Rick Rule on Energy: Look for Best Management Team and Risk-Adjusted Value
Source: The Energy Report (7/28/08)
In this interview with The Energy Report, legendary investor Rick Rule, founder of Global Resource Investments, explains how important his bottom-ups approach is to his investing strategy, and how he looks for the best risk-adjusted value and the best management teams. He says he usually find those in the alternative energy sector, especially in geothermal.
TGR: Do you think we've reached the top with oil and gas? Or are we going to $200? If we stay here anywhere north of $100, how does the economy deal with that? And are you more bullish on natural gas or oil at these prices?
RR: I suspect that the prices of both oil and gas will moderate. Markets work, and high prices moderate demand. North American natural gas prices can go up because North American natural gas prices versus other developed nations’ prices are reasonably low. As an example, liquefied natural gas (LNG) in Japan is selling at $15 to $16 per million BTU; the price of that same gas in the United States is $11.50. So, we have a bit of a pricing umbrella for natural gas.
There is no reason necessarily in the very near term why the price of oil is at $135 per barrel. The industry makes nice money at $100 per barrel. So, in the near term, the market will work and the price will come lower. Looking three, four or five years out, we have reason to be very concerned about the oil price.
The reason for that is that increasing amounts of oil production on a global basis are controlled by national oil companies, and the national oil companies in some countries that are prominent oil exporters now are not making sufficient sustaining capital investments to maintain their current production, let alone increase production.
The most prominent of the countries that are not investing enough money are, as one would expect, Ecuador, Venezuela, and Mexico. I'll add Indonesia to that; a lot of the cash flow from the national oil companies is diverted to social spending. There are suggestions that Iran is part of the same club — there is a lot of social spending — and as a consequence, there is not enough reinvestment of sustaining capital to maintain current production, let alone supply global supplies where world demand is increasing about 1.5 to 2% compounded per annum.
So, if you look out three to five years, the oil supply outlook is really awful. If you had a situation where both Venezuela and Mexico, as an example, cease to be able to export because of their subsidy to the domestic energy users and the fact that they aren’t making sustaining capital investments in their existing production, that does a truly ugly thing to worldwide oil prices, from a consumer's point of view.
Now, as to the economy’s ability to sustain it, I think the economy’s ability to sustain it is fairly good. On a real basis, there are estimates that energy in the U.S. is consuming about 14%. That’s down from 18% to 19% of GDP in 1981. So, the transition is manageable.
What we need to decide as a people is how we are going to organize energy investment and energy consumption. When people complain about high gasoline prices in the U.S., for example, at $4.20 a gallon, most of the developed world just looks at that and just laughs. And most consumers, when they look at $4.20 a gallon, have been conditioned to blame the oil companies.
In fact, if you look at the pump price of gas and you take out transportation fuel tax, sales tax, income tax, refining tax, ad valorum tax, and royalty, what you will find in a free enterprise place like the United States is it’s the government taking somewhere between 50% and 75% of the free cash flow available from the energy product chain and diverting the attention from social expenditures to the greed and larcenous rapaciousness of the major oil companies, which is fiction. It’s pure fiction.
The population at large frequently forgets that the oil industry had a very difficult time earning their cost of capital in the period, 1982 to 2000, and as a consequence of the fact that cash flows were very, very small during that period, we have what one would expect, diminished production
We have a production shortfall because capital expenditures that would have occurred during the normalized pricing environment didn’t occur. The voters want to deprive the industry of capital, that same capital that is necessary to increase the supply of energy that the voters would like to consume. If we continue with these activities, of course we're going to get higher energy prices.
TGR: We have been hearing a lot about “peak” oil, which contends that the world's petroleum supply is effectively fixed, and can't keep up with the rate that we’re consuming it. You’re producing a different argument—we and other nations aren’t investing at a rate to keep up the same level of production.
RR: Peak oil is really a concept, but when it occurs, it is really an economic rather than scientific phenomenon. High oil prices of the type that we’re having now work their way through the market, and a couple of things happen if the market is allowed to function.
One is high oil prices decrease demand at that same time that high real oil prices increase supply. A falling demand and an increasing supply causes a replay of the set of circumstances that happened in 1980, 1981, and 1982. Markets work.
What happens, unfortunately, is that markets are messy and societies don’t like markets, and so societies interfere, and ultimately, exacerbate the swings. As an example, when Venezuela subsidizes the consumption of energy and doesn’t reinvest in energy production, this means that, rather than the market working by limiting demand, they stimulate demand, and rather than the market working by increasing supply, the government reduces supply.
So, in the context of peak oil, if the markets—the markets in the context of $140 oil—were allowed to work their way through society, we could forestall peak oil for quite some time. Governments, however, are going to save us from ourselves and bring peak oil much, much more quickly.
People complain again in the United States about the rapid increase in gasoline prices; here in San Diego, there’s all sorts of handwringing and editorials. Well, the fact is that San Diegans don’t want to live near a gas station, and so they put political pressure to bear, not permitting gas stations in various communities, including my own. What happens is you have less competition. This is fairly simple stuff.
We haven’t permitted a grassroots refinery in the U.S. in 28 years. Gasoline demand in North America has increased about 2.2% compounded annually for 28 years, and we haven’t built a new refinery. We have only done “de-bottlenecking” of existing refinery complexes; so demand increases at 2.2% compounded and you don’t build a new refinery for 28 years—what would you expect to happen to refining capacity? Again, this is fairly simple stuff.
TGR: We're in a market where we’re looking at gold bottoming out. If people are sitting on the sidelines with cash right now, how would you balance between these three sectors — gold, oil and gas, and alternative energy?
RR: I don’t do it on a sector-by-sector basis. I do very much bottoms-up rather than top-down investing, and I would invest in a combination of the best risk-adjusted value in the first instance, and the best management team — the best conjunction of those two things. I usually find those in alternative energy because the alternative energy stocks have some net present value, whereas the mineral exploration stocks normally have no present net value.
Because the alternative energy sector is so unpopular, or rather so unknown, the management teams are there because they know about or believe in alternative energy, rather than because it’s a hot sector and they can raise money and draw salaries for two to three years. As a consequence of market conditions, the ubiquity of good management is in alternative energy rather than in minerals exploration. So, I would find myself drawn to the sector not out of any particular sector preference, but rather because there are much better relative values in that sector.
If I were to rate the sectors in the context of value it would be alternative energy, conventional energy, and mineral exploration. Conventional energy is not out favor, but the conventional energy is a better business than the mineral exploration business. The leading management team in conventional energy is much, much higher than it is in mining.
TGR: You have been a big proponent of geothermal energy. Can you give us some ideas on where to look for good geothermal investments?
RR: What I really like about alternative energy, like geothermal, is that for the first time in my life, in an extractive industry, the political forces, the social forces that usually disapprove of what I am doing are kind of patting me on the back and saying, “Attaboy!” I have support—when I say “I”, I mean the geothermal industry.
Governor Schwarzenegger is on our side; Willie Brown is on our side; Hillary Clinton is on our side; Al Gore is on our side; Barrack Obama is with us. I have never experienced this in the resource business in my life. Even with all the support we get in alternative energy, it is still not without political risk. For example, there’s a geothermal company on the boundary between Napa County and Sonoma County that has widespread support from the population, from the county commissioners, from the politicians. They are drilling in the largest geothermal complex in the world. The first well that they drilled came in under budget and with about 50% more capacity than anticipated. Sounds great, but California has an amazing ability to act irrationally in resource development.
In the neighboring state of Nevada, several geothermal companies are also finding good success. These companies are in a rational jurisdiction that is comfortable with extractive industries and needs the power. As a result, I feel very sanguine about my investments in Nevada-based geothermal companies.
The political support and risk balance also happen internationally. In Nicaragua there is a geothermal producer that is producing about 12 megawatts, and the deposit that they’re exploiting has been rated by GeothermEx, which is the largest geothermal consulting firm in the world, as having a 90% probability of having over 200 megawatts.
As fast as they can produce and finance, they will be able to grow, and they will be able to grow in a country where first of all, only 70% is electrified and 30% needs to be electrified. They are so power short that areas, including the capital city, experience revolving brown-outs and where about 90% of the existing electrical power is produced by burning fossil fuels.
That’s a wonderful set of circumstances. Is there political risk in Nicaragua? Of course; it is run by former Sandinistas; people who would be Socialists if they weren't broke. Those are risks; on the other hand, the people who are in control know they need to deliver for the populace and for the time being can’t afford to do the wrong thing. It’s amazing how the inability to do the wrong thing focuses your mind on doing the right thing. No guarantee that that continues however.
Rick Rule, founder of Global Resource Investments, began his career in the securities business in 1974, and has been principally involved in natural resource security investments ever since. He is a leading American retail broker specializing in mining, energy, water utilities, forest products and agriculture. Rule's company has built a national reputation for its specialist expertise in taking advantage of global opportunities in the oil and gas, mining, alternative energy, agriculture, forestry, and water industries.