Monday, October 1, 2018

For now $80 oil is more than good enough

Sometimes it is very frustrating to invest in commodities such as oil and gas, especially here in Canada. When companies such as Canadian Natural Resources (CNQ) -  and worse for many of its peers - trade at prices as if oil was at $30 dollars rather than at $75 per barrel, investors may be ready to throw in the towel.

Especially, if last quarter's ‘funds flow from operations' or cash flow increased by 57% compared to the previous year and stock prices still don't move up. After paying out of these juicy funds planned capital expenditures to maintain production, the remainder, i.e. free cash flow, is used for paying out dividends and to reduce debt or finance corporate expansion. And if you think Free Cash Flow was good in the last quarter then get ready for the next few quarters.  I bet, you would regret for the rest of your life if you had thrown in that towel.

We may use WTI and Brent Pricing as quick checks but they are often not representative of the pricing a company truly receives which includes production hedging and upgrading of oils into synthetic products which are often very differently valued than the benchmark spot pricing. The table below shows the product mix of CNQ in the 2nd quarter of 2018. Yes this can become extremely complex.

But the following 'back-of-the-envelope' estimate may help you see the light. In the 2nd quarter CNQ produced 1,050,376 barrels of oil per day. A quarter typically counts 91 days or 95.6 million barrels which it sold for $6.389 billion or Cdn. $66.89 per barrel. Compared to a year earlier when it got Cdn. $49.66 Cdn per barrel. For comparison, Q2 2018, WTI averaged around U.S. $ 68 and in 2017 it averaged U.S. $48.  How did they get rid of the Canadian Select price discount? Now you know: hedging and product mix. And yes, without the heavy oil discount, prices would have even been better.

So really, Canadian companies do know how to work around all the hysteria, especially when you have a smart management such as that of CNQ. When oil prices for CNQ rose from $49.66 to $66.89 or 35% its 'Funds from operations' increased by 57%!  Smart operator!

When markets quote today a WTI price of U.S. $ 75, you should not forget that Canada’s oil industry is coming out of a down turn and that the costs of drilling and overhead have fallen 30 to 40% from the highs of 2014 when WTI was U.S. $ 100 per barrel. AND... the Canadian dollar was close to 93 cents compared to 77 cents today.

In terms of Canadian dollars, the 2014 oil price was Cdn $107 per barrel and today it is Cdn $97 per barrel. If the profit margin in 2014 for a typical oil company was 8% then it made just over $8 per barrel ALL costs included, while today with expenses nearly 35% less and oil prices barely 10% less than in 2014, profit margins are nearly 40%! Yet, the market is pricing those oil companies as if they were trading at a WTI of $30!

Do you still think the stock market is efficient??  These days, many oil companies, especially those with low debt are raking in the cash!!  They will have profit margins comparable with Microsoft! But nobody pays attention.  No wonder many good analysts such as Eric Nuttall predict a doubling or more of the oil and gas producer share prices over the next few years. But investors don’t seem to get it. Now add a LNG plant and a bunch of market diversifying pipelines!

Economists rank Alberta next year as Canada’s leader in economic growth. But for you to win in the stock market of oil and gas producers, you must buy now because when rig prices, land prices and salaries start to pick up at $100 oil it is too late! The best profits are made starting today and over the next year or two. I hope that now you understand why $80 oil is good enough maybe even better than $100 oil.

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