will grow about 35%, driven by growth in developing nations. By 2040, Exxon expects nine of the world's 20 largest cities will be in India and China, and that these two nations alone will account for more than 50% of the increase in global energy demand. Even as fuel efficiency increases and technologies improve, oil will remain the No. 1 fuel type, with natural gas supplanting coal as No. 2.
The International Energy Agency (IEA) published a special report in June on this subject. The IEA projects that spending to meet energy needs will increase from $1.6 trillion ($1.6T) in 2014 to $2T per year by 2035. The IEA report estimates that the total spent to meet the world's growing need for energy will be $48T by 2035. Less than half of that spending will be in developing new energy supply; most will be to replace declining production from existing oil and gas fields.
This bolsters our belief that investment portfolios should increase exposure to oil and gas, and helps explains why the Encompass Fund produced a 17.4% return as of the end of August.
TER: What will be the primary source of new supply?
MG: The IEA forecasts that North America—the U.S. and Canada—will provide most of the new supply into the 2020s. After that, there will be more dependence on Middle Eastern oil and gas, according to the IEA.
Marshall Berol: I would add that whatever your views about climate change, the fact of that matter is that governments around the world are moving away from coal. China, for instance, is moving toward more use of natural gas, particularly around Beijing, because of pollution. China has announced that it will be closing almost 2,000 small coal mines. And after the Fukushima earthquake, use of nuclear power to generate electricity has become politically troublesome.
TER: Isn't an increased dependence on oil and gas from the Middle East troublesome? The Islamic State in Iraq and Syria (ISIS) army has already occupied much of Iraq and has moved into Kurdistan.
MG: Middle Eastern politics have become increasingly volatile, violent and unpredictable. We think it unlikely the jihadists are going to disappear, no matter how strongly the West responds to them. They are active in Lebanon, Syria, Iraq, Pakistan, Yemen, Libya and Nigeria, among other oil-producing countries, and present a constant threat to oil supply in both the Middle East and Africa.
TER: Even as the Middle East burns, the West and Russia are ramping up sanctions against each other.
MG: Vladimir Putin seems intent on increasing instability in Eastern Europe, not just in Ukraine, and that impact is likely to grow. In 2013, the U.S. exported more than $1.5T of goods, and less than 10% of that was either crude oil or petroleum products. That same year, Russian exports of crude oil, petroleum products and natural gas amounted to more than two-thirds of total exports, and composed more than 50 percent of the Russian government's total revenue. Much of these exports go to Europe: 30% of Europe's natural gas comes from Russia. There is a real threat that this supply could disappear. If that happens, natural gas prices will likely rise, and we'll see pressure on North America to replace the Russians as suppliers of natural gas for Europe.
TER: Do you believe in the peak oil theory?
MG: No, for two basic reasons. First, we're finding more oil, and a number of those discoveries are of very large reserves, such as those off the coast of Brazil, Mexico, Russia and Australia, among other places. Oil is also being found in more remote places, often very deep in the ocean. But it is there, and it will be produced, particularly with oil selling at $90 to $110 a barrel ($90–110/bbl). Right now West Texas Intermediate (WTI), at around $94/bbl, is very profitable for oil companies. We expect prices to remain in this range—perhaps even go higher—for some time.
The second reason Marshall and I don't believe in peak oil is that technological advances are being made that are increasing production, as exploration companies capture oil and gas from existing reservoirs that had eluded them in the past. Horizontal drilling and fracking are making that possible. We're seeing more horizontal drilling than vertical drilling now in the U.S. and Canada.
MB: That said, the technologies being utilized to increase production—horizontal drilling and hydraulic fracturing (fracking)—are more expensive than drilling was just 50 or 75 years ago, when you punched a hole in the ground and the oil came gushing out. These increased expenses, as well as a tightening of supply/demand, should result in a continued rise in oil and gas prices.