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John M. Devir
For many if not most Americans, North Dakota brings to mind images of bleak, snow-covered landscapes like those in the 1996 movie Fargo – a popular and award-winning if gruesome satirical classic (which, despite the name, takes place and was filmed almost entirely outside of North Dakota). But at PIMCO, we see North Dakota for what it truly represents: a homegrown “emerging market” and economic sensation. We believe the state’s booming oil production, along with developments in key shale basins in Texas and Canada, will help lead North America to the Promised Land: energy independence over the next dozen years.
Thanks to energy, North Dakota’s GDP growth crushes the national average In our December 2012 Viewpoint, “Energy Face-Off,” we highlighted the recent explosion in North American (which we usually define as the U.S. and Canada) crude oil production as a “game-changing” event that will have long-term impacts on global supply and demand.
We continue to believe this growth in liquids production will lead North America to energy independence by roughly 2025. Based on current Bentek Energy forecasts, North American crude oil production is expected to increase at an average of 10% per year from FY2013 through FY2017. Additionally, Bentek estimates that from 2013–2020, approximately 50% of all incremental global crude oil production will come from North America, totaling 4.5 million barrels per day, with four key producing regions the primary sources of the increase: 1) South Texas’s Eagle Ford Shale, 2) North Dakota’s Bakken Shale, 3) West Texas’s Permian Basin and 4) Western Canada.
North Dakota certainly feels the energy surge: The state’s GDP grew by a staggering 13.4% in 2012, according to a June 2013 report published by the U.S. Bureau of Economic Analysis (BEA) – see Figure 1. To put that into perspective, North Dakota’s GDP growth was more than 5 times greater than the national average and almost 3 times greater than the second-fastest-growing state, Texas. And Texas is a growth powerhouse, with the second-largest GDP of all states at $1.2 trillion. Texas has achieved a 3-year compound annual growth rate of 4.2%, which is more than 2.5 times faster growth than California, New York, Florida and Illinois (the four other largest states as measured by absolute GDP).
In their report, BEA cited mining, construction and transportation as the primary drivers of GDP and employment growth in North Dakota and Texas. North Dakota’s employment growth is ranked #6 among all states (with Texas at #7), and its unemployment rate is a shockingly low 3.0% (according to the U.S. Bureau of Labor Statistics (BLS) – see Figure 2). To put this into context, North Dakota’s unemployment rate is the lowest of all the states, 60% lower than the national average of 7.4% and close to the all-time historical low of 2.1% set by Connecticut in October 2000.
Notably, this economic and employment growth occurred despite North Dakota being the least visited state (according to CNN Money). With just under 700,000 residents as of July 2012 (according to U.S. Census Bureau estimates), North Dakota ranks as the 48th state by population, with Vermont and Wyoming ranked 49th and 50th, respectively.
Crude oil production growth in North Dakota and Texas is strong and sustainable Due to technological advancements combining hydraulic fracturing with horizontal drilling, crude oil production has increased a tremendous 54% over the past 3 years in the four major North American production regions named above (source: Bentek Energy). Additionally, due to ample access to capital, increased productivity and added drilling infrastructure, we believe production growth in Texas, North Dakota and Western Canada should grow 10% per year over the next 3 years. In our opinion, North Dakota, Oklahoma and Texas are critical states from a production, pipeline route, storage and end-market consumption perspective. We believe these states, which PIMCO refers to as the “DOTs,” stand to disproportionally benefit from the strong growth in the energy sector, particularly in onshore U.S. oil and gas shale development (see Figure 3).
Investment opportunities and implications In North America, the implementation of technological innovation in drilling has fostered a revitalized crude oil production forecast and has set the wheels in motion for energy independence by the middle of the next decade. Emerging shale plays have led to solid volume growth as well as the need for future investment to expand pipeline capacity. Additionally, strong asset quality, high barriers to entry, long-term contracts, inflation protection, noncyclical cash flows and significant growth in pipeline capacity have created attractive investment opportunities for both bond and equity investors.
Based on these tremendous growth prospects, our approach has been to identify and invest in the companies, including pipeline operating companies, favorably positioned to benefit from the prolific oil production in specific markets such as North Dakota and Texas as well as from the energy landscape in North America as a whole (see Figure 4). In our opinion, the midstream energy sector will grow more quickly than the overall U.S. economy over the next several years, which will provide continued support for current fundamentals.
North America needs growth and job creation more than ever. Given our longer-term outlook for increasing crude oil production, we feel the midstream energy sector is one of the most attractive secular growth stories. However, we note the energy industry and markets are cyclical and subject to unpredictable swings in both supply and demand. In a recession, global demand for energy can fall significantly, leading to lower prices and reduced transportation volumes. Geopolitical risks can be substantial, especially given the Middle East’s large contribution to the global oil supply. Additionally, proposed pipeline projects in North America require Federal Energy Regulatory Commission or National Energy Board (Canada) approval to proceed. This process can take a year or more and has attracted increasing opposition given environmental concerns and fears that a more balanced supply/demand market for commodities will lead to higher prices to consumers.
Overall, the emerging trends in North American energy, and especially in crude oil production, are likely to have dramatic ripple effects on U.S. manufacturing, foreign policy, defense spending, current account balance and the looming budget deficit. Even if the timeline for North American energy independence is extended, onshore production growth in North America in the near term will likely allow the U.S. to wean itself away from non-Canadian waterborne imports and significantly increase long-term national energy security.
In order to capitalize on these trends, investors should consider buying high quality midstream energy companies with abundant assets in areas with strong production and new development. Additionally, we have identified a selection of pipeline and rail transportation systems in both Canada and the U.S. that represent attractive opportunities to invest in the DOTs, which we believe to be North America’s new “emerging markets.”
A word about risk:
Past performance is not a guarantee or reliable indicator of future results. All investments contain risk and may lose value. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investing in the bond market is subject to certain risks, including market, interest rate, issuer, credit and inflation risk; investments may be worth more or less than the original cost when redeemed.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2013, PIMCO.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2013, PIMCO.
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