winkinatcha, not everyone agrees with you about oil. see below
PORTFOLIO POINT: Oil prices won’t be dropping any time soon. Supply growth cannot keep pace with increasing demand.
The oil price has now put on $US100 a barrel since I first read the talk of an "oil price bubble" forming around $US40 back in 2004. As the price continues to move upwards, the number of "bubble" articles in the press and from analysts gets larger by the day. The whole world is attempting to be the hero who calls the "top" of the oil price, but the problem is they have been trying for the last $US100.
The question you should be asking is this: What if the oil price is not a bubble? What if the trading short positions in oil are actually larger than the long positions? I have been reading all I can on the global oil and gas markets in recent months and nothing I have read in multiple industry journals and company presentations suggests to me anything other than the oil price going to $US170 in the medium term.
Even if you don't believe my view on oil and think the oil price is $US20 overpriced from a near-term perspective, you are still talking about $US120. That is still well above consensus analysts' forecasts. It is also way above the long-term prices the market is prepared to use for valuations.
You often get some of your best ideas from the most obscure places. The latest edition of National Geographic magazine arrived on my desk last week. There is an excellent piece on the supply-side limits of the global oil industry. The first chart below tells me why the oil price is not going back to $US60–70 anytime soon. The fact is supply-side growth is declining and simply cannot keep up with the ongoing demand growth for oil.
In recent times, with the exception of some of the enormous Petrobras discoveries in deep water off the coast of Brazil (Tupi), I cannot remember reading about any enormous oil discoveries anywhere in the world. Even when a big elephant like Tupi is discovered it is in very deep water and more than 300 kilometres from the coast. It will require very costly and complex new technologies to get the oil out to the market. These new and expensive technologies only further increase the cost of production of oil, in my view, as the little guys cannot afford the huge cost of these sorts of projects.
To put it simply, it's hard to see how production growth can keep up with ongoing demand growth, which in my mind equals one thing: the oil price will go significantly higher. In recent weeks much has been made of the Saudis’ move to raise production levels but remember the Saudis have been steadily increasing production the whole way up from $US35 a barrel and it hasn’t helped the price settle down.
Saudi Arabia's King Abdullah told oil consumers on Tuesday, July 1, that they should get used to high prices and not blame the country for the spike in the price of crude. Al-Siyassah newspaper reported him as saying: "Consumer countries have to adapt to the prices and the mechanisms of the market."
The volume of global oil discovered has steadily decreased since the 1960s despite the oil industry’s technical advances over that period. Most of the big, easily discovered oil fields have been located and the oil majors are now heading into amazing new parts of the world, such as the Arctic Circle, to look for oil. Remember, the Tupi discovery off Brazil is the largest find in more than seven years, yet its estimated eight billion barrels of oil is less than 7% of the 120 billion barrels of the legendary Ghawar field in Saudi Arabia, which was discovered all the way back in 1948. The lack of mega fields being discovered means oil companies need to produce around seven million barrels of oil a day just to maintain steady output, and multiple millions more to keep up with demand growth of 1.5% a year.
National oil companies
People also forget how much oil is produced by national oil companies. Everyone seems to think that much of the world's oil comes from the super majors such as BP, Exxon, and Shell, when in reality less than 40% of the world’s oil comes from those types of companies. The majority – about 60% – comes from the national oil companies and they control about 70% of the global oil reserves.
The problem is that for so many years when crude was below $US15 a barrel, these national oil companies did not spend enough to modernise or grow their production; the return on investment was so low there was no incentive. Here we are after 20 years of underinvestment in oil production from many of those national oil companies and there are production hiccups almost every day with old equipment simply not being able to handle running flat chat in an attempt to keep up with demand. (WorleyParsons is clearly going to have work in hand for decades from these national oil companies that are now trying to pump billions of dollars into modernising ageing plants).
China: short oil and unwelcome to buy producers
The one thing China just doesn't seem to be able to find is its own oil. It even had problems trying to buy its way into the global oil production market, as shown when the US knocked back CNOOC's bid to takeover Unocal in June 2005 for $US18.5 billion. When you look at the chart below from the International Energy Agency you can see why China is just going to become a bigger and bigger importer of oil as their economy continues to develop. As much as we talk about the intensity of metal use and data such as car ownership per capita, and how those going up in China are huge for global steel and commodities demand, the latter stage of that cycle means simply Chinese moving from bicycles to cars and the flow-on effects for oil demand are enormous.
Populist policies are NOT the answer
The thing I find most amusing is politicians putting "windfall" taxes on the big oil companies. In my mind this will just further raise the cost of exploration and production of oil and I cannot see how that will do anything to lower the oil price; if anything it will have the opposite effect. We have seen people ranging from presidential candidates in the US to Kevin Rudd to local government all talking about increasing taxes on oil companies and I honestly think they have no idea what they are talking about.
It seemed ironic that Australia's Resources Minister, Martin Ferguson, was at the big Saudi oil conference the other weekend to try and push for more production after recently pushing up taxes on condensate for Australian oil and gas producers in the budget. Work it out, Martin: you can't have it both ways.
Peak oil, Peaking oil or Peking oil?
Not many chief executives of the major oil and gas companies around the world like to talk about "peak oil" because it's such a politically sensitive issue. But it's interesting to see in recent months the chief executives of some very large companies like French giant Total, US giant Conoco and even Shell talking about how global oil production will peak at about 100 million barrels a day and most think that 100 million is an optimistic number. If that is the peak number, then global oil demand will outstrip supply before 2020 and we are just going to have to live to deal with higher oil prices, significantly higher oil prices.
In "real" terms, oil isn't expensive
I always like the quotes from Peter Barker-Homek, the boss of the Abu Dhabi National Energy Company (TAQA). He was talking about how everyone is obsessed with the price of oil and says what a disaster it is, yet, in inflation adjusted terms, the price of oil has hardly moved.
When you look at the inflation-adjusted prices over a 30-year view of simple products such as a loaf of bread, a carton of milk or the like, oil has hardly moved. In inflation-adjusted terms, crude oil was almost $US20 a barrel in the late 1960s before the oil shock of the mid-1970s led to a spike. In my view, it’s hardly as though the oil price has been on some monumental price spike since the 1970s; if anything it’s playing catchup. If you buy oil and pay for it in anything other than US dollars the price is really not much higher for you in inflation adjusted terms.
I think the energy stocks – both large and small cap – are about to go for another strong run over the next six to 12 months, as well as over the longer term. In my view, a bubble forms when everybody is universally bullish on something and there is no way that could be said of crude oil. If anything I am seeing universal bearishness. The "peak oil" believers are like members of a secret sect who don't dare air their views in public, but it is looking more and more as though they will be proved right. Also, a recent survey confirmed that Australian fund managers are the most bearish ever on the energy sector.
I retain a very strong overweight in the energy space. Woodside and Santos are the clear picks at the large cap end and I think a lot of local funds are looking at Santos from a backwards looking perspective, thinking it was a boring old Adelaide-based company selling cheap gas to the eastern states plus they had an ownership cap that made them takeover proof.
Santos: don't look backwards, this is an LNG growth stock
Well how times change. The ownership cap comes off in November and Santos is now an LNG growth company. If you believe in oil prices going higher then LNG pricing is going a lot higher as well. I continue to hear multiple examples of new LNG contracts being signed at LNG pricing parity (oil price divided by six). Therefore, with the growth in LNG production that Santos has planned over coming years (north of 10 million tonnes a year of LNG production), I think at $19.94 Santos is a true growth stock and will trade well north of $30 by year’s end. Rather than getting a discounted price for their gas from local customers, it will now get global pricing via these LNG markets. This is not boring old Santos any more; this is Santos the growth stock and potential takeover target.
Clearly BHP’s petroleum division is going to be printing money and it has solid production growth coming online right now. BHP is also a beneficiary of the move towards LNG pricing parity via its interests in the North-West Shelf and other areas. The cash flows coming into BHP headquarters from the oil and gas division will be enormous and further add to the cash hoard of the company. That cash hoard will find its way back to shareholders in the form of dividend growth. Currently BHP produces about 116 million barrels of oil equivalent and we have that growing to more than 150 million by 2010. Clearly, volume growth alongside pricing growth offers huge upside for BHP. Key in long-term oil prices of $US100 a barrel and the model spits out a valuation of more than $52 billion for the petroleum division alone. As I have written numerous times before, Petroleum is the sleeping giant that has been awoken at BHP.
It is also worth considering the growing index weight of “energy” within the benchmark ASX200 index. Did you know that Woodside Petroleum now had a higher index weight than Woolworths, Wesfarmers and Westfield Group? I don't know a single investor who claims to be "overweight" Woodside.
Have a look at the current index weights above 1% of the benchmark ASX200. This is amazing and shows you how large “energy” has become and how much financials have been de-rated. Energy stocks are bolded.
ASX200 index weights above 1%
I consider Rio Tinto an energy stock of sorts because of its high exposure to energy coal. The point is in the stocks that command more than 1% of the benchmark. ASX200 "energy" related stocks command a total of 23.5% of the ASX200 while financials command 22.5%. I believe it's the stocks over 1% index weight that you have to get right to beat the index. In Australian equities it is now more important to get the direction of "energy" right, more than the direction of "financials".
The other point is that BHP,Rio and Fortescue (aka the bulk trifecta) together now command 19.6% of the ASX200. The big four banks, with St George, Macquarie and Suncorp-Metway, now also command a combined 19.6% of the ASX200. I don't think I know a single investor who has more than 19.6% of their portfolio in BHP, Rio and Fortescue combined, but I suspect I know plenty who have more than 19.6% in the bank and investment bank combination.
Bulks and energy more important than financials
The benchmark is a relative benchmark and always evolving, but simple analysis of it confirms it is now more important to get the direction of bulk commodities and energy right over banks. How times change and this is why I spend so much time analysing bulk commodity and energy markets.
This is structural change. It's not speculators or a "bubble". It is structural change driven by demand outpacing supply growth. The equity market continues to stubbornly price bulk commodity and energy stocks as basic cyclicals at the top of their earnings cycles. It still amazes me that this is the case, but that is the opportunities for investors with conviction and belief in structural pricing change.
Therefore in energy we continue BHP at the mega cap end (also seeing Rio dragged up by BHP), Woodside and Santos at the large cap end. Santos is grossly under-owned, as I mention above. Stocks like Oil Search, Beach Petroleum, Australian Worldwide Exploration, Nexus Energy, Karoon Gas, Kairiki Energy at the mid and small cap end all look interesting with none looking expensive on any valuation technique that acknowledges structural change in oil prices. All I know it's never the top when everyone is calling it.
I think oil is a much larger chance of trading at $US170 a barrel before it ever trades at $US120 again. So says silly Charlie, the owner of a V8 truck!
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