Oil spill wreaks havoc on environment, complicates outlook

 

The market reacted almost immediately—in our view, actually overreacted—to the April 21 explosion. This response was not surprising, especially given the gravity of the headlines, the loss of human life and the black eye the event has given the industry as a whole. This will be sorted out as more is learned about cause and liability is determined. Hearings are already underway to determine what caused the explosion and the degree to which each company is responsible, with the expected finger pointing and “don’t blame us” attitudes on the part of energy company executives. It seems pretty clear to us that BP, which operates the well that is the source of the leak, probably has primarily responsibility. Three other firms were also meaningfully involved: TransOcean Ltd. (4.0% of holdings as of 5.15.10), Halliburton Co (4.0% of holdings as of 5.15.10), and Cameron (2.6% of holdings as of 5.15.10). The Fund had no exposure to BP, which stands to take the biggest hit. The Fund did have a stake in TransOcean, which owned the rig. We sold down the Fund’s position in TransOcean significantly but still maintain a small exposure. The Fund also had exposure to Halliburton, which provided cementing services, and to Cameron, which provided subsurface equipment. Halliburton’s and Cameron’s stock price fell on the news but have subsequently rebounded. Given our confidence in their long-term viability, we took advantage of their price declines to increase the Fund’s exposure to both. We are watching TransOcean closely and may buy back into it, depending on price and other factors. Going forward, we’re taking a wait-and-see approach as this situation continues to evolve.

Some market watchers may be surprised that there’s been little change in oil and gas prices in response to the event. In fact, prices have moved up, but that is in response to global demand, driven primarily by China and rapidly growing developing markets. The reason we’re not seeing immediate impacts to oil prices is because, even though global oil production has slowed, some 85 million barrels per day are currently being extracted. The story here is the tremendous damage to the environment and the fishing industry; the spill is relatively small in light of global production and stores.

 

When this event likely will drive prices higher is several years down the road, and is related to deepwater drilling, which was a source of controversy long before the current spill. Despite those opposed it—a group that is becoming larger and louder in the wake of the Deepwater Horizon spill—this method of extracting oil from underwater wells will not go away; offshore resources are too rich and global demand is too great and only getting greater.

 

Ironically, the explosions occurred just a few weeks after President Obama announced a plan to dramatically expand offshore drilling along much of America’s coastline, part of his larger “Clean Energy plan.” But for now, the spill has brought offshore drilling to a standstill. The Obama administration placed a six-month moratorium on deepwater oil and gas drilling and ordered a shutdown of offshore wells currently operating. We undoubtedly will see increased safety regulation and higher standards for offshore drilling that will lessen the chance of major oil spills. That bodes well for protecting the environment and ensuring the safety of rig workers, but it likely will slow construction of new rigs and increase rig operation costs. It also will cost more to insure offshore deepwater drillers, which also will contribute to higher prices.

 

Other nations are likely to follow suit. In fact, we’re already seeing an impact in Norway, one of the largest global oil exporters. Plans that had been in place to eventually open areas near Norway’s Lofoten and Vesteraalen islands, home to Arctic cod spawning grounds and sperm whales, are now being hotly debated; workers’ unions are urging the government to allow exploration in the areas to stem a recent decline in output, while environmentalists argue that the areas are too ecologically sensitive for oil and gas production. The area holds an estimated 1.3 billion barrels in crude and natural gas.

 

So, definitely, the spill is a wake-up call for the industry, and we expect to see more of the type of debate taking place in Norway. We just don’t think the recent spill will prevent further offshore drilling.

Despite the recent disaster, we remain optimistic about the future for the energy sector and the Fund. We’re probably more concerned about the strength and sustainability of global economic recovery than we are about the impact of the spill on near-term oil prices. Oil prices are moving higher as world economies continue to recover and the emerging middle class in developing continue to reach for a better standard of living. Supply and demand remain tight, as was the situation prior to the spill, and as we’ve said, we believe demand will only get stronger.

 

 

Consider All Factors: As with any mutual fund, the value of the Fund’s shares will change, and you could lose money on your investment. Investing in companies involved in one specified sector may be more risky and volatile than an investment with greater diversification. Investing in the energy sector can be riskier than other types of investment activities because of a range of factors, including price fluctuation caused by real and perceived inflationary trends and political developments, and the cost assumed by energy companies in complying with environmental safety regulations. These and other risks are more fully described in the Fund’s prospectus.