When folks want the straight goods on the oil and gas sector
they go to Oppenheimer's sage Managing Director Fadel Gheit. That's
what we wanted, too, when we asked him to spend some time with
The Energy Report.
In this upfront interview, Gheit rails against government
inaction on oil price speculation and predicts low gas prices will
soon lead to more M&A activity. Gheit's market commentary is
frank and insightful and could certainly impact your investment
The Energy Report:
The oil spill in the Gulf of Mexico ((
)) continues to get daily headlines. Is the spill affecting the oil
price or only the prices of companies with exposure to the Macondo
The spill really did not have any impact on oil prices. Oil prices
are basically reflecting increased concern about global economic
growth and China slowing down its economy; Europe is obviously
having problems with the bailout of Greece and the expectation of
bailouts for Portugal and even Spain. That casts a shadow on global
economic growth and therefore demand for oil is likely to be a lot
lower than earlier forecasts. That's why oil prices came down from
$86 to $70. The Gulf incident really did not have any impact.
You have a perform rating on BP (
) and Anadarko Petroleum (
), two companies involved in Macondo. What is the rationale behind
Well, we have not changed our recommendation on [[BP]]. We
downgraded Anadarko because its exposure to future liabilities
relative to size is almost 1.5 times the impact on BP. It is less
financially flexible than BP, so BP can go and borrow $10 billion
and still have a relatively acceptable debt ratio while Anadarko is
pretty stretched out as far as its financial flexibility. They are
two totally different companies, but unfortunately they are in the
same boat. Their stocks have suffered significantly over the last
But at the beginning of May, well after the accident, you still had
an outperform rating on Anadarko.
Correct. Anadarko and BP both lost 29% of their market value in the
last month. I thought for a while that Anadarko could withstand the
pressure a little bit because it has tremendous upside potential as
far as drilling. But then a lot of people concluded, including
myself, that it has very high exposure to offshore drilling, which
is likely to enter a new phase of government regulations. That
would make it less appealing than it was only 30 days ago. That's
the reason for the downgrade.
In another May report you had EOG Resources (
), Pioneer Natural Resources Co. (
), and Occidental Petroleum Corp. (
) rated as outperform due to their lack of exposure to what's going
on in the GOM. Tell us about these companies.
By definition companies that have very large exposure to an
unconventional play are immune to what is happening in offshore as
a result of the oil spill. Companies like EOG have very little
footprint or none when it comes to offshore. It is going into
production in the U.S. and focusing on liquid production growth and
because oil is selling at a significant premium to natural gas. EOG
and the rest of the independent oil and gas producers have
increased their focus on growing their oil production at a much
faster rate than they had planned only a few months ago. That's one
of the reasons that we still like EOG. We still like Chesapeake
Energy Corp. (
). We still like Devon Energy (
). All these companies are basically or predominantly natural gas
but they are increasing their focus on oil.
Are there other buying opportunities related to the Gulf?
I do not follow services companies, but obviously increasing
regulations will force producers to use more services to do more
tests and be more careful going forward. Money will go to the
service provider, whether it's a helicopter company or companies
that do basic drilling platform maintenance to make sure that we
are safe and sound. There will be winners in the new era of
In another Oppenheimer report it's stated that investors dumped
companies with exposure to the GOM after White House comments
regarding a possible moratorium on new drilling. Nonetheless,
drilling in the Gulf continues. Might this be a good time to pick
up some of those companies?
Investors will shy away from companies that are making headlines
for whatever reason. But a company like Apache Corp. (
), for example, is the largest operator of shallow offshore
platforms and a very good operator. It has a clean track record.
Obviously the stock came down very sharply on the news that there
could be a moratorium on drilling and permitting. It also has a
pending acquisition of Mariner Energy Inc. (
), which is focused on deepwater prospects. A lot of investors
looked at the acquisition as negative and sold off. I like Apache,
it has a very good management team, a very strong balance sheet, a
very strong track record, too. It has become an investment
You were on MSNBC the other day talking about supply and demand
fundamentals in the oil price. In another piece you said that some
of the big financial players like pension funds, Goldman Sachs and
Morgan Stanley are manipulating the oil market. Can you tell us how
that works and what sort of role this price manipulation is playing
in the oil price right now?
I truly believe that speculation is driving or has driven oil
prices in the last four or five years. Congress believed it too
that's why there were hearings. I testified before Congress on that
subject. The CFTC (Commodity Futures Trading Commission) chairman,
who is a former partner of Goldman Sachs, believed exactly what I
believe. The question is can we get Congress to really limit
speculation by financial speculators. That becomes a tall order
because of politics and lobbying and all these sort of things. I
believe that if we put limits on commodity trading by
non-principals-basically the financial players-I think you are
going to see little volatility. I think you are going to see the
restoration of supply/demand driven markets instead of future
speculation driven markets, which we have right now and have had
for the last five years.
Do you believe the government will step in?
I'm not sure. Elizabeth Warren, who is overseeing financial
regulation in Washington, said publicly that the financial lobby
and the financial industry is extremely powerful. Basically, when
there are bought politicians on both sides of the aisle it becomes
really difficult for Congress to push through this kind of
regulation. The fact is even the CFTC chairman could not convince
Congress to impose restrictions because his own staff shut him
down. I am not hoping for change.
Are you saying that consumers can expect artificially inflated oil
prices for the foreseeable future?
It's not only in oil prices. We've seen it in real estate and look
what happened-we had the financial meltdown. We're seeing it in
commodities because of knee-jerk reactions, because of
misinformation, because of a lack of government regulation. It's
sad but this is the environment we live in. Government is either
incompetent or corrupt and they put us in debt as a result. Like I
said, I'm a realist; I don't daydream a lot. If we believe that we
are going to have (oil price) regulations, then we will be
In your view what should the oil price be?
Theoretically speaking, in my calculations I don't see oil prices
justifiable above $60. There is an old rule called the one-third
rule. Basically the replacement cost should be about one-third of
what the oil price is. Right now the industry replacement cost is
less than $20, so the commodity price should not exceed $60. This
rule has been in place for 30 years and we haven't really changed
much. Actually a company like Occidental Petroleum, they limit the
replacement cost of a barrel of oil to 25% of what they think the
price of the commodity is likely to be. Having said that, they'd
love to see $80-$90 oil but they'd like to keep the replacement
cost under $15.
What is Oppenheimer predicting for oil in the next six months and
then the next 12 months?
We really don't predict too much because if you play the game by
the rules and everybody else is cheating you're guaranteed to lose.
I don't enjoy losing so in our income model we tell people what we
fear and what we think. When we do our earnings estimate, we
basically link our benchmark to whatever the NYMEX is telling us.
If the futures index is telling us it's going to be $80 next year,
we use 5% discount on that number. Right now we're looking at oil
prices on average to be about $77 this year and about $80 plus
dollars next year.
How do investors profit from $75-$80 oil?
There are a couple of things. Stable or lower oil prices will
always favor larger companies like Exxon Mobil Corp. (
), British Petroleum, Chevron Corp. (
), ConocoPhillips (
) but if oil prices or natural gas prices increase significantly
for whatever reason, whether through speculation or market events,
investors usually flock into the stocks of the independent oil and
gas producers because they have a higher beta. On the way down they
decline the most and on the way up they gain the most. So I'm still
very bullish longer term on domestic oil and gas producers.
What do you see happening in the domestic oil and gas producer
I think two things will take place. The survivors will get bigger.
They will acquire smaller companies. Apache is buying Mariner at a
decent premium, but they will extract good value out of it. I'm
very surprised that we have not seen more mergers and acquisitions.
If natural gas prices remain close to the current level and oil
prices don't go much higher, I think we are going to see a lot of
pressure on the smaller companies that have been waiting for a
very, very big payday that might not come. These companies will
probably settle for a lot less than what they had in mind; we are
going to see a lot of mergers and acquisitions. As a result the
independent oil and gas producers are very ripe for the picking by
larger companies, whether domestic or international. And, as I said
before, that will create value. These smaller companies have real
growth. The larger companies have little or no growth. So I still
like the oil E&P (exploration and production) stocks. I think
this is the future. Investors are basically thinking the same way.
Are there any high percentage takeover targets that you're looking
Companies don't buy other companies for one or two reasons; they
want to see the best fit. They look at value, not necessarily what
they are paying for the company. I mean one plus two should not be
three. It should be 3.5 or 4 or even 5. Then you're creating
shareholder value. I would say most if not all the independent oil
and gas producers are potential takeover targets. It's unrealistic
to think all oil E&P companies are going to be taken over.
Probably 10% of the independent oil and gas companies-if oil and
gas prices don't move much higher from the current level-are likely
to be acquired over the next couple of years.
Are we more likely to see takeovers of onshore E&Ps? Offshore
E&Ps? E&Ps in the oil sands? E&PS in the Bakkens?
What's the focus going to be?
The consolidation onshore is going to accelerate because I don't
see any real spike in natural gas prices any time soon. It's going
to be survival of the fittest. We are going to see consolidation in
the major and unconventional plays whether the Bakken Shale in
North Dakota or the Marcellus in Pennsylvania or the Eagle Ford in
Texas or Haynesville in Texas and Louisiana. Timing will depend on
where the commodity prices are going to be six months or a year
You see most of the consolidation in the gas and shale plays?
Yes, because this is the area where people were betting on higher
prices that never materialized. Most of them are beginning to think
realistically. I mean don't hope for $10 gas because it's not going
to come any time soon. You have to readjust your valuation of your
assets so you're most likely to accept a much lower bid than you
had in mind. That's essentially what XTO Energy (
) did with Exxon. XTO is one of the largest E&P companies. It
basically set the tone for what to expect in futures mergers and
What sort of models are you using for the gas price?
Almost everybody thinks that gas prices at best will reach $6 in
two or three years. Might even reach $7 but that's about it. Any
higher prices would bring more supply because everybody has
perfected the technology-everybody. This is no longer an exclusive,
private club. The smallest of the companies drilling in Haynesville
or Eagle Ford or wherever can do a better job than the largest
player in that play. If prices rise, supply is going to come at a
much faster rate. The market will have to reach an equilibrium.
Every time we see higher prices, you're going to see more
production. More production will bring the price back down and so
forth. The $5 to $7 range is probably good for the next four, five,
A recent Oppenheimer report stated that replacing reserves at
competitive costs is by far the biggest challenge facing oil and
gas-producing companies. To what extent does this make secondary
oil companies more likely to be takeover targets?
This is the basis for our thesis that there are fewer and fewer
areas for the large companies to go. National oil companies have
taken over. They are no longer in the passenger seat-they are doing
the driving. The oil companies basically serve those companies.
Nationals want to pick their brains of the oil companies and give
Why is that?
Because there is no access to large resources anywhere in the
world. Iranco is just as good as Exxon or BP at drilling onshore.
It's their backyard-every rock and stone in the desert. Why would
they need an Exxon or BP or Chevron to share their wealth? Russia
is learning very quickly. Five years ago they were inviting every
company to go over there and invest a lot of money. They learned
the game. Now they want to play it, so they try to push companies
out. Venezuela! Hugo Chavez confiscated the assets of Exxon and
ConocoPhilips. The fiscal regime is getting tougher. Terms are
getting tougher. The profit per barrel in North America as a result
of these changes is now the highest in the world for the large oil
companies or for whatever companies. After all is said and done,
companies make more money per unit of production in North America
than in any of other country.
The last time you talked with us you talked about Exxon, Royal
Dutch Shell Plc. (
), ConocoPhilips and Chevron. Please give us an update on those
Conoco is undergoing major restructuring. They are selling some of
their assets. These steps will generate about $15 billion. They are
going to use $5 billion to pay down debt; $5 billion to buy back
their stock. The other $5 billion will go to capital spending,
growth projects, tactical acquisitions or to buy back stock. And to
increase its dividend because they believe growing the dividend at
a higher rate is appealing to shareholders.
Exxon is waiting for the final approval of the XTO acquisition,
which could be the catalyst needed to get Exxon on the right track.
Exxon stock has not done well at all in the last two years. The
acquisition is not really going to move Exxon's production or
reserves but it's going to double Exxon's gas production in North
America. It will basically give Exxon all the tools of horizontal
drilling, which XTO perfected, to use on a global scale. That's
where the growth is likely to come. Royal Dutch is basically going
through organization and cost saving measures to improve their
competiveness and lower their operating costs under new CEO (Peter
Voser). He used to be the CFO so he's focused on costs. I wish him
luck and he seems to be doing a good job.
Chevron has the second best stock performance among major
integrated oil companies. It has a very strong balance sheet with
very low debt, and a very high level of cash on hand. It has a very
rich portfolio of projects. They are progressing with one of the
largest natural gas projects in the world-the Gorgon field in
Australia. The gas in Australia is going to be converted into LNG
onshore and then shipped to customers in Asia. It's a $42 billion
dollar project-the largest in the company's history. It's going to
take four or five years to build. They have a lot of projects that
will be following this one, unfortunately they are mostly natural
gas, which is what most of these companies are focused on right
What are your ratings on these companies?
We have "perform" ratings on all of these companies, unfortunately,
they have been underperforming the market. Although the market so
far this year is down about 4% all these stocks are down on average
about 17% or 15%. The only stock that has outperformed the S&P
500 this year is ConocoPhilips. It's down but it's down less than
Are you more bullish on natural gas or oil producers at this point?
You have to recognize the fact that oil is trading at 200% premium
to natural gas. It's an undeniable fact. A lot of companies, if
they have a choice, will increase their drilling on oil deposits
instead of gas. They will keep gas until the price is right and to
them the price is not right. Why waste the resource in an
overcrowded and oversupplied market? Longer-term I think we should
all be more bullish on gas. It's cheaper. It's cleaner. We should
have plenty of it. The technology has been perfected by E&P
companies and now the big and mighty from all over the world are
coming to the U.S. to learn the technology at the hand of the
masters. The masters happen to be the small E&P companies,
whether it's Chesapeake, whether it's EOG, whether it's Range
). It is really the future of this country. It's a commodity that
relative to oil is undervalued and in more abundance now than oil
and less political, which is very important. If the blowout in the
Gulf of Mexico had been a gas field, we might not be in the mess we
are in now.
Who do you like among the independent gas producers?
We like Devon Energy a lot. Devon recently sold its offshore assets
and is now an onshore North American play. The safest you can get.
The most stable area you can do business in. The focus is mostly on
natural gas in the U.S. and unconventional oil, which is basically
the oil sands in Canada. They are using the most advanced seismic
deep technology, which is basically
processing. They produce oil by injecting super heated steam into
the deposit and collect the oil. They are already producing from
one project-Jackfish 1. They are duplicating it and have almost
completed Jackfish 2. They have a permit to do Jackfish 3. Each
project produces 30,000 barrels a day. Very profitable, very long
reserve life, clean technology and a very well-managed company.
Devon was one of the pioneers of horizontal drilling in the Barnett
shale. They drilled more horizontal wells than any other company so
they are expanding in other plays. The recent sell-off program gave
them over $8 billion, which exceeded the high end of the forecast
of $7.5 billion. The money is going to be split. Half of it is
going to go to share buyback, which will be about 15% of the shares
outstanding. The rest will be used to pay down debt. Two things
that are likely to push the stock price higher. The reason the
stock has not done much is basically because it's a predominantly
natural gas play.
Are there any thoughts you'd like to leave us with?
I think price volatility will continue. I think it's a shame that
the government knows what's going on and either does not want to do
or cannot do anything about it. I think market transparency should
be the norm, not the exception. I think it's the volatility that
really hurts planning and future investment. Companies do not know
how to budget if they don't know where gas prices will be a week
from now or a year from now or whenever. Unfortunately, financial
players can gain at the expense of consumers that have to pay
dearly for the commodities that they are using.
Fadel Gheit is a managing director and senior analyst covering
the oil and gas sector for New York-based Oppenheimer & Co. He
spent six years with Mobil Oil and five years with Stone &
Webster. He has been an energy analyst since 1986 with Mabon Nugent
and JP Morgan and has been with Oppenheimer & Co. Inc. since
1994. He has been named to
The Wall Street Journal
All-Star Annual Analyst Survey four times and was the
top-ranked energy analyst on the Bloomberg Annual Analyst survey
for four years. He is one of the most quoted analysts on energy
issues and has testified before the U.S. Senate and the U.S. House
of Representatives about oil price speculation, and is a frequent
guest on TV and radio business programs. Fadel holds a B.S. in
chemical engineering from Cairo University and M.B.A. in Finance
from New York University.
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