Don Coxe - “Canadian Oil Sands Trust: Finally Taking Notice”
Nesbitt Burns Institutional Client Conference Call for August 5, 2005
Don Coxe
Chicago
“Canadian Oil Sands Trust: Finally Taking Notice”
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Thank you all for tuning in to the call, which comes to you from Chicago. I’m back from two weeks vacation. The chart we faxed out was of the Canadian Oil Sands Trust, the comment was “Finally Taking Notice”. In the last couple of weeks, a series of news stories have finally gotten the attention of a lot of investors into the Alberta oil sands. Since this has been a favorite theme of ours on these calls and in Basic Points for the last nine months what I want to do is update you on this because the question for a lot of people is…”Boy these stocks have really had a move, should we be taking money off the table?”
So I go back to the basic principle, is, you want to know why you own something. This becomes more difficult when you have stocks on a roll because people who had formerly been lukewarm in their endorsement of the stocks or who had put target prices which were fairly low then start revising their arguments and it becomes complicated for people to figure out “Well, what is my fundamental reason? Why did I buy this stock in the first place? Why did it matter to me?”
So I want to go back to first principles here, which we’ve talked about for four years, which is, the way to value resource stocks is on the value of reserves in the ground, unhedged, in secure areas of the world.
Now the advantage of that one quick statement is it makes it fairly easy to decide which kind of stocks you’re keenest about. And what it also does is, makes you somewhat independent of quarterly earnings reports. Now, I’m not saying earnings don’t matter, of course they do. But I’m not an oil analyst and I’m not a mining analyst. And they’re the experts who come up with the earnings forecasts.
I am looking at these investments as strategic investments. Strategic for investors and -we’re going to get to it a little later - strategic for other companies. So, what I’m interested in is that investors put together portfolios where their exposure to oils and mines – we’ll take the oils as a theme today, we’ll get to the mines a little later this month with an issue of Basic Points.
In the case of oils, I’ve consistently said that you should aim at having a reserve life index in your portfolio at least 50% bigger than that of the stock market itself. The reason for that is the real value in these stocks is that since the oil industry has long since completed its triple waterfall crash, the last ten [years] of which meant that there was very little new capex going on while demand just rose year in year out, what we’ve got is a situation where the value of these assets over the longer term is bound to increase.
And the neat thing about reserves in the ground in secure areas is what you can use is blended prices looking forward for the underlying fuel. If we’re talking about oil or for that matter coal, or natural gas, and what you’ve got is a way of saying is “What are they worth?”
Now, as you know, I religiously argued for two years that the forward curve was NOT a reliable way to value these, so you say “What a hypocrite you are”. No. My point simply is that the forward curve was in backwardation, which meant that the prices were falling as you went forward and therefore if you used the forward curve for the value of reserves in the ground, then you wouldn’t have been that excited and you particularly wouldn’t have been that excited about oil sands stocks. Because the oil sands stocks have to have a pretty high price for oil to start making any real money.
The kinds of numbers that our experts say is something north of $25 US a barrel, with the Canadian Dollar at .82 - .83. And this varies from company to company and depending on whether they’re mining it or using steam-assisted gravity drains and all the refining costs…there’s a whole bunch of variables in there which differ from company to company and resource to resource.
But if you build a portfolio where you overweight within your resource sector, those with mammoth, long-term reserves, the Methuselah reserves, then what you have is an asset which you can feel pretty confident about [that] is going to rise in value relative to the rest of the market over the longer term.
And the big reason for that…we published a piece a year and a half ago about Hubbard’s Peak. And the point was of that piece that most of the major oil fields of the world are nearing or at their peak and many are long since into long-term decline. And therefore what the oil industry collectively is going to need to do, and that is the private industry and OPEC together, is to spend billions and billions and billions of dollars to bring on relatively high cost production in some pretty dubious areas of the world.
But although those figures are out there which have been routinely used by the skeptics to say “Ah, there’s lots of oil out there, what are you paying for these stocks?” We’re going to need that to replace what we’re going to lose.
The astounding thing to me in the last couple years on these things has been that what everybody – and when I say everybody, the Street consensus – simply took the potential for all the new oil fields that could be brought on and then pointed out that we’re going to have massive oversupply. And, I mean…so, the result was they were continually predicting oil prices falling and they used the forward curve…then was the victim of that consensus because they enticed many of the oil companies into selling great amounts forward because they convinced them that their own brilliant investment bankers and analysts were predicting $30 crude oil, so lock in selling forward these high prices like $35 and $40 oil.
Well, the oil companies gradually came to their senses when they saw that under Rule 133 they were now being required to mark those forward sales to market, because they were being treated now under international accounting rules as a derivative. In the old days what they said was they’re pure hedges and therefore you could wait until the time of delivery and take the price at that time. This was the equivalent in effect, of the argument on stock options. They said “Ah, there’s no real cost to stock options” and the tax thing in the US only shows up at the time they’re exercised and that’s when you find out they have zero value up to that point and then all of a sudden they have big value.
So, once the accounting rules got straightened out and people said “No, wait a minute, if you sold millions of barrels forward, then you either have a profit or a loss, quarter by quarter. And if you were selling it at low prices and some of the companies were delighted to sell at prices like $26 and $27 a barrel, way through to the end of the decade, then what you’ve got is a commitment to sell for something at a gigantic discount. The other side of the trade, which is people like Southwest Airlines are cackling all the way to the bank. And what some of the companies have done is adopt the attitude that these are synthetic or artificial transactions. They aren’t really being used in valuation.
Well, again, we come back to our simple-minded approach which is, the value of the company is the value of unhedged barrels or mcf in the ground in secure areas of the world.
So, again, one advantage from the standpoint of investors on the line who are not experts in oil and gas is…you don’t have to do much analysis this way. I’m not against…I mean, sophisticated investors should be doing the analysis. As a generalist, what I try to say is you should have a huge overweighting in oil and gas stocks, as your basic principle there. You overweight it on the basis of reserves on the ground.
And of course there’s a different value to reserves in the ground in a producing situation as opposed to something that can come onstream four or five years later. And there’s two reasons for discounting those. One is simply the long time it’s going to take before you get any revenues and particularly with the oil sands, what you have is questions as to how much they’re actually going to cost to develop it.
When Fort McMurray turns out to have the biggest real estate price gains of any community in North America in the last few years, what you know is that production that you’re going to bring on stream five years from now is going to cost a lot more than the stuff that Shell Canada, Canadian Oil Sands and Imperial and Suncor have now.
Because they were able to hire people back at the time that Canada had massive unemployment and they were able to bring it on stream at a time the Canadian Dollar was very low relative to the US Dollar, which is where oil is priced. So, therefore, this is one case where stuff off in the future has to be discounted. But this does not argue against using barrels of oil in the ground as the essential valuation technique. Because fortunately, oil prices have gone up faster than costs for these companies.
And here we are sitting with spot oil at $61.80 a barrel, December oil at $63.80, December ’06 oil at $63.65. And so, what we have is a situation where oil we can price forward. And if you take the last month of this decade, which I regularly refer to on these calls…we’re at $59.90 oil.
Now, not withstanding that, Wall Street analysts have been routinely using figures like $45 now. They’ve moved up to that rate and of course they were dragged screaming and kicking to get up to those kinds of prices. But what you no longer have is any kind of justification based on the forward curve for using low oil prices. Unless, of course, you are predicting an all-out recession or that we’re going to have a worldwide plague. And I’m going to be dealing with that in a future publication.
Now, both of those things could well happen in this decade, but if you’re going to use a low price for oil, what you should predict then is say “We’re assuming a severe recession or we’re assuming that fifty million people are going to die of a plague.” In which case, low oil prices are an excellent assumption.
If you aren’t using that, then you have to say what is the evidence for that forecast?
Now, all of this you’ve been hearing from me before, so why is it the call now and why is it these stocks are on a roll? Well, you know, it’s the Rule of Page Sixteen. What you’ve been hearing from me for a long time has been the Rule of Page Sixteen, which is that these companies way off in what seemed like the frozen north to all sorts of investors in sunnier climes, all of a sudden as a result of, first of all, Secretary Snow’s visit up there. Secondly, the small Chinese acquisitions. Third, and what really got things rolling, was in one day Kinder Morgan buys Terasen. Which gives them ownership of a pipeline which is oriented towards the oil sands.
And, the Kinder Morgan people, their stock goes up $6 on the day that they make the acquisition because they point out how instantly accretive it is and then they proceeded to talk to the media about the fabulous growth that was coming from the oil sands. Now it’s so rare where somebody who’s paying up in price to acquire an asset that their stock skyrockets. So the Kinder Morgan announcement came the same day as Total announced they were buying Deer Creek, a small company with oil sands in its future. And the implied value, according to the BMO Nesbitt Burns analysts who are looking at this, that they’re paying for it, that they’re assuming that oil is going to be fifty bucks a barrel.
Now, those announcements really got the attention of investors outside Canada, who up until now, yes, there’s been lots of interest in these stocks, but they started really piling in to them. And so what we had was tremendous response into these Canadian oil sands stocks. And it’s carried right through.
Now I use Canadian Oil Sands because it suffers from two disadvantages in terms of foreign investors. First of all, it’s not listed outside Canada. It trades only in Canada. Secondly, it’s a trust, not a stock. And that means for some kinds of investors, they can’t own it. And third, as I discovered on a trip to Manhattan a few months ago, when you come up with a stock whose ticker symbol is COS.UN, what this does is raises suspicions among some investors that this must be some funny kind of company and maybe it’s not a real company at all. Easier not to do anything about it.
So, for many, they just took the refuge of going into Suncor, which is just fine. But now, Canadian Oil Sands, which owns about 35% of the syncrude project and which is managed by Imperial Oil is doing extremely well but it’s now attracted a lot of attention because of the fact that Newmont bought over 6% of the stock and Newmont, in it’s annual report, said that they were doing this to hedge their energy costs. Skeptics say, come on Newmont, what you realize is this is one of the world’s biggest mines. And the price of oil is going up a lot faster than the price of gold. It’s been a fabulous investment for Newmont.
But what the Canadian Oil Sands story is was developed beautifully this week in a piece by Gordon Tate, who’s the number one ranked income trust and royalty trust analyst in Canada. His publication, which I invite you to ask your Nesbitt Burns representative for, he carries through a valuation of Canadian Oil Sands, he raised his target price dramatically. And he’s got a chart there showing the sensitivity of Canadian Oil Sands stock to different kinds of oil prices. And different kinds of interst rates. He’s raised his target price to a hundred and thirty bucks a share, but he points out that every one dollar increase that you use as the long-term price for oil is worth five bucks a share in the value of Canadian Oil Sands.
Now that’s the kind of leverage you really love.
This kind of approach can be used in valuing the others, because at least you know their costs. It can be used with somewhat more care in the case of companies like Canadian Natural Resources who are bringing on massive new projects a little later on, and their costs keep rising.
And of course there is up against this, the argument that the Canadian Dollar – if my forecast is right the Canadian Dollar will, eventually, within a couple of years or so, go to par – that’s going to raise their costs so much because virtually all of their costs are in Canadian Dollars. However, I think the price of oil is going to do well enough to offset that.
Point of story is that the world is now starting to realize that contrary to the wisdom of Wall Street – which is, there’s far too much oil out there and don’t worry about oil shock except in the event of war in the Middle East, war in Arabia – what they’re realizing is that the big new deposits that could be brought on stream are in areas of the world where people such as Lee Raymond…the sainted Lee Raymond who’s going to be retiring as the head of ExxonMobil…Lee Raymond has had this old-fashioned view that you’re in the business to be making money. And that of course is in distinct contrast to the kinds of people who were running most NASDAQ companies in the 90’s. Making money for stockholders that is, as opposed to making money for option holders. So, Lee Raymond has indicated that he’s not prepared to do deals with the regime in Russia as it is now and he’s not doing new deals with Chavas and he’s not going to commit his stockholders money in areas where he sees substantial political risk and what he didn’t say in public was, of course, massive corruption.
So, what you’ve got is a situation where in terms of oil resources, the biggest oil resource that’s largely untapped in the world now in a politically secure area of the world is the Alberta oil sands.
And two developments that I’ve talked about before but I will update you on, that I expect announcements on very shortly. One, is that the SEC was asked in a brief filed in February to change its accounting rules for valuing reserves and specifically for oil sands reserves. And all twelve of the biggest oil companies signed on to it and I was intrigued because Total was one of them.
As it is under the current rules, and you’ve heard this so often but I’ll just repeat it, that it depends on what the price of bitumen is on New Year’s Eve. It is the ultimate Cinderella Story. And since bitumen prices collapsed last New Year’s Eve, mostly because of Saudi exports of very heavy crude, and very briefly, like for a few hours, were at a totally uneconomic price. Then that meant there was zero value. Poor old Shell had to write down their reserves through Shell Canada because of that.
So what they’ve said is “No, let’s use an average price for the year as to whether these are economic or not.” So I think that’s going to be granted by the SEC, but that’s held back Big Oil, because remember the reason why you should buy an oil sand company if you’re a big oil company, is to improve your reserve life index. Big Oil collectively has failed to replace its production for six years. So Big Oil collectively is like Big Pharmaceutical companies collectively, which is, that their reserve life index is declining.
Which means ultimately, you know, that your financial viability is in question.
So, putting all these together, we’ve got that and we have a final thing, which is that the question of whether the oil reserves in the oil sands will be classed as reserves in these international rating tables becomes a big one. The IMF is one of those that does one of these oil reserves ratings for the world, and they’re due to come out with something, we understand, that they’re looking at reclassifying the oil sands in reserves. And if they did that, then even if they took only half of what the potentially recoverable reserves would be, the oil sands would show like three times the reserves of Saudi Arabia. Which is again something that attracts attention from global investors, because they’re saying “Gee, I better be part of a deal that big”.
So, putting all this together, what we have is there are strategic reasons for investors to want to own these stocks even though their prices have gone up. And that means for people going into retirement, I’m talking about high net worth investors, they should own these because their income will rise in retirement because I think you can be very confident that over the long term that oil prices are going to rise faster than inflation.
Mutual fund investors because the price of so many exploration and production companies worldwide has risen so sharply that now you have to wonder that given their reserve life indices which tend to be in the range of ten to fifteen years whether these stocks don’t have a new kind of risk factor in them. And so, when you can buy companies that have, on the basis of resource, that is as opposed to proven reserves, anywhere from fifty to one hundred years, a Methuselah style thing, this is a wonderful thing to have tucked away in your portfolio. Something where those oil reserves are going to outlive you.
And that is the reason why, even for investors, the reserve life index makes sense.
But then we come to the oil companies who are watching their reserves dwindling and watching the chances of finding any new major deposits in a secure area of the world, these things being erased from the map, why I think Big Oil is still going to have to come in and what I’ve been telling you people now for a couple of years is…unlike what you did with Canadian deep gas companies where you let the American companies who desparately needed to improve their reserve life index, you let them buy Anderson Exploration and Canadian Hunter cheap, cheap, cheap, I’m saying, particularly to Canadians on the line, don’t let the Alberta oil sands stocks get bought up by Big Oil companies that are trying to save their reserve life indices. Don’t let them build up their RLI’s cheaply. Make them pay for it this time.
So, all in all, I believe that these stocks – notwithstanding their run-ups – represent very good value if you take a strategic approach. So, it’s that which is to me the overarching concept here. And as to the relative value of one stock to the other, our top-ranked team of Nesbitt Burns oil analysts can help you make those decisions.
I just want to get you looking at this region and telling you that the enthusiasm you’re seeing now is just the early wave of what’s to come.
Now, as to just a couple of other topics before we go to the questions, I’d like to comment on what’s happened to the mining stocks since we last talked. Earnings reports are, of course, spectacular for these companies, but the market is yawning despite the fact that these stocks have done quite well lately, we’re still looking at Phelps Dodge with a six multiple, Inco with a ten multiple and we’re looking at the big companies like BHP Billiton with a twenty multiple.
So, I think that we’re going to see further consolidation in the mining industry because these stocks are just too cheap. With copper sitting at a buck sixty-six a pound, you start running that through your cash flow forecasts for these companies and then valuing reserves in the ground in secure areas, then what you see is these stocks are really cheap and they’re now very, very cheap relative to the oil stocks. This is a thing I’m going to be coming back to later, so I’m just touching on it now, but as a new money investment I think those of you who have been staying away from these stocks shouldn’t stay away from them any longer.
Finally, with regard to the bond market, which we’ve been writing quite a bit about lately, today what we have is an upside breakout in yields on the US 10-year note. And it’s a pretty powerful looking chart, indicating that the conundrum of yields staying low is challenged. And it corresponds to a series of developments within the markets, one of which was, and I didn’t even mention this before because it happened while I was away, that the Yuan has been taken off being absolutely a fixed price to being what we can call an inscrutable float. An inscrutable float is our new term for the new Chinese monetary policy and what it means is that they’re talking about valuing the Yuan as against a basket of currencies but not exactly according to a formula that they’re not going to reveal and they will intervene only as necessary. It is a mystery wrapped within a question wrapped within an enigma.
But what’s clear is that they’re not buying Treasuries the way they were. This breakout on the upside in Treasury yields really coincides with China’s announcement on the Yuan. And since a lot of the other Asian currencies are doing the same, they’re following China since China now has the lead there, I think what this has done it at least temporarily removed a set of buyers from subsidizing the US bond market.
More to talk about that in the future, but those are what come up first now after coming back from vacation and I’m now ready for your questions.
Helena: Morning Don, appreciate your call. I know this is a very open question, I realize you’re not “lucky enough” to be a securities analyst, but what would be fair value on the mining stocks? Phelps Dodge, for example, even a ballpark range?
Don Coxe: Okay. Based on their powerful reserves, particularly in Chile, which I regard definitely as a secure area of the world, I think that anything…I will be surprised if the stock sits here. I think the company is very vulnerable to a takeover bid. And a takeover bid with the stock at $110 now could come…and I’m just guessing on this, but it’s simply that the Xstrata’s and the BHP’s of this world, they cannot replace in secure areas of the world, the kind of ore bodies that Phelps Dodge has. The company is debt free.
You know, if KKR were valuing this on a leveraged buyout, and they didn’t know it was a mining company…if they were looking at these numbers, they would be delighted to pay $140 a share for it. Then if somebody took the mask off and said “Oh, it’s a copper mine. Oh, well in that case we won’t pay up.”
Because what you have is the residue of these twenty years of the triple waterfall for the mining industry meant that nobody wants to pay up except now that we have Chip Goodyear who’s arguably the smartest guy in the whole industry saying that there are two cycles now, the short cycle which is the OECD economy cycle and we may be at the peak with that, but the long cycle which is the new middle class of China and India which is going to take decades to play out. And so, what you want then is long-term reserves of copper. And copper is particularly in acute supply problem.
So, I would be very surprised - if copper stays at these levels – if Phelps doesn’t run up, at some point, to a hundred and forty bucks or more. And if a takeover battle should develop, and I have no inside information on this but it’s just sitting there, then the price could go past a hundred and fifty because it’s an amazing resource.
As I say, if it was doing anything other than mining, there’s no way it would be sitting at these kind of value levels, free of debt, top-notch management and huge assets, reserves in the grounds in secure areas of the world. It fits all these criteria. So, to me, even though the stock has come up a long way, it’s still a cheap stock and it’s worth a lot more than what it’s sitting at right now. Okay?
Robert: Good morning, Don. Just on the subject of the base metals…from your standpoint in looking at institutional investors globally, I mean, how much of the base metal stocks do they own? Do they own them at all or do they have modest positions? I’m just curious.
Don Coxe: Well, of course, my problem’s always been to get them interested in it. You see, so many US investors are one way or another, tied to the S&P 500. And base metals are 1/10th of one percent of the value of the S&P 500. It’s pretty tough to develop in-house research when you’re talking about something like that.
When I go to London I meet lots of investors who know about them because of course the London market includes a good weighting in the mining companies with stocks like Rio Tinto and BHP over there. So, no, I was at one meeting in the Northeast with a very well known firm and I mentioned Inco and was asked what they did. And I said well they’re the world’s second biggest nickel producer. “Oh? What about International Nickel?” I pointed out that their name was changed a long time ago. Question asked “Do we follow that?” “No, they took it out of the S&P so we don’t follow it.”
And so, frankly, I have this problem of trying to get investors to look at these and they will look at the record of their earnings and their stock prices for the last twenty years and they say they’ve been crummy companies for so long, they’re finally looking okay. They probably should be shorted here rather than bought.
So, they have a residuum of failure because of the triple waterfall. So, for me, the problem is getting people to look at them as real companies that are absolutely crucial to the emergence for China and India. These are the companies that have to create…companies that have a combined market cap which is less than Microsoft and Cisco – they’re the ones that have to find, develop, mine and refine the ingredients by which the new middle class in China and India can emerge.
So they’re going to be absolutely strategic companies worldwide, but no, I find very few…I find some hedge funds that are good at it, but at this point, they just…for American investors, are just too small an item in the index to warrant doing the work on them.
Thank you all, we’ll talk to you next week.
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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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