Value Investing

Marathon Asset Management: OIL PEAK (February 2012)

Marathon Asset Management: OIL PEAK (February 2012). This was a great call! his is discussed in their new book Capital Returns: Investing Through the Capital Cycle: A Money Manager’s Reports 2002-15 we think – anyway read it below.

In the energy markets, as elsewhere, “there is no cure for high prices like high prices”

Following a relatively good stock market performance over the past 12 months for the energy sector (which is dominated by major oil companies) and with the oil price approaching its all time high (Chart 9), it makes sense to review our significant underweighting of the energy sector.


Various theories have been put forward to justify high oil prices and an increased asset allocation to commodities, chief among which is the idea of “peak oil.” Bullish forecasts suggest that increasing energy demand from emerging markets, together with declining oil reserves and rising production costs, will propel the price of crude oil to $200 a barrel or more. While a high oil price, however, is perceived to be beneficial for oil company profits in the short run, there are trends developing which will severely undermine both the oil price and energy shares during the coming years.

It is said that “there is no cure for high prices like high prices.” Thus, while the price of crude appears to be suspended at an elevated level, the very persistence of the oil price above $100 per barrel is encouraging developments which pose an increasing risk to the oil price and to oil company shares. There has been a surge in natural gas supply in North America. New technology and better drilling techniques have helped to boost the production and lower the cost of natural gas from conventional resources, as well as from shale gas. US shale gas reserves are estimated to be huge. Extraction techniques continue to improve and we are still at the very early stages of the fracking revolution, so potential reserves from shale gas are probably still underestimated, as was the case in the early days of the oil industry. These extra and cheaper sources of energy have brought down natural gas prices in the US and opened up a huge price differential between crude oil and gas. In the US, as least, these developments have resulted in a dramatic shift towards natural gas, away from oil and coal, as a primary source of energy.

Those who argue that the surge in gas supply will only impact North America are ignoring the fact that not only is the US still the largest consumer of crude oil (and is currently a net importer) but also that significant investment is being undertaken to be able to export this cheap gas. We are seeing gas import capacity in the United States being reversed to enable exports and new gas export facilities planned. In addition, to capitalize on the lowest US natural gas prices in a decade, industries are starting to shift capacity to the US and are even moving physical assets. In the case of Methanex, the world’s largest methanol maker, there are plans to dismantle an idled Chilean factory and ship it to Louisiana to be reassembled.

The high oil price is fuelling other significant changes in the energy markets. The transport industry is becoming much more fuel efficient (airlines are ordering new fuel efficient aircraft/engines and new fuel efficient ships are being ordered despite low cargo rates and a glut of older vessels). And there’s the increasing use of non-oil fuel for transport. Just look around. In Thailand, natural gas is already outselling petrol because of new technology used by taxis, tractors, buses and now some cars; in the US and in the UK (where there are tax incentives for “green” vehicles) there’s increasing evidence of not just hybrid vehicles but now fully electric cars (from economy models such as the Smart to the sporty Tesla) and facilities are being built to recharge these vehicles on the move; businesses are developing natural gas powered trucks (manufactured by Navistar and Clean Energy Fuels Corp) and hydrogen cell cars (by Acal). In short, there is no shortage of investment directed towards reducing the use of expensive crude oil.

Meanwhile, oil producing countries within OPEC have become somewhat complacent about the high oil price. Some are using the extra revenue generated by the high oil price to pour billions of dollars into social spending. Saudi Arabia now requires an oil price of $90 per barrel to cover its planned expenditure (other OPEC countries “need” even higher prices). This is up from $59 in 2008. But these high spending commitments require decent volumes as well as high prices. This makes any volume discipline to control prices more difficult, and so undermines the ability of OPEC to influence oil prices in the future.

Recent meetings with several of the largest global oil companies have also revealed some worrying signs. Senior oil executives appear to be anchoring their expectations about the future oil price on current market levels. Total, for instance, has raised its projection for long-term oil prices, which it uses to justify any exploration and acquisition spending, from around $20 per barrel a decade ago to a range of $80 to $100. The French oil major claims it is willing to spend $20bn a year based on this elevated oil forecast. Increased spending promises to boost Total’s annual oil production, something which the company believes will lead to a rerating (upwards) of its shares.1

Total is not alone. The whole industry is justifying rising levels of investment based on the inflated expectations of future oil prices. BP has raised the oil price it uses to test new projects from $16 per barrel in 2002 to above $60. Even the well managed Imperial Oil, with substantial low cost oil and gas assets in Canada (over 100 years of reserves at current production), is now using a forecast of $50-60 per barrel compared to $35-40 ten years ago. Petrobras is aiming to spend $225bn in the next five years and to more than double its already substantial production in the next decade. The Brazilian oil giant assumes the crude oil price will be $80-95 per barrel for the next five years. Its record breaking $70bn rights issue last year shows there’s no shortage of funding for new oil projects while the oil price remains elevated. 2

1 From the date of this article to the end of 2014, Total SA’s share price declined by 9% in US dollars underperforming the MSCI Europe index by nearly 26 per cent. 2 In September 2010 Petrobras conducted the largest share sale in history raising $73bn on the Brazilian stock exchange – a capital cycle red flag if ever there was one. Not all this money, however, found its way into increasing oil production. In March 2014, Federal police arrested Paulo Roberto Costa, former chief of refining at Petrobras, in a money laundering investigation. Mr Costa, seeking leniency, confessed to far more than that, according to The Economist. Construction companies that won contracts from his division diverted 3% of their value into slush funds for political parties, Mr. Costa claimed. Police identified nearly $6bn of suspicious payments making petrolão (the “big oily”) Brazil’s biggest corruption scandal.

On current earnings, oil company valuations do not looked stretched: cash flow is lowly rated and dividend yields are above average. But there is now a risk that oil companies’ new assumptions about a high oil price are fixing their costs at a high level. The more of their healthy cash flows these companies spend on high cost projects, the lower their current earnings and cash flows are likely to be valued. The operational leverage of oil company profits is rising so their earnings are particularly vulnerable to a severe correction in the oil price. And the longer the high oil price persists, the greater the risk of a correction. With this in mind a modest, and stock specific, weighting in the energy sector within our global portfolios seems prudent. It should at some stage add significant value to performance, at least on a relative basis.3

3 By the end of 2014 the Brent Crude oil price had fallen to $57, a decline of over 50 per cent from the date of this article (February 2012.) Over the same period the FTSE All-World Oil & Gas Index fell by 16 per cent, underperforming the broad FTSE All-World Index by over 48 per cent.

Capital Returns Investing Through the Capital Cycle

Capital Returns: Investing Through the Capital Cycle: A Money

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