An Interview with Rick Rule, Part V: On Oil & Gas
Source: Rick Rule, Global Resource Investments††(3/21/08)
In this final interview (Part V), we hear from legendary resource investor Rick Rule of Global Resource Investments (in conversation with John Pugsley of Stealth Investor), on oil and gas.
SI: Rick, weíve talked about prospects for continuation of the natural resources boom, about recession, about gold, and about silver and the base metals. The final, and perhaps most critical resource, the one necessary for the production of all of the other resources, is energy. There are many sources of supplyónuclear, solar, wind, geothermal, hydro, etc.óbut two sources dominate, namely oil and natural gas. Since you grew up in a family that was involved in the field, and itís been a central interest of yours for many years, there doesnít seem to be a better topic to wind up our interview. So, letís talk about oil and gas.
RR: Great! But where to start? I guess we should begin with this ongoing issue of peak oil.
SI: I assume youíre referring to Hubbertís Peak?
RR: Correct. Back in the early 1950s a geophysicist that worked for Shell Oil, M. King Hubbert, developed a model to predict oil production patterns. His model predicted oil production would peak and then go into terminal decline. The model showed a bell-shaped curve, and the top of this bell-shaped curve is referred to as ďHubbertís Peak.Ē His curve predicted we would reach the peak around 1970.
SI: Are we there yet?
RR: This is an economic question. I suspect at $90 oil, we are past the peak. I suggest at $200 oil, we arenít past the peak. Of course, this depends on the value of money itself. But if the price goes high enough, we could be 150 or 200 years from the peak.
SI: So, when the price goes up, consumption falls, and higher prices it stimulate exploration leading to new discoveries?
RR: Yes, and yes. In the first instance, a lot of the demand growth for oil is being driven by marginal consumers, consumers in places like Malaysia, China, India, Brazil. If your income is $150 a year, and the price of gasoline goes from $1 a liter to $2 a liter, it makes a difference to you. For those of us with higher incomes, if the price of gas goes from $3.50 a gallon to $7 a gallon, we grumble, but it doesnít change our consuming habits much. So a lot of the growth and demand is being driven by a marginal consumer who is much more price sensitive than you and I are.
In the second instance, a higher price will increase production. There are, in this country, by-passed oil discoveries that isnít put into production at $90 because the industry is afraid the price is going back to $50. The industry would put it into production at $200.
SI: For example?
RR: There are places where the remaining oil in place could be moved by steam, or could be moved by the injection of carbon dioxide gas. Tar sands of course. There are shield horizons, which are very tight but have an awful lot of gas in place, that could be stimulated to produce with artificial fracturing treatments. So, at $200 oil, assuming itís a constant dollar, two things happen. First, you impact consumption in a major, major way. Itís interesting to note, and I forget the exact numbers, but in 1982, energy, electricity, motor fuel, all that kind of stuff, was something in the range of 17 or 18 percent of GDP in the United States.. Now itís down to 12. The fact is that high prices in the 70s worked. People found a way to use less, they adopted more efficient transportation methods for example, and around the world we found more. I suspect that if we had an oil price that took total energy costs above 15 percent of GDP in the United States, you would see supply increase and you would see demand decrease.
SI: There would be a lot fewer SUVs on the road.
RR: And that would forestall the peak for some substantial period of timeóan infinite period of time in a financial sense. If you forestall the problem for 200 years at a 6 percent cost of capital, the problem doesnít exist.
SI: But none of us are interested in 200 years. A much more important question is, what happens in the next little while?
RR: People smarter than I have suggested that currently there is a $15 to $20-per-barrel premium added for political risk. Most of the surplus supply of oil in the world is produced from the Persian gulf, and it all has to get through the straight of Hormuz. [A strategic waterway, 30 to 50 miles wide, between the Persian Gulf and the Gulf of Oman, controlling ocean traffic to and from the oil-rich Persian Gulf area. Ed.] Itís a 40-miles stretch that separates the Suni Arabian peninsula from the Shiite Iran. Itís the part of the world where all kinds of people, ourselves included, are meddling. The suggestion is that the chances of the Straight of Hormuz being shut down, while it may not be a probability, is a big possibility. The impact on world oil prices is almost incalculable, so thereís a lot of suggestion that there is a $15-$20 critical risk premium built into the price of crude oil.
SI: But if one believes that in the next four or five years the Persian Gulf is going to get substantially safer, it makes perfect sense that the political risk premium would decline.
RR: Iím not personally of a point of view that in the next four or five years the world is going to become appreciably safer, but Iíll leave that guess to your readers.
SI: Still, youíre in agreement that if things got safer over there, the price of oil would have a tendency to decline.
RR: Absolutely, particularly if we could stabilize Iraq. Iraq is producing 1.2 million barrels a day, it used to produce 3 million barrels a day, with modern technology and the influx of capital, Iraq could probably produce 4 million barrels a day. If relations between ourselves and Iran stabilized to the extent that foreign investors, including American investors, could go into Iran, and Iran could access U.S. and French technology to revitalize their oil industry, they could produce another 2 million barrels a day.
SI: Would that impact the amount of oil now being stored?
RR: Of course. People would be storing less. There is a lot of oil thatís been pumped out of the ground and is now in storage. If youíre operating a great big refinery, the last thing you want to do is run out of crude. Youíll pay the interest on the capital to store the crude rather than run out of the supply. So, while now thereís hording in the face of political risk, there would then be dis-hoarding because people wanted to avoid the interest carry on the crude oil.
Looking further forward, as we discussed earlier in the interview, the thing thatís going to impact the crude prices a lot from my point of view, is the consistent under-investment of national oil companies in their domestic oil industry. People donít recognize that the oil industry has very high sustaining capital requirements. Re-completing wells, drilling new wells, implementing water floods, building and maintaining infrastructure for collection, gathering, processing, shipping, refining. And these investments in many, many countries in the world are not being made.
SI: Which countries are most at fault here?
RR: The principle short-falls are occurring in Mexico, which is very important to us in the United States. Venezuela, not surprsingly. Nigeria, which is a public-private model. There, nobody knows where the money goes, but it doesnít seem to be going back to the oil and gas industry. Iran. Russia. Indonesia.
SI: Thatís a pretty impressive list of exporters. What percentage of the world output do they now produce?
RR: I donít know the answer to that, but if you think about the fact that world oil supply is about 85 million barrels or 90 million barrels a day, and world oil demand is perhaps on the order of a million barrels a day less than latent supply, we have a wafer thin margin of supply safety. If, as some people are suggesting, Venezuela switches from being a net energy exporter to a net energy importer, that by itself takes care of the surplus.
From the American point of view, whatís particularly alarming is that despite the frosty public relations between the United States and Venezuela, Venezuela supplies about 15 % of the U.S. import requirement, and I suspect the Mexican number is about the same. Mexico is living off the Cantarell field, a large oilfield located 60 miles off the coast of the Yucatan Peninsula, in the Gulf of Mexico. It is the largest offshore development project in the world to date, with a total installed cost of more than $5 billion. Cantarell produces about one-third of Mexicoís total output of oil, which is approximately 1.2 million barrels per day.
The Cantarell field is now in terminal decline. The Mexicans have not spent anywhere near enough money, first of all, including the development drilling in Cantarell to manage its decline, and secondly, in looking to replace Cantarell. Mexico is in the odd position of actually importing natural gas from the state of Texas, despite the fact that they have the same belt of geology extending south of the Rio Grande that Texas has. They just havenít exploited the resource. Theyíve taken the money and used it to, if you will, subsidize the price of tortillas.
SI: So, are U.S. or other international oil exploration companies prospecting for the Mexican oil?
RR: In the case of Mexico, theyíre not allowed. The Mexican oil industry is completely nationalized.
SI: Thatís a death knell for any industry. And the other countries?
RR: Most of the world has a mixed model. In the case of Venezuela, the mixed model is fairly heavily skewed toward government ownership. There are private contractors in Venezuela, but the terms have changed fairly dramatically.
SI: If Venezuela turns from a net exporter to a net importer because of using the surplus theyíre getting from oil to finance social programs, whatís Chavezí future?
RR: If I were Mr. Bush, or Mr. Bushís successor, I wouldnít worry a lot about Mr. Chavez. I suspect he wonít be anywhere near as popular three years from now when he has no goodies to hand out.
SI: When Santaís bag of goodies is gone, who needs him? This has interesting implications for the oil price.
RR: Right. And also for oil assets in areas that are, at least regarded as, politically secure. In the context of our discussion of course, that leads to Canada, where most of your investments are focused.
SI: Yes. The Stealth Investor portfolio is heavily weighted in natural gas exploration and producing companies in Canada. In fact, our Canadian holdings are much heavier in natural gas than in oil.
RR: Which is right where you want to be. In the first instance, the energy price differential between oil and gas is the greatest it has ever been. The metric in oil is a barrel, and the metric in natural gas is a thousand BTU per cubic foot of gas, in other words, a million BTU of energy. The energy differential is 6 to 1, meaning the barrel of oil has six million BTUs, while 1,000 cubic feet of gas has one million BTUs. That barrel of oil trades now for $90, and the million cubic feet of gas changes hands for six bucks. So there is a wide, wide variance between the differential in terms of energy yield and the differential in terms of price. There are arguments that suggest that the natural gas price actually should be higher than the oil price, because burning natural gas for either transportation or for power generation, yields less carbon
SI: Which makes natural gas the politically correct choice.
RR: I wonít comment positively or negatively on that because Iím not a political analyst, but I do think that the price of natural gas should rise or the price of oil should fall. The gap between them should begin to go away. Itís my suspicion that if we get through the next three or four years of political risk in oil, and get to the point where there are production short-falls, the price of oil should not fall. This means that the price of natural gas should rise.
SI: Unlike oil, the price of and market for Canadian natural gas is local.
RR: Natural gas markets are much more localized that oil markets because itís easier to put oil in a tanker and take it places. With liquefied natural gas, increasingly natural gas is more of an international fuel, but itís still a series of local, national and continental markets. The Alberta natural gas market has traditionally been an over-supplied market. The price of natural gas in Alberta has been constrained because of a lack of physical capacity to move the gas from where itís produced, Alberta, to where itís burned, eastern Canada, California, and the eastern U.S.
SI: Itís just a matter of building pipelines?
RR: Thatís taken care of, the infrastructureís in place. We no longer have infrastructure capacity issues. We have a situation where the natural gas prices got well ahead of themselves, post Katrina. When the U.S. gulf coast got shut in, natural gas prices got very high and we re-built U.S. capacity, we drilled lots of wells in Alberta, lots of wells in the United States, and we imported natural gas. The other thing that we did is, we did a pretty good job, in the United States at least, of building storage for natural gas. That, in conjunction with a couple of fairly warm winters, produced a situation where weíve had a temporary, I think, oversupply of natural gas, which has driven prices lower.
SI: Oversupply in both Canada and the U.S.?
RR: Yes. But I think this oversupply situation is fairly short lived for lots of reasons. In the first instance, despite the fact that North America is one of the largest economies in the world, right now itís the cheapest markets for natural gas in the world,. We have LNG, liquefied natural gas price on the U.S. gulf coast of something in the range of $7.50 per million BTU and a landed price in Tokyo of $10 per million BTU. Well if you had a liquefied natural gas cargo, where would you go?
SI: That oneís sort of self explanatory.
RR: Increasingly, the liquefied natural gas is going to go to the market offering the highest price. In the event that other markets turn lower, that gas will get diverted to the United States, because the United States has the best infrastructure in the world for transporting that gas and storing it. So, we are the customer of last resort, but weíre not the swing customer.
The second thing thatís happening is that U.S. electricity demand is continuing to grow, but U.S. generating capacity is not growing. Because of concerns over carbon loadings, we arenít building coal-fired plants. Because of concerns related to Three-Mile Island, and although we talk about it, weíre not building nuclear plants. We arenít building oil-fired plants because the oil price is too high.
SI: And oil-fired plants also generate carbon.
RR: Correct. Other competition? With current technology, wind mills donít make sense except with subsidies. Nor does thermal. Geo-thermal works, but itís such a small business at present that it doesnít matter.
What matters is natural gas, and we are building natural gas plants like mad. Natural gas is a low carbon generator, the capital cost to build the plants are fairly low. The operating costs relative to oil-fired plants are low. Theyíre high relative to coal-fired plants, but weíre not allowed to build coal plants. So, despite the fact that we have finite supplies of natural gas, incredible increases in demand for natural gas. And natural gas is also in demand for conversion to a motor fuel.
Ironically, the other thing using up increasing amounts of natural gas is bio-diesel and ethanol. The reason is that corn, which is used to make ethanol, is really a product of nitrogenous fertilizer, which is extracted from natural gas. So you burn hydro-carbons in the form of natural gas, to make nitrogenís fertilizer to put in the ground to grow corn to produce the subsidized fuel, to replace the natural gas. Itís just natural gas in an inefficient extractive technology.
SI: You can smell the government in there somewhere.
RR: Thatís right. The other thing thatís happening is that the increases in gas supply that we had for a couple of years were a function of natural gas prices that were as high as $15 per million BTUs. The drilling boom that we experienced two years ago has turned into a bust since, obviously, $5.50 gas doesnít stimulate as much drilling as $15 gas did. What happens with many gas wells is that as much as 25 percent of the total production of the well occurs in the first 18 months. In the Gulf of Mexico, those numbers are much higheróas much as 40 percent of the productive capacity of the well will be extracted within the first 12 months. So whatís happened is that the spuds, the drilling of new wells, has declined as radically as the price has. This has been exacerbated in Canada, where Stealth Investor focuses, by the government of Albertaís decision to change the royalty regime on natural gas production. The imposition of higher royalty rate has had an amazing impact on natural gas drilling, to the extent that the largest natural gas producer in the province of Alberta, EnCana, has reduced its budget by 70 percent. Their reasoning is that they have 100,000 un-drilled locations in the Western United States, so theyíre going to take their budget down there. Theyíre not going to drill any natural gas wells in Alberta.
SI: Is this going to have a political impact?
RR: I think it might. Alberta has a history of conservative voting and the oil and gas industry is an important industry in Alberta. However, there is a populist movement in Alberta, which maintains that the resources are, after all, Ďoursí and the oil companies shouldnít get as much of the benefit that they do. On the other hand, there is also a memory in Alberta of what happened in 1982 when that industry turned south; there were bumper stickers in those days, ďThe last person to leave Calgary, please turn off the light.Ē It is an energy dominant economy, and the legislature may come to its senses. If they donít, the output of natural gas in Alberta will turn sharply lower and it will turn sharply lower very, very quickly.
There are two more monsters that you have to consider in the context of Canadian natural gas pricing. One has the impact of limiting supply. For many years, after you were successful in the oil and gas business you could convert your taxable corporation into a non-taxable trust, where you distribute the earnings to your shareholders, and there was no tax at the company levelóthe earnings were taxed to the individuals. When the ďtax leakageĒ as the Canadian government called it, achieved a billion dollars, the government said, ďNope, weíre not going to allow this anymore, weíre going to impose double taxation.Ē As a consequence the royalties trust structure has begun to disappear; itís being phased out over three years.
The royalty trusts were very aggressive buyers of oil and gas production, because of the tax beneficiation, the trust actually in many cases paid prices for assets that exceeded their net present value at those energy prices. Because of the front-end loading of the revenue stream and the tax beneficiation.
SI: This impacted the industryís capital costs, correct?
RR: In a big way. With the tax structure of the trusts changing, the availability and cost of capital to the industry changed dramatically, and it impacted the natural gas producers much more than it impacted the oil producers, because while the oil producers were sheltered by very high commodity prices, the natural gas producers werenít.
So, natural gas production in Alberta has been negatively impacted because of the Alberta royalty, and itís been negatively impacted because the cost of capital has gone up as a consequence of the changing in the trust law. What most people donít look at in Alberta, but what I think is critical, is that the demand for Alberta natural gas is increasing and will continue to increase at a very rapid rate. In many cases, particularly because of the oil industry. The tar sands and the heavy oil industry in Alberta run on natural gas; itís a function of generating heat to separate the bitumen, either by way of mining, and synthetic crude production, or by way of tertiary, steam flood extraction, and all of that business runs on natural gas. In 10 or 15 years there will be some number like 350 billion dollars of capital expended in Alberta in heavy oil and tar sand development, and every bit of it will rely on access to natural gas. Otherwise, this expenditure becomes stranded capital.
Thatís extremely important. First of all, the twin producer for the United Statesí natural gas business is Alberta, and demand is increasing in the United States. Demand is increasing because natural gas is cheap, and because it is a good source of electrical generating capacity. Second, Canada itself has a big energy foot print, meaning that per capita the Canadians use a lot of energy, among other reasons because itís cold up there in the winter. If you look at this winter, global warming forgot to come to this hemisphere. The third thing that nobody is paying attention to is that the heavy oil and tar sands industry in Alberta itself will be incredible users of natural gas, at the same time that the natural gas supplies decline in Alberta.
So Iím expecting that the price of natural gas in Alberta, in constant dollar terms, will rise from its current $6 per million BTU to some price like $9-$10 per million BTU. If the price of the commodity goes up by 40 or 50 percent, what that does to margins is absolutely incredible. I donít think itís going to happen this year or next year, but I think this will happen over two or three years. I think that you have to buy these companies in 2008, with the view of getting paid in 2010, or 2011; but I think the opportunities are incredible.
SI: The Stealth Investor was into these Canadian natural gas stocks a bit early, as we werenít expecting the changes in the laws. Any thoughts on where you see the bottom for these companies share prices?
RR: I was early, too. The stuff got cheap, and I was attracted at least to the differential between the oil price and the gas price. However, I think that the beginning of the bottom in the share prices for the Canadian natural gas companies will occur this coming summer for a couple of reasons. In the first instance, once winterís over, demand for gas, for heating, goes away, and the gas price declines naturally in the summer. What will exacerbate the outlook for the juniors this summer is an instrument in Canada called 51109, which is the third-party independent evaluation of the companyís reserves. This document, in addition to allowing investors to understand what a companyís resource in the ground is worth, also allows a companyís bank to establish that companyís revolving credit facility.
For calendar 2006, those reserve estimates were done at a natural gas price of about $8.50 per million BTU. For 2007, the numbers that will be released this spring will be based on $6 per million BTU. If you take the price from $8.50 to $6, you donít just reduce the companyís net present value by 30%. Because companies leverage against their present value by borrowing from banks, you might reduce its borrowing ability by twice that.
SI: Run us through a hypothetical example.
RR: Sure. For example, letís take a small company that went into 2007 with reserves valued at $100 million based on the $8.50 price. Letís assume that the bank had loaned the company 50 % of the net present value of its reserves, or $50 million, which the company used up the year before in order to bring its reserves up to $100 million.
Because the gas prices declined from $8.50 to $6, or 30%, the net present value of its reserves in the ground go from $100 million to $70 million. Since the bank is only willing to lend the company 50 % of the net present value of its reserve base, and the company already borrowed $50 million, itís in trouble. The bank now says, ďYour credit limit is 50% of reserves, and at the lower gas price, your reserves are now only worth $70 million. Fifty percent of $70 million is $35 million. So you must reduce your loan balance by $15 million.Ē The company can either issue new equity, at very depressed prices, or they can sell off reserves into a market where all of their competitors are also selling off reserves. Of course, if it sells off reserves, it further reduces the amount of reserves against which it can borrow.
To make a long story short, this summer many of the Canadian small-cap natural gas companies are going to go into liquidation. Thereís going to be a fire sale. It is going to be, from my point of view, the best opportunity for contrarian energy bargain hunters that weíve seen since 1992.
SI: For those who like to buy at fire sales, it will be great fun. The Stealth Investor has had a significant percentage of the portfolio in Canadian natural gas stocks, and over the past couple of months weíve sold a few of those that seem vulnerable to this problem, and expect that weíll be able to buy them back once the smoke clears.
RR: My experience has been that if you have purchased companies that are stress tested to some price like $6, and if they have relatively prudent balance sheets and management teams, they will survive and become even better bargains.
Companyís that are well run will absolutely thrive in this environment. Even though capital is expensive in this environment, those companies that have a core area theyíd like to expand, and that have access to capital, where their competitors have no access at all, will truly shine. In this case, a companyís shareholders may find their shares diluted, but what they will gain by issuing shares at a depressed price, or borrowing high rates, will be acquisitions to their core area, and increased efficiency. The guys who raised money in Calgary as pretenders five years ago will become extinct.
There are 450 small companies in Calgary, and the market ought to scrape a zero off that number. It ought to go back to 45, although it wonít because the marketís not that efficient. However, it could easily go to 150 from 450
Three years from now, when the gas price goes from $6 to $9 or $10, those 150 survivors will enjoy the dramatic reversal of their leveraging ability. The bank that this year valued reserves based on $6 will now extend credit based on $10, and everything that they wrote down, they write back up.
I see a truly spectacular opportunity, itís going to be an opportunity that only the courageous and patient of your subscribers will benefit from.
SI: Thatís the kind of subscriber we want.
RR: Thatís fantastic. The opportunity in the sub-$250 million market cap market in the Canadian natural gas industry from my point of view is absolutely superb. I see a situation where a carefully chosen portfolio, particularly to the extent that your customers can participate in private placements, will increase by 250 or 300 percent over 3 years. Magnify that with a warrant, and youíre talking about 400 percent internal rates of return over three years.
SI: Right, but letís not overlook the risk. There is still an appreciable downside risk, of an unknown amount, perhaps 30 to 40 percent?
RR: The fact is that speculators who are involved in sub-$250-million market cap companies naturally expose themselves to risk whether they want to or not to potential downside.
That said, the juxtaposition of risk to reward to me is incredible. I see no way at all that supply wonít be constrained dramatically and I see no way that demand wonít increase dramatically. If you have a situation where declining supply hits increasing demand, as we saw in the U.S. post Katrina, natural gas prices can triple. Iím not forecasting anything like a tripling, Iím being much more modest, but Iím forecasting a 80 percent to 100 percent increase.
SI: Good times ahead! Rick, my thanks for a truly fascinating discussion. I hope next time you return from you travels that I can have another chance to share your thoughts with my subscribers!
RR: It was a pleasure, Jack. As you can tell, I love to talk about natural resources. Weíll do it again.