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Newsletter #14: May 2, 2008
Crunch Time
Time for Natural Gas
Current Oil Outlook
It IS the dollar!
First the April numbers. The EIS portfolio was up 11% for the month, about the same amount as the oil and services indexes, a bit better than the S&P. Year to date being up 8% is good relative performance. About 3% of it was due to the options on futures strategy.
I added an option on some late 2011 natural gas futures contracts. I also disposed of most oil E&P stocks in anticipation of a pull back in the oil price. A fuller discussion of my sense that oil may be in pull-back mode for a while was posted here.
Crunch Time
It’s looking increasingly like Crunch Time for oil will be in effect during the 2010 to 2016 time frame. I’m being optimistic in forecasting an end date for it, but the starting time is, if not etched in stone, predictable with some substantial certainty. If any new reader wants to understand why supplies will diminish sharply around 2010, click on megaprojects, Mexico, Saudi Arabia, Russia, oil demand, and oil supply. You should be up to speed in about half an hour.
Crunch Time is when global supplies will start diminishing while demand is still trying to grow. It’s when the price of oil will move into the stratosphere as poor countries and poor people are priced out of the market and competition for oil is mainly between the wealthy. As I’ve analogized before, it will be similar to the competition for waterfront real estate in Palm Beach. And you know the price of that.
Prior to 2010 oil supplies should be able to grow somewhat, or if not grow at least compensate for the decline in older fields. After what I suspect will be a successful near term test of the $100 support level, the oil price should continue edging up, perhaps exceeding $200 by the end of 2009. But just as $100 oil is now starting to look like a bargain after we’ve seen oil pushing $120, so will $175 oil seem like a bargain when oil is trading at $200, etc.
The reason I suspect that Crunch Time may last only for about five years after it begins is that a number of new trends now being formed are likely to hit the market place in sufficient scale starting around 2015 to have an impact collectively. All of these trends will get stronger over time. They include:
- Substantial new oil supplies from Brazil and Khazakhstan. Also possibly from Nigeria, Iraq and Mexico.
- Scalable cellulosic ethanol capacity
- Substantial changes in the car fleet toward more plug-in hybrids and fewer gas hogs
- Adjustment of populations to depend more on mass transit, less on cars
- Adjustment of industrial production and distribution from trucks to rail
All of the above is, of course, a hazy – and, as I said, optimistic - guess. Nobody can know the timing or exact impact of these inter-related mega-trends. It’s like forecasting a battle among resurrected dinosaurs whose general dimensions are known but whose battle strategies and skills are not. But even though we cannot be certain about dates or degrees of difficulty, given the awful human dimensions of the oil shortage we will face I think it is incumbent on us to start making educated guesses about the future in order to increase the chances that as a society we might finally do something intelligent to mitigate it.
Time for Natural Gas
Natural gas sells for about half the price of oil on an equivalent BTU basis, plus it’s cleaner burning, thus causing less environmental impact. Not only is gas a better bargain and better quality product than oil, but gas demand also “sports some strong fundamentals.” North America gas supplies may come under pressure over the next few years as demand increases for fertilizer and as natural gas usage in transportation and electrical generation increases.
Overseas, natural gas demand strains can be sensed in the fact that recently Iran has gotten bids from China, India, and Switzerland to finance their gas projects in contravention of U.S. efforts to isolate Iran. The willingness of such countries to ignore strong U.S. pressures indicates how important new gas supplies are to them and perhaps - in the case of Switzerland, which may be acting as a proxy – to other unnamed countries.
Chris Skrebowski recently indicated that the availability of sufficient gas to supply Europe, particularly after 2009, is looking increasingly precarious. The short story is that the visibility of sufficient supplies of natural gas in Europe and Asia, given current trends, is a little hazy. The implication for North American gas is that Europe and Asia will give us stiff competition for LNG shipments. I have also recently posted a number of pieces (found here) indicating such intensified competition. The impact of competition for LNG, obviously, is that it would tend to boost the North American price of natural gas.
The price of gas in Europe and Japan is already much higher than it is in North America. My sense is that the North American price over the next year or two may appreciate more rapidly than oil prices. Therefore I have tilted my stock portfolio toward the gas side. You may notice that for the first time XTO Energy is one of my top five holdings. Moreover, as mentioned above, I have added to my options-on-futures portfolio a long position in late 2011 natural gas.
Current Oil Outlook
What about the near term outlook for oil? There’s been a lot of talk about why oil is “so high” – how much of that is due to speculation and how much to the weak dollar. I suppose the rest must be caused by supply and demand.
In that regard, recent postings include evidence of very high Chinese use of oil, weak supplies from Russia and OPEC, increasing domestic demand among oil exporting countries, and rapidly declining production at Mexico’s giant Cantarell field. On the other hand, to the extent this information relates to the supply side it should have much more impact on the out years (the Crunch Time) than on today’s market.
Here are some comments from one man in a position to know the fundamental forces acting on the price of oil, Chevron CEO David O‘Reilly as interviewed in The Wall Street Journal on May Day. You can read the whole interview here.
WSJ: Gas use in the U.S. is down. Do you see signs of that happening elsewhere?
D O’R: No. I was in Turkey a couple of months ago. The price of gas is almost $11 a gallon. They’re selling a record number of automobiles. Traffic is backed up all over Istanbul.
WSJ (paraphrased): What about cellulosic ethanol?
D O’R: It’s years off yet.
WSJ: When you hear politicians talk about oil independence, what’s your reaction?
D O’R: Unrealistic.
WSJ: Won’t ever happen?
D O’R: No.
O’Reilly credits booming global oil demand for the rise in oil prices. Is he right?
It IS the dollar!
I wrote about the role of speculators recently. My take, the short version: the best reason to think there has been some speculative push to recent oil prices is that most of the really scary facts about oil supply (the Saudi decision to stop building capacity, Mexican decline, Russia peaking) have their greatest impact in the out years more than today. So that suggests speculation.
What about the dollar? Well, if you measure the price of oil, a global product, in dollars as we in the U.S do, then fluctuations in the dollar must by definition impact the dollar price of oil. Here’s a chart from the U.S. Energy Information Agency that shows how much of a difference the currency valuations have made since 2001:
![clip_image002[13]](http://www.energyinvestmentstrategies.com/wp-content/uploads/2008/05/clip-image00213.jpg)
This chart clearly shows that oil has not been getting more valuable in absolute terms as measured against gold. Rather, all currencies have been depreciating compared with both gold and oil – but the dollar has depreciated more than the euro.
Hmmm. Could this be a reason why the OPECers are not pumping more oil but rather are saying that it’s all the fault of speculators? Maybe what they really mean by “speculators” is not the traders or their customers in a personal sense, but rather that the markets simply don’t think currencies are such a hot thing to own compared with certain truly useful things like oil.
I imagine that a chart of oil vs. copper or wheat or the stock of First Solar would show the same lack of appreciation in the price of oil that the chart of gold vs. oil shows because all these things have appreciated substantially compared with a dollar bill. On the other hand, oil vs. U.S. residential real estate or oil vs the value of an hour of labor outside the executive suite - things that have depreciated against the dollar - would show a full hockey stick shaped chart.
So what are we to make of this? Is it helpful? I think it is.
1. It tells us that the U.S., the most profligate oil consumer in the world, where humongous trade and budget deficits have become the financial theme of the Bush years, now pays the same price for oil in gold-adjusted terms that it paid in 2001. Meanwhile the Europeans, with fairly balanced budgets and far lower oil consumption per capita also pay the same in gold-adjusted terms for their oil but they pay about half the increase that Americans do in terms of their own currency.
2. It suggests that the world is in fact reasonably well supplied with oil as OPEC has stated since the price of oil in terms of gold has not risen, but
3. It also suggests that oil – unlike a residential house, an hour of labor, or a flat screen TV – is in sufficiently tight supply that it is failing to lose its value in the face of a currency that is depreciating much more rapidly than other currencies (which are also depreciating) compared with gold, and finally
4. It tells us that when the price of oil begins to appreciate vs. gold we will know for sure that demand is seriously outstripping supply.
As an energy investor, all this is a little humbling. It suggests that if I had invested in stocks related to virtually any commodity when I started investing in oil stocks I might have done just as well or better because all the commodities have appreciated against the dollar.
But I’m not about to give up on energy. If I’m right in my view as discussed at the start of this letter about the next seven or so years, oil and natural gas will begin to out-perform gold, agricultural commodities and, especially, base metals. That’s because the supply of oil, unlike supplies of gold or the other commodities, will stop increasing and will start declining in absolute terms. That will make all the difference.
Meanwhile demand for base metals is likely to crash because the declining supply of oil is likely to cause a stagnating world economy. Economic stagnation may possibly be exacerbated by a financial crisis if my views about Crunch Time are more or less correct. Not a happy thought, sorry to say.
Best wishes,
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18 responses so far ↓
1 paultaut // May 2, 2008 at 10:34 pm
Back when the first engineers took at look at Iraq’s infrastructure within the oil complex, they found antiquated machinery. BUT they also discovered a lot of water mixed with the oil…unless new fields are found in Iraq, enhanced recovery techniques will only hasten their depletion…do not look to Iraq for help.
Oil did a number on gold today…
If the US doesn’t slide into a recession, then oil usage forecasters will have to revise the downward bias already built into the oil markets. I think that realization occurred today.
The checks will probably allow consumers to use more oil than they would have. The various ideas being floated around congress, especially, the elimination of the Fed tax on gasoline will only increase demand at a time when demand destruction is needed.
I expect that before too long, The US Government will suspend the various blends of gasoline sold across the country…national emergency….just for the duration of the tight conditions…reduction in price, greater usage.
I believe this was also done after Katrina.
Everything the Politicians are doing right now is geared to prevent a deeper slowdown…if they succeed, it will only accelerate the price of oil…once it is used, its gone.
2 Peter Wenzl // May 3, 2008 at 4:46 am
…interesting thoughts, Jim – thanks! A few comments….
Regarding appreciation of oil vs. gold: when oil demand starts to seriously outstrip supply, widespread inflation caused by a surging oil price could increase the attractiveness of gold as a “save haven”. I’m thus wondering to what extent the surging price of oil might take gold with it. Perhaps the price ratio between the two might not change all that much, and appreciation of oil vs. gold may not be a sensitive indicator of the effects of peak oil starting to descend upon us. I’d guess appreciation of oil vs. a basket of base metals might be a more sensitive indicator because if scarcity of oil starts inhibiting economic growth, the prices of oil and base metals are likely to move in opposite directions. It could be interesting to chart this ratio over the last few decades, including the seventies and eighties?
Regarding your comment that oil will outperform other commodities: I’ve some doubts in the case of agricultural commodities, because agricultural production per capita may be close (or already beyond) its own peak (would be interesting to look at the stats). The improvement of crops (breeding) and agricultural practices may be unable to keep raising agricultural production sufficiently to compensate for the effects of population growth, the decreasing availability of arable land, the potentially decreasing energy (oil) input into agriculture, and the decreasing availability of other inputs such as water for irrigation and fertilizers (not only nitrogen produced from natural gas but also phosphorus, which is already beyond its own world-wide peak). In addition, investment in agricultural research has been in constant decline since the early nineties, and any new investments are likely to take many years to translate into improvements in the field. These improvements may be marginal and slow because there are biological limits to how much the yield of crops can be improved further. So I’m wondering whether “peak food” (in per-capita terms) could become an even more serious issue than peak oil, and whether the price of agricultural commodities might thus outperform that of oil, because after all crude oil is not very nutritious…
3 Charles // May 3, 2008 at 7:57 am
Jim,
I think your overweight of natural gas is the correct move in this environment, I have been overweight natural gas in the portfolio I run since mid-January. I am currently allocated at about 60% natural gas when the composite I benchmark against is closer to 25-35% natural gas. XTO is a great company and has excellent financial and fundamental valuation but I would look into a few other companies also, namely Chesapeake (CHK) and Southwestern (SWN). (EOG, HK, and DVN are also interesting plays) From what I have been able to conclude Chesapeake and Southwestern have better onshore shale exposure to large reserves than XTO does. I could be wrong but the growth potential doesn’t seem quite as high for XTO as it is for CHK and SWN.
The chart above is very interesting, I ran into it about two weeks ago on Seeking Alpha but I tend to think some of the logic regarding this graph is skewed. Many people will look at that graph and believe that crude should be around the $70-80 level. I believe this is inaccurate because thats against a currency (the euro) that has appreciated wildly since 2001. If you also graphed oil in regards to a currency that has held stable I believe you end up with an oil price in the $90-100 range. This obviously isn’t as drastic of a gain as $120 but it is still way up from the beginning of 2001.
Your point about crude not yet appreciating against gold is a great one, and I agree completely that this is bound to happen in the near and long term. (probably in your 2010-2016 range and maybe even longer) All in all this newsletter does a great job at putting things in perspective for all of us who have an interest in energy, thanks for you hard work.
Charles
4 ellwodo // May 3, 2008 at 10:33 am
I couldn’t agree more on overweighting natural gas and I also agree with the comment to look at CHK. Read the transcript of their conf call Friday. I think their “story” has all the other nat gas E & Ps beat. You also have to admire the enthusiasm of its chairman who has made over $100 million of open market purchases of its stock so far in 2008. (Disclaimer: it’s one of my biggest investments.)
5 K. Vora // May 3, 2008 at 11:12 am
Jim,
We do not buy gold to eat or go to work. Nothing happens to us if gold goes to $10,000 tomorrow, try oil at $1,000 a barrel overnight and we will totally despin.
Parity in oil and gas only means both are equally expensive and the reality is that average American’s wages have not grown to maintain the same parity. Since 2003, oil has nearly quadrupled and the real cost of living has gone up significantly, but not the wages have nearly been stagnant.
Yet we drive, we burn oil and gas as nothing has changed. Either we are all making money outside of “wages” or we are borrowing from future. Either way, we are heading to a fiscal crisis similar to depression, and frankly nobody would give a damn about oil or oil price, they will simply steal or kill.
I think of the scenarios of movies Mad Max and Blade Runner together, if something like that is possible.
K. Vora
6 Alan Beattie // May 3, 2008 at 12:02 pm
Thoughtful and professional update, although I think there are some causal factors & opinions missing and some different “take aways” from the data. Moreover I believe there needs to be considerable amplification.
Missing factors & opinions:
Near-term:
- It’s hard to determine exactly how robust the shift in national energy policy will be, come this next Presidential Inauguration. What is clear beyond reasonable doubt is that this administration has not just ignored Renewables and pampered Fossils, they have overtly squashed any potential breach of the oil/coal/gas dominion, virtually to the point of criminal negligence. The new enlightened policy will have profound effects on the global energy paradigm;
- Consider the “Siren” sounded by Fatih Boril in his recent interview with Astrid Schneider. Dr. Boril is Chief Economist & Head of the Economic Analysis Division of the International Energy Agency. Can be accessed at:
file:///Volumes/Drive%202/Projects%20G5%204:10:08/Investments/Solar%20Power/Peak%20Oil/IEA%20ALARM%205:2008/Fatih%20Birol%20(IEA):%20′Leave%20oil%20before%20it%20leaves%20us’.webarchive
Unlike the relative platitudes issuing from the cooked books of the US Energy Information Agency (Bush appointees), this gives a much more sober view of the next couple “Crunch” years;
- 80% of current global oil reserves are controlled by national oil “companies” who have no interest in boosting supply;
- The largest private energy corporation in the world (XOM) has made it clear that they will not be expanding current annual production through the end of 2012. They are more interested in stock buybacks than further development. They are essentially in liquidation mode. Another not-so-good factor for “Crunch Time;”
- The corn ethanol catastrophe is so… well catastrophic, that it will most surely be unraveled in the next year or two (to avoid massive global starvation), which will remove approximately 10% of already dwindling supplies;
- The global demand side is virtually inelastic because of the rapid expansion of China, etc. and their policies of price subsidies. No possible downturn in Western economies will make up for their exploding demand — remember, a bad year for China is 8% growth.
Mid-term:
- Getting at the “substantial new oil supplies” in Brazil, Khazakstan and other locals is wishful thinking at best. For instance, the massive deep water reserves off Brazil are at depths far deeper than anything that has ever been attempted. See:
file:///Volumes/Drive%202/Projects%20G5%204:10:08/Investments/Solar%20Power/Peak%20Oil/Deep%20Water/BRAZIL%20OIL%20TRAPPED%20BY%20500-DEGREE%20HEAT,%20SALT%20BARRIER.webarchive
And even if that nut is cracked, the cost will be prohibitive, even at over $200/bbl;
- As for cellulosic ethanol, the “energy return on energy invested” (sometimes called EROI), is so hopelessly low that it will never be a viable option for energy, given the rapid cost reductions in different Renewable energy technologies.
Different “take aways:”
- “Houston, we have a problem.” The near-term supply/demand balance is going to go so far out of whack so soon that it’s hard to predict the consequences, other than that they will be profound;
- “Trading” in oil service companies and natural gas is an excellent short-term play but not long-term investment — they are depreciating assets. It is also ethically questionable, given climate issues. But, hey, some people don’t mind investing in tobacco;
- The overriding conclusion that should be drawn from this discussion is that Renewables, specifically Solar and Wind, are the best investment opportunities in your lifetime. Going forward, they are already at grid-parity with any future Fossil energy generation technology project. No new “deep water” oil or “clean coal” plant will harvest energy as economically as Renewables already can. And Renewables won’t smother our children. And please, no pablum about how you can’t use Renewables to replace oil for transport - a) within 5-10 years all transport could be running off economical electricity supplied by Renewables, and b) we don’t really have a choice, if we want to get through the next decade without global resource wars.
Alan Beattie
ISI Strategies LLC
7 paultaut // May 3, 2008 at 9:28 pm
K…..right now the energy “war” is being fought on the $ basis…An actual conflict has been predicted. A major discovery in the South China Sea…Japan vs. China… what would we do? That little Russian Sub exploring off Canada’s Northern shore has already caused Canadian approval to start building a Naval Base there.
Think of all of the extra parking space the big cities would have if travel in and out would be limited to delivery vehicles and Vespas.
8 Mark L. // May 3, 2008 at 9:33 pm
I agree about Natural Gas taking the lead over Oil. I began repositioning my portfolio in January. CHK and ECA are more core Nat Gas holdings. I haven’t seen anyone mention ECA. I’d like to get any thoughts on ECA. Here is a quick overview of their highlights:
* Sustainable production growth – target 5 percent per year
* 25 million net acres in North America
* 18.9 trillion cubic feet equivalent proved reserves
* Approximately 10-year drilling inventory identified on existing developed lands
* Net debt to capitalization of 34 percent
* Net debt to adjusted EBITDA of 1.2 times
* Robust project returns – target risk-adjusted internal rate of return greater than 15 percent, after tax
Return value to shareholders; pay dividends and purchase shares
* Minimum 10 percent free cash flow target
* Free cash flow supports a growing dividend and share purchase program
* Doubled dividend in 2007 and 2008
* Purchased about 270 million shares since 2002
9 fran // May 4, 2008 at 10:10 am
K.VORA–
an ounce of gold has over time[xx BC to yy AD] provided value to purchase a suit of clothing and footware for a person. no, one does not eat gold; but gold at $12,000 does contain a potential message. it has reflected value on a consistent unit basis. how so for other fiat currency?
10 Charles // May 4, 2008 at 12:15 pm
Mark L.,
Encana (ECA) looks to be fundamentally valued very fairly, basically on par with Chesapeake (CHK) in most areas. However, there are a few advantages I would give to CHK. (I don’t know ECA as well inside an out as I do CHK but I have done some research on ECA) Firstly, CHK has better exposure to the largest U.S. Shales, namely the Haynesville, Fayetteville, and Barnett Shales. Most experts currently believe that Haynesville or Fayettevile is the biggest shale in the U.S and CHK has the largest and second largest stake in those two shales respectively. (Depending on when you read this that data may change as there has been a recent flurry of sales and purchases of nat. gas assets over the last few months.) The growth potential for CHK is probably somewhat higher than ECA and I know that CHK internal metrics are looking for higher than 5% production growth per year. Take a look at this link for some excellent insight on CHK.
http://seekingalpha.com/article/75357-reviewing-chesapeake-s-strong-quarter-pre-call-notes
Another very important factor is the management at the top. I can’t speak at all towards ECA’s management but Aubrey McClendon, CHK’s CEO, has consistently preformed for investors. CHK has beat earnings estimates excluding one time expenses for at least 22 straight quarters. He has also bought over a million shares of stock on his latest string of insider buying. I had the opportunity to sit down with Jim Cramer and talk with him specifically about Aubrey McClendon and he assured me that he would be around for a while and would continue to deliver the results that CHK investors have been accustomed to over the last few years.
I also believe that the discovery of a possible 20 Tcfe of reserves in the Haynesville Shale has not been fully priced into the stock. At the time of the announcement last quarter than number was almost twice as many reserves developed as CHK had on hand and the stock price hasn’t responded as well as it should have. (This also leaves an interesting scenario for the small company Petrohawk (HK) who owns up to 1/3 of the shale)
The hedging losses from Q1 2008 were unfortunate but CHK is currently only 71% and 40% hedged for 2008 and 2009 respectively. This will provide tremendous upside if the price of natural gas continues to rise (as most of us on this website believe it will) and will also help limit the downside if we run into a period of unusually warm weather.
I’d love to hear any more detailed insight you have concerning ECA.
Charles
11 Marshall Cole // May 4, 2008 at 5:33 pm
I am a retired CPA who has evolved into the investment field. I agree with you as to peak oil, however, I am quite ambivalent as to when this will occur. My strategy is to maximize my dividends and wait for the windfall which may or may not occur within my lifetime. To affect this, I am heavily concentrated in Cdn oil trusts and US gas royalty trusts. Any thoughts?
12 jkingsdale // May 4, 2008 at 6:49 pm
Re: oil and gas income trusts: I agree, especially for a portfolio that needs current income. You might also want to own some service companies, maybe the OIH index.
Re: ECA, CHX, XTO I note that ECA and XTO have virtually the same trading pattern over the past year, but ECA offers a nicer dividend. No argument about owning any of them. I don’t own CHK simply because someone I respect thinks they have lesser quality management than XTO or DVN. But I doubt that is a widespread view.
13 K. Vora // May 5, 2008 at 1:18 am
Fran,
Gold has a price, and, when expressed in inflation adjusted dollar, has essentially remained flat from BC to today. Does not bode well for investing in gold. As long as productivity rises and wages/incomes keep up with erosion in the purchase power of dollar it is a zero sum game. Currently we are simply eroding away the purchasing power.
Gold and other commodities price should be viewed as confidence measure of current political environment.
Oil is a commodity. Energy is a need. We have energy crisis, and we are facing major revisions in our assumptions of the need.
The local pizza joint owner is not happy as his business is down, pizza oven energy bill is high, and gas prices has impacted the delivery cost, and if that is not enough, due to traffic, the delivery time has increased from 30 minutes to 45 minutes, reducing productivity of the delivery person who is asking more per hour as his tips are going down. He still makes great pizza and only good sign is his pizza by the slice business has picked up. Changing needs.
Paultaut,
Regarding big cities – people will move to smaller cities! Vespa is not fun in snow and cold. We are misguided in thinking “oil from the ground” as irreplaceable resource, and only way to secure the supply is through wars.
14 Jack Miller // May 5, 2008 at 6:04 am
Well folks.
Naural Gas…it’s just a fade or a so called new bubble.
Be very careful.
Why?
Because ’some found oil and some didn’t ‘ to paraphase Getty. You can see the qoute every time you log on to Kingsdale site.
15 Mark L. // May 5, 2008 at 3:21 pm
Charles,,
Thanks for your insight on CHK. Yes, CHK has been my best performing NG stock. I began shifting my portfolio towards NG in February. I am long on DVN, APC, CHK, and ECA. I liked the dividend that ECA offers and felt it was a bit more conservative but still offered good upside. I also like their unconventional drilling programs in the gassy shales, coal beds, sands etc. with larger sustainable reserves for long term growth. What are your thoughts on APC? 85% of their reserves are in the US but have int’l presence in Algeria, China, Brazil, Indonesia and drilled 1,700 gas wells in 2007. Many other NG stocks have recently outpaced APC but I see APC shares were up 1.5% today and up over 6% in after hours trading.
16 Charles // May 5, 2008 at 5:56 pm
Mark,
Anadarko (APC) is a really interesting stock to me because I recently sold out of my entire potion for the investment group I work for and decided to put that money into Apache (APA) instead. (As you could probably have assumed I cover the energy sector of the S&P) Before you take too much confidence in what I say I have to admit that because of schoolwork I have been unable to keep up with APC earnings which I believe were released today. (From the after hours price I’d assume they beat estimates but thats not necessarily true) All my analysis on this subject is from before APC’s most recent quarter.
From a fundamental standpoint, APC may is probably the worst off out of all of the major natural gas players. (CHK, DVN, APA, EOG, XTO, SWN, etc.) Many analysts as well as I believe that APC won’t be able to sustain high growth rates and most analysts believe their 5 year compounded growth rate is going to be between 5-6%. This number may seem average enough but its pretty slow for their sector and sub-sector. If you are going to be in a company with subpar fundamentals I would much rather you own SWN who is arguably the fastest growing company in the sub-sector with most analyst predicting rates between 20-35% over the next five years. Southwestern also has the best exposure to the Fayetteville Shale, probably the largest onshore shale in America. Their portion of the shale was recently revalued at $18B dollars when the street had previously assumed it was only worth $5.5B.
Anadarko in 2005 bought Western Gas (I believe don’t hold me to that but it was a large acquisition) and has massive debt problems since that time. They have been keeping up for the most part with paying down this debt on the schedule they initially laid out but most analysts believe the synergies between Anadarko and it’s acquisition have not be nearly as great as originally believed. Not counting after hours, APC has underperformed the XLE and S&P energy composite YTD and for a combined total of the trailing 5 years. I believe their inability to quickly remove this debt from their books has been the main cause of this.
Another important point to make is that Anadarko is not a pure natural gas play so it won’t necessarily participate in same rallies as some of the more pure plays. I know APA has 65% of its revenues from natural gas and I’m pretty sure this is a higher percentage than Anadarko.
Going back to the fundamental evaluation I had to defend myself as I bought APA before their earnings call and I needed to show my colleagues why they should still believe in Apache over the long run. Here is a small sample of facts that I presented to them on Friday of last week. (The numbers are accurate as of late Thursday, please excuse the formatting in this box)
Before Trade
2007 P/E – APA -12, APC – 16.8
2008 P/E – APA – 11.3, APC – 16.8
PEG – APA 1.2, APC – 3.1
2007 EV/EBITDA – APA – 6.3x, APC – 7.9x
2008 EV/EBITDA – APA – 5.2x, APC – 5.8x
2009 EV/EBITDA – APA – 4.6x, APC – 5.7x
TTM EBITDA Margin – APA – 73.4%, APC – 49.7%
2008E EBITDA Margin – APA – 74%, APC – 62.4%
TTM Profit Margin – APA – 27.2%, APC – 8.9%
2008E Profit Margin – APA – 29.3%, APC – 14.9%
Credit Rating – APA – A-, APC – BBB-
Market Cap – APA – 41.99B, APC – 30.53B
BETA – APA - .85, APC – 1.01
WACC – APA – 8.59%, APC – 8.00%
ROA – APA – 10.60%, APC – 7.30%
ROE – APA - 19.78%, APC - 26.35%
ROIC – APA – 25.46%, APC – 8.81%
Debt To Equity – APA – 0.3x, APC – 0.9x
Apache is fundamentally favorable in 16 of the 18 ratios.
After Trade
2008 P/E APA – 9.95, APC – 13.82
PEG – APA – 1.01, APC – 2.58
2008E EBITDA Margin – APA- 74.9%, APC – 63.6%
Credit Rating APA – A-, APC – BBB-
Market Cap – APA – 41.95B, APC – 30.36B
BETA – APA – 0.82, APC – 0.98
WACC – APA – 8.80%, APC - 8.16%
ROA – APA – 11.94%, APC - 2.94%
ROE – APA – 22.67%, APC – 10.62%
ROIC – APA – 30.38%, APC – 8.81%
Debt to Equity – APA - .26x, APC - .09x
Apache is fundamentally favorable in 10 of the 11 ratios.
On top of this APA growth has been estimated closer to the 9-11% range. Anadarko also I believe operates in Nigeria which is one of the last places and oil company wants to be right now. Apache’s riskiest fields are located in Egypt and Argentina, countries that aren’t horribly large risks. This also accounts for less than 20% of current production and current reserves.
Going forward I really don’t see Anadarko outperforming or outproducing most of these other companies, especially CHK and SWN. (both of which I own and are my two largest positions) I also noticed that APC’s management makes about 4 times that of APA’s management even though their stock price has underperformed that of APA for a while going now up until about the last week and a half.
I also have read that Anadarko is planning to or already has begun to sell of some assets after their purchase of their new blocks in the Gulf of Mexico from the U.S. government auction that took place recently, although I believe that much of this has been priced into the stock price.
I have also run discounted cash flow models on both of these companies, and while these models aren’t nearly as complicated as those of the Streets I have come up with target prices of around $76 for APC and around $168 for APC. Those prices should be taken with a grain of salt because projects more than two years out, especially in the energy sector, are generally extremely difficult to predict.
If you have any more questions or conflicting points I’d love to hear them, I hope I was able to help.
Charles
17 Charles // May 5, 2008 at 5:58 pm
Mark,
BTW I just noticed that APC’s debt to equity number under “after trade” is incorrect, it is suppose to be 0.9x.
Charles
18 Jim Peterson // May 11, 2008 at 1:10 am
Jim,
What is your view about the probability that high oil prices will cause an economic slowdown, which will result in a lower demand for oil, which will result in a price pullback?
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