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Nesbitt Burns Institutional Client Conference Call for March 18, 2005
Don Coxe
Chicago
“The Cost of Big Footprints in the Sands of Time”
Charts: Oil Sands stocks
Thank you all for tuning in to the call which comes to you from Chicago. We faxed out the charts of the three leading oil sands pure plays and the comment was “The Cost of Big Footprints in the Sands of Time”.
I want to talk about the oil industry’s dilemmas in some detail this morning. But before I get into the main story, I’d like to pick out what I think was the factoid of the week. For those of you who did not see it, it was carried in the Chicago Tribune and I did not see it anywhere else, which is that Harley Davidson now has a market capitalization $1.3 billion greater than General Motors…the common stock. Since General Motors has more than $50 billion in debt outstanding, what that indicates to you is how serious the problems are for the Big Three.
And you may say “Well, General Motors is the worst off. At the moment Chrysler is doing well and Ford is okay.” But it’s a serious situation, not just for Detroit, but for Windsor and Oakville and Oshawa. And when you also look at the fact that Consumer Reports now ranks, I think it’s the Kea, as the best value in a family automobile and number one for reliability whereas the Korean cars used to be regarded as tin cans, the situation of the established automobile companies – the estimate is workers cost General Motors $70 an hour for pay, healthcare and pensions. That’s $70 US. This is clearly not sustainable.
So something is going to go wrong and it may be that time has just run out for the auto industry in exactly the shape that we see it in now. And that added in to the fact that year over year, the leading indicators in the United States are flat, that money supply growth is slowing sharply, mortgage rates are going up – I think we’ve got to start looking at the possibility that we’ve got a 1994-type situation. Where the Fed is tightening, it has to tighten, it was loose for a long time – I vividly remember how the Fed bailed out the US banking system by having a steep yield curve for years – and that yield curve is flattening. The Fed is doing what it needs to do here, but what that implies is some serious problems for economic growth in the US and I think for the US stock market.
So, that’s the backdrop. I’m going to be covering that in much more detail in the forthcoming issue of Basic Points, but I wanted to get those macro concepts out of the way before getting in to the story on oil. The story has changed somewhat from the simple thesis of the last four years on these calls and in Basic Points. What I’ve basically been telling you for four years, is you should be loading up on the oil companies - particularly the exploration and production companies – and the big oil companies based on their reserve life index, oil reserves and gas reserves in the ground in secure areas of the world.
I’ve hung tough with this, so much to the extent that I can be accused of being a one-trick pony, but now what we’ve got is a somewhat interesting variation on the story. And I want to take you through this because for the first time ever, I’m suggesting that those of you who are worried about the sheer scale of some of the profits that you have on some of the E&P companies and would like to feel a little more secure and diversify, you might consider moving into some integrateds or some pure refining companies.
Now I have NOT recommended these as against the E&P companies for four years, because I realize that for every investor out there, there’s only so much you’re prepared to put into the oil industry and I thought the real leverage was exploration and production, and particularly companies that were in a position to add to reserves.
And of course for the last eight months or so, I’ve been emphasizing the Alberta oil sands stocks as being a clear cut case of where you’re buying a huge number of barrels of oil in the ground in a secure area of the world.
So that’s been working out just fine, but it’s time to look beyond that. And I’ll tell you why I think it’s time to look beyond that. I was stunned, like I think most other people were, by the fourth quarter earnings reports on the refining side for Exxon Mobil and Conoco Phillips. The sheer scale of the profitability of their refining, which was far above analysts estimates. Now you may say “Well, come on, you haven’t been showing any respect for Wall Street’s oil analysts earnings forecasts, so why are you so interested in the fact that they got the refining wrong?”
Well it’s true that in terms of their ability to predict oil prices, since we had 17 straight quarters where the New York view, Wall Street’s view, was that oil prices were going to come down. That’s a fact. And as you know, I’ve been saying for two years that the first jobs that should have been outsourced from the US were Wall Street’s oil price forecasters.
But the one area that they justified getting any kind of paycheck at all was their ability to predict refining profits because that’s done off the crack spread. And they tended to be much better in this type of forecasting.
Well, it didn’t work in the fourth quarter. And a big factor in this, I believe, was that the extra production that the Saudis brought on and that OPEC is managing to bring on to meet this oil squeeze in the world is heavy crude, high sulfur, heavy stuff. And there’s only a little bit of refining capacity in the world left that will handle that kind of crude oil.
So, we had the phenomenon this week that OPEC announced it was bringing on another half million barrels a day of production and crude oil as measured on the NYMEX went to a new all time high. Well I think a big part of that is that we’ve got to separate out heavy oil and high sulfur crude from West Texas intermediate, which is what the subject is of that contract.
What we clearly have now, is a major global shortage of good oil…light, low sulfur. And we do seem to have pretty good supplies of high sulfur, heavy stuff. Now the alarming thing is, if you take the report that the Saudis published last year when they announced that they were going to bring on 5 million barrels a day of new production in this decade or by the year 2012 – which was greeted with huzzahs and that triggered many a phone call and e-mail from worried clients saying “Well Don, isn’t it time to get off your story?”, well when you read through the report, there were several aspects of it that were of interest. One of which was that they were going to be doing water flooding from the beginning and they needed $32 a barrel price to make this economic.
Now, that really caught my attention, I thought that should have been a page one story, it wasn’t even a page sixteen story. Because you tend to think of, in the established oil fields, that water flooding is petroleum Viagra for aging oil fields. So the idea of water flooding from the beginning was a shock.
And they explained that of course, this is heavy oil: poor porosity, poor permeability, tough to get out and it’s expensive to refine.
So that 179.5 billion barrels that the Saudis have, which the experts have assured us for years means that oil prices could never stay about thirty dollars for more than a few minutes turns out to be not very attractive stuff. So that was big enough of a threat and this has been confirmed then by what we’ve been getting as they’ve been expanding their production. In other words, Saudi light, which was the world benchmark really, they apparently don’t have much of that stuff and if they have, why haven’t they been bringing it on-stream?
So, it may well be that what we have is a different kind of oil story, which is, that there may be enough oil in the world to meet demand, although a lot of capital investment will have to go into creating it, but that what we don’t have is stuff that the refineries of the world can adequately handle.
Now, that seems like the kind of problem that could be solved. After all, all you do is add more refineries. Yeah, well, in this country we haven’t built a new refinery since 1978 and we’ve closed over a hundred. And in addition, as a result of the environmental rules that we have here, we have sixteen designer gasolines in the United States, so that if we have a squeeze as a result of a refinery shutting down, we had this happen to us in Illinois, they can’t move in gasoline from some other state easily, because it’s got to meet the Illinois air quality rules. And also, being in Illinois, it has to have ethanol in it.
All of this says that we are going to have quite a squeeze going forward on refining capacity and that this is going to be an even bigger and more reliable profit center for the integrated oil companies than the upstream operations. When I look at the multiples on the pure plays in this country, Valero and Tesoro, they’re trading at about ten times earnings, and I look at the multiples on the integrateds here, where you’ve got Conoco Phillips at nine, Marathon at ten and Chevron Texaco with a P/E of eleven – now that’s a blend, obviously, of upstream and downstream – but, it does argue for the idea then, that maybe the integrated stocks are a good way for people who are nervous about oil prices to reduce their portfolio risk and to get into an aspect of the business which for so long was considered something that you had to do just to be an integrated oil company, just to be in the game.
Because the refining and marketing side of the business was so erratic, such gigantic swings, which why the Valero’s and Tesoro’s sold sometimes at multiples as low as five and six times earnings, because the earnings were so erratic.
Well, if what we’ve got is that the companies that do have refining capacity to handle this glup and they buy then, OPEC produced oil at a huge discount to the price of Brent or West Texas intermediate, what you’ve got then is built-in profitability.
Because the overall price for refined products is set off the light crude and therefore this other stuff, since you’re able to refine it, what you get is the price for your refined products of that only your input costs are much lower for the raw stuff and you’ve got an efficient refinery to handle it.
That’s one part of the story.
Now I want to get to a story that is a page one story today in the Journal. It wasn’t when I was putting together this call, which is the amount of cash the oil companies have and what are they going to do with it? Because that was really what was going to be my call today, which was that the oil companies were rich with cash and what they’ve got to do is buy Alberta oil sands companies. Because I don’t see how else they can protect their reserve life indices. So a combination of a declining reserve life index and soaring cash reserves and the fact that the areas of the world that they thought they could invest in to protect their reserve life indices – namely Russia and Venezuela – have been taken off the options in the last two years. So, a huge shock for Big Oil.
Now that was planned to be the story, but now that it is on page one, all I’ll simply say is the numbers there are really impressive. When you see that ExxonMobil has $23 billion in cash, up by over 100% from the previous year end, Royal Dutch is up $8.5 billion, up from $2 billion, Chevron Texaco, $9.3 billion up from $4.3 billion, I mean, these companies are sitting on unbelievable amounts of cash and remember that one of the ways you measure these companies against each other is ROCE – Return On Capital Employed – and you’ve got so much cash in there which is earning 3%. So, one way of course is to go out and buy another oil company and we have Unocal in play at the moment.
But although that gives you some access to highly prospective territory in Asia, which is an extremely desirable part of the world to find stuff – anybody who has any doubts about it should look at the Canadian stock Niko Resources, what’s happened to that stock in the last year – but I think that what this is going to mean is that once the question of how you can take in to your reserve life index oil sands properties is going to mean that those properties which have been doing well, gosh knows, and I’ve been singing this song, but the song has moved from a duet to a quartet to a small choir to the kind of choirs that they do for performing the Messiah, as these stocks have just kept rolling ahead.
Now, looking at the money that the oil companies have and given the alternatives available to them to deploy it, the logical thing is to move in to the oil sands in a big way and the most logical way to do it from a start is to buy up existing oil sands companies. So, what I’m referring to here is of course, the term that is used in the industry when you put your operations there both for open pit mines and for the oil companies, which is the footprint. And the oil sands are the sands of time because what they have is reserves on a scale which is disproportionately huge relative to reserves elsewhere in the world.
The typical oil wells and oil fields will have a few decades of reserves maximum. But here you’re talking of something where you take together their proven, probable and possible reserves and you can get those proved up in a hurry with drilling, you’re talking of anywhere from fifty to a hundred years potential.
So these are the sands of time. And there’s currently briefs filed with the Securities and Exchange Commission here by the oil industry, prepared by Cambridge Research Associates, which is Daniel Yergin, which is asking the SEC to change the way it allows the oil companies to take in oil sands reserves. And dealing also with the distinction between proven and probable.
So this is a big, big application and it became more important as a result of this phenomenon of what happened when Suncor had a fire near year-end and Suncor supplies the diluent with the other producers use, which is added to their glup to get it to move through the pipelines. And Suncor’s diluent soared to $72 bucks a barrel and very briefly during the last few days of the year, bitumen, which is what they produce, fell to $4.53 a barrel. Under the SEC rules, you can’t count that in your reserve life index because it’s not economic. You use the value at year-end.
Now that approach of the SEC was a good back of the envelope approach for years but it produced a ridiculous distortion. And poor old Shell, which has it’s subsidiary of Shell Canada, they had to delete even more reserves from their reserve life index because they were technically not economic at year-end.
Now I just think that the SEC is going to look at this in the light of energy security for the US and they’re NOT going to want to have anything that discriminates against the development of the oil sands. So I will simply make a prediction that that problem will be resolved. And then what we’re looking at is a situation where what you’ve got is a few companies who have reserve life indices which look almost like science fiction, compared to the reserve life indices of conventional companies.
So, I think that a combination of events, some of which were predictable and some of which weren’t have lead to a situation where the value of those assets to a strategic buyer just keeps climbing.
Now from the standpoint of somebody who owns Canadian oil sands trusts, you can say “Well look, this is a lousy royalty trust, I can do much better with things like Penngrowth”. But Penngrowth, which is a wonderful company, they’ve done extremely well, it’s a short duration company because what it does is it acquires assets and it’s done very well by acquiring mature fields, largely, from big oil companies at a time when they were trying to conserve their money for big projects, particularly deep water Gulf of Mexico, which has become more and more important.
Of the projects Big Oil has brought on-stream in the last five years, where they’ve added reserves, it’s the biggest proportion of them that’s deep water now in the history of the industry. So, what they did, was they dealt off to the royalty trusts short duration assets, which made sense at the time, particularly since the industry believed this stuff that oil prices were headed back to fifteen bucks a barrel.
Well one of the things that happened in all of this was that ExxonMobil through Imperial dealt off an interest in Syncrude which became Canadian Oil Sands Trust. And boy, would they like to have that back now, as anybody who’s bought that stock can attest.
So, my thesis then is as follows: that the bookends of your oil investing should be extremely long duration reserves in the ground in secure areas of the world, but you could also go to the other extreme which isn’t even upstream at all, it’s downstream. But it’s companies that have the refining capacity to handle heavy oil.
It happens that Randy Olinberger and the Nesbitt research department upgraded this week that is an up-grader, if you want to put it that way, Husky Energy, which has a substantial operation of upgrading heavy oil and it’s an integrated oil company which also has substantial exposure to offshore Newfoundland – interesting company all around. And so there’s an example of the kind of way that you can look at, for diversifying your portfolio away from the pure E&P companies.
And I admit that I’ve displayed a bias towards those companies. I also said of course you should own ExxonMobil, which is one of the chapters of my book, because it met the test of not only being a terrific oil company but most important, it grown its dividends faster than inflation for more than twenty-six straight years. And they’re certainly going to keep on doing that.
So, putting together then what I’m telling you here, is that you should not be reducing your exposure in your portfolio to oils, notwithstanding that all sorts of people are telling you “Oil is peaking out and this game is going to be over”. I think what you can do is simply, within your portfolio, increase your exposure to the integrateds or even to the pure play refiners to, in this country there are others, but the obvious ones – and I’m not recommending these, in that sense, I’m simply saying that you can consider these as diversifications and I’ve never talked about them before.
And it depends on the individual situation of the individual investor how you do this. But, I’m taking away what was a negative bias to a group. And I’m not taking away my positive enthusiasm for the E&P companies and I’m sticking to my view that the way you should value them is reserves in the ground in secure areas of the world and that may be the five thousandth time I’ve said that in these calls.
Finally, as regards the base metals and gold, we’ve had a continuation of excellent performance of the leading base metal companies and once again what we’re looking at here is a situation of reserves in the ground in secure areas. And the evidence is very strong that Chinese economic growth is very strong. I think that in a year where we expected to have a bit of a sell-off because of that cottage industry predicting the China crash, but they’re being more subdued this year about it. So as a result the base metal stocks are holding up.
As for the golds, there’s better times ahead. Because I think that the strength in the Dollar now – this is the time of the year when you expect it because we’re coming up to March 31st and the Bank of Japan always seems to massage things pretty well for the Dollar and weakens the Yen. And so as far as I’m concerned this is a period of seasonal strength for the Dollar.
The trade deficit numbers were horrendous and so therefore the fundamental argument is stronger than ever about why the Dollar is going to go down and why gold is going to go up. But, it’s been overlooked because of this strength in the Dollar and there’s been a whole bunch of reasons both good and bad for that.
But, my argument at all times has not been predicting what’s going to happen in the next week or the next month but that the fundamentals are that the Dollar has to go down because the US trade deficit situation now, the Current Account Deficit’s now over 6% of GDP. I mean this is really serious.
The fact that the Canadian Dollar is back down through eighty-three cents, this is not a sign of a reversal. What we’ve got here is something that the fundamentals are still in place for driving the Canadian Dollar well through ninety cents on its way to par and the Euro – notwithstanding that the Eurozone has all these problems – one of the things that’s interesting is apparently the OPEC countries are suddenly buying all sorts of stuff from Europe where they have pretty established trading relationships and it’s also a way of expressing their resentment against the US – so we’re getting some uptick as a result of high-priced oil, feeding back in to the Eurozone. There’s not much else going on over there.
So, the story has changed only modestly, I’m adding, in effect, to the energy group one group that I have given sort of a lick and a promise to in the past because I just thought you should be emphasizing the big reserve story. I think that you can diversify your portfolio and buy assets cheap.
That’s it. Any questions?
David Miller: Good morning, Don. You mentioned a couple of refiners, or integrateds with refining capabilities, I think it was Husky and I didn’t catch the other ones, the other Canadian ones. Was that Imperial Oil? Again, recognizing that you’re not recommending them, but…
Don Coxe: The other one that our research department is recommending right up there is PetroCanada, which has a Canadian ticker symbol of PCA and it trades down here as PCZ. And I cited the Valero and Tesoro only as an illustration that with those companies that’s all you get, is refining and notwithstanding that their multiples have doubled, they’re still selling at a big discount to the S&P. I think that if we take that that’s the multiple that the market is assigning then, to refining, from looking at those we see that’s the multiple. I think the market is assigning too low a multiple to refining, because it doesn’t understand that the game has changed, now that the extra crude that is going to be brought forward from the OPEC zone over the next few years is likely to be overwhelmingly heavy crude, which means that those who have the good luck to have the refineries which weren’t the best things to own for years, they’re going to benefit from this by being able to process this glup.
And then you can work through on the integrated companies, how much you’re paying for upstream as against the downstream by comparing that multiple on the pure plays.
David Miller: One more quick follow-up. You had told us a while ago that there’s been a lot of progress in the people developing technologies to either eliminate the need for gas in processing the bitumen in the tar sands or otherwise just reducing some of the heavy development costs. Is there any updates, I’ve seen this company like Ivanhoe Energy or Opti and others that are working on it and I think that’s a positive sign that there’s a lot of the progress in the area but…any sense in when that’s going to become a real factor in the actual cost of the processing of the tar sands?
Don Coxe: Well, like you, I hear a lot of the buzz. The only sort of absolute development we got was Suncor’s announcement that they’re going to build a coking plant because they get coke out of their processing, the crude, and then they can use that as a source of fuel to alternate to natural gas and so that’s an example of using technology to control costs. Because one of the arguments, you’re absolutely right, is that if you keep expanding the oil sands then all the gas that’s going to come out of the McKenzie Delta is going to be needed in Northern Alberta just to get the heavy oil out. So, finding other technologies, this is a case of necessity as the mother of invention.
I hear both optimistic and pessimistic appraisals on these. I’m no petroleum engineer. All I’ll say is I have an optimism that when a need like this occurs and smart people with smart money get working on it, that they’ll find answers. You know, we got to the stage of thinking that the only technology in the world was related to semiconductors. It may prove to be that some of the best technology that’s developed in this decade will be related to lowering the cost of producing and refining minerals. That would be good.
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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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