Art Smith Believes in the Long-Term Bull Case for Oil
Source: The Energy Report (7/16/09)
The outlook for oil seems to be brightening amid scant new reserve discoveries and declining reserves at the world's large oil fields. "We believe we're in a fundamentally positive market for oil in the 21st century," says Art Smith, president of Triple Double Advisors, who anticipates oil moving back into the three-digit price range within three to five years. In this exclusive interview with The Energy Report, the 35-year veteran of oil analysis shares his knowledge of energy markets and reveals some of his own investment strategies.
The Energy Report: Art, what's your view is on the various fossil fuel commodities? Let's start with oil, which is hovering around $70—some analysts saying it's going to go to $100; some are saying we don't have enough economic support to even keep it at $60. What's your view?
Art Smith: I've been an oil analyst for 35 years and I would be the first to say if anybody tells you they know what the oil price is going to do in the next six months, they're deceiving themselves and you. It's a very interesting commodity because there are so few substitutes – especially for gasoline, diesel and kero jet—the essential transportation fuels.
In terms of the big picture, we believe we're in a fundamentally positive market for oil in the 21st century. We say that because of all the things that have been discussed about declining size of reserves discovered; the fact that the large oil fields, for the most part, have already been discovered and are in decline; and the fact that, while we're experiencing a moderate demand reduction stemming from the global recession, we think the market will move back into a period of tightness in the next three years. With a tightening supply/demand balance oil prices will make a move back into the three-figure area.
TER: When it gets back up to that three-figure area, is it bound to stay there given the supply and demand gap?
AS: Oil has obviously got political and other issues that affect it; but the overall view that major inroads by alternative fuels will undermine the oil market is, I think, misplaced. In effect, oil at $100 a barrel is still not expensive compared with what it does for you. Would you like to walk 25 miles or so for a couple of bucks? A miracle elixir that'll push your car down the road for 20-something miles for $3 (including taxes and other things) is still a great deal. We're believers in the long-term bull case for oil. We're in the Hubbert Camp, meaning that all the data we observe on reserve additions and size of wells that are drilled indicate that the law of diminishing returns is alive and well.
TER: So is the Hubbert Camp the Peak Oil Camp?
AS: It is one and the same. There's a very good organization the Association for the Study of Peak Oil, Peakoil.net, that does a solid job of trying to provide a fact-based backdrop of the real data. When you boil it down, the key driver is that oil demand globally will continue to increase and with continuing depletion of discovered reserves, ultimately, it will dissipate or eat away at the 6 million barrels a day of apparent OPEC surplus that now exists.
TER: Oil looks like a long-term positive outcome. I'm hearing a lot of differing opinions on natural gas. One is that we have so much natural gas in the U.S. that we shouldn't expect the price to go up any time soon. And the other is that we're going to see an explosion in LNG worldwide. What's your view on natural gas?
AS: Natural gas is one of the most complicated markets that I've experienced in many years. Unlike oil, natural gas is basically a market whose economics are dominated by regional activity. The big markets are North America and the OECD countries in Europe. In both of those areas we've seen a decline in demand; we've seen increasing supply and, therefore, downward pressure on wellhead prices. And, as far as the role of LNG goes, we're following the 25 to 30 major new LNG facilities that are slated to come on stream over the next five years and it looks like a bulge in new supply at a time when the markets are glutted.
The price of natural gas today is at $3.70 NYMEX or Henry Hub and, quite frankly, the economics of drilling for natural gas at those prices are not attractive. Someone aptly described the recent development as “too much of a good thing.” Even though the gas rig count has fallen by 58% since the peak in September of last year, there's still a lot of money in the market drilling these prolific shale wells and those are the big plays, they're the Barnett, the Fayetteville, the Woodford, and, most recently, the Haynesville, which is North Louisiana-East Texas and the Marcellus, which is another big play in Appalachia. The uniqueness of the shale wells is that they are much more prolific than the average producing well with conventional gas. Some of the wells in the Haynesville produce 20 million cubic feet a day. The average well has output of less than one million a day.
TER: Are these shale wells mostly located in North America, or are they worldwide?
AS: There's a lot of activity in Australia. The general concept the geologists have awakened to is that they never really thought these sorts of zones were able to produce enough gas to make them worthwhile; but they've developed hydraulic fracturing techniques, whereby they hydraulically drive pressures into the formation, open up fissures in the formation, and then the gas flows out. But the biggest plays are in North America.
The North American market is the largest market in the world followed only by Europe. I think the problem that my partner, Gabe Chavez, and I see about natural gas is that everyone is aware of the glut. We're producing maybe 4 to 5 Bcf a day more than we were several years ago, demand is down and petrochemical demand is weak, so we're facing an extreme oversupply and storage inventory is approaching max. Natural gas inventories are very, very high right now and they're marching ahead to a point where we could see gas wells having to be shut in for lack of a place to store the gas. That would, in effect, suggest further downward pressure on spot prices.
TER: Given this, how long would it take to get through the inventory that's above ground or is going to be produced? Are we looking at 5 years, 10 years, 18 months?
AS: It's something that will happen within the next 18 to 24 months. The markets are self-correcting. The statement is that the cure for low gas prices is low gas prices—have a declining number of rigs active. We have a number of producers actually drilling wells, but not bringing them on production because they're waiting for higher gas prices and the incredibly steep contango in the forwards market encourages oil and gas companies to wait until the winter months to produce or to sell into the futures market. If you look at the forward strip on gas, it quickly goes from $4 to $6 and higher.
TER: Given that we have enough supply, what we're basically talking about is just cutting production to match demand as opposed to not having enough supply. So we're just kind of playing a balancing game here of getting the price up enough to economically produce it?
TER: And if that's true, what's the investor play here?
AS: The investor play is shifted to oil for the most part and that's not just the investors, but the executives running the companies have refocused their budgets on plays in oil and natural gas liquids where the economics are much improved. The Bakken play in the North Dakota area, for instance, is still very, very active and we've had some recent activity with big deals cut between some of the large overseas oil companies. Statoil buying into a Chesapeake play in the Marcellus. Just in the last week, BG—that's the old British Gas—announcing a one billion dollar Haynesville investment with Exco, symbol XCO. So there's a lot of money to drill these prolific wells. The concern investors and analysts have is, how do we ever balance the market if we continue to add new supply?
TER: Art, is there a silver lining in natural gas as we look at cap and trade going through legislation and more focus on less-polluting energy sources?
AS: Absolutely. Take the big picture and step back and ask, what do we know now that we didn't know five years ago? Well, five years ago the Barnett shale play around the Ft. Worth area was just coming into its own and since then we've now discovered many shale plays, all of which appear to have tremendous resources. It brings up the issue that the U.S. has the ability to be very self-sufficient in gas for years and years ahead. And of course the Pickens Plan and Chesapeake CEO Aubrey McClendon have been supporting increased natural gas usage. Why don't we build natural gas vehicles? Why don't we burn more gas in power plants? Why don't we find other uses? So that's the good news for the business. But, again, the bad news is it's too much of a good thing.
TER: Is there a cost of conversion here? It's easy to say we should use more natural gas but, as you mentioned earlier regarding oil, there is, in essence, no substitute for the way that we use it. Could natural gas become a substitute for oil?
AS: Again, the big user of oil is transportation fuel. And what is the big market there? Automobiles and trucks. I'm not aware of anybody suggesting that we put compressed natural gas on jets or airplanes because of the storage issue. The biggest drawback to compressed natural gas (CNG) vehicles is they need to be refueled regularly. The range is maybe 150 to 200 miles and it's time consuming. It isn't nearly as quick as pulling up to a gas pump. And then finally, there's the whole infrastructure issue—who's going to build all these cars? Who's going to build out all the service stations of CNG? Utah's got a pretty active CNG market. It's probably the one that's showing the most signs of life. So that's a big picture; but you know, how do we get from here to there in a reasonable fashion?
TER: What about uranium? Uranium had this incredible rise up in 2007, dropped right off and has been going sideways. It appears that the fundamentals of uranium demand are about the same as they were two years ago.
AS: We don't spend a lot of time in uranium, but we follow it in that it seemed to go through the same commodity price boom and bust that most other commodities did last year. In part, the shortage came about when Russia had depleted the inventories and a big stockpile of uranium; and they've been selling it into the market at any price. And then when that was gone, they looked around and said, wow, there's no more yellow cake. You're facing the same kind of issues as mining, depleting resources and more expensive extraction.
TER: What about coal? That seems to be the one that no one's talking about.
AS: We look at coal pretty closely. Coal stocks have had a fabulous run up this year in the face of deteriorating fundamentals. Demand's down, inventories are up, prices are down, and the stocks are up, so explain that one to me. Part of it is that the equities became so oversold last fall and into March of this year that some of it has been just getting capital back in the system, and companies stabilizing and raising debt and equity capital have gotten out of the penalty box.
TER: So now that the stocks have returned to what we'll say is a correct value for what's there, since they were oversold, are there any plays in coal given the supply and demand issues?
AS: I would say the coal business has one great thing going for it and that is it has enormous reserve resources, hundreds of years of supply, and it is economically attractive. The downside is it's the number -one target of the cap and trade greenhouse gas group. I see room for ownership of coal in an energy portfolio. I think the stocks are ahead of themselves right now.
TER: And then finally, what emerging alternative energies do you see that are capturing your interest? Which ones are really going to take off?
AS: Not very long ago we were working with one of our clients on constructing an alternate energy portfolio and we looked at all the well-known areas. Of course, wind is probably the one that continues to grow rapidly. Solar has lots of interest, yet still seems to be far off on having breakthrough economics. And the ethanol play, obviously, has been widely discredited and has been a disaster. Then you get into other things that are pretty wild.
So the big plays are wind and solar. But, going back to a year ago when we looked at constructing a portfolio, we came to the conclusion that the stocks were grossly overvalued. They'd become bit up by this euphoria about alternate energy. And, while they looked good under an umbrella of $150 oil, they looked god-awful at $35 oil. So we've seen companies go bankrupt, lose their funding, etc. We don't have any investment in alternate energy.
TER: So your portfolio is really looking at traditional oil companies, some energy service companies and what you're calling "integrated." If you compare E&P versus integrated, would you say integrated is currently correctly valued in the market place?
AS: I think you're right. Integrated companies offer stability, good capital structures, dividend yields and, I think, reasonable valuations. ConocoPhillips (NYSE:COP), for instance, looks pretty attractive at these prices. It's been an underperformer this year. However, we focus on the exploration and production companies in oil service where there's a lot more action, where the companies can grow more meaningfully and provide better returns. So we have about 50% of our portfolio in some of the larger names in exploration and production.
We're very fond of the oil sands companies in Canada led by Suncor Energy (NYSE:SU) Canadian Natural Resources Ltd. (TSX:CNQ) (NYSE:CNQ)and Nexen Inc. (TSX:NXY) (NYSE:NXY). We like Occidental Resources Corporation (NYSE:OXY). It's just a terrifically well-managed company with great assets; it pays dividends and looks very undervalued.
And then when we get into medium caps, smaller caps, we have some oil-oriented companies that look attractive. We like Concho Resources Inc. (NYSE:CXO), Mariner Energy Inc. (NYSE:ME), Great Plains Exploration Inc. (TSX:GPX) and Forest Oil Corporation (NYSE:FST). And then in the small cap area, Arena Resources Inc. (NYSE:ARD) and Approach Resources Inc. (NASDAQ:AREX).
Rounding out our service sector, we have about a 10% weighting in some of the leading companies in that area. We like Smith International Inc. (NYSE:SII), the drillbit company, Weatherford International Ltd. (NYSE:WFT) and McDermott International Inc. (NYSE:MDR), which does construction. And then there's Unit Corporation, an exploration production company with an underdeveloped drilling subsidiary. It has most of the value in its natural gas reserves, but it has a big onshore drilling fleet that you basically get for free right now.
TER: What's intriguing about the service companies if we're looking at declining reserves in oil and these are drilling or drilling equipment companies?
AS: If you really take apart the oil service industry, it is an extremely fragmented sector. Within the oil service, there are the onshore drillers and the offshore drillers. You have the well equipment service companies like Schlumberger, Halliburton, Baker Hughes and Smith International. Then you get into companies that do boats like Tidewater and Hornbeck and companies that do hydraulic fracturing, like BJ Services. The business is reasonably good internationally, although there might be North American problems. Global activity for drilling is still up and there are big plays going on in Brazil, Angola and elsewhere.
For example Weatherford International's North American business is horrible, but the rest of its business is very good. We think the North American business will come back and, when it does, they'll be firing on all cylinders instead of just three or four now. So right now the service group is interesting because all we know is that the producers are beating up on suppliers to get costs down. You have to bring your cost down to a point where economics work again. Prices went ballistic there for three or four years and now the companies are reluctant, as is always the case, to cut prices. So there's a standoff in some ways. The good companies with the good rigs that are drilling in the Haynesville and others are still doing fine.
TER: If companies don't want to cut their prices and you only have so many drill rigs, is there any other option for producers but to pay the prices?
AS: Many companies elected to cancel contracts and pay an early termination fee rather than drill what were then very high day rates. Now Nabors Industries Inc. (NYSE:NBR), the largest land contract driller, I think, has 50% of its rigs idle. The business is such that the more you're in a commodity play, which would be onshore drilling, the more volatile your earnings are and less visible going forward. So there'll be some consolidations, somebody will go bust. Meanwhile, the offshore drillers like Transocean Ltd. (NYSE:RIG), Diamond and Noble are doing well because they have very lucrative deepwater contracts with the major oil companies—Petrobras, Saudi Aramco and others. So the different segments face very different current fundamentals.
TER: How would an individual investor know which of these service sectors has a positive fundamental?
AS: I think it's very much a function of the makeup of a company's infrastructure and management and how they are managing through the downturn. We're underweighted in service because we see this terrible earnings outlook. No one's sure what's going to happen in 2010, but we're absolutely sure the second, third and fourth quarters of 2009 are going to be miserable, and the expectation we have anyway is that analysts' estimates are still too high.
Again, we like the E&P sector the most. At John S. Herold, Inc., which I ran for 22 years, we were always looking for what we called "pacesetter E&P companies." A pacesetter company was one that had a strong management, which everyone looks for, obviously, but has an ability to invest a dollar in drilling and create two dollars or so of value. With companies that are able to do that over long periods of time, you'll see kind of a stair-step pattern. Each year the underlying value of the company—Herold calls it "appraised net worth per share"—goes up. Basically, they're good investors. They buy when the prices are low, they sell when the prices are high and, in the meantime, they develop reserves at a high economic value-added level. Those are the companies we try and stay with. Obviously, we like to buy them when they're undervalued, but most of the time we just hold on to them.
TER: Are there any that are undervalued currently?
AS: Yes, the ones in our portfolio. We like all the names that I mentioned to you a little earlier. We do write covered calls on our positions to enhance returns and provide some downside and, inevitably, sometimes the companies will be called away from us, but we'll replace them with companies that have not appreciated as much.
TER: You mentioned your portfolio is 50% E&P and 10% services, which leaves another 40%. Is there another big sector that you have that remaining 40% focused on?
AS: I'd say we're 50% very large E&P companies, 31% mid cap and I guess about 8% service. We have a little offshore development and engineering in McDermott, we have Marathon Oil Corporation (NYSE:MRO) in integrated, and a micro cap company called Approach Resources, which is under 200 million, but it's an outstanding value, somewhat hindered by a very small float and the fact that one of their private equity investors, Yorktown Partners, still owns a third of the company. Yes, we like to find little companies like that where we like the management and you're buying the reserves at very attractive prices.
TER: Over three to five years, you're very positive on oil. Can these small, mid-cap companies survive if oil hovers around where it is now for the next three years?
AS: I think they will. We're having a sorting out this year of the companies that did not manage their balance sheets well and found that they borrowed from the banks under an asset-based loan where the value of the reserves secures the revolver. And then, when the prices collapsed, obviously the borrowing base was redetermined down and, for some companies that put them in a violation of covenants. Now they're in the position of trying to sell assets to claw their way back to respectability.
Some of them are on heart and lung machines to keep the bankers happy. They're really not going to be able to go anywhere. They're way over-levered. We like to think they moved into the penalty box. They're now viewed by investors as poor managers of their assets. It's unfortunate there was such a severe and unexpectedly swift decline, but the good companies still look fine. A couple of the companies that we own, such as Plains Exploration and Mariner, have come to market with debt and equity deals and the investors have let them in saying that these are good companies with good managements and, yes, they have access to capital, albeit it may be an 11.5% coupon for many of them.
TER: This has been great. Thanks so much for your time, Art.
DISCLOSURE: Art Smith
I personally and/or my family own the following companies mentioned in this interview:Suncor, Canadian Natural, Mariner, Unit, Schlumberger.
I personally and/or my family am paid by the following companies mentioned in this interview:None
Arthur L. Smith is President of Triple Double Advisors, LLC (http://www.tripledoubleadvisors.com/). From 1984 to 2007, Mr. Smith was Chairman and CEO of the petroleum research and consulting firm John S. Herold, Inc. From 1976 to 1984, Mr. Smith was a securities analyst with Argus Research Corp., The First Boston Corporation and Oppenheimer & Co., Inc. Smith currently serves as a director of Plains All American LLP and Pioneer Southwest Energy Partners, L.P. He is a past appointee to the National Petroleum Council (NPC). Previously, he has served on the boards of the New York Society of Security Analysts (NYSSA), Parker & Parsley Petroleum, Pioneer Natural Resources, Cabot Oil & Gas Corporation, Evergreen Resources, Inc. and privately held Kuwait Energy. He is active in a number of petroleum industry associations, including the Independent Petroleum Association of America (IPAA). Mr. Smith also serves on the board of the non-profit organization, Dress for Success Houston and is on the Board of Visitors of the Nicholas School of the Environment and Earth Sciences at Duke University. Mr. Smith received a BA from Duke University and MBA from NYU’s Stern School of Business. In addition, he holds the CFA designation.
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