of doubles, five-baggers, or even tenfold returns abound in the resource
sector. These successes are exactly why we play the game: The discovery and
development of a new oilfield or gas basin can create immense value, and
being part of a story like that is extremely satisfying, not to mention
the potential for big resource returns can all too easily make investors
forget just how risky the sector really is. Investors are not the only ones
who get caught up in the hype – an exciting discovery can turn normally
conservative CEOs and geologists into starry-eyed daydreamers waxing poetic
about grand possibilities and great riches. As a story out of Brazil recently
reminded us, even the world's most successful investors can get carried away
by dreams of resource riches.
is precisely what happened to the richest man in Brazil. Eike Batista earned
his formidable wealth in the resource sector, starting with a gold-trading
firm and moving into precious-metals mining before branching out into oil and
gas. His empire is now contained within the EBX Group, a conglomerate of five
public companies with the same majority owner: OGX is an oil and gas explorer
and producer; MPX is an energy entity that generates power, mines coal, and
produces natural gas; MMX is a mining company with operations in Brazil and
Chile; LLX is a logistics company focused on resource-sector needs; and OSX
is an offshore oil and gas service provider that also builds ships and
is the firm that propelled Batista into the headlines in late June. Just
months after CEO Paula Mendonca reassured investors that the company was on
track to meet its targeted production volumes at its nascent Tubarao Azul
field, OGX admitted that the first two wells at Tubarao are only pumping out
half of their expected production. Since Tubarao is the company's first
producing operation, the downgrade forced OGX to slash its 2016 production
guidance in half.
market responded in kind, cutting OGX's value in half. The fall was the
biggest anyone at the Sao Paulo stock exchange can remember, erasing R$16
billion – US$7.9 billion – of value in just two days.
are many lessons to draw from such an investment calamity, but all of them
harken back to one primary fault: OGX overpromised and underdelivered. Blame
undoubtedly goes to OGX's management team, but questions remain. Why didn't
an incredibly successful and experienced chairman like Eike Batista provide
better counsel? Why did the company set itself up for failure by promising
answer to both questions is the same: they thought they could do it. OGX's
concessions in Brazil and Colombia contain resources totaling a whopping 10.8
billion barrels of oil equivalent (boe); and everyone at the company, including
Batista, let themselves believe they could develop those reservoirs with nary
a stumble and would soon be pumping out barrels and barrels of oil.
it had worked out as planned, OGX might still be worth R$50 billion (US$25
billion). But it is never easy to develop any kind of natural resource, and
even though the Campos Basin – where OGX kick-started its development
efforts – is in relatively shallow waters and does not present any
specific technical challenges (it is not a sub-salt deposit, like so many of
Brazil's offshore barrels are), it proved more difficult to tap than the
management team with more temperance would have incorporated the potential
for setbacks in its outlook, which would have meant more modest production
targets. Had that been the case, the company's share price wouldn't have
rocketed skyward the way it did, but perhaps OGX would have met – or
even bettered – its oil guidance.
what we got was a dramatic reminder that even highly experienced resource investors
can all too easily forget the litany of risks inherent in moving a resource
project from potential to reality. Developing resource deposits is very
difficult. Just about the only guarantee is that something will go wrong.
had already created $20 billion in shareholder value in the mining arena
before he set foot in the energy sector. He took that step in 2005, creating
OGX as his vehicle to participate in Brazil's burgeoning offshore oil
industry. OGX snapped up a raft of offshore concessions, gaining ownership of
almost five billion barrels of oil. Based on that resource, the company
managed to raise US$3.3 billion in its IPO in 2008, a record in Brazil at the
Eike was able to raise so much in OGX's public debut even though the company
had not yet produced a drop of oil speaks to the excitement Batista and his
team stirred up around the company. They spoke glowingly of OGX's future as
Brazil's largest oil producer and emphasized that OGX's offshore concessions were
not overlaid by a layer of salt, which was supposed to mean that the oil
would be easy to access.
and his management team at OGX took turns telling the markets just how much
oil OGX would churn out. CEO Mendonca predicted repeatedly that the Tubarao
field in the Campos Basin alone could produce as much as 80,000 barrels per
day (bpd). Batista loved to tell whoever would listen that OGX would be
pumping 730,000 bpd by late 2015. By 2019 the company was aiming for 1.4
all sounded fantastic, but when it comes to output forecasts, the proof is in
the pudding: Geologists and CEOs can talk about potential production rates
until their throats are dry, but the only way to know what a field will
really produce is to drill some production wells, open the taps, and see how
quickly the black gold comes out. And since OGX did not produce a drop of oil
until January of this year, investors had no way of knowing whether OGX's
forecasts were realistic. They just had to wait for production data.
January OGX produced its first oil, pumping from its initial Tubarao
production well. Excitement over the long-awaited moment lifted the company's
share price above R$18. Just six weeks ago, after several months of
production but before the company released any real data about Tubarao,
Mendonca publicly reaffirmed that OGX would be producing 40,000 to 50,000 bpd
from four Tubarao wells by 2013. His confidence suggested that things were
going well, but investors must have sensed trouble: OGX's share price slid to
R$10 by mid-June.
investors who fled the stock were right to follow their gut instincts –
things were not going well. On June 26 OGX revealed that its first two
Tubarao wells are currently producing just 10,000 barrels of oil equivalent
per day (boepd), half of what Mendonca said they would pump in their early
days. Since wells decline with time, OGX has now projected these wells will
produce just 5,000 boepd over their producing lifespans, far below the 10,000
-13,000 boepd originally forecast.
the end of 2013 Tubarao will now be producing just 20,000-25,000 boepd, not
the 40,000-50,000 bpd Mendonca estimated just weeks ago. By the end of 2015
Tubarao was supposed to be spitting out 730,000 boepd; now OGX expects less
than half that volume.
news had two instant ramifications. First, OGX's future cash flows were
slashed. Fitch now projects OGX will book earnings before interest, tax,
depreciation, and amortization (EBITDA) of $2 billion in 2015, down from a
forecast of $6 billion before the Tubarao production revision.
the company lost all credibility with investors. Analysts with Bank of
America Merrill Lynch put it well when they wrote that the production
downgrade "puts into question all the assumptions behind the company's
growth program." In short: No one has any reason to believe any of OGX's
production predictions… and since OGX grew into a R$58-billion company
based completely on its future production potential, much of the company's
value evaporated alongside its credibility.
is now down 62% since the beginning of the year. Its market capitalization
stands at R$20 billion. The company has deep pockets – its bank account
is well stocked and Batista's remains very healthy despite losing $11 billion
on paper in recent weeks – and so it will likely survive. But it will
never forget the lesson it learned in 2012: never underestimate the
challenges of resource development.
OGX investors will never forget the sting of a resource investment gone
terribly wrong. For Batista, who lost more than every other OGX investor
combined, the lesson is that pumping hydrocarbons is not the same as mining
metals. Mining has its many challenges, but exploration drilling and
metallurgical testing can determine with reasonable certainty where a gold
deposit lies, how much gold it contains, how difficult it will be to blast
apart the rocks and collect the ore, and whether the gold can be separated
from the other minerals to produce an economic product. Obstacles to mine
development and operation are still aplenty, ranging from water in the rock
formation that causes wall collapse to politicians in the country who want
more money, but defining an orebody is easier than outlining an oil
While OGX's drastic downgrade will certainly scare some
investors away from energy, that doesn't change the fact that the sector is
poised to be the next great bull market. We have to face it, most
of the easily extracted oil is gone, and the only way to meet the
world's energy demands will be by harvesting gas and oil in reservoirs
trapped miles beneath the earth and sea. For investors, the trick is
finding companies that can do this consistently and profitably; but doing
that requires extreme due diligence on every potential investment...
otherwise you run the risk of getting stuck with an OGX.
one infamous quote put it, a geologist looking for an oil reserve is akin to
a blind man in a dark room looking for a black cat that may or may not be
there. If you manage to find the cat, you still have to figure out how it
behaves… but you're still completely blind.
oil reserves, the resource is a liquid under immense pressure from a mixture
of gases, and the reservoir holding this liquid-gas balancing act has to
remain under high pressure or wells will run dry. Maintaining pressure
requires a sealed unit; while exploration drilling and geophysical surveys
provide some information about reservoir size and pressure, there is no way
to be sure the reservoir does not connect to an adjacent reservoir or some
other kind of geologic formation that will impact production.
is precisely what happened at Tubarao. When flow rates declined much more
rapidly than anticipated, OGX geologists reassessed their data and concluded
that natural fractures connect the reservoirs feeding the first two wells.
With two wells pumping from a joint system, pressures in the reservoirs
this will happen to every Tubarao well is yet to be seen, but it is certainly
possible. And Tubarao is just one of the fields OGX is developing – if
OGX has been equally optimistic in projecting production flows from its other
oil and gas fields, the company and its remaining investors could be in for
many more unpleasant surprises. And this from a reservoir that was not even
supposed to be that hard to develop! Most of Brazil's vast hydrocarbon wealth
is contained in reservoirs that lie underneath deep waters and shifting salt
formations; by contrast Tubarao is in shallow waters and outside of the salt
zone. In addition, OGX operates in a country with fairly good oil
infrastructure and reasonable, well-defined levels of government take. Just
imagine how much harder it can be when the geology gets complex, the
environment is harsh, and the fiscal rules of the game change under your
is the nature of the oil and gas game. The days when one could drill a
simple, shallow well into the Texan soil or Saudi Arabian sand and be
rewarded with gushing flows of black crude oil are over. Today's oil
discoveries are in increasingly challenging reservoirs that demand evermore
sophisticated technologies to unlock.
inescapable truth is that developing a successful new oil project becomes
more difficult with every passing day. The result is that every investor who
fails to appreciate this new reality will see an investment sideswiped by an
unexpected geologic complexity, or a greedy government that takes a bigger
piece of the pie, or a lengthy but ultimately fruitless battle for permits
that relegates a promising project to the history books, or some similar
obstacle that stops a project in its tracks.
does not mean that oil and gas is a hopeless investment landscape! It means
that every energy-investment decision requires careful due diligence and that
investors have to take every company promise with a grain of salt. The rising
risk barometer also makes it even more important for investors to temper
their greed – it is better to sell too early, locking in a small or
mid-sized gain, than to wait too long and lose it all.
energy exploration and production landscape is becoming more difficult to
navigate every day. Without a guide you could easily get lost, regardless of
how many gains you've booked already – for proof of that, look no
further than Eike Batista.