Oil and gas reserves around the world are growing scarcer by the minute, and people are looking to their governments for answers. However, leaders' responses are often motivated more by the desire to boost approval ratings than by the need to find real, long-term supply solutions. The individual investor may not have the power to shift the tone of the emotional debates surrounding the oil and gas industry, but he or she can devise a strategy to profit. Sprott's Rick Rule, and Casey's Marin Katusa and Louis James sat down with The Energy Report to discuss what it means to participate in a politicized market and how politics affect their buy and sell decisions.
The Energy Report: When it comes to energy, hasn't the sector always been steeped in politics? Or has the political environment made an even more pronounced impact since the 1970s, for example?
Rick Rule: I think energy markets are even more political now. When I was growing up, the U.S. energy business still had a couple of federal energy regulatory committees. It is really tough to comprehend how badly they screwed up in the 1970s. They trampled and obliterated every market they got into. It looks as though they intend to do the same again. The political response always seems to be an attempt to fix a problem after the market is well on the way to fixing it itself.
We North Americans have been given a tremendous gift, which we can now unlock through technologies that bring the total cost of producing gas down substantially. We're going to enjoy a substantial dividend from that. How that dividend gets spent will not be decided in west Texas or northern Alberta. It's going to be decided in Ottawa and Washington, D.C. That's really a shame, because some of it's likely to subsidize inefficient consumption and energy that wouldn't otherwise work.
|""The theme, 'Navigating the Politicized Economy,' does not only refer to regulatory burdens, but also to the overall responses of governments around the world to the crisis that we've been predicting for many years." – Louis James"|
Government increasingly shapes energy markets, and rarely for the better, which is truly sad. As an example, the political discussion with regard to fracking is almost anti-science. Fracking has become another "F" word—never mind that it's lowered our cost of energy consumption by half. When critics talk about the potential degradation of groundwater supplies, they suggesting that the frack could somehow impart enough energy to channel through 2 kilometers (km) of very hard rock and pollute an aquifer that might be 100 meters (m) deep. Such unfounded attacks could only happen in a politicized economy.
Marin Katusa: Another reason why U.S. energy markets are more politicized now is that China's consumption is reshaping global demand. Meanwhile, Russia still has a stranglehold over Europe's natural gas production and distribution, and Putin has been to Israel three times since he was elected this past spring, while Obama is yet to visit Israel during his presidency. Now it's looking as if Russia will become the largest investor for the liquefied natural gas (LNG) facilities in Israel. America may save itself through its ingenuity with shale technologies by being able to replace the low labor costs with low energy costs from natural gas, but because of the increased politicization, America is losing the global resource advantage it once had.
Louis James: Let me pull back to a bigger picture. The theme, "Navigating the Politicized Economy," does not only refer to regulatory burdens, but also to the overall responses of governments around the world to the crisis that we've been predicting for many years. That's the context, not just the minutiae of various enterprises and their regulatory problems, which they all have. It's about how the world is responding to crisis. The response is political and, as Rick indicated, very feelings-driven. It's not a rational or scientific way of optimizing outcomes. It's political, which means pandering to voters, which means doing whatever the larger number of usually less-informed people want, as opposed to whatever science or engineering may determine is an ideal way to do something. That's scary. How you deal with that is more of a philosophical than an engineering question: How do you personally plan your life in a world in which everything is more political every day? I think everybody should be asking that question.
TER: Marin, you pointed out in one of your articles that politically motivated supply chain disruptions—related to military actions, sanctions and such—affect the price of oil to the point that you're projecting an increase in the baseline.
MK: There are a lot of risks out there. A deposit such as Ghawar, which is the greatest producing oil deposit in the world today, was discovered 60 years ago. It is being depleted, but not replaced by new discoveries anywhere near that scale. What if there's a collapse or an engineering failure at the deposit? So many technical and social issues can disrupt the production. If a deposit like that goes down, what happens?
|"It's always the time to invest if you find the right companies. But it's important to understand that we are in a 'Pick Right, Sit Tight' energy market."|
Remember, it's not the old seven sisters that are the largest producers today, but rather politicized economies—the new seven sisters, which are all national oil companies that produce oil from deposits that the original seven sisters developed many decades ago. They haven't brought in the modern technology and entrepreneurship that Rick spoke about to enhance and streamline these deposits. Another factor is that in a lot of these areas, the major exporters are soon to become net importers. Already, about half of what Saudi Arabia produces is consumed domestically, and Mexico may be unable to export oil by the end of the decade.
TER: But as the price a barrel of oil goes up, don't more oilfields become economically feasible? And if that's true, does it replace the supply that is no longer coming from Mexico?
MK: No. No new wells coming on produce as much as Ghawar produces per day. With North American shale, you have to pop out so many more wells and perform many multifracks to produce even a fraction of what a superwell in the Middle East does.
RR: Marin makes an important point that warrants emphasis. My father worked in Saudi Arabia in the 1970s, and they'd drill a 1,500-meter well that would produce 50,000 barrels per day with no water at Ghawar. This was truly a spectacular business, when a well that cost maybe $1 million (M) to drill would make something like $4,500/day. That's about as good as it gets. The industry talks about the recycle ratio, which is the amount of new oil that can be discovered and developed on the operating margin from a barrel produced. The wells that we're replacing those wells with—a very good well today might have a 2x recycle ratio, whereas those wells had maybe a 15x recycle ratio. So the industry has become much more capital-intensive than it was, and the recycle ratio is lower.
Furthermore, the social take from global energy production, which includes taxes, royalties and regulatory burdens, is much higher: The rate per barrel climbs each year. In many jurisdictions around the world, the game is over—they take 100%. And for years, governments in countries like Mexico and Venezuela have diverted a substantial amount of free cash flow from their domestic oil industries to subsidize spending programs.
In an industry as capital intensive as oil and gas, starving it of sustaining capital impairs its ability to exploit assets for much-needed oil. The catch-up spending necessary is truly spectacular.
TER: So in an increasingly politicized industry, is there any investment opportunity? Is this the time for North American companies to shine in comparison to cash flow-strapped producers in less friendly jurisdictions?
MK: It's always the time if you find the right companies. This is why I urge people to be very careful and patient and to do their homework. The sectorwide bull is not here right now. It's company specific. Rick and I have talked about Africa Oil Corp. (AOI:TSX.V) for the past four years. We were the first ones to talk about it publicly, finance it and recommend the company to investors. But while Africa Oil has done fantastically well, the other juniors in the East African rift are at the same price they were a year and a half ago, at the peak of the junior energy market. This is why it's important to understand that we are currently in a "Pick Right, Sit Tight" energy market.
TER: But oil has really been bouncing along pricewise in the same band for a couple of years. It sounds as if it's about to break out of the band.
RR: I don't think it will break out anytime soon. There is a dichotomy between domestic natural gas, which is keeping energy prices moderate as regional crude oil markets are developing. We hadn't seen such wide differentials before. For example, the market for Brent, for international light sweet crude is quite high, particularly relative to the price being paid for light sweet medium crude, which is becoming landlocked and doesn't sell. You have a series of regional markets.
|"Volatile markets are very good for me. I like to buy stuff when nobody else wants to buy it. In the 1990s, those swings sometimes took years, and now they sometimes take weeks."|
MK: There are price differentials even within the regional markets. As a result, producers in the Bakken get a different price than producers of the same type of oil in Eagle Ford. The discount differential for Canadian oil is even larger. Distribution is another factor. So just because oil went to $120 per barrel (bbl) doesn't mean the oil company you invested in is getting $120/bbl; what matters is what the company is getting on its netback. Again, it's very company specific and more regionalized than people realize.
LJ: One more point—the speculative component to energy prices goes away if the global economy visibly tanks. So the near term certainly presents plenty of opportunities for lower prices, and this should be seen as a buying opportunity for the very best picks.
TER: Marin, last time we talked, you said that risk mitigation is the key to success, but in a risky market like this, how do you do that?
MK: Many factors come into play. Louis and I have had the advantage of working very closely with and being mentored by both Doug Casey and Rick Rule, so I think the key thing is to first look at areas that interest you. At that point, determine your risk appetite as an individual investor and start doing your homework. It always starts with the people. That's the most important "P" of the eight Ps. You also have to look at what type of investments a company is doing, its stage of development, its financial metrics and so forth. Risk mitigation is complicated, but those are some quick and easy places to start.
RR: Another thing that many people can do to mitigate risk is hire help. For instance, if you can have 40 people in the Casey organization working for you six or seven days a week, and you get that help for the price of a $1,000 subscription that you can leverage against a $1M portfolio. It's pretty stupid not to do it.
I agree with Marin that people are the most important factor, but another key concern is balance sheets. In a capital-intensive business, if you don't have any capital, you don't have any business. That's it. Stop.
Beyond that, strong due diligence comes down to traditional securities analysis. It's pretty simple in the case of oil and gas juniors. You look at three things:
- Recycle ratio, or the amount of new production you can bring on with the margin from prior production
- Reserve life index, meaning how many years of production you'll get from a deposit
- Ratio of proved undeveloped to proved developed producing conversion ratios
If you have those three things down, I wouldn't say it gets easy, but it gets doable. You don't even necessarily have to get them right—just closer to right than your competitors. Risk mitigation just requires knowing more than the people you're bidding against in the market.
TER: But you want to look at those sorts of things in any market. Do you change how you invest in a volatile market?
RR: I do. Volatile markets are very good for me. I like to buy stuff when nobody else wants to buy it. In the 1990s, those swings sometimes took years, and now they sometimes take weeks. The idea that I get more frequent sales—in other words, there are more frequent panics—is not anathema to me. It's nice for me. If the market gives me the opportunity to buy something at a 50% discount to what you think it's worth, I'm going to do it. As you get older, if you're successful, you learn that sometimes stuff is cheap enough. You don't wait for the absolute bottom. The fact that you get these opportunities more frequently is good.
TER: How about the sell side?
RR: I've also had to be a more frequent seller. It used to be that for successful positions my average holding was something like 70 months. In the last two or three years, I've had situations in which every level of greed was fulfilled in three or four months. I guess that's wonderful, but certainly the volatility you talk about has changed my parameters.
TER: Do your stock picks differ in a volatile market?
LJ: I'd say that when the risk appetite in the market changes, it changes what kind of investments we recommend. Volatility is our friend for the reasons Rick outlined. If you want to shoot for the 50-baggers or 100-baggers, you're not going to get them on multibillion-dollar companies. That means taking chances on a large number of earlier-stage companies.
But higher volatility generally means more risk aversion. Under those circumstances, we look for less-risky plays; a development story rather than a grassroots story would be more appealing. The share price trend in development-stage companies is well established: Share prices spike on the discovery, decline during the boring engineering phase and then come up as the company ramps up to production. It's what Marin calls the pregnancy period, the nine months up until first pour. It's a very reliable trend. If you can find a company with no discovery risk, with all the technical risk addressed, with the right people and a real project that will produce, the chances are very high that its stock will go up when it goes into production. So we'll look for much lower-risk investments of that nature when people are more risk-averse, which perversely tends to be when the market is more volatile.
Logically, the math says stick with the plan, but if you broaden it out, you can capture more spectacular wins. It doesn't take many 100-baggers to pay for all the ones that didn't work out. This is basically what Doug Casey does, but few people have that discipline. But few people have the discipline to do that, so we tend to alter our recommendations when people are more risk-averse.
MK: A volatile market doesn't change the way we evaluate companies. It changes the way we execute on the information.
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