Thread,
Good article from Worth On-line.
TCG
worth.com
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98/03-Drilling We Must
By Leland Montgomery
The world needs new oil-fast. John Tozzi's money is on the outfits that help find it.
Deep in the heart of San Francisco's financial district, hedge-fund manager John Tozzi squints at the flickering phosphorescent screens arrayed before him. "The bears are having a field day," he mutters as he watches his portfolio of stocks-heavily concentrated in the volatile oil-drilling and oil-services sectors-tumble yet again. The Cambridge Investments energy partnerships run by Tozzi rank among the most successful hedge funds of the past five years, but since late autumn, the partnerships have posted annualized total returns in the neighborhood of negative 25 percent, knocking their performance back to midsum-mer levels. Tozzi just shrugs it off. "We've lived through a number of these downturns," he says, "and we'll live through many more, no doubt."
Despite the late-year setback, Tozzi earned an average total return of 50 percent for his investors in 1997, topping off a four-year run in which the partnerships returned an average of 51 percent annually. And he's convinced that his numbers can only improve. "The energy story has all the makings of the most explosive investment theme I've ever been involved with," he says. Energy stocks, especially those of the supply and services companies, "are under-owned, under-researched, misunderstood, with explosive revenue, earnings, and cash-flow gains, all selling at a discount to the market."
"Our production surplus is running out. There simply aren't enough straws in the ground to produce what we need."
It's difficult, at first glance, to see why Tozzi thinks the fundamentals are in his favor. Winter temperatures along the densely populated mid-Atlantic coast hovered between 50 and 60 degrees through most of late December and early January, holding the prices of natural gas and home heating oil well below their usual midwinter highs. Iraq has resumed oil-for-food exports, dumping more crude on a market reeling from OPEC's early-December decision to raise production quotas by 10 percent. Little wonder that oil has tumbled from $20 a barrel last November to about $16.50 in mid-January.
Good reasons, you might think, for a savvy player like Tozzi to short every oil stock he can borrow. Instead, he's buying up the stocks of oil drillers and oil-field-services companies-the outfits that supply the specialized equipment needed to draw hydrocarbons out of the ground. He's doing it because, in his view, one stark fact trumps the entire fundamental case against oil: The world is experiencing the tightest supply-demand balance in oil and natural gas in a decade. "We are pumping 97 percent of proven producing capacity," says Tozzi. "If the Asian economies hadn't slowed, in fact, we could have been in deep trouble." It's not that there's no more oil down there, explains Carl Thorne, CEO of Ensco International, an energy-exploration and - production company, "but our production surplus is running out. There simply aren't enough straws in the ground to produce what we're going to need."
The conditions Thorne describes are the reverse of the past 15 years. At the height of the glut in the mid-1980s, demand for oil was equal to only 73 percent of supply, while the natural-gas market choked on far more production-would you believe 30 years' worth?-than it could possibly absorb. The textbook result: a collapse in prices, from $28.50 a barrel of oil in 1982 and $2.66 per thousand cubic feet of gas (mcf) in 1984 to about $16.50 per barrel and $2 per mcf today.
Take a trip along the U.S. Gulf Coast, and you'll find ample proof that the long downturn is over. In Corpus Christi, Texas, Shreveport, Louisiana, or any of a dozen other coastal cities, the few oil-drilling and -supply facilities that survived the slump are frantically busy. "There's a tremendous shortage of equipment out there," says Tozzi. He means everything from shallow-water jack-up rigs to deepwater submersible rigs to the prosaic supply vessels that hopscotch from one drilling platform to another across the Gulf.
But wait a minute. How can oil prices be dropping if production surpluses are near record lows? The answer is technology: Using three- dimensional seismic surveys, an exploration company can map an oil reservoir many thousands of feet underground. New directional-drilling techniques make even horizontal drilling possible, allowing an exploration company to tap directly into the richest portion of an underground oil-bearing formation.
The result is more strikes per holes drilled-one in four, compared with one in ten a decade ago. "Technology has materially reduced the cost of finding and producing oil," says C. Russell Luigs, CEO of Global Marine, an offshore-drilling contractor. "In the late 1980s, most wells weren't profitable when oil was at $19 a barrel. Today, many are." Bob Gillon, a vice president at John S. Herold Co., a natural-resources research firm in Stamford, Connecticut, does the math: "So long as finding costs stay around $5 a barrel and production costs total another $5, then it is very clearly a profitable industry, even if oil is at $17."
While extraction costs have fallen, most of the world's oil is being pumped from fields that are more than 30 years old. "Few people understand the rate at which current supplies are being depleted," says Tozzi. The Saudis and Kuwaitis still appear to have vast reserves, but Venezuela is depleting its proven reserves by 20 percent a year. Meanwhile, the older fields in the North Sea, most of them British, are shrinking 12 percent a year. "We're losing about 4 percent of our productive capacity each year through depletion," says Matthew Simmons, who heads his own investment firm in Houston. That means the industry needs to find an additional 4.8 million barrels a day of productive capacity to meet demand.
The companies whose stocks Tozzi likes [See: Drill Bits Chart] are the ones that aid the search. He reasons that exploration-and-production outfits will have to drill where the biggest opportunities lie-and where it costs most to drill: in previously untested waters in the Gulf of Mexico, in the North Sea, and along the west coast of Africa. "Not only do 70 percent of the world's unproven reserves lie offshore," he says, "but the equipment is complex, in short supply, and takes years to build. That's why the dynamics of the offshore business are so powerful."
The daily cost to lease a deepwater rig in the North Sea has risen from $32,000 in 1994 to $165,000 today.
The numbers are compelling. According to Global Marine, 547 rigs were available for lease two years ago, and only 465 of them were actually out working. Today, 542 rigs are available, and 498 of them are leased. Day rates-the amount per day that an Exxon or a Mobil will pay to lease a deepwater rig for the 30 to 60 days it takes to drill a well-have been soaring. The cost to lease a deepwater rig in the North Sea has risen from $32,000 a day in 1994 to $165,000 last December. And those rates could climb higher: The number of drilling permits granted in the U.S. alone in December 1997 rose 231 percent from a year earlier.
Tozzi has aggressively invested in oil-field services and supply since 1991, producing double-digit returns most of the time. He launched his first energy hedge fund, Cambridge Energy Fund International, in 1994. It returned 64 percent in 1995, 91 percent in 1996, and 45 percent in 1997. But every so often, the sector is buffeted by outbreaks of unwarranted pessimism. "We try to take advantage of these periods of fear by boosting our holdings," Tozzi says.
That's just what he's doing while the short sellers pound on his stocks. He figures that oil companies need a "significant increase" in the number of new deepwater drilling rigs to satisfy the ever growing thirst for oil. [See: The Rig Squeeze Chart] To capitalize on the trend he sees, he bets on companies with managers who have experienced the bad years. Guys like Thorne of Ensco (NYSE: ESV; recent price, $25.56), Sheldon Erikson of Cooper Cameron (NYSE: RON, $50.63), and Luigs of Global Marine (NYSE: GLM, $19.94) know how to maximize earnings through the ups and downs of the oil cycle and maintain financial discipline, reinvesting earnings in new and upgraded equipment while keeping their balance sheets strong and their bank accounts stuffed with cash. Tozzi also knows the power of market share. "When you're Cooper Cameron and the big dog in subsea pressure-control equipment," he says, "you dictate the pricing, not your customers."
Tozzi is convinced that his favorite sector's latest boom has several years to run. He'll know the party is coming to an end, he says, when he sees the return of 1980s-style conditions: a cushion of excess oil and gas production to the tune of 8 to 10 percent, rather than the 2 to 3 percent of today, and an oversupply of drilling equipment. But that's still a ways off. "I expect we'll have to cash out eventually," Tozzi says, "but not before 2002 at the earliest." |
