The Energy Report: Things have been pretty hectic on the global economic and financial fronts lately and the energy markets seem to be defying the expectations and predictions of many analysts. What's your take on where we are and where things are headed?
Byron King: We're living with volatility, most of which is due to international currency and exchange rates. The dramatic decline in the euro has caused a capital flight to the U.S. and a strengthening of the dollar, which results in lower oil prices. The other big macro-type issues include the looming economic slowdown in China. More news stories are coming out about negative demand indicators in China, which will definitely be bad for Chinese consumption growth. The country may use less oil than people forecast. The Saudis are producing at least 1 million barrels per day (MMbbl/d) in excess of what they normally would. So, between the rising dollar, slowing growth and excess production in Saudi Arabia, we're seeing these gyrating low prices.
TER: One hundred and thirty dollar per barrel oil and $5 a gallon (gal) gasoline failed to materialize as predicted, and now there's talk of $60/bbl or even $50/bbl oil in the shorter term. Some oil analysts are now predicting $3/gal gasoline by early November. What's your expectation?
BK: Extremely high or low prices aren't realistic for the long haul. The world economy will hardly function with $130/bbl oil. The airline industry shuts down right away and much of the rest of the world will suffer accordingly. A $5/gal gasoline price makes for an instant U.S. recession. Whatever economic strength we saw in late winter and early spring got stuck in the mud when gasoline prices went over $4/gal on the East Coast and toward $5/gal in California. All of a sudden, the U.S. economy lost traction, and we're sliding back into recession.
And while the world economy can't deal with high oil prices, Credit Suisse's $50/bbl oil prediction, though it may happen, would not last long. For one thing, the seven sisters of oil exporting—Saudi, Iran, Nigeria, Kuwait, United Arab Emirates, Russia and Venezuela—simply cannot afford under $85/bbl oil because they have their own bills to pay. Those lowball prices could be reached because of events, but they won't remain because of supply-and-demand economics.
TER: Is the $80–90/bbl range reasonable?
BK: This morning, West Texas Intermediate (WTI) oil was trading in the $78/bbl range. That's rather low by recent standards. A WTI price of $80/bbl is enough to keep the North American oil industry working. A $90/bbl level for Brent, the international standard, will keep the international oil industry alive. It will tighten things up for the big oil exporting countries, but they'll be able to avoid bread lines and riots. The number that oil has to find is $80–85 in North America and between $90–100 internationally.
TER: Have upside speculators been chased out of this market at this point?
BK: This is still a trader's market, with rising prices and falling prices. For people with a really strong stomach and money to play the short term, have at it, boys. This is your market. The last thing the traders want is for oil to stay static at $85/bbl, though the rest of the world might like that for budgeting and projecting purposes. For traders, the last couple of months have been terrific. The people who understand the market and are successful over the long term know that you sell on the way up and buy on the way down. It's a question of understanding the market dynamics. As Mark Twain said, "If you're going to throw your eggs in one basket, you have to watch that basket." When you're trading at the margins and a move one way or the other could wipe out your capital, you have to keep your eye on things. But the big oil thinkers don't worry about today's headlines. They need to think about the very long term.
TER: Big companies are usually able to absorb oil price fluctuations, but what happens with the smaller companies during periods of low prices and volatility?
BK: It's been a tough world out there for small companies without deep pockets. The energy business, in general, is for companies with money. A small gold miner versus a small oil company carries a difference of at least one or two orders of magnitude. The equivalent of a $20 million ($20M) gold company would be a $200M oil company. With the small guys, the big concerns right now are geographic and economic.
If you're in the natural gas business in North America, you have to be deeply concerned. Natural gas prices are at historical lows and the cash flow just isn't there to support much development. A small company may have tens or hundreds of millions of dollars tied up in leases. If you don't somehow drill or exploit these leases in one way or another, you're going to lose them. So not only would you not be drilling or extracting, but you'd lose your leases, too. That's a terrible predicament.
So what will we see in North America? There will be some cutbacks in drilling. It's already happening, but we're going to see more of it. It will affect the smaller drillers and service companies first. The big guys—Halliburton (HAL:NYSE), Schlumberger Ltd. (SLB:NYSE) and Baker Hughes Inc. (BHI:NYSE)—will also feel it but, they have much deeper pockets and they're large and international. So we'll see some rigs get stacked, but I don't think we'll see as many as some of the gloom-and-doomers are forecasting. A lot of these smaller companies have to keep their geologists and engineers working and drilling or all of that money that they spent on leases in the last five to ten years goes down the drain.
Overseas is another story. You almost have to take each country as you find it. Argentina is a disaster with what's going on with Repsol YPF SA (REP:BMAD). A couple of weeks ago, a company called Pan American Energy LLC saw its operations literally overrun by rioting workers—one of the largest and oldest fields in Argentina was almost shut down because of political issues and labor unrest.
Look at Poland. A lot of people were thinking Poland was going to have its own shale gas revolution, but a couple of weeks ago, Exxon Mobil Corp. (XOM:NYSE) decided to pull out of Poland after a couple of bad wells. Now, the cynics are saying that Exxon is getting better deals from Russia. Russia is the big fish that Exxon wants to land, so it's going to walk away from Poland.
One more country I'd throw in is Libya, which was a big oil producer. With the recent shale revolution, its exports almost ceased. Now, it has put a lot of things back into shape, but what I hear is that many of those repairs were jerry-rigged and could start breaking down. Secondly, the security situation is not nearly as good as the operators would like to see.
TER: Do you think that there will be enough cutbacks in domestic natural gas production to trigger a price rise in the foreseeable future?
BK: Prices have to rise, and they probably will rise sooner than conventional wisdom suggests. I'm sort of a contrarian by nature, but the fact is they're giving gas away as it is, so I don't see much downside from here. I do see upside potential, as well as more demand from more places. We're already seeing a complete upheaval in the electric-generating industry with coal-fired plants. There are no new ones being built and they're scaling back on upgrading the old ones because they may not operate long enough to pay back.
That has impacts elsewhere in U.S. industry, such as with companies that do the engineering and supply the parts, engineering and such for upgrading pollution controls on coal plants. They're about to enter their own mini-recession because of lack of business. Natural gas is also playing havoc with the renewable energy space. Natural gas-fired energy is so cheap that the windmill guys and the solar guys are losing the battle of economics on that alone. I expect to see slightly less gas supply and likely more demand than what people have anticipated.
TER: What are some of the oil and gas majors that would be good shots to weather the ups and downs?
BK: In the international realm, Royal Dutch Shell Plc (RDS.A:NYSE; RDS.B:NYSE) is in very good shape. It is a wonderful, technology-based company that has deep pockets and a very aggressive plan to grow its resources and reserves over the coming years.
Another one that I think is just a spectacularly well-run company is Statoil ASA (STO:NYSE; STL:OSE), of Norway. It is truly one of the world leaders in offshore work and has made a major commitment in North America. People in North America should know there's a new kid on the block. I think we're going to see great things from Statoil.
Further down in North American domestic plays, I'm keeping my eye on a company called Denbury Resources Inc. (DNR:NYSE). Denbury is a very advanced independent as independents go—and is making a lot of good moves in the tertiary recovery area using carbon dioxide to get the last drops of oil out of reservoirs.
In Canada, I've been following a company called Cenovus Energy Inc. (CVE:TSX; CVE:NYSE) for two years now. It is a very rapidly growing player within the Alberta oil sands play. It has lots of acreage and lots of investment to grow things with very good economics. The one major issue for Cenovus and for all of the Canadian oil sands operators is access to markets. The Keystone Pipeline debacle was not good for the oil sands players. At the same time, the Canadians are moving very firmly toward finding another way of doing it. We may or may not see that northern pipeline get built to the upper Pacific Coast, but there is certainly a plan in place to take some of that Alberta oil sands product down to Vancouver for export, which will be to the long-term, strategic detriment of the U.S. Regardless of who is president next January, we will see some sort of a Keystone Pipeline expansion to move more oil sands product out of Alberta and down into the U.S.
TER: Can you give us a little more detail on the revenues and market caps of Denbury and Cenovus and where you think they might be going?
BK: Cenovus is a $32 billion ($32B) market cap company. The price:earnings (P/E) is around 12. It is making money, and it pays a nice dividend—2.8%. It's been a bit of a sleeper for many investors, but I think Cenovus is a great choice for investors looking for exposure to the Canadian oil sands plays. It is a good, strong idea with a lot of upside and a lot of growth potential, and it pays a nice dividend while you're waiting.
Denbury has a $5B market cap. The P/E is about seven, with no dividend. This is a stock where I'm looking for internal growth to bring the capital gains back to investors over the long haul.
TER: What other companies are interesting at these levels?
BK: I'm a big fan of the oil service sector. Right now, Schlumberger is trading down around $60. Schlumberger is one of those companies that almost never gets cheap because too many people know how good it is. When it trades in that low-$50–60 range, I always consider it a buying opportunity. When oil prices recover, that $60 Schlumberger stock is going to be an $80–90 stock. If you can just bear with the market gyrations, it's almost a guaranteed 40–50% gain.
Right now, with things as volatile as they are, investors want to be very careful about going too deep into these very turbulent waters. To the extent that you do go in, it would be with companies that have a really strong upside such as Cenovus or Schlumberger.
TER: Do you have any thoughts on Encana Corp. (ECA:TSX; ECA:NYSE)?
BK: Encana is also a very strong Canadian firm. It has almost a $14B market cap and a relatively high P/E of 27. But the dividend yield is a nice 4%. If you're looking for yield, Encana would do it for you, but with a P/E of 27, I think it's priced more like a growth stock than others. In this oil market, I don't know if management can really live up to those kinds of expectations. I'm not negative on it; I'm just saying, be careful.
TER: To summarize, what do you think the average investor should be doing these days if they want to play the energy markets?
BK: I would be very wary of most gas plays just because of the economics. I would also be wary of the oil service sector, with the exception of Schlumberger, which happens to be cheap but won't be cheap for long. In terms of the larger oil plays, I'd suggest Statoil for international and technical competence with a good growth profile in front of it and, in the oil sands, Cenovus. I don't want to give too long of a list to the investors out there because this is not the time to be too bold.
This market could confound people greatly. We're at the beginning of a presidential election cycle where government statistics and government announcements will become completely meaningless because everything will become politicized. There are many beaten-down ideas out there. The market is filled with underpriced value, but you want to find the best of the best of those underpriced values. I think I've given a few names in this discussion. I'll be able to sleep well at night if investors act on those.
TER: Should we wait a little bit for the oil market to bottom out before it's an ideal time to get in or should people be averaging in?
BK: I think people should view the market as trying to find a bottom. Right now, it's OK to nibble, but it's better to watch and wait.
TER: You've given us a good overview of where you think the market might be headed and some good names to look at. Thanks again for your time.
BK: Thanks for having me.
Byron King writes for Agora Financial's Daily Resource Hunter. He edits two newsletters, Energy & Scarcity Investor and Outstanding Investments. He studied geology and graduated with honors from Harvard University and holds advanced degrees from the University of Pittsburgh School of Law and the U.S. Naval War College. He has advised the U.S. Department of Defense on national energy policy.
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1) Zig Lambo of The Energy Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: Royal Dutch Shell Plc. Streetwise Reports does not accept stock in exchange for services. This interview was edited for clarity.
3) Byron King: I personally and/or my family own shares of 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. I was not paid by Streetwise Reports for participating in this interview.