21/01/2009 - 22:00

Corporate power needs to swing back

21/01/2009 - 22:00


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IN the current global cyclical economic downturn, plummeting commodity prices have already met with a swift response from producers.

Corporate power needs to swing back

IN the current global cyclical economic downturn, plummeting commodity prices have already met with a swift response from producers.

Despite a recent bounce in the price of some metals and even some relief for the spot price for iron ore, Briefcase predicts that, with a weaker demand outlook, more capacity will need to be closed down or idled before balance can be restored and inventories are stabilised.

So far, Briefcase estimates that about 10 per cent of global nickel production, or 140,000 tonnes of annual nickel production capacity, has been taken out of the equation. And there will be more cuts to come as the nickel price hovers around $US5 per pound, well below the cash operating costs of about 50 per cent of nickel producers.

Similar production cutbacks have been achieved for copper, lead and zinc. Globally, producers of coal and iron ore have also responded to weaker markets with their own cutbacks, but Briefcase expects that a continuing decline in the world's industrial production will put additional downward pressure on commodity markets until at least mid-2009. The next upwards cycle is likely to get moving by late in 2010 and Briefcase predicts that by late 2011, physical shortages of metals and energy will once again be apparent on most commodity markets.

Costs for exploration and production equipment are plummeting. Over the past year, leasing day rates for offshore jack-up drilling rigs in Asia have fallen from around $US225,000 per day to $US130,000/day, and could fall back to around $US67,000/day later this year, which was where rates stood in 2004. There is a growing global glut of drilling equipment as new-build floating equipment comes off production lines.

Some shipyards in Asia have been building gear on spec, with no firm drilling contracts to go to, so we should expect that day rates will be under further pressure as drillers compete to cover costs while keeping the banks off their backs and trying to keep their teams together. Exploration and production companies that have not contracted gear are in a strong position to substantially cut project development costs as a result of these lower equipment costs

We have already seen Nexus Energy and Roc Oil cancel deals they were working on for floating production gear. Briefcase sees some substantial cost reductions flowing through to projects such as AED's Puffin, Roc's Baskar Manta Gummy and Nexus' Crux development, but none of these projects will be progressing to production or expansion at the current oil price. In fact, companies are deferring field development drilling while the oil price is so low.

In the Taranaki Basin, Australian Worldwide Exploration has switched plans, preferring to drill an exploration well rather than the scheduled Tui oilfield development well, reasoning that a new discovery would add more value at present than additional production at sub-$US50/barrel oil.

Elixir Petroleum recently had a rare piece of good news, gaining a short extension to its North Sea permit 211/18b, which contains the Leopard prospect. This is excellent news, since a nearby oil discovery at the Cladhan prospect appears to support potential for this type of stratigraphic play in this part of the North Sea.

Pre-drilling, Cladhan was estimated to hold potential for more than 300 million barrels of oil in place, providing a potential recoverable target of 100 million barrels of oil. Also, in action to the east of the company's Sierra Leone permit, Tullow has announced excellent appraisal drilling at its Mahogany oilfield, offshore Ghana, which now looks like being a billion barrel field.

Meanwhile cash flow continues from Elixir's Gulf of Mexico permits, but the company will have to resolve the farm-out of its Leopard Block in the North Sea and sort out payment for a multi-million dollar Sierra Leone 3D seismic data dispute before support returns. Elixir is a high risk and very high reward play.

Buru Energy has changed tack to meet the prevailing winds. With a market capitalisation of about $32 million and net cash of about $60 million, Buru has recognised that cash is a prime asset to have in this market. The market undervalues Buru because, on balance, most investors believe the company's cash will be squandered on unfruitful exploration in the Canning Basin, where even a large discovery would add little value at today's oil price and market conditions.

The company now believes it is prudent to conserve cash by scaling back exploration activates in the Canning and looking for lower risk oil and gas development opportunities on a broader playing field. Clearly there are plenty of distressed assets up for sale and Buru is in the fortunate position of being able to take its pick of the best opportunities. A move to secure low-priced hydrocarbon assets, which are close to production, enhances Buru's investment case and hence the market has lifted BRU's shares on this news. Briefcase expects that Buru will be patient and that even better deals will avail themselves by mid-year

Roc Oil has been a massive underperformer. The company is presently producing about 15,000 barrels of oil per day (BOPD) and has net debt of about $135 million. Briefcase calculates hydrocarbon reserves of 54 million barrels of oil equivalent, so at 52 cents per share, the company trades with an enterprise value of $8 per barrel of reserves.

At the current low oil price, assisted by some hedging cover against low oil prices, cash flow from oil produced by its 24.5 per cent Chinese-owned operation will just cover capital commitments, while production from the 3.5 per cent owned Chinguetti oilfield, offshore Mauritania, has been boosted to around 18,000 BOPD by a recent development well.

Most importantly, about 11 per cent of the company's shares had been overhanging the market until Nexus sold the last of its holding earlier this month. Removal of this stock overhang offers a potential trading opportunity, though so far, selling continues from other quarters and the stock has failed to bounce.

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Briefcase eagerly awaits developments that will undoubtedly flow from the malfeasance we have witnessed over the past decade in the stock and bond markets and within corporations, leading up to the sub-prime lending crisis and subsequent global financial crisis.

In my mind, one area that needs urgent attention is a rebalancing of corporate power back towards a company's shareholders and away from executives. Executives need to be made aware that the only reason they can be as productive as they strive to become is because the shareholders have entrusted them to work with the company's assets.

These assets belong to shareholders and not to the executives and it is the shareholders who deserve a return, while the executives deserve a wage.

I would be most surprised if I could not find 20 people who would be ready, willing and more than able to run Wesfarmers, for example, on the handsome annual salary of $1 million, thus pushing at least an additional $5.7 million down to the bottom line for shareholders.

In addition, a restructuring of regulatory bodies and research houses is called for, to ensure that the regulator is focused on achieving a well run and fair marketplace, and not on ultimately securing a nice job with a big broker or investment bank, based on an ability to do a great job of not rocking the boat, supporting unreasonable market valuations and cheering on unsustainable business models.

Finally, the research houses should ideally be paid by investors to rate investment product and not by the issuing parties. I know only too well that analysis has to be paid for and the stuff that floats down to you from internet chat rooms can do a lot of damage.

n Peter Strachan is the author of subscription-based analyst brief StockAnalysis, further information can be found at Stockanalysis.com.au


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