Exploring Hydrocarbon Depletion
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Page added on March 22, 2012
Today crude oil and related oil producing assets are substantially “undervalued” and misunderstood by Wall Street analysts and main street investors. With seemingly high prices for crude oil and refined products like gasoline, widespread disbelief exists that oil can climb yet higher. On the contrary, the sheer size of record money printing by the U.S. Federal Reserve and a lack of understanding of the Peak Oil problem presently give petroleum quotes a solid foundation to rise markedly in 2012-13, based on our work. We are confident a combination of factors will propel crude oil to US$500 a barrel before the year 2020.
Please read our Crude Oil is Going to $500 a Barrel (Part 1) article explaining the elementary arguments for ever rising energy pricing going forward, and why ConocoPhillips (NYSE: COP) is our favorite integrated Oil stock holding.
Whether it’s the backwardation of futures pricing for crude oil, or well below S&P 500 average valuations for Oil companies with P/Es of 8-12 “trailing” after-tax profits, Wall Street conventional wisdom expects oil quotes to FALL appreciably from US$105 a barrel in 2012-13, not RISE toward $200. Yes, the price of crude oil has risen a remarkable 900% since the 1999 ultra-low price of US$10 a barrel. However, commodities in general are 5-10 times the pricing of 1999, with hard money substitutes for paper currency like gold 500% and silver 800% higher the last 13 years.
Let’s compare the relative pricing of the two most important commodities on the planet, gold and oil. Specifically, gold is the ultimate hedge against inflation (reckless money printing) and “the” hard currency of choice throughout human history, while oil has been “the” engine fueling the movement of people, goods and economic growth the last century. Believe it or not, today’s US$1700 gold divided by US$105 crude oil price is right at the post World War II average ratio of 16. During 2005, the Gold/Oil Ratio was as low as 7 (equal to $240 crude oil per barrel at $1700 gold an ounce). Considering the high odds of a war shock to oil supplies coming soon, and the problems associated with Peak Oil supply already biting the oil market, any number remotely near the 70-year average should be viewed as a LOW price, not a high one, in our humble opinion!
Another relative value indicator to compare is the Dow Industrial price versus a barrel of crude oil. Today the Dow/Oil Ratio is around 123 (13,000 Dow/ US$105 crude oil). The average since leaving the gold standard in 1971 is 140, and if you exclude the stock market boom years of 1995-2005, that average is closer to 80. By this measure oil is again fairly valued to UNDERVALUED in early 2012. The 1974 Arab oil embargo low ratio was 40, the 1981 all-time low was 25 from the Iran-Iraq war, and the 1990 oil spike from Iraq invading Kuwait produced a 50 number. Assuming the stock market stays close to current pricing, there is plenty of room for oil to rise 50% or even 100% in price in 2012-13, especially if a new Middle East war with Iran erupts. How high could petroleum prices climb under a worst case scenario disruption of supply from the Middle East? To reach the 25 all-time low ratio (or all-time high valuation of oil vs. stocks), stock market wealth levels right now would require a rise above $500 a barrel in crude oil!
Of particular interest to investors in 2012, Oil company valuations do not discount or anticipate ANY potential rise in oil/gas prices going forward. They are quite inexpensive on a relative basis to current earnings and cash flows historically, including comparisons to the alternative stock investments you could make in the S&P 500 average company, and yields in the bond market. At this point they offer substantial upside, above and beyond a significant and sustainable advance in raw energy commodity prices in the future. At US$200 crude oil in 2013, most of the oil assets we hold in the Relative Value portfolio could be “returning” 20%-40% annually in after-tax free cash flow, on our invested dollars today. Where else in the marketplace can you find safe, risk-adjusted returns close to this potential?
If you can only purchase one Oil & Gas related investment, buying a diversified ETF holding partnership is the way to go. The SPDR S&P Oil/Gas Exploration & Production (AMEX: XOP) ETF employs a replication strategy seeking to track the performance of the underlying index, and it currently holds over 70 petroleum stocks. This ETF is concentrated in oil reserves and production mostly in the U.S. and Canada, safe and stable nations far from the problems of Middle East supply. State Street markets and manages the XOP ETF, with very low cost and annual position turnover. Click here to learn more about XOP at the official SPDR website. We mentioned XOP as one of our favorites in a December 24, 2011 Barron’s article. XOP is a large, nearly 5% position in the Quantemonics Investing Relative Value portfolio as of this writing.
Charts courtesy of StockCharts.com
Devon Energy (NYSE: DVN) is a terrifically managed business in the Oil & Gas industry. Given the future for oil/gas we envision, DVN scores as perhaps the strongest managed in terms of balance sheet and capital investment focus, of the stocks we have watched the last year in the Energy sector. With 60% exposure to natural gas and 40% to crude oil approximately, Devon is the best long-term natural gas play we can find. From a free cash flow standpoint, DVN’s management has done an excellent job of not diluting existing shareholder value to grow reserves and production, unlike many competitors in the sector. We like their shareholder friendly focus from a “margin of safety” point of view.
While natural gas prices are at all-time lows presently in America compared to crude oil and other commodities (U.S. production of natural gas has exploded the last 5 years, especially in the Dakotas, and a warm 2011-12 winter crushed seasonal demand), prices remain high in Asia and Europe. Because of the difficulty in transporting “gas” economically and scarcity of developed reserves overseas, traditional natural gas prices will remain high for years to come by most estimates. Devon is intelligently preparing for expanded “liquefied” natural gas exports to Asia in particular, to capture the spread in prices, exporting America’s low gas price for profit. The Chinese firm Sinopec is investing nearly $3 billion in partnership with DVN between 2011-14 to develop oil/gas resources in America and avenues to deliver natural gas to the energy hungry economies of Asia.
Since 2009, Devon has been executing an interesting strategy of lowering their oil asset risk profile. They have been selling off all overseas and offshore assets to focus on low environmental and political risk oil and gas production on land in the U.S. and Canada. While most in the industry considered this a quacky idea years ago, the BP oil spill disaster in the Gulf of Mexico in 2010 and escalating political problems in the Middle East since 2011, make this change in focus look borderline brilliant! Considering the company’s balance sheet has improved during this transition, and their asset holdings are large and diversified, a P/E of 10 times Wall Street’s low 2012-13 profit estimate seems like a real bargain to Quantemonics. You can do more research at Devon Energy’s 2011 SEC 10-K filing here.
Hess (NYSE: HES) is a large integrated Oil/Energy company with global exploration and production properties, owning refineries, retail gas stations and oil storage terminals mainly on the U.S. East Coast. HES has undergone a major transformation the last decade, and the company’s asset base is markedly different than even five years ago. HES has done a wonderful job of taking overseas generated cash flows and earnings to re-invest in U.S. focused assets. Following the risk aversion model at Devon, HES produced only 5% of its oil in the Middle East during 2011; it closed a significant money losing refinery in the Virgin Islands in early 2012; and they are a sizable player in transportable natural gas liquids. At the end of 2011, 75% of all new wells under development were located in the United States.
Hess is hard at work trying to keep the environment clean, workers happy, plus local causes and community projects funded. The company regularly scores highly in corporate citizen surveys, and is annually on the list of top rated U.S. corporations. Amazingly for an Oil company, HES lacks meaningful lawsuits or EPA demands on its assets at the beginning of 2012. In terms of socially responsible investing, HES may be the best choice in the Oil & Gas industry for advocates of a balance between corporate profits, better living standards and a stronger society.
Perhaps the best “value” of the oil stocks we own, it trades close to tangible book value and at a low 8 times estimated earnings for 2013, given steady prices for oil and gas. The CEO at Hess has been an aggressive buyer of stock under $60 a share the last 12 months, as the company’s production profile is set to rise in the intermediate future. Learn more about Hess through its 2011 10-K filing here. Overall, the combination of statistics we review argue for considerably higher earnings and shareholder worth for Hess into 2013. HES is one of our biggest Oil sector holdings currently in Relative Value.
ATP Oil & Gas (NASDAQ: ATPG) owns an estimated 20-30 years of oil and gas reserves in the stable nation regions of the Gulf of Mexico, the North Sea near Europe and in the Mediterranean off the cost of Israel. While owning quite valuable oil assets under the ocean, the company’s stock has been in steady decline for years, as the company has encountered expensive problems developing their reserves, and incurred higher than expected costs along the way. Today their balance sheet is quite weak, with too much debt, and almost no equity or cash on hand for common shareholders. It is one of the most hated stocks on Wall Street honestly, after disappointing operational results, year after year.
So why do we own it in Relative Value? The logic revolves around the underlying value of the company given a spike in oil and gas pricing in 2012-13. In effect the company may get lucky, and be able to not only survive, but thrive with an escalation in energy selling prices. This position is very high risk, given flat to lower oil/gas pricing, but on the flip side has INCREDIBLE upside potential, given a sharp rise in oil RIGHT NOW. It’s kind of like buying a risky call option on oil prices, without having a predetermined expiration date. When we purchased shares in the low-$7 range, the ATPG position represented less than 3% of our portfolio. (Note: from an overall portfolio risk standpoint, even a low 3% weighting may be higher than the average investor should consider taking in ATPG.)
ATPG reported a year-end 2011 SEC pre-tax PV-10 value of $4.2 billion for proved reserves and $7.3 billion for proved and probable reserves compared to $2.6 billion and $4.8 billion respectively, at year-end 2010. After subtracting conservative estimates for total liability growth and development costs for production, today’s fully diluted sub-$700 million equity capitalization is quite low. You can review the ATPG 2011 10-K filing here.
ATPG’s undervaluation is a direct result of the massive short interest of roughly 30% of outstanding shares. Basically, a large number of investors are betting against ATPG remaining in operation, from its overleveraged balance sheet and capital intensive needs to actually drill and produce oil from the reserve category. While shorting ATPG was an intelligent strategy during a period of oil price decline, the math has CHANGED radically the last few months as the price for oil globally zig-zags higher. Moving off an ultra-low stock valuation in 2011, skyrocketing oil and gas prices in 2012-13 would help shareholders to truly “leverage” the underlying value of ATPG’s extensive reserves and future production.
ATPG also holds real takeover potential as oil and gas prices rise. A larger better-funded Oil company could refinance existing high interest debt to lower the cost structure, integrate the development and planning costs for future revenues in-house, while acquiring significant long-term reserves in safe, politically stable locations. All told, the potential reward vs. risk proposition in ATPG is just too good for us to pass up, understanding as a matter of fact this stock could go to zero in a year or two, if our judgment on oil prices is incorrect.
Much like the foot dragging policy by Democrats and Republicans regarding massive deficit spending from the U.S. government year after year, absent-minded world “leadership” has looked the other way as Iran has been busy developing a capacity for nuclear weapons. Just like the out-of-control government debt situation requires significant PAIN to fix, Iran’s near completion of a nuclear bomb has boxed the world into a dangerous choice in 2012. Do you want a painful conventional war in 2012 that costs thousands in innocent lives and a spike in oil prices, OR the serious threat of thermonuclear war in the Middle East hanging over the oil market indefinitely?
Sitting back and doing nothing is likely the most horrific long-term choice we can make. A nuclear arms race from neighbors Saudi Arabia, Iraq, Kuwait and Bahrain, with the potential for the loss of life of millions in 2013 or 2014 could be our future. The false choice of avoiding a war before the November elections, could have catastrophic implications for the world in no time flat. Either western leaders take away Iran’s nuclear material and capabilities in 2012, or we pass into a whole new, much scarier world. Oil prices will not decline from a nuclear armed Iran, but remain at a new permanent level of worry. What choice do we really have?
The real choice for oil investors is not whether an attack on Iran is coming in 2012, but how will Iran react to such an event. Will they accept the reality of being stopped in their push for nuclear weapons and greater political power in the world? OR, will they lash out and retaliate as their latest rhetoric threatens? Conceivably they could strike back at oil assets in neighboring nations for years, and increase terror attacks on American and Israeli interests. What would America do later in 2012 or 2013 after a major terrorist attack on U.S. soil? Plenty of questions with few good answers!
Federal Reserve Chairman Ben Bernanke during Congressional testimony in March 2012, basically said there was nothing he could do to lower gas and energy pricing (raising interest rates would do it by the way), and gave his blessing to a sharp jump in oil and inflation rates later in 2012. He is working under the delusion that higher rates of inflation will be a good thing, as nominal business earnings and tax receipts will rise, while high levels of existing debt become smaller in repayment, inflated dollars.
The downside of this thinking and all the PONZI money printing by the U.S. central bank is a spike in inflation will create massive new unemployment as a dislocation side effect and Uncle Sam will find it MORE difficult to refinance its enormous debt level from an explosion in interest expense. Pure MADNESS is my opinion of the direction we are headed. Inflation the last four decades has ravaged the savings base of past economic glory, and our leaders want MORE inflation, not less? The dirty little secret Bernanke doesn’t want you to know is deflation could be the answer to righting the economy long-term, extinguishing unpayable debts, enriching the savings base for the banking system, maintaining a realistic level of investment, and increasing consumption demand. Deflation saved America from depression many times in the past – it is a natural and cleansing economic phenomena. However, the overleveraged banks might get hurt for a few years? I will stop there.