Category Archives: Energy

lower oil prices: stock market implications

June 29, 2012 By in economics, Energy, Industry Analysis, Recent Market Action, Refining, Stock ideas Tags: , , , , , Leave a comment

falling crude oil prices

It late February, the West Texas Intermediate oil price was $110 a barrel.  Now it’s $80.

North Sea Brent crude, which is much easier to refine and therefore sells at a premium, was at $120 four months ago.  Now it’s at $92.

That’s a price drop of around 25%, even though June is seasonally stronger period for demand than late winter.

That’s good news for consumers, especially in the US.

Here’s why.

a thumbnail sketch of the oil market

Petroleum is a peculiar commodity, for several reasons:

–huge size.   The world uses around 80 million barrels daily.  At the current $80 each, that’s $6.4 billion a day in value, or $2.3 trillion a year.

–disproportionately large consumption by the US.  The US makes up about 4.5% of the world’s population–but uses over 20% of the global oil output.  How so?  It’s partly because the US is a rich country.  But it’s mostly, in my view, the result of long-standing (and misguided) policy in Washington to subsidize an inefficient domestic auto industry.  (We’re the only industrialized country without an effective energy policy, and we’ve been like this for forty years–but that’s a topic for another day).

–supply is very inflexible.  Most pools of oil are buried under great pressure deep beneath the earth.  Draining these reservoirs without drilling a gazillion wells in each is a complex process that involves starting–and keeping for years and years–a steady flow of crude from all parts of the field toward the surface.  In almost all cases, stopping, or even trying to slow down, the flow can be disastrous.

As a result, when demand slows, as it is now, the only way producers can sell their surplus output is to lower the price–sometimes by a lot.

implications of falling prices

There are two major ones for stocks:

1.  Most oil (and natural gas) companies make the bulk of their money from developing oilfields and selling the output.  Lower prices translate directly into lower profits.  There may be different shades of bad, depending on whether the producers own the oilfields outright or have production-sharing agreements with third parties.  But it’s not good.

The one exception is companies that whose business is completely “downstream, ” that is, who refine and sell petroleum products, especially gasoline.  They’re buyers of crude oil, so their margins may expand as prices fall.  Ultimately, though, competition forces them to pass on almost all their lower costs to customers.

2.  Falling oil prices are a boon for consumers, particularly in the US.  Sustained over a year, a $30 per barrel reduction in the oil price means an extra $1,700 in spendable income for the typical US household.  That’s the equivalent of a 6%-7% pay raise.

think modest

That’s not enough for the Porsche or the Tiffany tiara you’ve been eyeing.  And the extra income won’t be particularly noticeable to the affluent.  But it will be an important boost, I think, to the everyday buying of ordinary Americans.  So Wal-Mart and Disney (I own DIS) should benefit.  Generally speaking, average citizens should continue to feel better about their economic circumstances, even as the economy shifts into a lower gear (is there one?) and job growth slows.  So retailers who sell low-ticket items should have the wind at their backs.

question from a reader: the merger of Alpha Natural Resources and Massey Energy

September 26, 2011 By in Current Market Thoughts, Energy, Industry Analysis, Private equity, Stock ideas, Uncategorized Tags: , , , , , , , , , , , Leave a comment

the question
24.149.88.16

I listened to a debate recently on the merits of small commodity companies
acquiring larger ones. The company in question was Alpha Natural Resources purchasing much larger Massie Coal.
Can a smaller commodity company like ANR actually make the investment finacially feasible when they bought a company that was already foundering?
I enjoy your blog greatly!

my thoughts

At the outset, you should be clear that, although I’ve done extensive research in natural resources over the years, I don’t know much about the coal industry. So personally I don’t know enough to want to buy ANR stock.  But I can see several issues a buyer might want to explore.

background

ANR, which has private equity roots, was formed in 2002 to buy assets from Pittston Coal and has since growth by acquisition.  Its largest purchase to date is Massey Coal, a 2000 spinoff from Fluor.  It bought Massey in June 2011 for about $1 billion in cash plus just over 100 million shares of ANR stock, worth $5 billion+ at that time.

By revenues, both are roughly equal in size.  Mine output seems to be similar as well, with 5/6 thermal coal for power generation and 1/6 higher-value coking coal for blast furnace steel making.

Massey is the owner of the Upper Big Branch Mine in West Virgina, which experienced the worst domestic coal mining disaster of the past forty years on April 5, 2010.  A methane gas explosion there killed 29 miners.

Since the Massey takeover, ANR shares have lost about 60% of their value.  Part of this is due to general selloff of commodity stocks on worries about economic slowdown, part to former Massey shareholders cashing in their profits, part to ANR’s announcement in September that sales volumes will be lower than expected.

merger issues

My experience is that there are two types of risk in a merger like this:

–Are Massey’s safety problems confined to this one mine, or has that company been cutting corners to increase profits of other mines as well?  Certainly, industry gossip may provide clues.  But until ANR actually analyzes the Massey properties one by one in detail, it won’t know for sure.  Aside from the human issue, the question is whether ANR will have to make substantial capital investment to get the Massey mines functioning properly.  In other words, are the Massey properties actually less profitable than they appear to outsiders?

–Does ANR have the management depth to run an enterprise twice its former size.  It may be able to rely on the former Massey management.  But suppose they just refuse to do what ANR wants?  Sounds silly, but culture clash is a significant risk.  The risk going in is much higher when there’s evidence of badly-run operations.

In addition, is the ANR management composed of deeply knowledgeable and experienced coal miners?  …or is it basically a financial company doing a “rollup,” that can make generic efficiency improvements but entrusts the actual operation of the business to others?  I don’t know.

–One positive thing.  The combination was done mostly for stock.  So increased financial leverage isn’t a risk.

specific questions

A quick look at Value Line shows that ANR achieves only about half the operating margin of the VL coal industry.  Why?

My guess is that coking coal may be as much as a third of ANR’s profits, although only about 1/6 of volumes shipped.  At least some of that goes to China.  If so, have recent profits been inflated by flooding and transport problems in Australia?  How long will that advantage last?

the influence of speculators in the crude oil market

July 11, 2011 By in Current Market Thoughts, Energy, Industry Analysis, Stock ideas, Strategy Tags: , , , , , , , , , , , , Leave a comment

The conventional view taught in business schools is that speculation is good.

Boiled down to its essentials, the argument supporting this view is a very simple one:  suppose there were no one to take the other side of the trade of, say, a farmer seeking to guarantee a minimum price for his corn crop that would ensure he’d cover his costs and have something left over to keep body and soul together.  There may not be enough cereal makers or animal feed producers who want to hedge their costs in the same amounts and at the same time as the farmer.  If not, who’s left to be the buyer of the commodity contracts the farmer wants to sell?  The answer:  speculators, who have purely financial motives and who will step in to stabilize a market by buying and selling commodity futures contracts before prices get too wacky.

In this picture, the main players are the producers and users of commodities; speculators play a minor role, though a convenient one for the theory.

 

I don’t know whether this was a solid description of the way commodities markets worked a generation or two ago,  or just a product of the many simplifications of the real world that academics need in order to have their mathematical models work more smoothly.  But even if they once were correct, do these ideas still work in a world where prop trading, hedge funds and commodity-based ETFs abound, and where brokers have made it much easier for ordinary investors to buy commodities futures directly?

the case of crude oil

In 2008, after an oil price spike that saw the price of crude nearly double from a starting point of $80, the Commodity Futures Trading Commission issued a report, based on the traditional thinking, which found that speculation played little role in the upward move.  The Baker Institute of Rice University is the most well-known of observers who criticized the CTFC findings.  It said the commission had ignored its own data, which showed a dramatic rise in the involvement of the proprietary trading desks of investment banks, of hedge funds, and of commodity funds in oil trading.  On the Baker Institute’s reckoning, these speculative entities made up half of the market (and they all wanted to bet that oil price would rise).

Apparently in response to this criticism, on July 5th,the CFTC published a relatively large set of data showing the relative importance of hedgers and speculators in various commodities markets, including crude oil.  What called my attention to the report was an article in the Financial Times that says speculators make up a majority of the trading in metals, agricultural and financial futures–but in crude oil, they comprise well over 90% of the trading volume!!  (I’ve cast my (unpracticed) eye over the figures.  I don’t see the 94.5% speculation the FT reports, but most categories of crude show hedgers make up less than 20% of the market.  Same difference.)

my thoughts

The CFTC is proposing that the government limit the number of positions a speculator can hold as a way of limiting their influence.  And the International Energy Agency has already organized a limited release of some of the crude oil stocks held by oil-consuming nations in an effort to cause speculators to liquidate.

CTFC action would just make speculators relocate, however.  The IEA has a worry, too –that speculators have deeper pockets than it does.  Both agencies are treating symptoms, not the root cause, of high oil prices.

In a lot of ways, the current oil situation reminds me of froeign exchange during the Bretton Woods era of fixed currency rates.  During Bretton Woods, countries periodically tried to defend a certain currency level, even though that level was ultimately being undermined by structural economic problems that at least one of the countries involved refused to address.  The banks speculating against the currency exchange rate were, in effect, betting that the structurally weak country didn’t have the political will to make needed changes.  Generally speaking, the banks were right.  They thought it was like shooting fish in a barrel.  Ultimately, the Bretton Woods arrangement collapsed.

The structural issue for petroleum in today’s world is the failure of Washington for more than a third of a century to fashion an effective energy policy that reduces the country’s dependence on crude oil.  In part, this has been a way of protecting a politically powerful but badly run domestic car industry–which is even now lobbying hard against proposed increases in fuel efficiency standards for cars and trucks that would bring the US into line with the rest of the developed world in ten years or so.

The massive speculative bet is that the current situation won’t change much–resulting in higher oil, a lower US dollar and slower economic growth in the US than would otherwise be the case.

investment implications

The straightforward bet on this issue would be for or against the stocks of oil producing companies.  Slow growth domestically and a weaker US$ would also favor US-listed companies with significant operations outside the US, however.  For anyone, like me, in the weak-$, slow-growth US camp, I think the latter group of stocks will do relatively well under most oil price scenarios, making them the better way to go.

 

 

thoughts on the International Energy Agency release of strategic oil reserves

June 24, 2011 By in Current Market Thoughts, economics, emerging markets, Energy, Industry Analysis, Recent Market Action, Stock ideas Tags: , , , , , , , , , , Leave a comment

the IEA action

Yesterday, the International Energy Agency (IEA), an organization of oil consuming countries, announced its 28 member nations have agreed to release 60 million barrels of their collective emergency oil supplies, at the rate of 2 million barrels daily for thirty days starting early in July.  The idea is to offset upward pressure on the oil price that might arise during the summer high point in demand.

The extra oil, which represents a bit less than 4% of the total government reserves of the IEA, is ostensibly to replace crude lost to world markets by fighting in Libya.

The agency has done this twice before.  The first time was when Iraq invaded Kuwait in 1990; the second was after Hurricane Katrina.

Of the 60 million barrels, North America (read, the US) will supply half, Europe 30% and Asia the rest.  Each country will decide for itself how it will achieve its goal.  The US intends to release crude oil from the Strategic Petroleum Reserve.  Japan, in contrast, is simply going to reduce by three days the amount of refined petroleum products that refiner/marketers are legally mandated to maintain.  This presumably will ultimately lead to decreased purchases of crude by Japanese oil companies.

a stop-gap measure

The release of petroleum reserves is a stop-gap measure.  It appears to have been well-timed enough to be shaking some speculators out of their long positions in oil futures, and may therefore get the world through the summer months with lower gasoline prices.  But the move is also reminiscent of the ultimately futile attempts of the signatories to the Bretton Woods currency agreements to defend fixed exchange rates.

structural issues

In the case of oil, two structural issues stand out:

–the increasing affluence of the developing world means ever higher demand from these countries for fossil fuels for power generation and for transportation, and

–the US, the only developed country without a sensible energy conservation policy, consumes almost a quarter of the petroleum the world produces, even though it  represents just over 4% of the population of the globe.

effect on stocks

The initial reaction from financial markets is that the IEA action is bad for oil stocks and good for consumer names, especially in the US.  To some degree, I think this is the right response.  But production-sharing agreements signed between the big international oil companies and producing nations over the past twenty years call for progressively increasing percentages of oil sales revenue to go to the nation rather than the oil company as prices rise.  So the negative effect of the current price fall will likely be less than markets expect.  Also, the IEA move is more a temporary reprieve than a problem solution for hard-pressed consumers.

As a result, I think that, as it unfolds in the coming weeks, the IEA move will prove a better occasion for selling US retail stocks whose customers are ordinary Americans and buying oil names that it is to do the opposite.

 

crude oil production contracts: a simple overview

April 26, 2011 By in Current Market Thoughts, economics, Energy, Industry Analysis, Recent Market Action Tags: , , , , , , , , , , 2 Comments

Financial commentators have been pointing out recently that neither the large international integrated oil companies’ profits nor their stock prices are rising in line with the upwardly spiking price of oil.  This has to do with the changing nature of production-sharing agreements in the development of sovereign oil deposits.

There’s a ton of jargon in the oil business used to describe the often complex process of deciding how revenues and costs from a project are split up among the parties involved.  This is a highly simplified outline (but still good enough, I think, for a stock market investor) of how it works:

Generally speaking, an oil company (or group of companies) leases oil and gas rights to a specified block of acreage owned by a government through a competitive auction (in the past, colonial-style political or military coercion could easily have been the real key, however) .  In some cases, the winner will pay a large up-front fee.  In all cases, he is obliged to pay for and drill a specified number of exploratory wells over a specified time period, or else forfeit the lease.

If economically viable quantities of hydrocarbons are found, the oil firm must begin commercial development, again within a certain period of time.  The company “carries” the government, that is, it pays all development expenses.  Typically it can gradually recover these costs once production begins by being allocated an extra share of output until it has been recompensed.

Sometimes, the oil company takes physical possession of some or all of the oil and can do what it wants with it, sometimes not.  This can be a big deal in times of shortage.  For companies designated as “national champions” in nations like China or Japan, and asked to find supplies that can be sent back home in a pinch, it’s always a big deal.

three frameworks

I’ve seen three major contract frameworks, one following after the other, since I began watching the international oil industry in 1978:

1.  When I became an oil analyst, the typical arrangement called for the ol company to pay a fixed fee, say, $.50 or $1 a barrel, to the government that leased the mineral rights to a major international oil firm.  The oil company owned the oil, and might resell the crude immediately or refine and market it.  Such a firm made a good profit even when oil sold for under $2 a barrel.  But when prices rose in the early Seventies and again later in that decade, reaching as high as $35, the oil companies enjoyed the entire windfall.

This was a mixed blessing.  The contracts were seen as so unfair and one-sided that many oil-producing countries nationalized their oilfields and threw the majors out.

2.  In the 1980s, new contracts retained the general form of their predecessors but were renames production sharing agreements.  They called for a sharing of production revenues in specified percentages, say 70/30, with the oil company receiving the smaller portion.  That worked for a while.  But as prices rose from $12-$15 a barrel to $25-$30, and the majors began to make huge profits relative to their invested capital once more, the same problem of perceived onesidedness arose again.  Producing nations reacted in a somewhat similar vein as earlier, but either levying new taxes or simply unilaterally mandating more favorable terms to contracts.

3.  During the past decade or so, a new type of contract has emerged.  Again, the general form of the original contract has been retained.  But the production sharing arrangements call now for the oil producing country to receive an escalating percentage of revenues as the oil price rises.  While the contract terms tend to be expressed in this manner, the intention, I think, is to cap the returns to the oil major from a given project at, say, 25%-30% yearly.  The producing country basically retains everything above that.

Are the oil companies okay with this latest development?  Well, they continue to drill.  Of course, a lot depends on the riskiness of a specific project, but I think the oil company investment conclusion is that getting a 25% annual return for the life of a twenty- or thirty-year project is better than getting a 100% return for two years and then losing the project entirely.

stock market implications

For individual stock market investors, though, it’s important to realize that professional portfolio managers, or at least the oil analysts who work for them, understand the rules of the new order.  So they won’t chase after the stocks of companies that they know have large proportions of newer contracts.

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