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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.
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?
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.
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"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."
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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.
Did you miss the latest Casey Conference? It's not too
late to profit from Casey Research's 28 selected experts who made
"Navigating the Politicized Economy" an event to remember. The audio collection is now available.
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