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Don Coxe
February 18, 2005
Ocean Ridge, Florida
Topics include:
- How to value natural gas companies
- Outlook for LNG
- Case for owning Alberta oil sands companies
- Update on base metal stocks
- Update on regional banking stocks
- Commentary on Putin’s strategy in regard to energy and base metals
“Got Gas?”
Thank you all for tuning in to the call which comes to you today from Ocean Ridge, Florida. The chart that we faxed out was two gas prone companies and the question that we rhetorically fired was “Got gas?”.
So I want to talk first today about the way to look at the valuation of the natural gas oriented companies and obviously companies such as Burlington, Devon and Encana are the ones that come to mind.
And I want to contrast those companies in valuation techniques with the oily stocks. And I think probably over the years since I’ve been telling you to be overweight in both these groups, what I haven’t done is distinguish what the investment characteristics may be of one group or the other as they take on different defining characteristics.
Encana is particularly interesting because when they sold their Buzzard Field in the North Sea to Nexen and put the proceeds into buying Tom Brown in this country, which is Powder River coal bed methane, what they’ve basically said is they’re going to take their big bets on gas, not on oil.
And in the case of Devon and Burlington, these are the companies that bought out those Canadian gas companies and you know, those of you who have followed me for years, much to my deep chagrin and regret because they bought them at prices that turned out to be steals since Canadians and Canadian analysts continued to value them on the basis of sixty five cents per MCF for natural gas.
So, what we’ve got then is a situation of the basic reserve life index problems of the United States gas companies. This is an industry that’s failed to replace its production year in year out for more than a quarter century. And meanwhile, as you know, natural gas, which has always promoted itself as the wonder fuel, then as people got more and more concerned about air quality and when you couldn’t build new nuclear plants as a result of the foam fleck types (?), what it meant was that natural gas got a bigger and bigger share of all new electricity generation plants in the United States.
Well, then of course, we came in to this millennium and it’s been a very gaseous millennium. We’re looking at 5.93 for gas now and this is despite the fact that in the major metropolitan centers of the Northern US, it has been an unusually warm winter. Kind of thing that delights the Kyoto advocates but what it should mean is that gas would be very cheap. And analysts scratch their head and say why with the amount of gas in storage and given the fact that the weather is so mild, why is gas 5.93?
Today, just this weekend, we’re at the 2/3 mark for winter as calculated by the astronomic style which is December 21st to March 21st and we are very nearly at the end of what the meteorologists call meteorological winter, which is December, January and February, the three coldest months of the year. Which should mean that natural gas would be selling for considerably less than it is.
Well, of course, one big reason as you all know is the substitutionality of natural gas for distillate in all sorts of industrial applications. And since oil stays up at forty seven dollars a barrel, what that does is it means for these kinds of industrial applications, natural gas gets priced as its energy equivalent.
And going forward, it’s hard to see that those kinds of relationships are going to change, which means that those people out there that still use 3.75 an MCF for natural gas, I think are going to continue to be wrong.
However, there is one big thing on the horizon, that we’ve talked about from time to time on these calls, but I want to update you on it and that is LNG, liquefied natural gas. Now you know it’s been our position, that LNG which is supposed to be here by now, is not going to come, that 9/11 basically changed the logic of liquefied natural gas. Now, the economic logic is inescapable, but as we learn from nuclear power, if people are concerned about living anywhere near some situation that’s going to blow up, then the economic logic is put aside.
Now in the case of the LNG, as you get these tankers, and they measure liquefied natural gas by the ton, not the MCF, and when I was recently in Boston down at the harbor area there, you were at the area where the LNG tankers come in. And they were proposing a massive new expansion in Boston, this because that’s the part of the country where they really need lots of natural gas, and it’s been held back by citizens groups and by politicians because of the possibility that all you need is an al Qaeda terrorist with a Stinger missile and maybe that would be enough to get rid of the voters who gave Kerry one of his few strong majorities. Which is certainly the kind of thing we’ve got to be scared about.
I mean, I don’t know what the real risks are of this. I’ve been at sufficient industry meetings to know that there are deep divisions on this point. And Transcanada, as you’re familiar, tried to get an LNG pipe into Maine and once again they’re being met with resistance from people who are worried of what would happen.
The industry continues to be soothing about this, particularly the notably aggressive Lee Raymond of ExxonMobil who says that “We’re going to deliver LNG at 3.75 an MCF and we’re going to hold down energy prices right through the next decade”. Because in Qatar and in Trinidad, what you have is just massive reserves of natural gas. And also in Indonesia, as a matter of fact, Lee Raymond got very familiar with the effect of LNG in Indonesia when shortly after the merger with Mobil that plant blew up. And that produced a huge sell off in the stock exchanges of Japan and South Korea, because that one facility was supplying a big percentage of the total energy consumption of Japan and South Korea. It was also supplying over fifteen percent of the total earnings of ExxonMobil.
So it can be an incredibly profitable business for Big Oil. And Qatar comes out of that rare category of a Gulf state where the politics seem to be good and where the big oil companies are quite eager to invest.
The way I think you should look at it for now, is that between now and 2011, when Lee Raymond’s forecast could come true, we’re going to have sustained high gas prices. And that by then, even though they can bring it in at a cheap price, that because of the declining output from lower 48 wells, that prices will hold up.
In addition, of course, one of the bits of optimism the industry has had was the pipeline bringing Canadian gas and North Slope gas down into the Midwest. Again, I’ve been to conferences discussing this and the industry has what I regard as dewy-eyed optimism about how easy it is to get this approved. And they shouldn’t really have that view. If you go back to 1981, when the pipeline was first proposed, it was overruled by the judge who sat on the commission on the basis they planned to drive the pipeline through Old Crow which had twenty four hundred consecutive years of habitation there. And when the industry says “Yeah, but there’s only a hundred people there, we don’t mind moving them” the judge, justly in my view said “Well if you’ve got that kind of sensitivity I don’t think we should approve the project.” He thereby saved Imperial Oil and Shell Oil Canada because they were assuming hundred dollar oil and that was the justification for the economics of bringing gas down then.
Well now, what we have of course is expensive oil and there’s no question about the economic viability of high arctic gas, but once again, the Inuits have not agreed. And this keeps getting held up and in addition we’ve got a battle going on between a Canadian route and a route from Alaska. And we have some very powerful Senators from Alaska who are insisting on that route. So, from my perspective, you shouldn’t be counting on early deliveries of gas coming out of that part of the world into the gas short US.
So my view then is, that notwithstanding that you’re reading all this stuff about LNG and suggesting that natural gas reserves should be valued at lower prices, I think when you balance all the risks you’ve got at least five years of security and it’s quite obvious if we can get through a winter like this without gas prices really falling, then gas in the ground should be valued at something like it’s ordinary barrel of energy equivalent. Which means that these good gas companies, such as the charts we showed and the others, remain, in my view, excellent investments.
They are not, however, as attractive as the oil stocks that have long duration reserves. So, if you’re thinking about new money going in to the group, then I’ll reiterate what I’ve said in Basic Points and in these calls which is, that the most attractive, from almost any standpoint are those of the oil sands companies – the Alberta oil sands. Because there is no competitor now in the world for them in terms of duration of reserves in politically secure areas.
Now I can’t predict what oil prices are going to do this year or next year but I can simply say that when you’ve got fifty to a hundred years of reserves then at some time during that period of time, the price people paid for the stock right now is going to look trivial.
Well, so, when we get beyond oil and gas, this is also a time when we like to come back to looking at our base metals stocks. And I’ve talked so often about the kingpin of the whole group, BHP Billiton, but it was great fun to read their report for their second half of last year. BHP takes the audacious view that they shouldn’t have to and they refuse to issue quarterly earnings statements. They say that’s not how they run their company. So they issue semi-annual reports. And for the last six months of last year, their earnings were up a modest 110% to US $2.8 billion.
Let me put that into perspective.
That means that in the last six months of last year, they earned 28% as much profits as WalMart earned in the whole year. So we’re not talking about a small company here.
And the base metals component of their group, the earnings before interest and tax rose 213%, they said partly because of a 34% increase in the price of copper and of course if you check out copper today you’re going to see it’s selling at a much higher price than it was on average in the last six months of last year. But when you go through it, it’s really fun to see such things as that how well they did on their coking coal. Their earnings up there were 99% increase from last year. But they’re going to be increasing the price this year by 120%.
Now, I continually run into people who say “Well, we’re growth investors and yeah, these are just deep commodity cyclicals. They’re not growth stocks.” Well…I think the list of true growth stocks is now probably, you know, about as modest a list as it’s been since I came into this business. Because we kept losing groups that are considered growth groups, most obviously the Big Pharma companies.
So it seems to me that when you can buy companies such as Phelps for eight times earnings, Inco at nine times earnings, what you’re looking at is companies whose earnings are bound to grow simply because of the fact that they are tied to the growth in Asia.
And I want to take that on to the next part of the story which is Alan Greenspan’s conundrum this week. Now you may say “How are these two stories inter-linked?”. Well they are interlinked because the US yield curve is saying that the US economy is going to slow down. Maybe even go into recession. The spread between the 10-year note and the 2-year, they’ve just been dramatically narrowing in.
Now again, no surprise to those of you on these calls, but we reach the stage where you start to worry that the bond market is telling us that the consensus forecast of 3 to 3 ½ % economic growth – that we haven’t got a chance of reaching them.
Now, one is always tempted to say that it’s different this time. And in fact, it may be. And I intended to discuss this in the forthcoming issue of Basic Points which I’ll be putting together next week. But on the other hand, I think that you ought there on the call should be a little concerned that what we have now is recession or near recession conditions in several of the Eurozone countries, including Germany, Italy, Holland. We have technically a recession now in Japan. And now we have a US yield curve showing the kind of signal that in the past signaled an oncoming recession. And you have to ask the question, maybe we’re going to have a slower economy this year than we thought.
Well, the beautiful thing about investing in the base metals is that they are not driven by the economies of Europe and North America. What you do when you buy these stocks is you are taking a bet on economic growth in coming years in Asia – particularly China and India.
So, I would make the case that what you do is you get the chance to bet on the fast growth regions as against the slow growth regions. But that the rest of the stock market, the rest of the S&P or the MSCI Global and everything, is tied primarily to stocks whose earnings are driven by the slow growth regions.
Now, if you believe this, what it means then is that you actually have lower economic risk investing in the big base metal companies than you have investing in cyclical companies base here and tied to the economy here, because they are completely dependent on what happens in the US, Canadian and European economies. And whatever happens to China and India and obviously they’re going to slow down if we have a recession in the rest of the world – on any realistic time horizon, they’re going to grow faster than we are.
And what we have is these lovely ratios. In the case of China, if you’ve got a unit of GDP growth as measured and they announce, what you can assume by that, and I’ve just done some calculations, for the growth of consumption in metals, it’s on the average three times what the GDP number is. So therefore if GDP is up 9%, then you can assume metals consumption’s up about 27%.
Well, when you think about it, there are so few new base metal mines of any size being brought on and when you realize that we’ve run down three quarters of the inventories of the base metals in the London Metal Exchange, the Shanghai and the Comex Exchange, it seems to be we could stand some slowing down in China because we’d still be at the second derivative situation, which is, if we slow down to 3% growth in China, we’d still have a 9% increase in consumption of metals. We don’t have the inventories to deal with even that demand.
So, although I am very much aware from the feedback I get that people are saying “Look, these stocks have run so far”, as a matter of fact I was seeing clients in New York this week and one individual said part way through the presentation that he hadn’t heard one noun, adjective or adverb that was controversial, because everybody knew that the Chinese economy was strong and that base metal stocks were a good investment, he said, “You can see that in the price of the stocks, look what’s happened. You’ve got Phelps from 24 to 100, everybody knows what you’re saying, this is a waste of time.”
When I demurred to the point of pointing out that Phelps trades at eight times earnings which is more than a 50% discount to the rest of the market, he says “Yeah, but the stock never pulls back so therefore it means everybody agrees with you”.
Well, I don’t doubt that 95% of those who listen in on these calls agree with me but at such point as these base metals start to trade anywhere close to a multiple of cyclical stocks even, here, then perhaps we can assume that we’re approaching consensus. It ain’t that way now, it’s got a long way to go.
Now, the question about the ability of the bond market to forecast the economy is something that has broad implications. It’s worrisome because…it’s worrisome also for another group that I’ve been so strong on which is the banks, the regional banks. Because the steep yield curve has been Alan Greenspan’s great gift to the banking industry historically. He bailed out the US banks in the early ‘90’s with that and then out of this recession once again the steep yield curve meant banks did very well. Even when they had some loans to write down.
So, as the yield curve goes from steep to shallow, certainly if it goes to flat, then I think that people really will be proclaiming the likelihood of recession. It’s already narrowing in, which means that bank spreads are going to narrow. On the other hand, what we’ve seen is the banking business has switched amazingly from being a corporate oriented business where the yield curve is really crucial to being a consumer oriented business where the yield curve is less important. And indeed, the mortgage backed area where what they are doing is investing up the curve anyway.
So, again, reflecting concerns expressed at meetings of clients in New York, I am not taking off my overweight position in the bank group – notwithstanding what’s happened in the yield curve, because, you see, the corporate sector is awash in cash of its own and it’s not relying on the banks the way that it did before. So that this isn’t, in looking at the way they develop their earnings, the shape of the yield curve is not as important I would argue for the banks now as it was.
So, I grant you that if you look from bank to bank you’re going to find a lot of them that are an exception to that statement. That’s a broad brush generalization. But there’s hundreds and hundreds of banks in this country, our firm Harris Investment Management has gotten all the way up to number one ranked in the country but a big reason for it has been that we’ve been pretty good at finding the good regional banks. So I’m sharing with the rest of you, the view that this remains an attractive are of investing.
Finally, before we get to the questions, I’d like to draw everybody’s attention to a piece that was on the editorial page yesterday of the Wall Street Journal, “Give Putin A Break”, and it’s a piece by Padma Dasai who’s Harriman Professor of Economic Systems at Columbia. And the reason I’d like you to look at it is that, for those of you who are reading the current issue of Basic Points where I’ve tried to analyze Bush’s foreign policy and a big part of it is the relation with Putin, this is the only thing that I have read anywhere that makes me feel any better about what I’ve written. Because the torrent of anti-Putin commentary in the press, the demonization of him is such, I mean I just wish as having been a Cold Warrior growing up, just wish that the mainstream media back then had ever said anything as insulting about the Communists as they do now about Putin.
So, they got it wrong then, of course, and maybe they got it wrong now. But I do think it’s very important, particularly as we try to look forwards at the whole situation of the energy and base metal stocks, that Putin is in a position to be incredibly influential on outcomes in both cases, because Russia is still the best hope for major new deposits in both those categories – about them being brought onstream. So, if you can discern, as you go through and read this piece by this lady, that he has a strategy and that he’s not just a throwback to some really bad Czar or some really bad Communist, then what you can see is that there are opportunities there and that what Bush is doing is the logical way of trying to prevent a new global oil shock and also trying to manage China’s entry into the global system.
So, simply because it was some kind of endorsation of this, I wanted you all to see it.
Anyway, that’s the story for today, are there any questions?
So that’s it, any questions?
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Don Coxe Profile from the BMO websites:
Donald G. M. Coxe is Chairman and Chief Strategist of Harris Investment Management, and Chairman of Jones Heward Investments. Mr. Coxe has 27 years experience in institutional investing, including a decade as CEO of a Canadian investment counseling firm and six years on Wall Street as a 'sell-side' portfolio strategist advising institutional investors. In addition, Mr. Coxe has experience with pension fund planning, including liability analysis, and tactical asset allocation. His educational background includes an undergraduate degree from the University of Toronto and a law degree from Osgoode Hall Law School. Don joined Harris in September, 1993.
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