Deep-Sea Oil Reigns Supreme for Byron King
Source: The Energy Report (10/1/09)
Energy and resource sector expert Byron King tells Energy Report readers in this exclusive interview that he has not bought into the argument that the recession is behind us and he is absolutely sold on deepwater drilling and other plays that bode well for oil as long as the price stays above $70 a barrel. Meanwhile, he's hunting for new investment alternatives in the natural gas arena, and hoping to see the geothermal industry rebuild what he sees as its broken business model.
The Energy Report: We've seen quite a rebound in the markets since we spoke in May, and governments across the world have begun releasing some positive economic news. Are we out of the recession as Bernanke has told us?
Byron King: I don't agree with that all. It's like at the funeral home where they put really good makeup on the corpse and people walk in and say, "Oh, he looks so good." Then you think to yourself, "Wait a minute. If he looks so good, why is he dead?" That's where we are now, I think, with our economy. We're still in the recession, it has been well-masked.
Let me digress and say that yes, the stock market rebounded. The "sell in May, go away" thing didn't work this year. So if you stayed in the market, you probably benefited very well from the market recovery. But it was a recovery not rooted in fundamentals. Part of it is that we've had a banking recovery, too. But that was because of massive infusions of new liquidity out of the Federal Reserve and the Treasury Department into the financial sector. That's not the prescription for long-term health.
As with someone really sick in the hospital, the problem isn't putting him on life support; the problem is getting him off the respirator. Now the question is how to stop hemorrhaging public money into the system, and in fact, begin pulling some of it back out.
TER: Last time we spoke in May, oil was about $50, which was up from its low of $33, and you thought $50 was looking like a good price. What's your thinking now that oil is trading in the $70s?
BK: $70 is better for the producers and that leads into a whole other discussion. We'll get to that in a moment. At the same time, I think $70 is a rather low price; I don't see us going back to $140 as it was back in 2008, but as things tighten up worldwide for a variety of reasons, I can see oil drifting up to $80, $85, $90 a barrel. Past that price, a lot of things in the American economy and in the rest of the world economy don't work very well or just plain stop working. We've been down that road and learned that lesson. Some catastrophic event—the whole war in the Middle East scenario, Strait of Hormuz scenario—would give you oil at $250 to $300 a barrel in a hurry.
TER: Consumption won't really be significantly curbed until oil gets somewhere above $90 a barrel and producers like it even at $70, so they're going to continue producing, they'll keep their rigs going.
BK: At $70 a barrel, the easy oil, obviously, is still getting produced. It costs only a few dollars a barrel to lift it out of the ground in Saudi Arabia. And at $70 a barrel, a lot of the frontier areas, the marginal oil, the really tough oil, is still economic as well. It's kind of the best of both worlds.
But at $50 a barrel, where it was when we talked in May, the big Athabasca processors or operators drawing from Canada's oil sands were very nervous. They didn't sleep well at night. At $70 a barrel, they're feeling better because they can cover their costs. Even at $70 a barrel, I should note, they aren't going to be building much in the way of new oil sands operations there because the capital expenditure is still pretty high and $70 won't justify it—not anymore, not in today's dollars.
TER: Will $90 a barrel justify expansion?
BK: Oh, yes. You'd see a large influx of capex into the oil sands up in Canada. Actually, the cynic in me says that maybe one of the reasons we won't see $90 oil is because the OPEC people of the world don't exactly want the Canadians bringing another two million barrels a day into the market. They've learned to live with what the Canadians are putting out now. But they don't want much more.
TER: In our last conversation you thought the real sweet spot for energy was deepwater drilling.
BK: I still think that. I love offshore deep water. I am so excited about it as a long-term energy play. We're now at a point where we know how to do deepwater. The technology has progressed to the point where it's a testimonial to the ingeniousness of the human mind, that people can do what they do—that they find and explore and drill and produce that stuff from the long distances offshore, in the mile and two-mile water depths, to the depths below the sea floor—five miles and more—to get that oil. It is just a monument to modern genius that we do that. It's a great, great, great investment space for the energy investor.
TER: You sound even more enthusiastic about deep-sea oil than ever.
BK: I am. There's been nothing but good news from the deep waters over the summer. And I mean from around the world. We've had discovery after discovery in deep waters in the Gulf of Mexico, offshore Brazil, offshore Africa, in the Mediterranean. I'm also excited about some of the exploration being planned in the far North Sea, above Norway and Russia. One of these days we'll see great things happening in the Arctic, above Russia and maybe even Alaska.
TER: Byron, what's responsible for this recent confluence of deepwater finds? What's new or different from a year ago?
BK: I suppose it's like that perfect storm, where the technology for deepwater drilling has caught up with the abilities of the explorers. The explorers have systematized a method of looking down underneath the salt layers in the subsea. It used to be those salt layers underneath the sea floor were so thick and so opaque to seismic that you just had no clue what was underneath it. The modern signal processing, the computer ability to process the data with the algorithms, combining it in a holistic sort of way. Now they take basic earth science, they add remote sensing from space, literally looking for oil slicks on the surface of the water that would give them indications. They do geochemistry for the oil, the geophysics for the magnetics, for the electrical fields, for the gravity fields. It gives them a feel for what's down there at great, great depths.
We're talking miles below the sea floor, which is already a couple of miles below the ocean surface. And then the advances in drilling. Really, a lot of this technology has just all started to come together in the last five years—after decades of research and development. The industry works in five-year cycle, so decisions made four, five and six years ago finally got capitalized, budgeted and scheduled. The ships went out. They started drilling. Sometimes it takes two years to drill one of these wells. Finally the news is starting to come in, and I mean from the tip of the drill bit. The down-hole equipment is so smart that it can signal up the drill string and tell people on the drill deck, or even thousands of miles away in Houston, what's down there in real time. We're really at a historic time in the development of offshore deep water.
TER: About three years ago, the whole concept of peak oil began gaining traction in the media and at conferences. Do discoveries of these major oil fields in deep water negate this peak oil concept?
BK: I'm not going to say they negate the peak oil concept. They buy us some extra time to deal with the issues of peak oil. Peak oil is a lot of things to a lot of different people. The doom-and-gloomers think that mankind is doomed in any event and are out there building underground bomb shelters and packing them full of freeze dried food, canned tomatoes and everything else. They love peak oil because it ratifies their whole world view.
If you look at peak oil in the sense that we've drilled up about half of the conventional oil that we're ever going to find and it's all downhill from here, yeah, finding all this oil offshore might move that point down the calendar. Maybe we've bought five years. Maybe a decade. We'll still have to deal with the decline eventually.
The other thing, though, about peak oil is if you define it as conventional oil, it doesn't mean that there aren't a lot of other hydrocarbon molecules out there. There's a lot of hydrocarbon resource out there, and we're starting to see prices and technology unlock it.
A couple examples are the oil sands of Canada, or the heavy oil of the Orinoco—which sad to say is under the control of Mr. Chavez of Venezuela. It's there, if people choose to develop it. By the way, that Venezuelan resource will be there a lot longer than Mr. Chavez.
And then there's the whole expanding world of natural gas, the tight-gas plays.
TER: Before we get to natural gas, help our readers understand how an investor gets involved in playing that deepwater sector.
BK: There are a couple of different routes. There are the drilling companies. My two favorites would be Transocean Ltd. (NYSE:RIG) and Diamond Offshore Drilling Inc. (NYSE:DO). Then there are the subsea equipment makers. They make the equipment that goes down on the sea floor, beneath 8,000 or 10,000 feet of water, below the crush depths of the deepest diving submarine. This equipment is going to work down there without maintenance for about the next 15 or 20 years. This is astonishing technology. It comes from the likes of Cameron International Corp. (NYSE:CAM) and FMC Technologies (NYSE:FTI). Also in there are GE Oil & Gas, a division of General Electric Company (NYSE:GE) and its Vetco Gray subsidiary. This is a great, great company in the business of making oil and gas equipment, but you have to buy all of GE to participate at that level.
In addition to those that do the drilling and provide the equipment, there are the companies that really do know what they're doing in the offshore space. It has some political baggage, of course, but Brazil's Petrobras (NYSE:PBR) is really one of the most talented offshore deepwater exploration companies in the world. Petrobras has revolutionized deepwater exploration and drilling.
If you want another great offshore driller with less political baggage, StatoilHyrdo (NYSE:STO) is the state oil company of Norway. Another great player in the offshore deep water space is a Spanish company called Repsol (NYSE:REP). It came out of nowhere 15 years ago to turn into one of the world's great offshore companies. Then, of course, you come back to the traditional western majors, the likes of BP (NYSE:BP), Chevron Corporation (NYSE:CVX), Shell Oil (TSX:TNP) and Exxon Mobil Corporation (XOM).
If you want a larger independent as opposed to a major oil company, you might like Hess Corporation (NYSE:HES). I think Hess is a really well-run, very geologically smart company that knows what it's doing in the offshore plays. All of these are companies are positioned to do very well in the coming years in the deep water.
TER: You described Transocean and Diamond as drillers, but suggested that Petrobras, Repsol, and Statoil are doing some drilling as well. What's the difference between these two categories?
BK: Petrobras, Statoil and Repsol are integrated oil companies. They're out there doing the geology and finding exploration prospects and drilling up. They hire drillers to do the actual work of turning the bits. Companies such as Transocean and Diamond operate drill ships. They buy and build a drill ship, staff it up and equip it, lease it to the oil company, and then drill a hole in the ocean floor on behalf of the oil company. They don't participate in the oil. They just get paid for drilling. Paid very well, I should add.
Your question reminds me that I also should mention some of the classical oil service companies —Schlumberger (NYSE:SLB), Baker Hughes Inc. (NYSE:BHI), Halliburton (NYSE:HAL) and Weatherford International Ltd. (NYSE:WFT). All of them supply levels of technology, drilling services, drilling support services and geophysical services that are absolutely critical to developing offshore deep water.
TER: What type of investors should be looking at something like just a pure drilling play, such as Transocean versus an integrated oil company like Petrobras?
BK: If you're going to day-trade your way in or out, neither the sector nor the niche matters; you try to find something that's moving one way or the other.
If you want exposure in the drilling niche for the long term, you'll be dealing with the cyclical aspect of the industry. They have a few goods years; they have a few bad years. It depends on your timeframe. But if you want to be in the drilling niche and remember how those cycles can affect the drilling companies, you want the best-run drilling company you can get your hands on. That would be Transocean or Diamond. They own fleets of drill ships. They own the rigs. They have the people who have built entire careers out of working in this industry. They know it from the inside out.
If you're looking for an investment in the oil industry that's outside of the traditional American concept of investing in Chevron or Shell or BP or something like that, companies like Statoil, Repsol and Petrobras are big world-class integrated oil companies, but they're "foreign" names in the American mindset, so they're underappreciated in the U.S. market space.
You can generally get more for your dollar with companies like those—Repsol and Statoil in particular. Now I need to note that recent goings-on in Brazil have created a bit of a selloff in Petrobras stock. My view is that it's a near-term opportunity for someone who wants to get in.
TER: Where are we in the drilling cycles you mentioned? Is this a time to buy into these drillers, or are they at the top?
BK: They're not at the top yet. They're working toward it. As oil prices rebound, I think we're going to see more—and more consistent—drilling activity. Looking out over the next five years, I see a lot of strength and a lot of upside left in companies such as Transocean and Diamond.
In the fourth quarter of last year, we had perhaps once-in-a-lifetime opportunities. Everything got torpedoed. If you were sitting around with cash in your account and went out and really almost threw darts at the board of almost any sector and bought those stocks last November, you've probably made money by now.
TER: Absolutely. You were about to say something about the whole expanding world of natural gas when we interrupted to ask about investing in the deep-sea sector. Everyone's talking about record high levels in terms of natural gas storage, yet prices continue to climb. What's going on there?
BK: I think a lot of people are playing around with the gas market, which tends to drive the prices up. There's an immense glut of natural gas. Storage sites are filled to the brim.
Along with this, we're seeing immense levels of natural gas resource being uncovered, whether it's in Pennsylvania in the Marcellus Shale, or in the St. Lawrence Lowlands in Quebec. Just a week or so ago around Utica, New York, they spudded a well that's going to test three different black shales. So there is a lot of additional potential for natural gas output.
At the same time, I do see a growing use for the natural gas as energy supply in the U.S. People still want to heat their houses, and there's a lot you can do with natural gas for fuel substitution. That is, there's a growth market for natural gas-powered vehicles in fleet usage, such as municipal bus operators or delivery companies like Fed Ex or UPS.
A lot of natural gas is headed toward electric power production. I always used to cringe when I would think about that. Gee, we're burning perfectly good natural gas to spin a turbine and make electricity so that people can leave the lights on in an empty room. I still cringe at the waste of a fine resource like natural gas, but maybe not as much as before. We're at a point now where some of this electricity is as cheap as the coal-fired stuff and it puts out one-fourth of the CO2 emissions.
In the meantime, what's holding things together for some producers, in the Marcellus, for example, is that it produces a very wet gas. They have methane and ethane but all sorts of other natural gas liquid fractions coming out of it, too—from butane to some of the purest gasoline fractions you could ever imagine.
The producers aren't making any money on the natural gas. They're making the money in processing the gas, and then selling the liquids. They're making enough that they can afford to either break even or even lose a little bit producing the natural gas. So I'm looking for ideas in that investment space that don't involve investing in drillers and operators. It's more like finding those that can make money processing and transporting the gas.
TER: In comparison to oil and natural gas, we know that geothermal doesn't account for much of the energy pie, but last May you felt that geothermal was the best place to be in the alternative energy sector. Are you still feeling that way?
BK: I've been following geothermal for years. I knew people who were doing it back in the '70s. Even then, I thought it was totally cool technology and couldn't understand why it never really caught on. In the last couple of years, with rising energy prices and increasing environmental consciousness, a lot of money has migrated to a number of small niche opportunities in the geothermal space. For the past couple of years, a few who were both lucky and good managed to make some money, but most people couldn't really say with any sincerity that the industry has been good for most investors and shareholders.
What's dawned on me as I've watched this unfold is that the geothermal business model is badly broken. We have a bunch of smallish companies in which one or two or a handful of people try to do everything. The same people who are out there doing the exploration are doing the leasing and raising the money to drill a well or two. They drill a discovery well, then do some confirmation and some more engineering. A very small—almost microscopic—group of people do the assessment work for these geothermal companies. They come up with the reports indicating how much geothermal power potential they have. Then they go out and bank it and market it and they raise money.
These are all the same people. The same guy who was doing exploration two years ago and leasing last year and exploration drilling this year will be raising money this winter, and then next spring will start the confirmation drilling program. He'll drill his well. Then, once he gets his report from Geothermix Distribution Inc. (a privately held company), he'll go into the utility business, shopping for a power purchase agreement with some utility company. After he designs and builds a power plant, he'll have to get into the regulatory business and build power lines and such.
It's a business model that's NOT designed for the benefit of investors. There are no waypoints where the deal ever gets monetized. It's all about spend, spend, spend, and dilute the early shareholders.
TER: Doesn't that situation point toward consolidation of the small geothermal plays?
BK: It does. We're now seeing consolidations in which little mom-and-pop operations are rolling up into big mom-and-pop operations. Just bigger versions of the same old thing.
I think that the geothermal space is due for a transformation in terms of the business model. It will be a lot more like an oil industry model, where instead of leasing a section or two, it will become a matter of leasing 10,000 or 20,000 acres at a time. We'll see aggressive programs that develop the steam wells, which then get sold to an upstream entity connected with a utility company. That'll be the point where the project gets monetized for investors.
Then the utility will worry about building the power plant, stringing the wires and dealing with the public regulators. It'll make a lot more business sense. It'll fit in a lot better with the public utility regulation model we use in the U.S. And it will attract more money into the investment space. Oh yeah, and it'll lead to a lot more successful projects that actually spin a turbine and generate clean, green power. Imagine that.
TER: So you're not such an ardent fan right now.
BK: I'm in a wait-and-see mode. I would love to see geothermal do better. I would love to see some of the dynamism that's going on in the industry right now bear fruit. I'd love to see some of the new companies that are coming out do well. But I'm not about to jump into a bigger, rolled-up mom-and-pop company just because it's bigger and says it's better now. I haven't seen the business model shift to a point that makes it more friendly toward shareholders. Show me where you're planning to monetize things. Show me the money-point.
TER: When you're talking about the bigger mom-and-pop stories, that would be the Magma Energy Corp. (TSX:MXY) and the GTO Resources, Inc., for instance?
BK: Yes. What happened was that Magma came along and took seed money from Ross Beaty, a very successful investor who knows what he's doing. Ross knows his way around the worlds of both geology and the stock markets, so he managed to roll up a number of small geothermal operations and turn them into Magma Energy. He raised a lot of money for all of the things that he's going to do in the future. Well, okay, that's good. I hope he does well.
Then within a week or two of his successful IPO, we heard this announcement that GTO, Ram, Polaris and Western were all going to come together. It's what I just said. A lot of small operations that were struggling are now teaming up into a larger operation. The hope is that the whole will be greater than the sum of the parts.
Maybe that will happen, but I haven't seen evidence that makes me comfortable, so I won't counsel anybody to rush out and load their pickup trucks, so to speak.
TER: Thank you, Byron. We appreciate your good humor as well as your good advice.
DISCLOSURE: Byron King
I personally and/or my family own the following companies mentioned in this interview: Western Geopower, Polaris, Cameron International, FMC Technologies, StatoilHydro, Repsol, Halliburton and Baker Hughes.
I personally and/or my family am paid by the following companies mentioned in this interview: None.
Byron King earned his bachelor's degree in geology (with honors) at Harvard, and then worked in a major oil company's exploration and production division. He "earned his wings" in the U.S. Navy and the U.S. Naval Reserve, logging more than 1,000 hours of flight time in tactical jet aircraft and recording 128 aircraft carrier landings. Based in Pittsburgh, Pennsylvania—site of the historic G20 Summit last week— Byron practiced law there after earning his Juris Doctor credentials at the University of Pittsburgh School of Law. A prolific author and popular speaker with a gift for wrapping historical context around his observations, Byron contributes to Agora Financial's Daily Reckoning, Whiskey and Gunpowder and Penny Sleuth. He also edits Energy and Scarcity Investor and Outstanding Investments newsletters.
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