Dave Forest: Stick with Proven Track Records and Potential for Discovery
Source: The Energy Report (7/9/09)
From drill rig counts to oil/gas ratios and renewables, Pierce Points author Dave Forest shares his thoughts on the direction the energy sector is headed in this exclusive Energy Report interview. Since predicting commodity prices in the short to medium term is almost impossible, Dave looks for companies with a solid track record and the potential for discovery, which is where the real money investing in the exploration sector is made.
Dave Forest: Yes, the 6:1 ratio of the oil price to the gas price is a long-standing rule in the energy sector. It's based on energy equivalent. So, basically, if you burn a barrel of oil, you get about 6 million BTUs of energy out of it. If you burn one Mcf of gas, you get about a million BTUs out of it. So the assumption has been that 6 Mcf of gas is, therefore, equivalent to one barrel of oil, which makes sense on an energy equivalent basis.
The problem is that people have started to translate that into a value equivalent, saying that, because of that, then 6 Mcf of gas should be the same price as one barrel of oil. So if we see a situation where oil is getting above the 6:1 ratio, then the prices must be about to turn. The reason that breaks down is because there simply isn't that much capacity to switch between oil and gas. The argument would be that, if oil becomes a cheaper fuel, people will use oil; and if gas becomes a cheaper fuel, people will use gas. There's only, in practice, a very limited amount of the market in places like the U.S. that can switch between oil and gas. It amounts to only about 10% of the total energy demand in the country. So the ability of switchable users to set prices is actually fairly limited, thus the 6:1 ratio works well as an energy equivalent. It doesn't work so well as a value equivalent.
TER: What if we look at the worldwide market for oil and gas? Is there an ability on a worldwide basis to switch between the two?
DF: There is some. Again, most countries worldwide do have some switch-ability; but the ability to switch requires specialized equipment, which requires a larger capital investment and many users simply don't make that investment. They build either oil-fired facilities or gas-fired facilities and then they live with the price whatever comes. So, worldwide we're not looking at a huge amount of capability to switch between the two fuels.
TER: So that's not a good investment strategy. Another one that we hear a lot about, particularly with oil, is the drill rig counts. When oil really dropped in price, a lot of drill rigs came off and analysts were predicting this increase in oil prices. Can you discuss drill rig counts? Do they predict the price of oil?
DF: Yes, people, particularly investors, really like these rules because it's a very shorthand way of investing. You can say, well, if the rig count has dropped this much, then supply is going to drop, so it must be time to buy oil. But, in fact, you always have to look at the situation behind the numbers.
What we see happening right now in North America is that over the last five years or so, we had a pretty good time in the oil and gas sector. We had high oil and gas prices and, because of that, we had a big increase in drilling, so we had a big build-out in the drilling rig fleet. People were building new rigs so that they could go out and drill more wells.
What's happening now is we're returning to a more normal state. As prices fall, a lot of rigs are being retired. The ones that are being retired first are the older ones. The older rigs—the ones that are less efficient—are the first ones to be pulled out of the field. Because of that, we're seeing a drop in the rig count; but we're not necessarily seeing a drop in the efficiency of the drilling sector in terms of the amount of wells that they can drill in a given period of time.
The numbers coming out of the southern U.S., particularly, are that the rigs that are still left in the field are doing as good a job or better than some of the old rigs in terms of getting holes completed quickly. So the number of active rigs has dropped, but the efficiency in terms of drilling wells is maintaining. We may not see the decrease in production that many people who are looking at the drill rig count numbers are expecting.
TER: The price of oil has been increasing, from a low of $35 to its current price of around $70. And drill rig counts have been going down during that timeframe. What do you think are the reasons for the increase?
DF: There's pretty good evidence that a lot of the rise in oil has been speculative. Oil in times of positive market sentiment often becomes an investment vehicle, because it's now easy to buy oil futures; so oil has become an investment vehicle for many investors around the world. Groups like OPEC, Exxon Mobil Corporation (NYSE:XOM) and others involved in the oil sector have all said they believe much of the recent run up in the oil price is due to speculation rather than an improvement in fundamentals. When we look at what's actually happening in the world, oil demand is falling almost everywhere except China—and even China has slowed down its rate of increase in oil demand. So nothing has changed for the better in terms of the data and yet the price is going up, so we suspect there may be some speculative influence there.
TER: Oil demand going down is not a problem if supply is going down faster. But, based on what you're saying, supply is not really decreasing.
DF: Supply has held relatively steady for the last few months even if the price has been rising. OPEC has basically decided to hold steady where they are and OPEC is, more or less, the limiting factor in terms of oil production.
TER: What would your investment strategy around oil be at this time?
DF: We favor investing in the companies rather than the commodities themselves. Predicting commodity prices in the short to medium term is almost impossible, so we like the companies—especially those with a solid track record. We look for companies that are going to do okay at $35 oil, well at $50 oil, and spectacularly at $100 oil—that way you're safe regardless of what happens with the oil price. And with these companies, you also get the potential for discovery, especially with the smaller companies, which is where the real money investing in the exploration sector is made.
TER: A lot of these technologies —deep sea drilling, oil shale and tar sands— sound to me like the new discoveries are going to be more expensive to produce from. Am I right in that, or is technology catching up so that these new discoveries will be economically viable at $35 oil?
DF: There's nothing on the radar screen right now that would provide a relatively low-cost source of new oil. There is some research going on into converting coal into a West Texas intermediate-like oil product and that does have some indications of producing relatively low-cost oil down the road. That's still a bit of a ways out. In terms of technologies that are relatively mature at this point, we're looking at things like enhanced oil recovery, where you inject water or chemicals or CO2 into a well to recover more of the oil that's in the ground. Or things like oil sands. There's some work being done on oil shale. And all of those things, from what we know at the moment, entail higher production costs.
TER: So one of the earlier investment guidelines you gave us was to invest in companies where they have proven track records and can make money at $35 oil, make a lot of money at $50, and go hog wild at $100. What are some of the companies that fit in that category now?
DF: Right now the major problem we're seeing in terms of the oil exploration companies is that most of them are saddled with debt. Times were quite good during the last five years in the sector when commodity—oil and gas—prices were rising. When oil and gas prices are rising, it makes sense to take on debt, put the money into the ground and generate reserves—and companies did that. Most companies took on large amounts of debt, and the commodity prices have gone away but the debt hasn't. Most of these companies are carrying debt now to the tune of 5, 10, even 20 times cash flow. So we're having a bit of a hard time right now locating companies in the E&P sector that we like. We're looking for ones that are debt free or almost debt free or have a low debt to cash flow ratio. So far, I haven't found a lot of candidates that we like that fall into that category.
TER: What about some of the majors? Have you looked at Exxon, Shell Oil (NYSE:RDS-B)?
DF: The problem with the major companies is that they basically trade as a proxy to the oil price. I mentioned before the potential for discovery as being one of the reasons for buying oil stocks. If you buy a small junior company and it discovers 10 million barrels of oil in the ground, that will change the share price and the value of the company materially. If you buy Exxon Mobil and they discover 10 million barrels in the ground or 100 million or 500 million, it does very little for the share price of a company that large. So you basically remove the optionality value from your investment and we like having the optionality value because it's given us a lot of 10:1s and 20:1s on our money.
TER: So, for the investors reading this report, at this point the whole E&P sector is a little bit dicey and you haven't really found any spectacular buys at this point?
DF: Yes. You want to be particularly selective right now. Indications—particularly in the gas sector—are that we could see relatively low gas prices for a prolonged period of time. If that happens, a large amount of companies are going to run into problems servicing their debt, especially if interest rates start to rise. So we're being selective. We are seeing more on the international side that we like, especially given that natural gas prices in a number of other parts of the world (particularly Europe) are indexed to oil. So gas prices there are more attractive. We are seeing some companies there that we like, though nothing that we're buying yet.
TER: So, speaking of natural gas, there seems to be a lot of conflicting information and feeling about natural gas prices in the U.S. While, natural gas prices are low here, some feel that they're naturally going to go higher because the drill rig counts are down and we have to fill up the storage for the winter. Some feel that we've got so much natural gas in the U.S., it's ridiculous that the price is going to stay low for many years to come. What's your view on this?
DF: One issue with that is, which price are you measuring? One of the problems they're having in the U.S. is that they've discovered a lot of shale gas, but most of that's only in a few places. A lot of it is in Texas, Louisiana and a few other states and one of the problems they're having is moving that gas from those places into some of the large markets in the U.S. There just isn't that much pipeline capacity from the southern U.S. to California or to the Northeastern Seaboard, where the big gas markets are. So you're having a bit of a situation where there's a large discrepancy in gas prices between different areas.
Unfortunately, the Henry Hub, which is the gas price we look at most often when we talk about U.S. gas, is located in the south. So it's a little bit like taking the temperature of a room next to the freezer door. You're measuring things at the most depressed point in the market. So it's important to look at what price you're looking at. In some of the eastern markets, you are getting higher prices. That said, the advent of shale gas has materially increased production in the U.S. for the first time in a decade and indications are that's continuing. At the same time, U.S. gas demand is dropping because of the recession. Manufacturing is cutting back, plastics makers and chemical makers are pulling back and so we're seeing demand falling at a time when production is finally increasing—that's not a good recipe for prices.
TER: With some of the cap and trades that are starting to move through the U.S. legislation, wouldn't that bode well for natural gas?
DF: It should, though there have been some issues in terms of the U.S. government recognizing natural gas as a clean fuel. But, yes, that would be one development that could be good for natural gas because it is a lower carbon emitting fuel than things like oil.
The other development to watch is there's a movement afoot in the U.S. government to regulate what's called fracking—a process that oil and gas companies use to crack the gas-bearing formation in order to increase the gas flow rates in wells. Fracking is a critical part of shale gas production. There is some belief that fracking has the potential to pollute groundwater aquifers—people's drinking water—so there's a movement to regulate that and make it more expensive for oil and gas companies to drill and frack wells. That could be another development that puts a damper on gas production and potentially could help prices.
TER: If there is significant natural gas in the U.S., and if we just take the cap and trade and fracking away from this, but it's located in areas that the demand is not necessarily at, what other alternative does a place like New York City have if they are set up to use gas? They've either got to import it at some rate or bring it in from Texas. Wouldn't it be cheaper to keep it within the U.S? Wouldn't the demand naturally go to Texas?
DF: In New York, they are getting the gas. They're paying a lot to get it because there isn't much competition in terms of gas coming into the area, so they're having to pay a premium for their gas over other parts of the U.S. What the gas suppliers in the south want to do, and what they're starting to do, is build competing pipelines to those markets. That way, there can be two, three, four or five different suppliers of gas to the market, thus creating competition amongst different gas sources and, ultimately, lower prices.
TER: With natural gas, it seems like you almost need to go country to country. In Europe, they are, of course, reliant on Russia and the pipelines coming from Russia; and Putin's playing a few games there. So what's the worldwide market look like for natural gas?
DF: The other big trend in natural gas, aside from U.S. shale gas, is the global buildout of LNG capacity. Recently LNG prices have been relatively high. We've had spot LNG prices as high as $20 per MMBTU, which is a historically high price. That spurred a lot of development of LNG facilities around the world.
Countries like Qatar are building a number of new facilities over the next couple of years. So there is a large amount of new LNG export capacity that's going to come online. All of that was built when gas prices were high and demand was high. Gas prices have now fallen off in most parts of the world and demand is falling off in most parts of the world. Now the question becomes where is all this gas going to go? Is it going to be able to find a market, and at what price?
TER: Where is it going to go?
DF: Well, the short answer is it will go wherever the prices are highest; but it's sort of a race to the bottom. The assumption for a lot of the builders of these LNG facilities is that the U.S. would be sort of their market of last resort. If they couldn't get a good price in Europe or in Asia, they would just send the gas to the U.S. because they would pay good money for it. That assumption is now kind of out the window due to all the new domestic shale gas production in the U.S. and falling demand in the U.S. So where is it going to go? I don't know. I suspect there are a lot of LNG terminal owners who are out there wondering the same thing. The other big markets are Europe and Asia and we'll see what prices are like in both of those markets in a couple of years.
TER: This sounds like yet another sector investors should be wary of coming into. Is there an investment play here in terms of U.S. natural gas or global gas?
DF: There are certain parts of the market that, for the moment, are relatively insulated from this flood of gas. Places like the Netherlands still have a government policy of indexing their gas price to oil. For decades it's been government policy that gas should be priced according to the value of the fuel it displaces. So those areas sort of have higher gas prices ensconced by law, and those are going to be the places you would want to invest if you want to invest in a gas producer. That way, you'll avoid the competing gas supplies and lowering gas prices. Those areas will probably have a more favorable gas price compared to other parts of the world.
TER: Are there producers in the Netherlands?
DF: Absolutely. The Dutch North Sea is an important producing area. Cirrus Energy Corporation (TSX.V:CYR) is a TSX-listed company that is about to produce gas in the Netherlands.
TER: Some analysts are big on the oil services companies. Is that something you are following and can comment on?
DF: Well, one thing we have thought about the services companies—the services sector—is that it might be a good sector to short. We talk about what happens if gas prices stay low in North America, if we get this flood of shale gas and the prices stay low. One of the things that will happen is there will be a deflation in services costs then. Three-dollar, four-dollar gas is not necessarily a bad thing. If you look back seven or eight years, we had two-dollar gas and gas producers were still making money because the cost to drill wells and the cost to produce gas was a lot lower. Services costs were a lot lower. So if we get a situation wherein we get $3 to $4 gas for a prolonged period of time, one of the potential outcomes is that we might see a deflation in services costs such that producers can now make money at $3 or $4 gas. In that situation, you'd obviously see cash flows decrease for services companies. So you could, if you wanted to go long the E&P sector, short the services sector as sort of an insurance policy against a prolonged period of low gas prices.
TER: If we have a prolonged period of low oil and gas prices, why would going long on E&P be a good strategy unless you're balancing with the short on the services?
DF: I guess if you weren't sure about what's going to happen to gas prices, if you thought there was some chance that we might see an increase in gas prices, but you wanted to hedge against the possibility that they don't increase and we get things just bumping along at three or four dollars.
TER: These are complementary plays.
DF: Yes, exactly. That would be sort of a way to hedge your down side in the E&P investment strategy.
TER: Any speculation on any new alternative energies that are going to emerge and bring either great investment opportunities or incredible energy opportunities?
DF: Yes. We keep an eye on renewables, too, and geothermal is certainly a viable source of energy. The economics on geothermal power plants make a lot of sense—more sense than solar or wind in most cases. There are a lot of good businesses that are built running geothermal plants.
TER: We're in the state of California, which has a variety of these geothermal plants. Some of them have performed well in the market and some have not. Do you have any that you're looking at that you think will outperform?
DF: Nothing that we're invested in right now. We're waiting to see what happens with electricity demand in the U.S. and around the world. But, as we were discussing before, a lot of the money to be made in the geothermal sector is to be made at the early stages of project development. So, going out, securing the land, doing a bit of initial drilling to test the reservoirs — you can spend a few tens of millions dollars on an initial program and prove that you've got enough hot water in place, you have the potential to create an asset that's worth $200 or $300 million dollars as a generating facility and then add significant value that way. So that would be the kind of thing we would want to look for in a geothermal or a renewable energy developer. It would be somebody who's got a supply of early stage projects that they're doing some work to advance.
TER: Are there any now?
DF: Yes, most of them have sort of moved along. Reservoir Capital Corp. (TSX.V:REO) is developing some run-of-river projects, which is another interesting renewable energy source, in Eastern Europe. They're sort of involved in acquiring earlier stage projects and doing some work to develop them. So there are companies out there sort of using the project generator model as applied to renewable energy.
TER: Any other renewable energies that seem interesting? I notice you're bypassing wind and solar.
DF: We're not big on any of those. Those technologies have some technological hurdles to overcome before they're competitive unsubsidized with other energy sources.
TER: Very good. Any other investment ideas you would like to share with our Energy Report readers?
DF: I think I've spilled all my secrets.
TER: OK. Thanks!
DISCLOSURE: Dave Forest
I personally and/or my family own the following companies mentioned in this interview: None
I personally and/or my family am paid by the following companies mentioned in this interview: None
A professional geologist, Dave Forest currently writes the free weekly e-letter, Pierce Points (www.piercepoints.com), which covers global commodities markets. He also serves as Managing Director of Notela Resource Advisors' Vancouver office. His analyses have been featured on BNN, Kitco.com, Financial Sense and The Daily Reckoning. Dave, who worked in the mining and oil/gas sectors for a decade, previously managed Casey Research's Energy Research Division.
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