I’ve just updated my Keeping Score page. IT and Healthcare up, Energy way down.
Category Archives: Energy
oil: the view at 30,000 feet
Oil is either a very complex subject or a very simple one.
There’s a wide variation among various types of oil, the kinds of input a given refinery can process, the politics/stability of the countries that provide the different grades of oil to the market, and the regulatory regimes in different countries where refined oil products are used.
Nevertheless, there are general patterns that can be of investment significance.
In particular, I think it’s at least possible that we’re entering a period of extended oil price weakness, due to slow economic growth in the US, and to a lesser extent in the EU, plus the sharp rise in unconventional oil production in the US.
Here’s why:
supply/demand
In the short run, oil supply is relatively invariant. Major oilfields are very expensive long-term projects designed to bring large deposits of subterranean oil to the surface. Once the oil starts flowing, it can’t be stopped without risking major damage to the oil reservoirs. This could mean a lot of extra drilling to reach now-isolated pockets of crude. So capping wells to reduce supply generally isn’t done.
Same with oil demand. In the absence of large price moves, people will continue to use transportation fuel in the same way. Industrial processes won’t change. So this major portion of demand is pretty much locked in. And until a shockingly large heating bill comes in the mail, people won’t turn the thermostat down.
Because both supply and demand are relatively inflexible, small changes in either can result in large changes in price. We saw this a few years ago when oil spiked above $150 a barrel as desperate users bid up the price of scanty supplies. But the opposite could equally well occur: panicked producers, running out of storage space to put barrels of crude customers don’t want, offering large discounts to get someone to take them off their hands.
On the supply side, OPEC is the largest factor, accounting for about a third of world output.
On the demand side, the US is the world’s largest, and most profligate, petroleum consumer. We use 20% of the world’s oil while representing less than 4% of the globe’s population. As I invariably try to work into the conversation, the US is also the only developed country not to have an energy policy that promotes conservation. The intent has been to protect an inefficient domestic auto industry that ended up imploding in the last recession anyway. One unintended effect has been to help preserve OPEC’s immense economic power.
shale oil
What’s new in the supply/demand story is coming out of the US. It’s the rapid rise in production of shale oil, which has lifted total US crude output from 5 million barrels a day in 2008 to just shy of 9 million now–with at least another one million b/d gain likely over the next year.
Arguably (read: this is what I think, but have no definitive evidence for), the main reason oil prices haven’t been spiking up despite turmoil in the Middle East is the steady new flow of US crude from places like North Dakota.
The International Energy Agency has just pared a bit from its estimate of oil demand over the coming year, based on slowdown in the EU. Large-scale purchases of new, more fuel-efficient cars in the US may begin to put a lid on domestic gasoline consumption, which is the biggest part of US oil usage. China, the #2 world oil user, with about half the consumption of the US, is also growing a bit more slowly than anticipated.
Will all this be enough to tip the world oil supply/demand balance in favor of oversupply (and significantly lower prices)? Who knows? …but maybe.
effects?
…a shot in the arm for stocks generally (other than the oils). Lower gasoline prices would mean higher discretionary income for ordinary Americans, which would be a plus for mass-market consumer stocks.
Bet on this? …no. Just something to think about, to consider what we’d buy if signs of a weakening oil price began to emerge.
North Dakota, fracking and flaring
My internet is working again!!!
Oil production in North Dakota, driven by hydraulic fracturing in the Bakken shale, has risen from 400,000 barrels a day to over a million over the past three years. This has elevated the state to second place in oil output, trailing only Texas–and the coastal waters surrounding the US. At today’s rate, North Dakota accounts for 15% of total national output of crude.
No wonder North Dakota has sailed through the recession without many bumps or bruises.
Part of this expansion has been enabled by the wasteful practice of allowing drillers to “flare,” or burn, associated natural gas at the wellhead. Last week, the North Dakota legislature took a baby step toward controlling this activity.
what flaring is
Many underground hydrocarbon deposits contain both oil and natural gas. So output that reaches the surface is a mixture of the two. Even in a remote area where there are no pipelines, crude can be saved in holding tanks and periodically trucked away. Not so natural gas, which requires either a pipeline or complex (and expensive) cryogenic system to get it to market. This lack of transportability is the main reason natural gas often sells at a steep discount to crude oil based on heating value. It also makes the gas a liability.
A generation ago, the most common way of dealing with natural gas that came to the surface with crude oil was to divert it to a safe distance from the well and set it on fire. In today’s world, the accepted practice is to require the driller to pump it back underground. That way it can be recovered and sold once there’s a transport mechanism in place.
Not so in North Dakota, though, where about 30% of the natural gas brought to the surface is wasted and burned. Statewide, that’s about $50 million worth a month–four times that in energy value using its crude oil equivalent. The 30% compares with 5% of gas flared from wells in Texas.
Environmentalists have been squawking about flaring for some time. Landowners, too, who see potential royalty payments going up in smoke.
So last week, the ND legislature acted. It is forbidding new wells to flare natural gas–meaning they must have a way to pump gas back underground–but does very little to stop the practice in already-producing wells.
The obvious consequence of this action is to raise the cost of future drilling in North Dakota. This will gradually lower the profit growth of companies drilling there. My guess, however, is that it will do little to slow the growth of production, since the new legislation just removes “Free lunch” from the bar.
natural resource production companies: accounting quirks to watch for
mining
Mining is mostly about how a company develops resources that have already been discovered, sometimes very long ago.
1. Metals orebodies can vary considerably from one part ot the next in the proportion of valuable minerals they hold. Standard practice is to mine the highest-grade ore when prices are low, and the lowest-grade when prices are high.
Not a lot of operating leverage this way. But the idea is to enable the mine to stay open even during the inevitable cyclical downturns. Doing the opposite, which will likely boost the stock price in good times, can lead to disaster during the bad. There’s no easy way for an outsider to tell, except by the reputation of company management. In the case of gold, we may find out who’s been prudent and who’s been reckless when the 2013 financials are published.
2. Same thing with site preparation. Standard, and prudent, practice is to routinely spend money on things like removing overburden (layers of dirt covering the ore) in places where the company is not mining today, but plans to in the near future. This activity can be quite expensive. But it’s necessary. On the other hand, a firm can make short-term profits look considerably better by not doing so.
oil and gas
Oil and gas is much more involved with finding new deposits, and how to account for those costs, than metals mining.
1. Companies have two ways to account for the costs of buying mineral rights and doing exploratory drilling. They are:
–successful efforts, where, as the name suggests, only successful fields are put on the balance sheet and gradually written of as oil and gas is produced. The costs of unproductive areas are written off as expense as soon as they’re incurred.
–full cost, where all exploration costs, both for productive and non-productive projects, are capitalized and written off against production.
Successful efforts is more conservative, but normally results in lower earnings.
2. Accumulated costs are written off pro rata as each unit of oil or gas is produced. The amount expensed against the revenue from each unit is its proportionate share of the total cost of finding and developing all oil and gas (it’s a little more complicated than this, but this is basically what you need to know). That proportion, in turn, is calculated based on periodic estimates by petroleum geologists’ of the total size of reserves.
Big oil companies use their own geologists; smaller ones hire outside consultants. The important point is that this estimate–and therefore the amount of cost written off per unit produced–can vary a lot, depending on the particular consultant hired. It may also depend on the tone, conservative or aggressive, company management sets.
Just as important, as I mentioned yesterday, oil and gas price changes can alter the size of total reserves. The cost of recovery doesn’t change, but the amounts of hydrocarbons that can be brought to the surface at a profit can be. Lower selling prices can raise the per unit amount expensed; higher selling prices can lower the unit amount. Potentially, lots of operating leverage–that’s completely out of management’s control.
3. A minor clarification of #2: subject to some limits, the company decides how to group reserves and associated costs into different “cost pools” for figuring out depreciation and depletion. Artful grouping of these pools can help disguise an extended run of bad drilling luck. Not usually a worry, except with small firms with limited history.
4. As with any other capital construction project, when oil and gas companies explore and develop with borrowed money, they can capitalize (that is, put on the balance sheet rather than expense immediately) the interest expense on that borrowing. The interest expanse becomes part of the general costs that are written off against oil and gas production. For smaller companies with an ambitious drilling program, this can sometimes create the peculiar (and potentially disastrous) result that it shows positive earnings while it is suffering cash outflows. This is because interest is being paid to creditors but these payments basically don’t show up on the income statement. Check the cash flow statement!!
natural resource production companies: proved reserves
Early in my career I interviewed for a job with a company that had brought in a new chief investment officer to revamp its research department–a job I (luckily, as it turns out) didn’t get. In the interview, the CIO said he thought that any competent analyst could figure out most industrial or service companies, but that there were three areas that demanded special expertise, They were: financials, technology and natural resources.
Personally, I’d take technology off the list, leaving financials and natural resource companies as the real specialist endeavors. I’ve coped with financials by either avoiding them entirely, buying plain vanilla commercial banks in emerging markets, or by mirroring the index (so they neither help nor hurt performance). As it turns out, I spent about eight years concentrating on natural resource companies at the start of my career (true, during the last century). Rightly or wrongly, I feel comfortable with them.
Two thing make natural resource production companies unusual:
–their revenues depend on the price of the mineral commodities they mine, which can be very volatile, and
–their stock market value most often depends on the amount and value of their proved reserves, something that only appears tangentially in the firms’ financial statements. Companies routinely disclose at least some information about their reserves, but it’s in supplemental disclosure that you have to find elsewhere in the annual.
proved reserves
Proved reserves are deposits of minerals that can be recovered:
–at a profit,
–with today’s technology, and
–at currently prevailing prices.
Almost always, natural resource companies have more stuff in the ground than they report as proved reserves. Two possible reasons: the minerals genuinely aren’t recoverable at a profit, given today’s technology and pricing; or (commonly with small companies) the firm hasn’t wanted to spend the money to get hard geological evidence of the extent of their holdings.
why this is important
1. When prices go up, two good things typically happen to natural resource companies: the value of each unit of reserves rises and the volume of reserves rises as well. The opposite happens when prices fall.
Most people don’t realize the volume part. That will be particularly important this year when gold mining companies report their reserves.
2. When technology changes–as is currently the case with the development of horizontal drilling and hydraulic fracturing in shale–acreage that previously seemed worthless may suddenly become a big source of profits.
In the case of natural gas in the US, this is a two-edged sword. The amount of new gas production that fracking has spawned is so great that it has lowered the domestic gas selling price. This means that some high-cost operations that were previously economically viable are no longer so–thereby moving those reserves out of the proved category for the companies affected. For particularly maladroit drillers, where the value of the reserves found is barely higher than their finding costs (i.e., where the stock market appeal is purely the bet that prices will rise steadily), fracking can be a death knell.
More tomorrow.