IN THE NEWS / Seeking Value In The Smoky Ruins Of The Scorched Oil Patch
Globe & Mail Dec 5/98
In a year of remarkable events, the fact that crude oil price have plummeted to lows not seen in a decade may seem to be just another element of the emerging post inflation era.
West Texas intermediate one month futures briefly traded as low as $10.82 (U.S.) a barrel on the New York Mercantile Exchange last week. On an inflation adjusted basis, that's lower than the 1972 price, ($2.80 a barrel) just prior to the Yom Kippur War, and the first Arab oil embargo.
These days, parents would be better off advising their children to grow up to be cowboys than commodity fund managers, like John Di Tomasso, head of the Victoria based Di Tomasso Group. (In a previous career he was one of Bay Street's top equity managers, run-ning the Royal Insurance portfolios with a value investor's discipline. As for the switch of careers, thus far commodities have not performed satisfactorily. On the other hand, the move to Victoria has been eminently successful.)
From Mr. Di Tomasso's vantage point, submerged oil prices are only part of the story. The entire commodity group has been scorched. On an inflation adjusted basis, the Commodity Research Bureau index components are at a record low, lower even than in the depths of the Depression.
Oil is important, not only because it is the heavyweight commodity (still a 9 percent weighting on the Toronto Stock Exchange, compared with 5.5 percent for gold and precious metals, 2.3 percent for the forest stocks, and 4.1 per cent for base metals).
Oil also provides an insight into the market forces at work that will improve commodity values.
The big screen view is this: Low energy prices are annihilating returns for oil and gas producers. With diminishing cash flow from operations, capital spending falls.
And with plunging profits and cash flow, even the most patient investors begin to lose interest in providing more capital. New equity issues disappear. For that matter, so too do companies because it be-comes a lot more fruitful to accu-mulate oil and gas assets by acquisition than through risky exploration and development activity. (Some 15 significant publicly traded Canadian producers have disappeared in the past year, including Wascana Energy Inc., Elan Energy Inc., Norcen Energy Resources Ltd., and Morgan Hydrocarbons Inc., to name a few.) Of course, all this mergers and acquisition activity does nothing to build production or reserves, though lawyers flourish, thankfully.
When investors beat a retreat from the oil patch, lenders are generally not far behind. The value of reserves falls, thanks to low prices. Because of diminished security to backstop loans, credit becomes more expensive or unavailable for lower quality borrowers. All that is happening now, and will persist. The outlook for prices is abysmal. Organization of Petroleum Exporting Countries' meeting Vienna last week appear to have accomplished little.
And, the world is awash in oil. North American crude inventories now stand at 341.8 million barrels, well ahead of last year's levels, and at the top of the seven year range. Gasoline and distillate inventories are at or near record levels.
Warm weather, though fervidly blessed by Ontario mountain bikers, adds to the sad tale. Even natural gas, the last redoubt of price strength for western Canadian energy producers, is weakening as storage capacity throughout North America verges on full.
There is no quick fix for energy, other than some drastic political event curtailing production from a key international supplier.
However, smart investors know that the elements for a more fundamental recovery are already in place.
As my Calgary based colleague Robert Feick recently observed, the 24-month readjustment process to low prices actually began early in 1998, when exploration and development budgets started falling under the axe. "We're well into it now," he says.
The key is that oil production capability swiftly deteriorates without constant reinvestment. Mr. Feick estimates that the Canadian decline rate is roughly 12 per cent annually. In other words, unless the lads are busy in the field, Canada's conventional crude deliveries will soon begin to sputter.
On a global basis, the annual decline rate from tied in reserves is 7 to 10 per cent. Offshore declines tend to he higher: 15 to 16 per cent annually. Producers prefer to maximize production from those capital intensive projects to quicken the return on investment.
"Low prices will eventually give way to reduced supply, which will ultimately give way to higher prices," Mr. Feick concludes. "That's why it is a boom and bust industry."
Companies that already reflect a more realistic outlook include Crestar Energy Inc., Renaissance Ltd., and gas weighted Anderson Exploration Ltd.
And smart investors know that the senior players, like Imperial Oil Ltd., Petro-Canada and Suncor Energy Inc., which produce oil and refine and market product, are rocks of stability in these market conditions.
Dunnery Best is a senior vice-president and director of Merrill Lynch Canada Inc. Merrill Lynch Canada may provide advice or un-derwriting services to companies mentioned in this column. |
