Thursday, January 5, 2012

Many Guru’s like investing in energy, but…

 I am an oil and gas guy. I worked in the industry for over 30 years, since May 10, 1979 to be precise. “Oh Godfried”, the female followers of this blog may say, “But on your photo you look SOOOO good! Yet you must be a pretty old geezer”. My modest answer: “It’s the vitamins Ma’ am”. J

Apart from the BS’ing, I have seen a fair bit of the ups and downs of the oil industry over the years. That’s why I am not a fan of investing in junior oil companies. You’ll need, in addition to expertise, a lot of wind in your back. I have seen some very smart people bite the dust. Large companies have staying power, but they may also fall victim to a take-over.

Right now, the Alberta petroleum industry is not doing as well as the oil price may make you believe. The reason is that the oil industry has two legs; yes the oil leg is strong and muscular; for now. But the other one, the gas leg is shrivelled. So Mr. Petroleum is limping. The oil industry is not only capital intense, it is also ego-intense. If you think CEOs of any industry are egocentric maniacs, then the petroleum industry has a disproportionate number of them. Not just any entrepreneur can make it in this industry, many try though. I would say that Alberta’s Petroleum industry is as entrepreneurial as you can have it with many very smart people.
It seems easy at the end of a downturn to get a start-up going and then, along with all others, your company ‘explodes’ in the next oil and gas boom. But the tough part is the down-turn that unavoidably follows. During a boom, in addition to oil and gas prices, labor prices, drilling prices, land prices rise rapidly and simultaneously investors’ money is pouring in. Your new company’s shares are doubling and quadrupling. The ‘upturn’ is often one massive slugfest, but… something else goes up in this rising tide of wealth and that is the entrepreneurs' ego. They outbid each other for land at ever higher and crazier prices. They run all after the same ‘hot trends’ – just like ‘investors’ in the stock market. And then, a trigger-event – say a recession; a warm winter with an abundance of gas supply, or a new technology happens. The oil or gas price goes down and with that the profits of the new entrepreneur’s empire –the economics of their projects during the boom were often so marginal in order to get that much desired ‘growth’ that even a slight decline in oil or gas prices spells financial disaster. The next ‘black Monday’ has arrived with a vengeance. Somebody has to pay the piper and all those ‘hot entrepreneurs’ and CEO’s see their future crumble and succumb in Warren Buffett’s falling tide.

The last boom was from 2004-2008, when both gas and oil prices were high. It is not only the juniors that get caught in this crazy circus; large company CEOs are dragged along as well – especially those who want to leave a ‘legacy’ can do some really stupid things. My prime example is EnCana.  During the last boom it forgot all about the importance of diversification and to increase so-called ‘shareholder value’ it copied the strategy of other conglomerates. However, EnCana forgot that those other conglomerates were spread out over much broader market sectors than just ‘oil and gas’. EnCana in its vanity thought that it could enhance shareholder value by splitting off their oil and gas operations; yes they created Cenovus focussed on heavy oil with the remaining gas assets staying with EnCana. This was done at the veritable top of the oil and gas boom. And ‘nobody’ saw the 2008-2009 recession coming. The recession lowered energy demand in North America and both oil and gas prices fell. But to make matters worse, there was this new technology – multi-stage frac’ing or fracturing that allowed the old reservoir rock fracturing technology to revive. It enabled operators to fracture ‘tight gas reservoirs’ that were considered un-producible by generations of oil and gas people. Using the new technique, these reservoirs produce at high initial gas rates followed by a super fast decline rate. With good gas prices, the initial high gas rates could pay-off the well in just under a year and the rest, however small, would be gravy. And of course the ‘reserves’ that could be added to the company’s inventory (which determines its book value) were just incredible. The economics were slim, but the reserves…. Aaaah!
The stock market loved it. Next you knew, as with any new fad, everyone wanted ‘resource plays’; ‘unconventional gas’. Whole companies switched strategy overnight to join the band wagon. Non-performers like Talisman dumped many of their properties and bought into the new ‘unconventional gas play’ with a vengeance. EnCana bought up enormous amounts of tight gas holding land in Texas; and promoted pipedreams like ‘Cut Bank’ in NE BC. They locked in the gas price by hedging their production for many years out and to fulfill their obligations they had to add more and more production capacity. Many others drilled into the bandwagon as well – until the enormous initial gas supply combined with the Great Recession caused the gas prices to crash. Kaboom! Just then EnCana spun-off Cenovus! The timing couldn’t have been worse – but EnCana had one big reprieve – their gas price hedging program – it allowed it to keep on being ‘profitable for several more years while they kept on drilling until they hit the wall!  The gas price hedge programs came to an end and a hoped for recovery of gas prices had not occurred. The company got into the red.

EnCana was not the only one that got hit – so did numerous small gas producers. The juniors, along with EnCana had one thing in common – they all were focussed on gas. Many of the juniors hit the dust; while EnCana – no longer diversified – is rapidly becoming a speculative play on that elusive long-hoped for rise in gas prices. How any management team could expect oil and gas prices to stay high is still a mystery to me – other than the ever-present ego of executives blinded by the success of the ongoing 2004-2007 boom.  Dome, Home, Petro Canada, Ulster, Rio-Alto, Big Bear… do I have to mention more companies that all fell into the same trap – boosted egos that lost all sense of caution.

So, if you think that the same breed of managers doesn’t run the oil side of the industry then I have a bridge for sale in Manhattan. And guess what, the new technology to cause a possible oil price crash is here as well. Multi-stage frac’ing! This time not of tight gas reservoirs but of oil reservoirs. The concepts have been proven by companies like Crescent Point and copy cats such as NAL and PetroBakken. In the U.S. and in Canada the technology is gaining steam. In North Dakota the Bakken reservoirs are coming alive with a vengeance. Next are Colorado and Utah; old oil targets from many generations ago are coming alive again.  The U.S. is rapidly become a net exporter of oil again.
Today the tensions in the Middle East are driving up the oil prices. Yet, the new oil plays and their supply are rapidly on the rise; oil production in Iraq, Libya and Syria may soon resume and the Iran hot spot may cool. The new plays are not cheap though – more expensive than SAGD and Oil sands mining and this may place a bottom under oil prices.

But then so was there a bottom supporting the gas price that did not work – break even costs for gas projects are close to $6,50 per mcf  while the gas price is hovering around $3.50.  There may be factors for companies to drill longer than economically feasible such as stock-market-sexy reserves addition, Pugh clauses and of course the gas liquids. The same could be the case for oil and we may see a period of lower, more moderate oil prices in the not too distant future.

Yes, energy companies are undervalued right now, but don’t expect a dramatic recovery. Don’t run into the sector blindly because there are definite clouds on the horizon as described above. Also, with an era of lower, moderate oil and gas prices ahead along with an economic recovery that is likely better than many expect, industrial companies, manufacturing and high-tech are the ones most likely to benefit. I expect a resurgence of these sectors, especially in the U.S.  Also, with cheaper energy prices, the BRIC countries may resume rapid economic growth soon – both in exports and domestically. It is this thinking that mostly drove my November outlook for 2012 – I am still sticking with that one.

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