John Licata: Playing the Energy Sector in '09

May 28th marks the next OPEC meeting. Will there be more production cuts? John Licata, chief investment strategist at Blue Phoenix Inc. doesn't think so, noting that even those cuts are being offset by "much production coming from non-OPEC members." In this exclusive interview with The Energy Report, conducted on April 20, John discusses the underlying forces that continue to drive crude's price volatility and explains why he foresees a "super spike" in natural gas—the likes of which we haven't seen since 2003.

The Energy Report: The market is going a little bit crazy today, especially the NASDAQ and oil. To what do you attribute that?

John Licata: A lot of it has to do with early strength that we saw in the U.S. dollar. I believe today we're trading at one-month highs vs. the Euro. I think there's been some expectation. Some of the forecast from the energy companies were thought to be kind of gloomy. There's a lot of uncertainty related to a recovery, and some people are really concerned. That's why we're seeing a sell-off in much of the service names and the drillers. Crude oil is actually trading at an area I think has more downside to go. We could trade below $40 and I think what also sparked a sell-off in the oil patch was Goldman Sachs saying that we could see $45 before $65. This is something that I've been saying for the last couple of weeks and I maintain that now.

Late last week, Chesapeake Energy (NYSE:CHK) cut their production yet again and they're usually a barometer for what the other E&P names are going to do; so I fully expect many of the other natural gas E&P players to follow Chesapeake's lead, so to speak, and do the same. When we look at the prices of crude oil, I honestly think the contango spread between May and July, which is around $5 right now, is awfully wide. To me, that indicates that there's plenty of near-term supply to meet demand.

People are also starting to talk about the hurricane trade. I think that's premature—we're still a couple of months away. OPEC is slated to meet on May 28th. And I don't think that they're going to be as willing to cut production as many people think they are. We've actually seen more production come on line from Russia and other non-OPEC members. Even though OPEC is trying to cut, those cuts are being offset by much production coming from non-OPEC members. I actually think that the trade to be short E&P players is still valid and we still have downside to go. Like I said, I still think we can trade below $40.

TER: How soon do you think it will get to $40?

JL: It's hard to say in terms of putting an actual timetable on it, but if I had to I would probably say within two weeks.

TER: And how quickly do you think it'll start moving back up to $65?

JL: I really don't think that we're just going to put in a bottom and move straight forward. I do think we need to see signs of the economic recovery. There's been a correlation with the price of oil and the U.S. stock market of roughly 36% from September to now. Prior to that, from the year 2001 to the fall of 2008, the correlation was zero. So I think we're going to go back to the old supply and demand fundamentals and I think that crude oil is going to stop trading along with the U.S. stock market.

Once that happens, and people realize that so much continued unemployment here in the United States is going to cause less demand for jet fuel, it's going to cause less demand for gasoline. With that being said, I think that's going to weigh on the refiners' need to get their refineries filled as well and that's also going to weigh on the price of crude. So, unless we start seeing the economy pick up, and the IEA has said that they don't believe that's going to happen in the second half of this year, I think that we're going to be in a slow move higher towards $65. Frankly, we're still in April. We have a long way to go before the end of the year.

TER: So, we may not even see $65 in 2009?

JL: I think we can. Once we get through the summer months, we can see the economy start to show some signs of life; but I think that the oil market is going to go back to its own fundamentals. We're going to maybe look at where the dollar is trading, as well. There is plenty of oil in the market place right now, but all the E&P budgets being cut is going to show that, when there are actually any signs of demand increasing, we're going to see a massive short covering.

TER: You said earlier that a good thing would be to start shorting the E&P players. What other options do you see in the energy sector for investors?

JL: To be honest with you, I actually like natural gas and I think it has been trading step by step with the price of crude oil for far too long. Natural gas is a very interesting commodity because it could be used for air conditioning—and, before you know it, the weather's going to start getting warmer with the summer months.

Baker Hughes Inc. (NYSE:BHI) recently came out with a report on rig count in North America. It actually dropped from 1,600 rigs to, I think, the mid-700s now. That's a dramatic difference since September. So I think that natural gas can actually see a super spike similar to the one that we saw back in 2003, where prices actually doubled. Obviously, I don't want to bet on a hurricane, but if I had to play a hurricane, I'd probably look more at natural gas than crude oil at the moment.

TER: Natural gas trading is somehow linked to crude right now and crude's linked to the stock market. What's going to cause natural gas to decouple and get this super spike?

JL: The rig count. To come down from 1,600 to less than 800 since September, that's dramatic. The fact that Chesapeake is once again cutting their output levels is a telltale sign that others are going to continue to follow. We're getting at levels where it's uneconomical for natural gas producers to continue producing natural gas. Three dollars and fifty cents for natural gas, to me, seems like there's not much downside. If I was playing any of the energy commodities, I just feel that natural gas is much closer to a bottom than gasoline prices or crude oil.

I think the upshot is going to come from a low rig count. Frankly, so many rigs have been taken off the market since the fall (roughly 50%), that I think that investors are going to be watching the price of natural gas going up quite substantially right before their eyes when we even hear about an outage or hurricane threat. You can't just take a rig out and put it back in and have it ready overnight. That takes some time. So all these delayed projects, in the Marcellus region, Haynesville region and in the Bakken, have been pushed back to 2010 and, in some cases, 2011 and 2012. There will be what I call "Rock and Awe effect," where investors are going to be staring in awe as the price of natural gas continues to move higher.

TER: Companies like Chesapeake have got to have some individuals like yourself, who are projecting the price of natural gas. Why are they pulling the rigs off now?

JL: Think about it. If I'm correct and I'm looking for the prices to move a lot higher, wouldn't they, themselves, stand to do better if they start taking more off the market? I think that they're being very tactical about it. Basically, they're shutting off the wells. They know full well that if they keep doing that, we're going to start to see a spike. Once we see the spike, they'll gradually put them back on.

TER: As an individual investor, how do I take advantage of this natural gas situation?

JL: I've always been a fan of the United States Natural Gas Fund (NYSE:UNG). I own that personally, as well. That's a great opportunity for people who want to get involved in the actual futures rise. So the UNG offers a really compelling price right now, trading in the mid-$14s. If I'm right and the price of natural gas is going to recover by year end, I think you can easily see that move into the low $20s.

TER: Will we need to see an increase in crude oil prices if they're still linked, or will the rig count make it move independently?

JL: The rig count, I think, is going to make it move independently; also, natural gas will be a much bigger beneficiary of any heat waves that we see come summer time.

TER: Are there any other equity plays that could be done other than using an ETF?

JL: I like companies like Swift Energy Corp. (NYSE:SFY), Bill Barrett Corp. (NYSE:BBG) and Berry Petroleum Company (NYSE:BRY). Those are some good names in the group. Funny enough, you would think you'd see some consolidation in the space, yet many of the producers that I've been talking with say they still think that assets are not as cheap as they would like to see and they're all living within cash.

TER: In our previous conversation, you mentioned Alon USA Energy Inc. (NYSE:ALJ), a refinery. That's not a natural gas play. Is that a crude play?

JL: It's actually a play on asphalt and a play on the dieselization in the United States, which I think will happen within the next couple of years. Alon is a quality refinery. Around 14% of its revenues actually come from asphalt, and I think that's going to be a big beneficiary of President Obama's stimulus package. Some of the smaller refiners like Alon USA and Holly Corp. (NYSE:HOC) are some of the best performers year to date, far outperforming names like Suncor Energy (NYSE:SU), Valero Energy Corp. (NYSE:VLO) and Tesoro Corporation (NYSE:TSO). The company's up north of 20% year to date, so I think a company like Alon is positioned very well for growth. Management is doing a very respectable job acquiring assets like Krotz Springs, and it's very interesting to see that it's going to be one of the front-runners for dieselization; again, something I think that is going to happen quicker than most people think.

TER: Is Holly Corp. also a refinery, or are they involved in asphalt or something else?

JL: Holly Corp. is another refiner. It's a name that I actually like very much right now; it's more of a gasoline and diesel play, as well. I actually like Holly Corp. I was really intrigued by an acquisition they recently made. They purchased Sunoco's 85,000-barrel-a-day refinery in Tulsa, Oklahoma. The reason I'm so enthusiastic about this deal is because they paid less than $800 per barrel for the refinery. I find that extremely interesting because in June of last year, Alon USA paid roughly $5,000 plus for the Krotz Springs refinery they purchased from Valero. So I basically think that Holly Corp. just got a steal with their recent acquisition, and it also gives them some diversity with location. I think they're going to be very well-rewarded as crack spreads start to move higher as we move into the summer.

TER: You were recently on CNBC with Maria Bartiromo. In that interview, you mentioned that you see further downside in some other commodities like gold and copper and suggested shorting some of the big integrated oil companies. Can you explain that a bit more?

JL: Yes. I think we can see some downward pressure in a Brazilian oil company, Petrobras (NYSE:PZE). If I think that crude oil prices are going to move below $40 and the lower crude oil gets, the more uneconomical it is for Petrobras to take the oil out of the ground in large fields, such as Tupi (one of the largest fields recently found).

Just to prove my belief that they know they need money to help their cause right now, their CFO was in Asia last week and they were: a) trying to get a joint venture partner; or b) trying to raise money. I think that they stand to be at a major disadvantage to some of their peers just because their offshore projects are quite costly, and I think that that's coming at a time when crude oil prices are moving lower. So from a short-term trading perspective, I think Petrobras is a really good short.

TER: You're very bullish on natural gas. We see you're bullish on gold and platinum and palladium. How do you compare these various plays, natural gas against gold?

JL: I think the potential for the price of natural gas to double is tangible. So, in terms of best commodities pitting themselves against each other, I like natural gas over gold—and that's saying something, considering I'm very bullish on the price of gold. Both crude oil and copper, I think, are near-term shorts, but I do see more of an upside for crude oil by year-end than I do for copper.

TER: And for crude you’re expecting good short term plays, but in terms of shorting it.

JL: I do.

TER: But by year end, we’re seeing it back up to $65?

JL: Yes. I think we can see north of $65 by year end. I still think that we can see below $40 near term. I said this in my CNBC interview—for the last couple of weeks, when crude was well over $50, I said it looked heavy and I don’t really see how demand has been picking up. It hasn’t. Just look at the IEA cutting their projections by one million barrels a day in terms of demand. That’s an enormous amount and, as I mentioned earlier, there’s still a lot of non-OPEC production coming to market. So I do think that the opportunity for crude oil short term is to the downside.

John J. Licata is Chief Investment Strategist at Blue Phoenix, Inc., an energy/metals independent research and consulting firm based in New York City. He has appeared regularly in the media (CNBC, Bloomberg TV/Radio, Business News Network, Barron's, etc.) over the years for his insights/forecasts in the commodity spectrum. Blue Phoenix Inc. correctly predicted $1,000 gold and $100 oil in the past 12 months.

After studying economics and graduating from Saint Peter's College (where he received the Wall Street Journal Award for economic excellence), Licata set his sights on Wall Street. During his more than 13-year career, John has held both trading and research positions on the NYMEX, Dow Jones, Smith Barney and Brokerage America. Early in 2006, he founded Blue Phoenix, based in New York City.


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