Oil and Gas Services Avoid Geopolitical Risk: John
Stephenson
Source: Zig Lambo of
The Energy Report
(1/17/12)
http://www.theenergyreport.com/pub/na/12303
With oil reserves less and less accessible to western majors,
producer stocks can carry significant geopolitical risk. In this
exclusive interview with
The Energy Report,
First Asset Investment Management Inc. Senior Vice President John
Stephenson explains why service-oriented companies are smart
selections for risk-averse energy investors. No matter what
happens in the oil and gas business, the companies doing the
drilling have solid prospects in this market environment.
The Energy Report:
2011 was a pretty exciting year with oil prices all over the map,
largely fueled by the European debt crisis. What do you expect
are going to be the hot topics affecting energy commodities in
2012?
John Stephenson:
The spread between Brent and West Texas Intermediate (
WTI
) prices, which was a big story in 2011, will continue to play a
role. I expect a lot of talk about how WTI has once again resumed
its place as the global benchmark. Another big topic, as it
always is, will be the continuing geopolitics of oil, be it a
possible Arab spring in Saudi Arabia or Iran's nuclear program
and how that impacts the world. In terms of possible black swan
events, the Environmental Protection Agency (EPA) or other
regulators could limit horizontal drilling and fracking. However,
that could be very positive in the short run for natural gas
prices.
TER:
What caused the big spread between the WTI and the Brent
prices?
JS:
Everyone used to look at WTI as the main global benchmark for
crude oil prices, and Brent historically traded at a slight
discount. Then, over time, Brent started trading at a premium to
WTI. What people have to understand is that these benchmark
contracts specify grade and location. The delivery location of
the WTI crude contact is Cushing, Oklahoma. Because it's
landlocked, you can't get crude in from the Gulf region, which
actually traded in line with Brent. There also wasn't enough
pipeline capacity to get the large inventories of crude that had
built up in Cushing out to other global markets. So it really was
an infrastructure issue that caused the price spread. Now,
various companies have gotten together and proposed pipeline
alternatives that would alleviate this glut of oil at Cushing.
Therefore, you've seen the spread go from $25 to about $11.40,
where it is today.
TER:
Your management company, First Asset Investment Management Inc.,
manages a variety of different commodity-focused funds. What is
your 2012 energy outlook?
JS:
Our outlook is very supportive and positive for oil. One of the
interesting things about oil is that despite the dire headlines,
mainly out of Europe, oil has held in as well as it has. In fact,
it's been hitting eight-month highs recently. Why is that? Partly
because demand is so strong. We saw record demand globally in
August and near-record demand in October and November and
continuing strong demand despite the fact that Europe appears to
be dipping into recession and growth is potentially slowing a
little in Asia. This is why I'm very positive on this and expect
to see oil go higher.
Natural gas, on the other hand, is very weak. It's
sub-$3/million cubic feet (MMcf) right now, and I think it will
continue to be weak. Historically the period between December and
March is when natural gas trades at a premium to its summer
prices. This is actually the first winter I can recall seeing it
trading at a discount.
TER:
Weak natural gas prices are a result of increased shale gas
production through fracking, which has created a significant
oversupply in the last year or so. Is this going to continue, do
you think?
JS:
Yes, the U.S. has 200-250 years of reserves of shale gas at
current production rates. I don't see any reason at all for it to
change unless, of course, the EPA or someone else were to rule
that fracking was detrimental to the environment and there was a
moratorium placed on drilling. That could be a black swan event
and could change things. If things continue the way they are,
there's no doubt that prices will stay low. Now, clearly, there
is some opportunity to export this, but that means building a
liquefaction terminal, probably on the Gulf Coast or some other
part of the country where people are willing to have a
liquefaction facility. That would turn natural gas into a liquid
to be transported to Asia or potentially to Europe, where the
prices are much higher than they are in North America.
TER:
So even though we may have hit peak oil, we certainly haven't hit
peak gas.
JS:
No, I don't think we've hit peak gas. Four years ago, the talk
was that we were running out. They were going to build terminals
on the Gulf Coast to take liquefied natural gas from Trinidad and
other places, gasify it and put it in the U.S. pipeline system
and supply the northeast in particular with natural gas. Now
we're finding we have so much of this stuff in various shale
deposits that we have the potential to become a huge energy
exporter. Hopefully that will be the case, but for now we don't
have the infrastructure in place to make that happen.
TER:
In some respects it's a happy turn of events compared to previous
supply concerns.
JS:
Not if you're a producer of natural gas, but if you're a producer
of oil, it's great. If you're a consumer of electricity, then
it's great.
TER:
As far as your portfolio selections and your outlook for this
year, you're clearly leaning much more toward oil and gas
liquids. What other factors do you think are going to be
affecting prices this year and into the future?
JS:
What impacts prices for commodities is supply and demand. I think
you're going to see that demand continues to grow. The reality of
why we've hit record world demand is not because consumers in the
U.S. are doing so much driving. It's rather because consumers in
Asia are doing so much driving. China is now the number-one car
market in the world. Who would have thought? If you look at total
energy consumption, including coal and other sources, China has
overtaken the U.S as the number-one consumer of energy in the
world. That trend will continue and put upward pressure on oil
prices over time.
The other theme that I think is important for investors to
understand is that most of the majors have had real trouble
finding replacement reserves to keep producing at the same level.
Most of the industry has run from one country to another, where
they've been kicked out. When Lee Raymond was running Exxon, he
ran over to Russia, then to Nigeria, then Venezuela. The
settlement that Venezuela was willing to offer Exxon for its
assets was a pittance. This is typical of what we're starting to
see around the world. It's very hard for most of the majors to
find new reserves and to continue to produce at the same levels
because most of the world that has energy is not open or friendly
to the West. This creates a huge problem for these companies.
Given that backdrop, investors need to find companies with
reserves in geopolitically stable locations, or where companies
are not in the business of generating the reserves; they're in
the business of helping oil companies produce those reserves.
That leads you to the service sector, which I think is a
lower-risk area. Investors can stay in North America and invest
in companies they know and understand without worrying about
geopolitics.
TER:
What are some of the names that you like in the service
sector?
JS:
I think if Saudi Aramco, the largest oil company in the world, is
going to do a job and it's going to produce a new field, it will
call in Halliburton Co. (HAL:NYSE) or Schlumberger Ltd.
(SLB:NYSE). It's not going to call in Exxon Mobil Corp.
(XOM:NYSE). It doesn't need Exxon's expertise or capital. But it
does need Halliburton's or Schlumberger's expertise. These global
majors are going to do well on the service side. In the last
25-30 years, the industry has gone from positive bullish cycles
to bearish cycles. The people who had the expertise in down-hole
seismic techniques, who understood how to operate drill bits at
various angles and how to cement and case wells and all of these
other things became outsourced to the service industry. The true
oil business expertise is in the service industry; that's why I
see it as a sound investment.
TER:
So if I may make a mining metaphor, it's the guys that supply the
shovels to the miners that are going to make the money, not
necessarily the miners.
JS:
Absolutely. It's the California Gold Rush all over again, except
it's the global energy rush, and you want to be in the picks and
shovels business, not necessarily in the prospecting business
laying claims. If you're a Western company and you're laying
claims, chances are you're laying claims in some part of the
world that doesn't want you there and that may kick you out down
the road. Then what do you have?
TER:
What are some other companies in your portfolio holdings that you
particularly like at this point?
JS:
One area to look at is the smaller energy service companies, like
Calfrac Well Services Ltd. (CFW:TSX) and Trican Well Service Ltd.
(TCW:TSX). Again, there is an increasing amount of drilling
that's happening, even on the gas side. It's just happening with
these new horizontal drilling and fracking techniques. These are
the guys who supply this equipment. That's very strong.
I also think you want to look at the oil companies that don't
have problems with reserves and short reserve life, including
some of the Canadian oil sands producers. I would recommend
Suncor Energy Inc. (SU:TSX; SU:NYSE) and Canadian Natural
Resources (CNQ:NYSE; CNQ:TSX). These stocks are cheap. They're
trading as if oil were $55 or $60/barrel (bbl) when it's over
$100/bbl. These low valuations offer a great opportunity.
TER:
Looking at your portfolio in your First Asset Energy and Resource
fund back at the end of last quarter, Sept. 30, you were about
78% in cash. Was that a strategic decision? Have you changed that
cash into equities at this point?
JS:
No. We were very defensive at that time, and I think the reason
was pretty simple: Europe was blowing up and when any major
economic zone is blowing up, I don't think you want to be in
commodities or commodity producers. Now we're seeing that the
market has stabilized, and you're going see growth going forward.
Valuations certainly never got ahead of themselves in either
individual stocks or in any energy sector, so I expect valuations
to move higher at this point.
We're no longer at that same cash level. Our position at that
time reflected an overall nervousness about the world. When you
have these dominant issues, you need to take your money off the
table, which we did. Ultimately, the trade was to the downside,
and we preserved value by doing that. I'm very proud that we were
able to raise so much cash and be truly defensive at a time when
the market was dropping quite substantially.
TER:
Are there any of your other attractive portfolio holdings that
you'd like to discuss at this point?
JS:
I think in terms of other commodity themes that are working well,
certainly Freeport-McMoRan Copper & Gold Inc. (FCX:NYSE)
would be a great name-that's on the copper side; it is the
largest pure copper producer out there. On a similar vein with a
little bit better growth and a little bit more sensitivity to the
market-meaning it will move a little more dramatically than the
market itself-would be First Quantum Minerals Ltd. (FM:TSX).
That's another name that I think does very well.
We haven't talked a lot about the agricultural names. If we're
talking about the broad resource base, it's been a tough time in
the agricultural space, particularly for the fertilizer
companies. But I continue to think Potash Corp. (POT:TSX;
POT:NYSE) looks attractive, especially at this level. Agrium Inc.
(AGU:NYSE; AGU:TSX) looks attractive at this level. It's a little
more defensive than Potash. The Mosaic Company (MOS:NYSE) has
struggled. I would probably recommend CF Industries Holdings Inc.
(CF:NYSE) over Mosaic. Those are the areas that I would look
to.
Also, in terms of other oil and gas producers, Canyon Services
Group Inc. (FRC:TSX) does well. Transocean Ltd. (RIG:NYSE;
RIGN:SIX), a big supplier of offshore platforms, will do well in
this environment. Even Baker Hughes Inc. (BHI:NYSE) is
transitioning its fleet to more horizontal drilling from straight
vertical drilling. Those are all names that we have held and will
continue to hold in the future and expect to do well.
TER:
To sum things up as far as the energy outlook for 2012, what
would you like to tell us?
JS:
I would say that energy remains the most important of all the
commodities. It will be the most important in 2012 and likely in
2020. Even though we're over 100 years into the energy era, we
are still very much dependent on oil. While it may seem expensive
when we're filling up at the pump or when we look at the futures
prices, it's still cheaper than orange juice on a volumetric
basis. There is no substitute for oil, at least no good
substitute. There is no technology right now that is commercially
viable enough that could change the industry in the way that
horizontal drilling and fracking changed the natural gas world.
So I think you're going to see oil prices move considerably
higher.
Demand no longer is being driven by America; it's being driven
by Asia and predominantly by China. That trend will continue. In
many parts of the world where demand is growing the fastest,
namely the Middle East as well as some parts of South America and
Asia, fuel prices are subsidized. In an environment where
gasoline prices are subsidized, the consumer isn't feeling the
full impact that we feel here in North America. So for those
reasons, I think we'll see oil prices move higher, stay higher
and exit 2012 at least $130/bbl. Natural gas prices, on the other
hand, will remain range-bound in the $2.50-3, maybe $4, range.
It's very hard to see a successful investment strategy for
investors there, other than with the service companies that are
going to be the beneficiaries from all of that drilling.
TER:
I think that pretty well sums it up. We appreciate your thoughts
and input today.
JS:
My pleasure.
John Stephenson is a senior vice president and portfolio
manager with First Asset Investment Management Inc., where he is
responsible for a wide range of equity mandates with a particular
focus on energy and resource investing. He has been recognized by
Brendan Wood International (BWI) as one of Canada's 50 best
portfolio managers for the past three years. He is the author
of
The Little Book of Commodity Investing
(John Wiley & Sons, 2010), which has been translated into
five languages and
Shell Shocked: How Canadians Can Invest After the Collapse
(John Wiley & Sons, 2009), and writes a free bi-weekly
investment newsletter,
Money Focus,
which reaches a global audience of more than 125,000
(www.reportonmoney.com).
Stephenson is regularly quoted by Bloomberg News, Reuters,
The Associated Press,
The Wall Street Journal
and
The Globe and Mail
and is a frequent guest on Bloomberg TV, CNBC, CNN, Fox
Business and Canada's Business News Network (BNN), Sun TV and the
CBC. He is frequently the keynote speaker at investment
conferences throughout North America. Stephenson holds a degree
in mechanical engineering from the University of Waterloo, an MBA
from INSEAD, as well as the Chartered Financial Analyst (CFA) and
Financial Risk Manager (
FRM
) designations. He lives in Toronto.
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DISCLOSURE:
1) Zig Lambo of
The Energy Report
conducted this interview. He personally and/or his family own
shares of the following companies mentioned in this interview:
None.
2) The following companies mentioned in the interview are
sponsors of
The Energy Report:
None. Streetwise Reports does not accept stock in exchange for
services.
3) John Stephenson: I personally and/or my family own shares of
the following companies mentioned in this interview: None. I
personally and/or my family am paid by the following companies
mentioned in this interview: None.
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