Spot valuation 22c, page-43

@Clueso,

Commenced on the CSL threads, this is a continuation of a discussion about oil prices, and investing directly in the oil sector. (Apologies for the tardiness in replying.)

I know you were asking an opinion about WPL, but the reason I'm responding on the HZN threads is because I think its a better investment than WPL, or any of the other large, listed oil companies in Australia.

But before discussing the investment merits of HZN (vs WPL), I think it is important to preface any investment thinking about oil stocks with some discussion about the fundamentals for the oil price.

Now normally - probably 99% of the time - I have zero interest in investing in commodity businesses.
Because, to me, they represent the ugly shareholder value destroying trifecta of:

1. No pricing power
2. High degrees of capital intensity
3. Finite asset lives

To top this off, I have a strong view - based on much evidence - that trying to forecast commodity prices with any amount of accuracy is overwhelmingly a bit of a fool's errand, because it is impossible to get it right on any reasonably sustainable basis.

However, every once in a blue moon - maybe every 10 or 15 years - some unique set of circumstances can be identified which offer the opportunity to be able to make a reasonable prediction of commodity prices (if not accurately, then certainly directionally).

In the case of the global oil industry, we are seeing - according to my assessment of it - a supply-side shock of sorts in the making. Due, in great part, to that very "ESG" influence to which you alluded in your post on the CSL thread.

We know that the geophysical nature of oil fields is that they experience a natural decline from the very first day they commence production. So - forgetting about increasing supply - just to stand still requires continuous investment to be made.

According to WoodMackenzie, one of the world's pre-eminent oil & gas consultancies, to maintain global oil output at the current 91 m bpd, around US$600bn pa needs to be spent on oil exploration and development globally. For the past few years, the world has been running at roughly US$300bn, so half of the rate required to maintain output.

While the International Energy Agency, in its March 2021 report, "Oil 2021 - Analysis and Forecast to 2026" forecast that non-OPEC supply will increase by 7%, from 63.1m bpd to 67.6m bpd, given the current rate of under-investment in supply, globally, there must be a measure of downside risk to that expectation of a 7% ex-OPEC supply increase.

Against that muted supply picture, between 2020 and 2026, global oil demand will increase by 14% (by 9% in OECD countries and 19% in Non-OECD countries), from 91m bpd to 104 bpd.

So the ex-OPEC deficit will rise by a very significant 31%, from 27.9m bpd to 36.5 m bpd.

That's a big gap for on which the world would need to depend on OPEC to fill.

And remember, that's based on assumptions of expected ex-OPEC supply increase which are not being supported by the level of capital investment inputs that are required for such an increase.

If non-OPEC output stalls at roughly the current level, which is not at all implausible, then the OPEC deficit gap would grow each year to reach 41 mbpd in 5 years' time, from 28mbbl today, so to keep the market balanced OPEC output will need to be 13mbpd greater (a~45% increase) in 5 years' time than it is today. There is zero precedent for that happening in the word of OPEC.

So that's the top-down picture, as I see it.


Now to the specific company investment, and why I chose to invest in HZN (as opposed to the perception of a more "reliable, less risky", WPL).

For starters, WPL has a significant LNG component to its business and while the LNG pricing is liked to the oil price, the linkage is a muted one, meaning that WPL's earnings and cash flows are less directly influenced by movements in the oil pirce, compared to HZN. And its really maximum oil price leverage I'm seeking because it is specifically oil market tightness in coming years which is the thesis being applied. The global LNG industry has its own unique industry structure, which is different to the global oil industry, and I've not made a sufficient study of what's happening in the LNG world in terms of behaviour of the various participants, neither on the supply nor the demand side.


Second, one of the things that I hate about this industry is the never-ending reinvesting of cash flows straight back into the business, with indeterminate financial return outcomes. WPL has (as is always the case) a long list of projects that require vast sums of capital to be spent on them ... either to explore them or to build them.

But what I want is for the cash flows being generated by business - which I can value - to be harvested and returned to shareholders. In other words, I want a predictable run-off situation which I can buy at cents in the dollar. HZN offers that, I think, and the appointment of a director representing 19.9% shareholder Samuel Terry Asset Management significantly increases my conviction that my capital management wishes are going to be met. I am very sure that Nigel Burgess brings little other than a mandate to Harvest Surplus Capital.


Finally, while HZN obviously deserves to be cheaper than WPL, what it is now is ridiculously cheap - at the current oil price it looks like it is being valued on a mere 2.0x to 2.5x Free Cash Flow, the bulk of those cash flows destined for the bank accounts of the owners of the business in coming years, I expect.

And I'm 100% certain the company will be producing oil from its existing assets for a lot longer than 2 or 2.5 years.

.