Fadel Gheit: Oil Prices to Remain Inflated, but Don't Pass on Gas
Source: The Energy Report (10/8/09)
Ranked #3 on Forbes' Best Brokerage Analysts for 2009, Oppenheimer Senior Analyst Fadel Gheit sat down with The Energy Report to shed light on existing conditions in the oil and gas sector. In terms of oil prices, "financial players are more in control now than oil companies or OPEC," according to Fadel, who is currently more bullish on gas than on oil. "Despite the fact that gas stocks gained significantly this year," he says, "we think the upside potential remains great."
The Energy Report: Why is there such a high ratio and differential between natural gas and oil right now?
Fadel Gheit: Because oil is a global commodity; gas is a regional commodity. You can have a huge discrepancy in gas prices from country to country, from continent to continent, because of a lack of adequate transportation—the means of shipping to take gas from where it's found in abundance to where it's needed. For example, gas in the Middle East has no value because there is no local market for it. Most of the oil-producing countries actually flare gas because, basically, they use gas, you call it, as a drive. They use gas to pump it back in the oil field instead of water, because they don't have water, so they use natural gas that comes as a co-product with oil to pump it back into the wells to push oil because that's what they want. They want oil; they don't want gas.
We do the same thing in the Alaska North Slope. The oil companies that operate the fields put away the used gas to push it back into the oil field to lift up oil because there is no pipeline to take the gas into the lower 48. So the reason that oil will always sell at premium to gas is because of the ease of transportation from one place to the other. Pound for pound, it's only the transportation differential between oil delivered to Rotterdam or oil delivered to Houston. Oil, also, is the more politically-driven commodity than is gas—much more politically driven. If OPEC decided to do something and if Russia, OPEC and other producers decided to slow down, guess what? Oil prices will go up. We don't have a cartel or consortium to control natural gas.
TER: Sometimes I think Putin thinks that he has the beginnings of a consortium.
FG: It's very difficult to implement. Theoretically, it could happen, but I would say decades from now because the global distribution system is light years behind oil. Ships are not available and cheap enough to make natural gas a global market yet. As I said, it will take decades in order for us to reach parity between oil and gas. Gas is a much more preferable fuel. It's cleaner, it doesn't have any messy spills and it doesn't kill. But, obviously, how to transport it is the tricky part.
TER: Supply and demand seems to be an equilibrium at about 80 million barrels a day. What's going to kick in demand?
FG: Two things. Oil prices have not been driven by supply and demand fundamentals for years. This was exacerbated by the incredible influx of money from financial players into the commodity markets over the last five years and especially oil, which basically created the oil bubble that we had last year. Supply and demand fundamentals are beginning to play a secondary role now in oil prices. Financial players have much more clout and basically manipulate—influence, if not manipulate—oil prices; that is very clear. That's why we have the investigation by the CFTC and all the hearings. I am not holding my breath to see any changes because the politically motivated individuals and the incredible lobbying by financial institutions make it very, very difficult to regulate or enforce regulations in the books to stem that incredible increase in financial institution influence on the commodity prices.
TER: So do you have a view as to where oil is going to go over the next 6 to 12 months?
FG: I can tell you oil prices will remain inflated and not fully reflect supply and demand fundamentals. I just got a call from the Kuwait National Oil Company. They are wondering when this is going to end. I said, don't hold your breath. It's not going to end. They basically believe what I believe—that financial players are more in control now than oil companies or OPEC or anybody else. They play on the perception or the outlook—oh, OPEC is going to cut production. Okay, then they jack up, they start making bets that oil prices will go higher. We have not had any supply problems with the brief exception of the hurricane and, even with the hurricane, the fact of the matter is that the hurricane impaired our refining capacity more than oil supply. The Kuwait guy was just telling me that after Hurricanes Rita and Katrina, everybody said, 'oh, send us more oil.' He said, why do you need more oil? You don't have the refining capacity to process the oil. There's no shortage, yet oil prices obviously moved up very sharply because financial players, again, gave this perception that, my God, we're going to run out of this or out of that. But in fact, we had a shortage of gasoline not because we did not have enough oil. It's because we didn't have enough facilities available to process the oil that we have.
TER: So that provided the squeeze, but just further down the food chain?
FG: Absolutely. For all practical purposes, the reason I think oil prices will remain inflated is because I truly believe the financial players—who've already tasted blood and are not going to let go because this has now become the single-largest source of trading revenue—are betting on commodity futures. First of all, the derivative, which destroyed the financial market, was basically like a chain letter. You send it to your neighbor and so forth, nobody can really catch it anymore. It's like the flu. It just will become contagious throughout the world. If you look at the income statements of the major financial institutions, they don't break up their revenue from oil trading. But it's a multi-billion dollar business for the large players like Goldman Sachs and Morgan Stanley. And they absolutely refuse to and do not disclose it because it is more lucrative than bank robbery. As I said, it's not illegal because it's deregulated. One of the biggest players now in addition to ETFs, believe it or not, is pension funds. Pension funds are buying huge amounts of oil because it is something that they think will continue to generate huge returns and they have and they've been very successful. Anyway, I find it very difficult to believe that the CFTC will be able to regulate trading.
TER: What would you recommend in terms of an investor's portfolio of some of the stocks that you recommend they buy? Maybe start with some major integrated companies.
FG: Actually, on the major integrated oil companies we think they are going to do okay. But, as I predicted earlier this year, they are not going to outperform the market. So we think "market perform," and that is at best. The market perform was the fact investors are willing to pay the stocks, number one, because they are safer, more secure and they pay dividends. All these things are very positive and that is an attribute that you cannot find at the smaller companies. However, smaller companies offer things that the large companies don't have and that is basically the upside potential.
We've been bullish on smaller integrated oil companies like Hess Corporation (NYSE: HES), Marathon Oil Corporation (NYSE: MRO), Murphy Oil Corporation (NYSE: MUR) and Hess did not do as well, but Marathon and Murphy clearly outperformed the market. Why? Because any exploration success will be meaningful for any of these companies and they are more leveraged, if you will, to improvement in oil prices.
A company like Exxon (NYSE: XOM) is the largest company in the world—the largest oil company—obviously. They are down so far this year 12%. The market is up 18%. So you're basically down 30% vs. the market; that is not a good year for Exxon. It has the strongest balance sheet, it has more cash than debt, but investors say 'why should I care?' There is no capital. They cannot grow reserves, they cannot grow production. There is no gross prospect, so why should I pay any premium for stock if it's going to give me 2% or 3% dividend yield? That's not enticing enough. So we shied away from companies that have exposures to refining, especially the larger companies, because, as I said, the larger companies have no prospects for real growth or interesting or meaningful growth. They can hardly keep their production from declining, let alone grow it. Because most of their operation is outside the U.S., rising nationalism limits their access to resources. Venezuela kicked Exxon out, for example, and ConocoPhillips (NYSE: COP). The Nigerian situation makes life more miserable for Chevron Corp. (NYSE:CVX) and for Royal Dutch Shell plc (RDS/A). Russian corruption and arm-twisting by the government and all these things make it very difficult for oil companies to do anything there. So our focus has been from the beginning and continues to be the large and the small, basically, the E&P companies or the domestic oil and gas producers, and they have done very well.
TER: What are some of the names of the small and large companies?
FG: The large cap E&P are Anadarko Petroleum Corporation (NYSE: APC), Apache Corporation (NYSE: APA), Devon Energy Corporation (NYSE: DVN), EOG Resources, Inc. (NYSE:EOG), Noble Energy, Inc. (NYSE:NBL), Occidental Petroleum Corporation (NYSE:OXY) and XTO Energy, Inc. (NYSE: XTO). The smaller names—actually, I don't have many of them and that's where we're going to expand—are Cabot Oil & Gas (NYSE: COG), Comstock Resources, Inc. (NYSE: CRK) and Pioneer Natural Resources (NYSE:PXD).
TER: Any other points you'd like to make before we wrap up?
FG: Yes. We are more bullish on gas than on oil. Oil prices are up 62% so far this year, but natural gas prices are down 53%. So if you do pair trade, you're off by 95%. The reason being, as I said, because oil prices are manipulated and also politics get into the way when natural gas prices are depressed because of the glut in natural gas, so it's more a reflective of what's happening right now. So we went, again, with the conventional wisdom and we said, despite depressed gas prices, the upside potential in gas stocks is the highest because they offer real growth opportunity. We saw that clearly today. Anadarko announced some discovery in West Africa. The stock is up 10% in one day. Obviously, Exxon will never be up 10% in any one day even if they discover another Kuwait. So you can see, the relatively smaller company—anything compared to Exxon is small—that has the added catalysts, which is upside potential for exploration, obviously, gains the most.
So any company that has exposure to exploration did very well, especially if they delivered on this promise and basically made discoveries; and Anadarko is obviously the one that benefited the most because they have announced a new discovery almost every month. How many times did Exxon announce a discovery? Not for years. So still, despite the fact that gas stocks gained significantly this year, we think the upside potential remains great and we think the upside potential is greater than the downside risk. We don't think that gas prices can go any lower from there because they cannot be sustainable at lower prices because that will dry up domestic production and, basically, 80% or 90% of our demand is satisfied by domestic production. So the market will be self-correcting.
The longer gas prices remain low, the more violent, if you will, the rebound and the price is going to be. But I still believe we are not likely to see gas prices going to $8 or $9 as they were a year ago. We think more likely they're going to basically be within the trading range of, say, $4 to $6, closer to $5–$6. When you do that, you bring the gap in expectation between buyer and seller closer and, therefore, you get what you've been waiting for, an industry consolidation. This industry needs to reconsolidate so desperately because that would bring additional efficiency, clout, diversification, economies of scale and it will lower risk and increase return. It's only a matter of time before that will take place, which will be good for the stock, good for the industry and good for the country.
TER: This has been great, Fadel. Thanks so much for your time.
Oppenheimer & Co. senior analyst Fadel Gheit is a Managing Director covering the oil and gas sector. He spent six years with Mobil Oil and five years with Stone & Webster. He has been an energy analyst since 1986 with Mabon Nugent and JP Morgan and has been with Oppenheimer & Co. Inc. since 1994. He has been named to The Wall Street Journal "All-Star Annual Analyst Survey" four times and was the top-ranked energy analyst on the Bloomberg Annual Analyst survey for four years. He is one of the most quoted analysts on energy issues and has testified before the U.S. Senate and the U.S. House of Representatives about oil price speculation, and is a frequent guest on TV and radio business programs. Fadel holds a B.S. in chemical engineering from Cairo University and M.B.A. in Finance from New York University.
Company Specific Disclosures
The analyst/associate/member of the analyst's or associate's household owns a long position in BP.
The analyst/associate/member of the analyst's or associate's household owns a long position in COP.
The analyst/associate/member of the analyst's or associate's household owns a long position in CVX.
The analyst/associate/member of the analyst's or associate's household owns a long position in DVN.
The analyst/associate/member of the analyst's or associate's household owns a long position in RDS/A.
The analyst/associate/member of the analyst's or associate's household owns a long position in XOM.
The Oppenheimer & Co. Inc. analyst(s) who covers this company also has a long position in BP, COP, CVX, DVN, RDS/A, and XOM.
A member of the household of an Oppenheimer & Co. Inc. research analyst who covers this company has a long position in BP, COP, CVX, DVN, RDS/A, and XOM.
Oppenheimer & Co. Inc. expects to receive or intends to seek compensation for investment banking services in the next 3 months from XTO.
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