Taking a long-term view on energy assets

18/03/2009 - 22:00

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BRIEFCASE notes that many oil and gas stocks, such as Pan Pacific, Carnarvon Petroleum, Cooper Energy and AED Oil, show little if any market value for their ongoing operating cash flow from production activities, while some trade at or below their cash as

Taking a long-term view on energy assets

BRIEFCASE notes that many oil and gas stocks, such as Pan Pacific, Carnarvon Petroleum, Cooper Energy and AED Oil, show little if any market value for their ongoing operating cash flow from production activities, while some trade at or below their cash asset backing.

One reason for this apparent disconnect between assessed asset values and market value is that, by their nature, resource companies work with depleting assets. In the absence of rising commodity prices, notional value will always decline as a resource is exploited, unless reserves are replaced and expanded, which requires risky, ongoing exploration spending.

This leads on to the way long-life resource assets are valued. Long-life assets - such as the massive Olympic Dam copper, gold and uranium mine and Queensland's coal seam gas (CSG) producers - transcend normal valuation techniques, largely because of the strategic nature of their very long project lives. A normal net present value calculation does not factor in the strategic value of such long-lived projects.

World-class resource projects with low operating costs have the ability to survive through many commodity price cycles, while ongoing pure exploration spending associated with such resources is virtually unnecessary.

The table above illustrates how major oil companies, such as BG, Petronas, ConocoPhillips and Shell, have been prepared to pay an average of 86 cents per thousand cubic foot (Mcf) for 3P CSG resources, even in a market where immediate gas sales can attract a price of only $A2.90-$3.50/Mcf. Clearly the 'majors' look towards long-term project status in Queensland's CSG operations and also display the strongly held view that energy prices will rise in real terms over the medium to long term, especially as this gas gains access to global energy markets via planned LNG production facilities at Gladstone.

Briefcase's favourite quote by Warren Buffett from this year's Berkshire Hathaway shareholder letter is, "We never want to count on the kindness of strangers in order to meet tomorrow's obligations. When forced to choose, I will not trade even a night's sleep for the chance of extra profits."

I love this quote. Business operators now need to think of debt providers as strangers and understand that they will not always be kind enough to lend money in tough times.

Despite rising unemployment, which is a lagging indicator of economic activity, there are signs of life in the local economy. Australia's Reserve Bank said total credit provided by financial intermediaries increased by 0.6 per cent over January 2009 following a fall of 0.2 per cent for December.

Over the year to January, total credit rose 6.1 per cent. Housing credit was up 0.5 per cent to 7.4 per cent on the year. In the US, inventories of houses for sale have begun to decline, indicating that the market is clearing that overhanging stock and stability may be achieved later this year.

However, on the downside, personal credit was down 0.2 per cent to be down 4.9 per cent on the year as people save and repair personal balance sheets, which Briefcase sees as being necessary in any case.

While Australian and Canadian banks appear to be in relatively good shape, much of the Western world's banking system is thought to be technically insolvent and most Eastern European nations are also bankrupt, if one is to believe reports out of that part of the world.

Briefcase believes that a global consensus will form to deal with this banking mess over the coming two months. Outright collapse is clearly not a desirable option and the situation is recoverable with state assistance.

Whether this involves the setting up of 'bad banks' to hold toxic debt, or some other solution such as full or partial nationalisation, it is highly likely that a solution will be implemented before May this year. The medicine will be painful and may push the US S&P500 Index below 600 points, with the All Ords Index now having a downside target at around 2,750 points, despite recent 'feel-good' rallies.

Commodities are also on the move. After falling to $US35 per barrel late last year, Tapis crude oil recovered to trade over $US50 per barrel and, at $US47 per barrel, WTI crude has regained its traditional 5 per cent premium to lower ranked Brent crude.

A move above $US53 per barrel by Tapis would set a technical up upside target of $US71 per barrel for Tapis crude, which Briefcase believes is a real possibility during the second half of 2009. In the meantime, trade is expected to remain between $US40 and $US50 per barrel until mid-year.

OPEC's meeting last weekend was expected to announce further production cuts, which would support the price. A reduction in oilfield development drilling activity globally will result in reduced oil deliverability during the back end of 2009, further limiting supply. On the demand side, US consumers appear to be spending more time at the wheels of their Hummers, as the price of petrol sits at around $US1.90/gallon, so consumption may only fall slightly this year as the downturn takes its toll in industrial production.

Similarly, the widely used industrial metal copper, which tends to lead the prices of other base metals, appears to have bottomed at $US1.38/lb and recently traded up to $US1.65/lb, with further recovery towards $US1.90/lb likely during the back half of this year. Copper inventories rose about 430,000 tonnes over the past 10 months to trade at about 550,000t, but inventories have declined by 28,000 tonnes in recent months, supporting the recent price action.

In the US and around the world, exploration and development work in the petroleum sector is plummeting. The US's drilling rig count has dropped 42 per cent (861 rigs) since its peak in September 2008, while over the border in Canada; the rig count decreased by 24 per cent and will fall further as the summer arrives.

Meanwhile, the International Energy Agency (IEA) forecasts a drop in global demand for oil of 980,000 barrels per day (BOPD) in 2009 and a 1 million BOPD increase in demand in 2010, if the global economy recovers.

Briefcase calculates that global oil demand will have declined by at least 1.5 million BOPD during 2008 and 2009. Most importantly, the IEA expects that the impacts of the credit crisis on project cancellations will lead to a situation where the industry has no spare crude oil capacity by 2013.

Oil Movements, an organisation that monitors shipping activity, expects a 431,000 BOPD drop in OPEC shipments in the four weeks ending March 21 compared to the prior four-week period. Total shipments are expected to fall to a five-year low of 22.7 million BOPD. By the time you read this, OPEC will most likely have announced further cuts to production and Russia is likely to join in to stabilise the oil price at above $US50 per barrel.

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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