Oil and gas reserves around the world are growing scarcer by the
minute, and people are looking to their governments for answers.
However, leaders' responses are often motivated more by the desire
to boost approval ratings than by the need to find real, long-term
supply solutions. The individual investor may not have the power to
shift the tone of the emotional debates surrounding the oil and gas
industry, but he or she can devise a strategy to profit. Sprott's
Rick Rule, and Casey's Marin Katusa and Louis James sat down with
The Energy Report
to discuss what it means to participate in a politicized market and
how politics affect their buy and sell decisions.
The Energy Report:
When it comes to energy, hasn't the sector always been steeped in
politics? Or has the political environment made an even more
pronounced impact since the 1970s, for example?
Rick Rule:
I think energy markets are even more political now. When I was
growing up, the U.S. energy business still had a couple of federal
energy regulatory committees. It is really tough to comprehend how
badly they screwed up in the 1970s. They trampled and obliterated
every market they got into. It looks as though they intend to do
the same again. The political response always seems to be an
attempt to fix a problem after the market is well on the way to
fixing it itself.
We North Americans have been given a tremendous gift, which we
can now unlock through technologies that bring the total cost of
producing gas down substantially. We're going to enjoy a
substantial dividend from that. How that dividend gets spent will
not be decided in west Texas or northern Alberta. It's going to be
decided in Ottawa and Washington, D.C. That's really a shame,
because some of it's likely to subsidize inefficient consumption
and energy that wouldn't otherwise work.
|
""The theme, 'Navigating the Politicized Economy,' does
not only refer to regulatory burdens, but also to the overall
responses of governments around the world to the crisis that
we've been predicting for many years." - Louis James"
|
The government increasingly shapes energy markets, and rarely
for the better, which is truly sad. As an example, the political
discussion with regard to fracking is almost anti-science. Fracking
has become another "F" word, never mind that it has lowered our
cost of energy consumption by half. When critics talk about the
potential degradation of groundwater supplies, they suggesting that
the frack could somehow impart enough energy to channel through 2
kilometers (km) of very hard rock and pollute an aquifer that might
be 100 meters [M] deep. Such unfounded attacks could only happen in
a politicized economy.
Marin Katusa:
Another reason why U.S. energy markets are more politicized now is
that China's consumption is reshaping global demand. Meanwhile,
Russia still has a stranglehold over Europe's natural gas
production and distribution, and Putin has been to Israel three
times since he was elected this past spring, while Obama is yet to
visit Israel during his presidency. Now it's looking as if Russia
will become the largest investor for the liquefied natural gas
[LNG] facilities in Israel. America may save itself through its
ingenuity with shale technologies by being able to replace the low
labor costs with low energy costs from natural gas, but because of
the increased politicization, America is losing the global resource
advantage it once had.
Louis James:
Let me pull back to a bigger picture. The theme, "Navigating the
Politicized Economy," does not only refer to regulatory burdens,
but also to the overall responses of governments around the world
to the crisis that we've been predicting for many years. That's the
context, not just the minutiae of various enterprises and their
regulatory problems, which they all have. It's about how the world
is responding to crisis. The response is political and, as Rick
indicated, very feelings-driven. It's not a rational or scientific
way of optimizing outcomes. It's political, which means pandering
to voters, which means doing whatever the larger number of usually
less-informed people want, as opposed to whatever science or
engineering may determine is an ideal way to do something. That's
scary. How you deal with that is more of a philosophical than an
engineering question: How do you personally plan your life in a
world in which everything is more political every day? I think
everybody should be asking that question.
TER:
Marin, you pointed out in one of your articles that politically
motivated supply chain disruptions-related to military actions,
sanctions and such-affect the price of oil to the point that you're
projecting an increase in the baseline.
MK:
There are a lot of risks out there. A deposit such as Ghawar, which
is the greatest producing oil deposit in the world today, was
discovered 60 years ago. It is being depleted, but not replaced by
new discoveries anywhere near that scale. What if there's a
collapse or an engineering failure at the deposit? So many
technical and social issues can disrupt the production. If a
deposit like that goes down, what happens?
|
"It's always the time to invest if you find the right
companies. But it's important to understand that we are in a
'Pick Right, Sit Tight' energy market."
|
Remember, it's not the old seven sisters that are the largest
producers today, but rather politicized economies, the new seven
sisters, which are all national oil companies that produce oil from
deposits that the original seven sisters developed many decades
ago. They haven't brought in the modern technology and
entrepreneurship that Rick spoke about to enhance and streamline
these deposits. Another factor is that in a lot of these areas, the
major exporters are soon to become net importers. Already, about
half of what Saudi Arabia produces is consumed domestically, and
Mexico may be unable to export oil by the end of the decade.
TER:
But as the price a barrel of oil goes up, don't more oilfields
become economically feasible? And if that's true, does it replace
the supply that is no longer coming from Mexico?
MK:
No. No new wells coming on produce as much as Ghawar produces per
day. With North American shale, you have to pop out so many more
wells and perform many multifracks to produce even a fraction of
what a superwell in the Middle East does.
RR:
Marin makes an important point that warrants emphasis. My father
worked in Saudi Arabia in the 1970s, and they'd drill a 1,500-meter
well that would produce 50,000 barrels per day with no water at
Ghawar. This was truly a spectacular business, when a well that
cost maybe $1 million to drill would make something like
$4,500/day. That's about as good as it gets. The industry talks
about the recycle ratio, which is the amount of new oil that can be
discovered and developed on the operating margin from a barrel
produced. The wells that we're replacing those wells with-a very
good well today might have a 2x recycle ratio, whereas those wells
had maybe a 15x recycle ratio. So the industry has become much more
capital-intensive than it was, and the recycle ratio is lower.
Furthermore, the social take from global energy production,
which includes taxes, royalties and regulatory burdens, is much
higher: The rate per barrel climbs each year. In many jurisdictions
around the world, the game is over-they take 100%. And for years,
governments in countries like Mexico and Venezuela have diverted a
substantial
amount of free cash flow from their domestic oil industries to
subsidize spending programs.
In an industry as capital intensive as oil and gas, starving it
of sustaining capital impairs its ability to exploit assets for
much-needed oil. The catch-up spending necessary is truly
spectacular.
TER:
So in an increasingly politicized industry, is there any investment
opportunity? Is this the time for North American companies to shine
in comparison to cash flow-strapped producers in less friendly
jurisdictions?
MK:
It's
always
the time if you find the right companies. This is why I urge people
to be very careful and patient and to do their homework. The
sectorwide bull is not here right now. It's company specific. Rick
and I have talked about
Africa Oil Corp. (AOI:TSX.V)
for the past four years. We were the first ones to talk about it
publicly, finance it and recommend the company to investors. But
while Africa Oil has done fantastically well, the other juniors in
the East African rift are at the same price they were a year and a
half ago, at the peak of the junior energy market. This is why it's
important to understand that we are currently in a "Pick Right, Sit
Tight" energy market.
TER:
But oil has really been bouncing along pricewise in the same band
for a couple of years. It sounds as if it's about to break out of
the band.
RR:
I don't think it will break out anytime soon. There is a dichotomy
between domestic natural gas, which is keeping energy prices
moderate as regional crude oil markets are developing. We hadn't
seen such wide differentials before. For example, the market for
Brent, for international light sweet crude is quite high,
particularly relative to the price being paid for light sweet
medium crude, which is becoming landlocked and doesn't sell. You
have a series of regional markets.
|
"Volatile markets are very good for me. I like to buy
stuff when nobody else wants to buy it. In the 1990s, those
swings sometimes took years, and now they sometimes take
weeks."
|
MK:
There are price differentials even within the regional markets. As
a result, producers in the Bakken get a different price than
producers of the same type of oil in Eagle Ford. The discount
differential for Canadian oil is even larger. Distribution is
another factor. So just because oil went to $120 per barrel [BBL]
doesn't mean the oil company you invested in is getting $120/bbl;
what matters is what the company is getting on its netback. Again,
it's very company specific and more regionalized than people
realize.
LJ:
One more point-the speculative component to energy prices goes away
if the global economy visibly tanks. So the near term certainly
presents plenty of opportunities for lower prices, and this should
be seen as a buying opportunity for the very best picks.
TER:
Marin, last time we talked, you said that risk mitigation is the
key to success, but in a risky market like this, how do you do
that?
MK:
Many factors come into play. Louis and I have had the advantage of
working very closely with and being mentored by both Doug Casey and
Rick Rule, so I think the key thing is to first look at areas that
interest you. At that point, determine your risk appetite as an
individual investor and start doing your homework. It always starts
with the people. That's the most important "P" of the eight Ps. You
also have to look at what type of investments a company is doing,
its stage of development, its financial metrics and so forth. Risk
mitigation is complicated, but those are some quick and easy places
to start.
RR:
Another thing that many people can do to mitigate risk is hire
help. For instance, if you can have 40 people in the Casey
organization working for you six or seven days a week, and you get
that help for the price of a $1,000 subscription that you can
leverage against a $1M portfolio. It's pretty stupid not to do
it.
I agree with Marin that people are the most important factor,
but another key concern is balance sheets. In a capital-intensive
business, if you don't have any capital, you don't have any
business. That's it. Stop.
Beyond that, strong due diligence comes down to traditional
securities analysis. It's pretty simple in the case of oil and gas
juniors. You look at three things:
- Recycle ratio, or the amount of new production you can bring
on with the margin from prior production
- Reserve life index, meaning how many years of production
you'll get from a deposit
- Ratio of proved undeveloped to proved developed producing
conversion ratios
If you have those three things down, I wouldn't say it gets
easy,
but it gets doable. You don't even necessarily have to get them
right-just
closer
to right than your competitors. Risk mitigation just requires
knowing more than the people you're bidding against in the
market.
TER:
But you want to look at those sorts of things in any market. Do you
change how you invest in a volatile market?
RR:
I do. Volatile markets are very good for me. I like to buy stuff
when nobody else wants to buy it. In the 1990s, those swings
sometimes took years, and now they sometimes take weeks. The idea
that I get more frequent sales; in other words, there are more
frequent panics; this not anathema to me. It's nice for me. If the
market gives me the opportunity to buy something at a 50% discount
to what you think it's worth, I'm going to do it. As you get older,
if you're successful, you learn that sometimes stuff is cheap
enough. You don't wait for the absolute bottom. The fact that you
get these opportunities more frequently is good.
TER:
How about the sell side?
RR:
I've also had to be a more frequent seller. It used to be that for
successful positions my average holding was something like 70
months. In the last two or three years, I've had situations in
which every level of greed was fulfilled in three or four months. I
guess that's wonderful, but certainly the volatility you talk about
has changed my parameters.
TER:
Do your stock picks differ in a volatile market?
LJ:
I'd say that when the risk appetite in the market changes, it
changes what kind of investments we recommend. Volatility is our
friend for the reasons Rick outlined. If you want to shoot for the
50-baggers or 100-baggers, you're not going to get them on
multibillion-dollar companies. That means taking chances on a large
number of earlier-stage companies.
But higher volatility generally means more risk aversion. Under
those circumstances, we look for less-risky plays; a development
story rather than a grassroots story would be more appealing. The
share price trend in development-stage companies is well
established: Share prices spike on the discovery, decline during
the boring engineering phase and then come up as the company ramps
up to production. It's what Marin calls the pregnancy period, the
nine months up until first pour. It's a very reliable trend. If you
can find a company with no discovery risk, with all the technical
risk addressed, with the right people and a real project that will
produce, the chances are very high that its stock will go up when
it goes into production. So we'll look for much lower-risk
investments of that nature when people are more risk-averse, which
perversely tends to be when the market is more volatile.
Logically, the math says stick with the plan, but if you broaden
it out, you can capture more spectacular wins. It doesn't take many
100-baggers to pay for all the ones that didn't work out. This is
basically what Doug Casey does, but few people have that
discipline. But few people have the discipline to do that, so we
tend to alter our recommendations when people are more
risk-averse.
MK:
A volatile market doesn't change the way we evaluate companies. It
changes the way we
execute
on the information.
Disclosure:
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not
receiving compensation for it. I have no business relationship with
any company whose stock is mentioned in this article.
See also
Don't Expect Teekay Tankers To Have Good News In
2012
on seekingalpha.com