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Nesbitt Burns Institutional Client Conference Call for August 31, 2005
Don Coxe
Chicago, IL
Thank you all for tuning in to the call, which comes to you from Chicago. The timing of the call is that I’m going to be out on the West Coast at the end of the week and it was not set specially because of the hurricane. But it happens that the story is a big one and it gives me a chance to take you through what I think is unfolding in the energy sector of the market.
There’s always a big, big danger, when you’re in the midst of a crisis, of coming up with conclusions that aren’t sound on an investment basis. Let’s separate out the human tragedies and the horrible devastation that this - which is probably going to be the biggest natural disaster since the San Francisco earthquake of ’06 – let’s separate out all those parts of the story from the investment theme here, which we talked about in recent weeks, which is the question of the outlook for the energy stocks and specifically the oil stocks.
As we said last week, we’re getting a little concerned about the fact that people are getting on side with this story that weren’t there before it, this has been accelerating.
Let me begin by saying the way I try to discipline myself when there’s a story unfolding –entirely on Page One – is I try to look at aspects of it which aren’t being carried on the Page One part of the story. First of all, let’s deal with the fact that we’ve got all sorts of people who, in the past, ridiculed the idea that oil prices were going to be strong for years to come. We’re now talking in terms of $80 and $100 oil.
There’s always the possibility that these people have actually gained wisdom, but I go on the theory that people who’ve been bad betters for years on the racetrack, if they give you a tip now on a horse and it happens to be the horse you were betting on, you might wonder whether you want to make that bet, given their lousy record.
As this thing unfolded, I’ve been watching in detail, the way the futures curve has been behaving as to what the nature of the story is. Now there’s no question that at this stage still the energy industry itself doesn’t know much about how much damage has been done. You’ve seen the statistics about how many people have been called in from drilling rigs and how much production has been lost. And in particular, the big part of the story that has been emphasized is the story of the refining capacity in the United States. About 10% of it is being shut down, for a variety of reasons, one of which is no electricity down there and they can’t even get through on the phone.
What you’ve got to, as investors, discipline yourself to do at a time like this is to say “Well how does this effect the longer term valuation of the shares that I own? Is this a time to buy more because we’ve had a supply side shock now?” Up until now it’s been demand-side shocks…the oil story. This is a genuine supply-side shock and supply –side shocks have been the ones in the past that produced spikes in oil prices followed by collapses in oil prices. They also triggered recessions.
But let’s look at it realistically. This isn’t a supply-side shock like shutting down Iran or Saudi Arabia. This is the production of oil from the Gulf of Mexico is significant, it’s just over a million barrels a day or a million and a half barrels a day. And a million and a half barrels a day may not be shut down for weeks and months, that is only a big deal because we were already tight, which is the story we’ve been talking about for three years. What this does is throws into sharp relief the problem that was there before and why it was that we wanted to own these stocks.
But as usual, the big story isn’t on Page One. The big story is what’s happened to natural gas. Natural gas has had a phenomenal performance which has been sustained. Meanwhile, oil is trading at a lower price now than it was Sunday night…right through the curve. Now that, to me, is the significant part of the story which you aren’t getting from the Johnnies-Come-Lately to the oil story.
Because what that is saying is that the combination of the ability of the government to release oil from the Strategic Petroleum Reserve, plus the assumption that eventually the electricity’s going to come back on, is going to be enough to prevent a sustained move into a totally higher zone for oil prices. Now that is despite the fact that this is the worst possible time for a supply-side shock given the International Energy Agency’s quarter by quarter forecasts for oil production worldwide and oil consumption worldwide.
This is the quarter – the fourth quarter is the one – where they were predicting a deficit. The only one that we’ve seen in years and years and years. And so that has been a factor underlying the pricing of oil and oil futures, is that because in the fourth quarter, what you have is the switchover to producing distillates, particularly heating oil.
What happens is this is a time where you have your refineries operating flat out and you have enormous demand and you haven’t got a collapse in gasoline demand, you’ve got a drop in recreational demand, but you’ve got all this demand for heating oil.
There’s never a good time to have a hurricane that knocks out 10% of your refining capacity and a million and a half barrels a day or production. This is the worst possible time. Therefore, this was the time, I say was now, when you most would have expected that we’d have seen a pop to something like $75 or $80 crude and most particularly, that you would have seen a huge move in the forward curve.
Well, if you follow the forward curve – you can follow various ones, but I like to always check what the December 09 contract does relative to spot oil. Why December 09? Well, of course it’s the last one in this decade, but when you start getting out to anywhere near that end of the curve, the pricing is done essentially by producers and consumers. Why? Well, you may say “Well there’s such small open interest, speculators could play it like mad.” No, that’s not the way it works.
Speculators are involved in the spot and near months, where they’re big factors. When you get out to that end of the curve, it’s largely priced by producers and consumers and the reason for it is actually although the volume of the open interest isn’t big, it’s being used as the benchmark pricing for all sorts of OTC, that is, private deals that are done in oil and refined products.
So what that is is the combined perceptions of producers and consumers of what the price of the product is going to be further out. And with all the excitement that we had in the spot and all these headlines and all these people on TV warning of impending disaster, the December 09 contract just…fluttered a bit and then sold off slightly.
This was the biggest dog that didn’t bark of our time.
What that was saying was that the people who knew the industry best were saying “Yeah, there’s going to be short-term disruptions here, but it doesn’t change the basics.” Which is that oil is worth something like $68 or $69 a barrel. And that’s a lot, but it isn’t something where you change your view as a result of an unexpected disaster.
We have never talked, on these calls, that you should be buying oil stocks because there’s a good chance that oil’s going to eighty or one hundred dollars. I’m not ruling that out. It’s more likely than oil going to thirty bucks, which was of course the kind of thing that all sorts of ‘wise’ people were telling us, right through this piece.
But that’s not the point. The point is, that oil supply and demand are in balance. As long as the global economy stays strong, what we’re going to have is that the move will tend to be to the up side in oil prices.
What’s reassuring about this is we have not had the kind of spike that we had with major supply side shocks like when Jimmy Carter connived at getting the Shah dumped in Iran, that kind of thing. No, this is a very modest response. Yet this is the story that dominates the TV and the front page, that something dramatic has happened to oil.
If this were one of these geopolitical things, then we’d see the out month contracts up sharply. Hasn’t happened. And if we take the March contract for oil, March next year, it spiked from sixty-nine bucks to seventy-one dollars in no trading at all overnight when the hurricane hit. And it’s sixty-nine ninety now. Now this is a pretty thick contract in the sense that there’s lots of open interest here. Lots of trading going on, but it’s in a very narrow range.
So what this is saying is that, at the moment at least, the assumption is that this will be a short-term shock that can be dealt with to a very considerable degree by the use of the Strategic Petroleum Reserve and it doesn’t change the basics which is this delicate balance we’re going to have to live with until…I say until…we have a global recession. In that case, oil prices become cheap again.
As to the argument that this will produce a recession, I’m not an economist, I’m not going to get into that. But what you as investors have to think about is – particularly those of you who have been following this story faithfully with me over the last few years – what you should be doing now, given the fact that the oil stocks are running merrily ahead of the oil. That’s something to think about.
Furthermore, the huge move in natural gas suggests that maybe within your E&P portfolio, you should be downgrading the oil stocks in favor of the natural gas stocks. Because in the case of natural gas, this is a questions of U.S. supply and demand. Now this is one case where the Gulf of Mexico really is a huge story, because it’s significant to U.S. production of natural gas.
What you can make a case for then is that the gassy stocks are a better buy in here than the oily stocks with one major exception, which is the oil sands stocks. Now why do I make that an exception? It’s because – and this is the argument you’ve heard me using for the last year – these stocks should sell at their enterprise value. Or at least you should invest in them based on their enterprise value. What they are worth to a strategic buyer who needs to get a longer reserve life index.
And because these are such long reserves, then although you don’t increase the pumping capacity of them, that’s only done at massive costs and lots of delays, what you’ve got is reserves that are going to last for decades or maybe even the next century. So they’re a unique asset.
What I’m drawing out of these developments here, is that nobody should be buying oil stocks based on $80 oil right now unless they know something that nobody else does. What you should be doing here is looking also at other sectors of the industry.
Now last week we talked about the oil service stocks as an alternative move for those who have huge built-in profits in the oil companies themselves and want to diversify a bit within the group. And it’s interesting to see how the oil service stocks have responded very positively to this. The ones I like to look at are the Baker-Hughes, the Halliburtons, the Pride Internationals, the Schlumbergers. They’ve done very well in response to this, Schlumberger’s up a buck sixty today.
So what they’re saying is, a lot of money is going to be made on the servicing of these. But, again, we’re not talking about gigantic moves, but what you can say with absolute confidence is that this hurricane is good news for oil service stocks. That’s an easy call to make.
Furthermore, you know that that’s not just a blip. That they’re going to be working very hard in the Gulf and in that whole region to make up for this and it will tend to, as a result of getting twelve dollars and thirty five cent natural gas, what that means, it’s going to accelerate the drilling for natural gas in the lower forty-eight states next year.
Therefore the drillers, the down hole companies like Smith International, these kinds of stocks, what you can say is they are the winners from this. Now, it sounds macabre to talk about winners from a disaster, but again, I’m talking about what you do with your investment portfolio in response to an unexpected shock. Something of this proportion means that you’ve really got to draw distinctions within your portfolio as to which things have improved their outlook and which things the outlook really isn’t affected much by.
I would argue that in terms of the straight E&P companies, that apart from giving some support for oil prices, what the futures curve is saying is that nothing has changed. There’s been bigger moves in other sectors of the market then there have been in the oil futures. Also, what you’ve got to understand that a lot of people don’t understand, the difference between gas and gasoline, which means they’re mixing up the stories.
I watched and writhed through an interview on TV, where an energy trader was trying to explain what was going on. This was within the first twenty-four hours of the event. They were talking about what was happening to gas prices and the interviewer immediately focused on “…those oil companies, look what they’re going to charge, three bucks at the pump”. And they carried on about a four-minute discussion where the energy trader was trying to get across the notion of gas, being natural gas, and the interviewer was just concerned about the price of gasoline.
With that being the kind of received wisdom that people are going to get out there, I’m suggesting to you that you look at the fact that we now have a brand new trading zone for natural gas and this isn’t going to go away in a hurry, because what we’ve lost out of this is all these days of injection of natural gas that we needed to do before coming into the winter.
So now we start getting into a story of supply-side shock that’s going to have sustained impact. Because once we get into late fall and the heating season, then there’s no net injection going on in the lower forty-eight states, we start to have drawdowns.
And yes, going into this hurricane, the reserves of natural gas on hand were good looking but not great. Now what we have is a situation where because we’ve cut back all this output from the Gulf, we’re going to have the potential for a squeeze, should we have a cold winter. Now the argument against a cold winter is that we’re being afflicted by global warming, I’ve seen two stories which allege that this hurricane was caused by global warming. So presumably the people who publish those kinds of stories will also publish a story saying don’t worry about home heating costs during the winter because it will be a warm winter.
For those who are NOT going to accept that kind of reasoning, if we’re going to dignify it with that now, what you should be looking at is here is a situation where the natural gas squeeze gets worse. If we should have a cold December and a cold January, then I don’t know…but the sky’s the limit on natural gas prices. Whereas that will not necessarily mean any big move in oil prices because heating oil at all times will be offset by the declining consumption for gasoline.
I am not saying that oil prices can’t go up from here. I’m saying that a prudent person, noticing this huge change in the consensus…we have switched from a curve that was in backwardation to a curve that was briefly in contango and now is a sort of a level curve, because we’ve had such a huge move. So, we’ve got spot oil at seventy bucks, but we’ve got December crude at $69.75 and we’ve got the out months, the extreme one that I’ve talked about which is way down at $62.50. Way down. $62.50 is still highly profitable oil.
And if you use that for valuing reserves in the ground, which you will recall is my basic theme for how you invest in these companies, that assigns a huge valuation that isn’t in these stocks. And I don’t know when it will be, but in terms of the spot, since this call began, spot oil prices have been slumping a little bit. We’re now at sixty-nine and a quarter. Not a big deal but what it tells you is that some of these scare stories which are being promoted by reporters who are not experts in the energy industry may not be all that well based.
So we have then, the new consensus, which is that oil prices are going to keep going up. My rule of Page Sixteen tells me that now that we’ve got this kind of consensus and this kind of story, that prudent people would be diversifying a little bit and taking some of the risk out of their portfolios. I think that to the extent that you’ve got a gigantic overweight in energy as a result of having bought these stocks when we get really keen on this story and just let them ride, then what you might want to do is take some profits in here.
Yes you want to remain substantially overweight in the energy group, there’s no doubt about that. But frankly, I’ve talked to some people who have gigantic overweights. I mean we’re talking just huge. Which means they are now in a position of taking a very big bet that two things won’t happen. First of all that we won’t have some global slowdown which will knock down the prices but number two that we won’t have a stock market sell-off because if we have a stock market sell-off, then there’s no question that these stocks will sell down.
They’ll probably outperform the market on the down side but remember that when you have a sudden sharp shock to the market, two kinds of stocks tend to do worst: those that have been doing worst going in to the sharp shock and those that have been doing best. And that’s for inverse reasons.
If the stock market’s selling off heavily, the stocks that you were worried about because they were going down, you dump. But now you’ve got losses. And as a human reaction, it’s easier to take profits than losses and you’re looking at the stocks that even though they’re down somewhat from the highs, that you’ve got big profits in, and even from a tax standpoint now, you’ve generated some losses and you can offset, this is a time you can sell some of the profitable ones.
What I’m saying is, the overall stock market doesn’t look that appealing. I will remind you that since late winter, I have been, in my recommended asset mix at near the bottom end of my range for recommended equity exposure. Now this is for U.S. pension funds, but it has some relevance for even Canadian retail investors. What I’m saying is, the U.S. stock market is not appealing. And that’s still by far the most important and influential in the world.
The last five weeks we’ve had pretty weak performance, despite strong economic numbers and despite a tremendously well-performing bond market. Look, we’re at 4.04 on the 10-year Treasury note. So, we’ve had those things in the background which should encourage the stock market. Earnings have been good and yet the stock market has been declining.
What this suggests is the market is vulnerable to some piece of bad news. And we’re coming in to September and October, which tend to be the bad news months. So, if you’ve got a gigantic overweighting in stocks that have doubled and trebled, you might want to take some money off the table, or do some diversification within your portfolio into those that will be less vulnerable on the down side and that is the purer natural gas plays, because that really looks good and some of the oil service stocks.
Because what you can be pretty confident about is that finally Big Oil is moving up its capex. Took them a long time to realize that higher oil prices were here to stay, but they’re unzipping their wallets and a lot of this stuff is being spent in area that are really expensive, deep water Gulf of Mexico. Now that’s not going on right now but it will be as soon as this is all over. And places like offshore Nigeria, places like offshore Angola, these kinds of things.
So what you can say is that this is an industry that tends to enter into pretty long contracts and so it suffered. These stocks trailed the rest of the oil industry. I would want to go out and talk to, over the last few years, to clients that are in the oil service industry. They always asked me the same question. “Don, why is it with oil prices doing so well, why is it when I call up the oil companies they aren’t increasing their capex?” And of course I would reiterate to them “The best investment opportunities come from an asset class where those who know it best love it least because they’ve been disappointed most.”
It took quite a while for the industry to come around that maybe these prices were going to last. Only when the industry started to move on this did Wall Street start to change their price forecasts after fourteen straight quarters of predicting oil price drops.
So, we’ve had a huge change then in the consensus. And maybe that means that a lot of the pricing is already moved in it. They’re still cheap, because they’re still only valuing oil in the forties, but on the other hand, what I don’t know is when they will get expensive. But this is not the occasion to say that you move more money into them because of oil prices surging up because of an unexpected hurricane.
Now, pardon the intensity in this, but I’ve been talking to people who are getting quite excited about all this and my gut reaction is to say, this is a tragedy and rarely does one profit from tragedies. And in any case what you shouldn’t do is forget why it is you are investing in this group in the first place, which is the long-term value of secure reserves in the ground, unhedged. And what the forward curve is saying is the value of those reserves hasn’t changed, despite all the excitement. So what that means is you can move around and decide what you want to do and maybe reduce your portfolio risk.
I reiterate that I still think the cheapest commodity stocks are the base metal stocks. Nothing good has happened to them in the face of all this, and in fact, to the extent that there’s a perception that oil prices may be heading to eighty or a hundred dollars, then people can say “Well, there’s going to be a recession coming on that and that’s going to be bad for base metal prices.”
So this may be a bad news story for the group that I’ve said is the cheapest. And I can’t assess all of that. All I can tell you is that the front page story is a high risk activity and as I say you can’t make serious money by a story that’s on Page One.
This will be a fast moving story and maybe it will change in a way that indicates the refineries for months. Maybe it will change in a way that indicates the pipelines under the sea have been devastated and it’s going to take a year to restore the. All of that is possible, but it’s not a reason to put new money in to the group.
That’s it. Any questions?
Web: Hi Don. You said one thing I would like you to elaborate on it. You said that a supply-side shock triggers a rising price, normally and rapid decrease in price followed by a recession. Can you elaborate more on the possible recession?
Don Coxe: Well, you see, first of all, this is a supply-side shock which hasn’t produced a huge rise in price. So therefore, I’m not going to put this in the same category as the Arab oil boycott, which produced both recessions in the 70’s. The Arab oil boycott and then the fall of the Shah of Iran and then the Iraq war.
So, we got those supply-side shocks. We got a supply-side shock here, but oil prices aren’t substantially higher than they were a week ago. Therefore, it’s not the kind of price spike that causes a recession. However, it may well be that prices a week ago, as they work their way through the economy will be enough to slow things down globally. Look what’s going on in Indonesia. Indonesia’s an oil exporter, but because they fix the prices for fuels to their citizens, they’re draining their budget and they’re in trouble and their currency is in trouble and they’ve had to raise interest rates to something like nine and a half percent.
So you could make the case that this was already baked in the cake, that we were going to have a slowdown, driven by where oil prices were. But, if that’s the case, fine. Again, not being an economist I’m not going to make that forecast. What I am going to say is, on the evidence on the spot and right through the prices to the end of this decade, this is not a supply-side shock that will trigger a recession.
The only big bad news is natural gas. It’s not an oil story. So maybe on natural gas, if it goes to fifteen or eighteen dollars or something as a result of a really cold winter, then that might be enough to really slash consumer spending. But what I want to resist, is the temptation of people to say that this is a supply-side shock like those earlier ones and so therefore it’s going to lead to the same results. No. At least so far, we’re already into Wednesday, what this has not done is produced a rise in oil prices. So therefore it’s a shock to humanity, it’s a shock to that region of the world, it’s a tragedy but it isn’t enough to say that this gives us a recession.
_____: What will this do to the price of lumber and do you think it will be sustainable?
Don Coxe: Well the lumber story is all tied up in this whole softwood lumber dispute and the fact the Americans have finally won a case at the WTO, which really, really fouls things up. Obviously there’s going to be a lot of lumber to consume as they rebuild. But what’s different about this disaster is that it wasn’t the wind and rain damage as the hurricane went through that’s the big deal. It’s all that water that’s left.
So, therefore, I don’t know how much…if you compare it to hurricane Andrew, which devastated South Dade County and that area and produced big, big increases in lumber as they rebuilt, what you had was a tremendous wind storm that flattened buildings and then they rebuilt them.
They rebuilt them out of insurance proceeds and out of Federal disaster relief funds. And so that was good for lumber. Now, there’s lots of buildings that have been flattened here all the way to Biloxi, but I don’t know how much of that…it’s too early to make that kind of call. There’s going to be a lot of rebuilding, but since we have the problem with lumber that it’s tied up in this U.S. – Canada dispute, I’m going to stay away from that one. Thank you.
Thank you all for tuning in, 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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