Category Archives: Mining

shale oil and shale natural gas (iii): shale gas

January 31, 2014 By in Industry Analysis, Mining, shale oil and gas Tags: , , , , , , , Leave a comment

shale gas vs. shale oil

The impact of the development of shale oil deposits in the US is primarily macroeconomic and global.  The effects of shale natural gas, on the other hand, are very specific to the US.

Why?  …for natural gas, in almost all cases you need a pipeline to deliver it (the other (very expensive) option is cryogenics).

As I mentioned in my post two days ago, over the vast majority of my investing career an Mcf of natural gas (one thousand cubic feet, the basic unit) has sold at more or less the same price as oil, based on heating value.  Today an Mcf sells for only a fifth of that amount.

What happened?

The simple answer is “shale.”

Three factors, the first two of which natural gas and oil share in common:

1.  Most of the costs of finding oil and gas are up front–finding prospective acreage, buying mineral rights and then drilling a well. There’s also the cost of “dry holes,” meaning wells that come up empty.

In a successful well, outputs typically beings to flow to the surface without much assistance.  The out-of-pocket cost of delivering a unit of oil or gas, once the upfront money has been spent, is pretty low.  So prices can fall a lot before output is forced off the market by negative cash flow.

2.  It’s actually worse than that.  Petroleum engineers want to create a steady underground flow of output to a given well, to ensure that the most hydrocarbons will be drained before another well must be dug.  Stopping the flow creates the risk that output will start up later at way under the former rate–and that (expensive) extra wells have to be sunk to get at the oil or gas.

In the case of natural gas, sellers also typically have long-term contracts that require them to be able to deliver specified amounts. So they’re not free to turn off the taps, even if they wanted to.   Also, oil and gas sometimes both come out of the same well so the operator is stuck taking the latter to get at the former.  In this case, giving the gas away may be cheaper than reinjecting it into the ground–which is what most places require by law.

And, of course, the development company may need cash flow from its wells to pay salaries, service debt or fund capex.

3.  Unlike oil, natural gas can’t just be sold into a global commodity market, for use anywhere.  No pipeline network, no potential customers with gas furnaces and hookups to the local gas utility = cap the well.  The gas is worthless (this was the situation in the US right after WWII).

Today, the US is crisscrossed by huge networks of gas pipelines, so that’s not a problem.  But the customer base is relatively static in the short term (the pipeline thing).  In a situation where supply is expanding and demand is relatively inflexible, the only way for the market to clear is for prices to drop through the floor.    …which is what they’ve done.

It seems to me they’re going to stay there for a long while.

implications

Natural gas customers will continue to enjoy lower bills for heating and air conditioning.  For residential users, this means more money to spend on other stuff.  For industrial, it means higher profits.

Electric utilities are starting to substitute natural gas for coal in power generation.  Again, lower consumer and industrial prices.  European companies are already beginning to complain that their electricity costs are a competitive disadvantage.

The US petrochemicals industry is structured to use natural gas feedstocks;  Europe is based on oil.  …a huge advantage for US firms.

Foreign hydrocarbon-intensive industries are beginning to relocate plants to the US to benefit from low natural gas prices.  These are typically not labor-intensive operations.  So other than construction work, no employment bonanza.  But every little bit helps.

I think we’re still in the early innings of this story playing out.

investments?

I can think of three areas:

–strong consumer discretionary companies will probably enjoy a small, but continuing, tailwind

–shale oil and gas exploration/development companies.  I haven’t looked, but my instinct would be to zero in on small rather than large, and the lowest-cost operators.

–equipment suppliers (I own Chicago Bridge and Iron (CBI)), although these have had quite a run over the past six months.

 

shale oil and shale gas (ii): shale oil

January 30, 2014 By in shale oil and gas Tags: , , , , 2 Comments

conventional wisdom…

In recent years pre=shale oil),conventional wisdom about world oil supplies has been dominated by several ideas:

–that world oil production is at, or near a peak (Wikipedia has a good summary

–that steadily increasing demand will be generated by nations like China and India (when three billion Asians trade in bicycles for motorcycles, and then motorcycles for cars…), leading to sharp price increases

–the continuing pivotal role of OPEC–despite members’ competing national agendas–both in supplying oil to the rest of the world, and in asserting the rights of the oil-producing nations to be fully paid for selling their principal asset to the rest of the world

–the (oversimplified) asymmetry between major industrial oil consuming nations, which–ex the US–have little petroleum output of their own, and producing nations, with not much going for them economically other than oil

–the central role of the US, the largest and most profligate oil consumer in the world, in moving D-day for a supply crisis closer to the present.  Two powerful special interest groups, Big Oil and Big Autos, have forged a unique alliance to block the (demand-lowering, government spending-funding) taxation of oil and oil products that is the norm elsewhere.

Less talked about, but still important, is the activity of  hydrocarbon “national champions: in places like China and Japan.  These are firms, some publicly traded, whose main mission is to secure oil supplies for delivery to the home country in times of shortage.  To them, profits are a distant second to getting control of barrels.

Other forms of planning for the upcoming shortage have been high up on the political agendas of most countries (ex the US) for years.  The development of nuclear power generation is one prominent example.

…may be turned on its head,

in two ways:

1.  The situation of the US, as the glutton at the world energy table, is changing.  It’s not that we’re consuming less.  It’s that, thanks to shale oil, domestic oil production is beginning to increase.  Also, the extremely low relative price of domestic natural gas, thanks to shale gas (tomorrow’s topic) is prompting users who can do so to switch from oil to gas.  The shale revolution is also beginning to get foreign oil users to relocate plants to the US so they, too, can use cheap gas as a feedstock.

2.  The shale oil/gas business is so new that no one knows yet what deposits may lie within the borders of large European or Asian oil-consuming nations.  These may also be very large, although natural gas recovery faces the distribution infrastructure issues I outlined yesterday.

consequences

There are certainly geopolitical implications as/if the asymmetry between petroleum producers and petroleum users shifts.  If/as that happens, will the Middle East be as important in politics?  Probably not.

Commodities speculation based on the idea of ever-rising oil prices may abate.

Alternate energy, particularly forms requiring large government subsidies, may lose investment appeal.

The oil industry itself may shift further away from the idea of Indiana Jones-like exploration for mammoth new oilfields toward the profit calculations of pocket protector-equipped mining engineers assessing recovery prospects from well-mapped shale prospects.  This probably favors smaller companies over larger ones.

Energy exploration and development firms with marginal success rates, whose main appeal is therefore their leverage to rising energy prices, become (even) more speculative than before.

natural resource production companies: accounting quirks to watch for

January 15, 2014 By in Energy, Gold, Industry Analysis, Mining Tags: , , , , , , 1 Comment

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

January 14, 2014 By in Energy, Gold, Industry Analysis, Mining Tags: , , , , , Leave a comment

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.

 

 

gold mining stocks?

January 9, 2014 By in Gold, Industry Analysis, Mining, Portfolio management, Stock ideas Tags: , , , , , , 1 Comment

gold mining stocks

I spent part of the day yesterday looking at gold mining stocks.

the potential attraction?  …over two years of dreadful performance.

Since mid-2011, the gold price is down by about a third.  Over the same time span, many gold stocks have lost between half and three-quarters of their value.  And that’s during a period when the S&P is up by about 50%.

Sentiment about gold has also taken a decidedly negative turn.  Hedge fund managers are no longer bloviating (how about that word?) about the superiority of the yellow metal over “fiat money.”  Boiler rooms are no longer filling the airwaves their odd sales pitch that “Gold has tripled over the past five years.  (Therefore you should) buy some now!!”

In addition, I think that 2014 will be a year of consolidation for the S&P.  So a 3% dividend yield plus the chance of, say, a 15% gain looks to me to be substantially more attractive than it might have been a year or two ago.

my verdict

I’m not so interested, for two reasons:

1.  I think the gold price is still too high.  In the past, the gold price hasn’t bottomed until it reaches a level where at least some existing mines become uneconomical.  This means that the cash a company must spend (not including non-cash costs like depreciation) to produce an ounce of gold is greater than the selling price.  As best I can tell (a long time ago, I would have considered myself an expert, but I’m certainly not one now), that’s below $1,000 an ounce.  The price may never get there, but, as an investor, I’m looking for situations with more upside than downside.  I don’t see that here.

2.  I don’t think companies have completely stabilized themselves yet.  The industry took on a lot of debt to fund what have turned out to be ill-advised capacity expansions at the top of the market.  That’s par for the course.

As far as I can see, these projects have by and large been at least temporarily mothballed.  However, there’s still the debt to deal with.  It isn’t so much that there are borrowings on the balance sheet that bothers me.  It’s that financially leveraged firms have to continue to mine in order to repay their lenders.  So supply isn’t taken off the market as quickly as it might otherwise be.  A number of companies had stock offerings last year.  Good for them, but this just prolongs the adjustment period.

All in all, I don’t find the risk/reward to be favorable enough right now.  Maybe in six months.