09/08/2005 - 22:00

Tim Treadgold: Briefcase - Oil pundits may need to readjust

09/08/2005 - 22:00

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Oil at $US60 a barrel is a pain for motorists, producing petrol prices of $1.20 a litre and more. But not everyone is moaning about the higher cost of fuel, and neither should investors with a nose for profit – and eye for opportunity.

A casual look at the oil sector for most punters goes no further than checking the share price of Woodside and/or Santos. That is far too shallow, for two reasons.

First, the oil sector consists of many more stocks than the top two, and new floats are popping up on a routine basis. Some are actually doing quite well, even if they look rather cheap and fragile should the oil price turn down.

And that leads to the key point when contemplating the oil sector; when will the price decline – and, more importantly what is the correct price to use when valuing an oil stock?

It might come as a surprise to novice players in the oil patch but the experts, both those inside oil companies and the outside analysts, are deeply conservative. For many years, decades actually, they used $US17 a barrel as the long-term price for oil. They did this because a price (any price?) had to be used in spreadsheet calculations for valuing a project.

Even when the oil price scaled the $US30 mark, the experts persisted with their $US17 assumption. Why? Because they always had, and what else is there to go on but history, and a habit of the oil price revolving around that magic number.

Today, an increasing number of oil-sector insiders are using numbers as high as $US30 a barrel when making their long-term assumptions for valuing potential new projects, and in calculating the extent of their reserves. The reserve valuation process is critical to all oil stocks, but it varies widely depending on the price assumption.

Quick readers will have spotted the point being made by Briefcase. What if the oil price sticks around the $US50 or $US60 a barrel mark for longer than the experts assume? In other words, is $US60 a barrel the new benchmark and, if so, what does that do to valuations in the oil patch?

Lots, is the correct answer. And it’s worth pointing out that some analysts are starting to tell their clients the sky-high oil prices are here for at least the next five years because of China’s appetite for the stuff, the lack of new developments, the high capital cost of future projects (especially those in ultra-deep water), and declining reserve levels at the oil majors.

Both ExxonMobil and Shell, for example, reported bumper profits in the June quarter – but also reported a 4 per cent and 1 per cent respective decline in reserves. This doesn’t seem a lot, but it is a deadly development for an extractive business that must replace more than it produces or eventually go out of business.

For mere mortals the oil scene, therefore, becomes an interesting investment playground where small producers such as Beach, Arc, Australian Worldwide, Roc, Petsec, Amadeus and Stuart start to look attractive, especially as most of this bunch are trading on price/earnings multiples of 14 and less while Woodside and Santos are at 18.

While there is always a discount factor for quality and size, a potential investor (and this is not investment advice) needs to consider (a) are the big boys in Woodside and Santos being fairly valued if the oil price is destined to stay up, and (b) if the answer is ‘no’ then the leverage effect at the small end of the sector is multiplied – which produces much food for thought because the small oils might be seriously undervalued.

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Someone else thinking hard right now is Andrew Forrest, who remains super-keen to develop a new iron ore business in the Pilbara, but who has just been hit with what seems to be a somewhat sobering cost estimate for rail and port construction of his Fortescue Metals Group project.

Rather than costing $1.44 billion, the latest estimate for infrastructure is $1.95 billion, and the total cost somewhere around $2.3 billion – with the potential for a cost blow-out one of the risk factors mentioned in the BBY analysis of Fortescue reported last week by Briefcase.

It’s an unwise man who gets into a debate with Mr Forrest over costs and profit forecasts but it seems that this cost blow-out might represent one arm of a rather unpleasant pincer for Fortescue.

As well as facing rising costs there are signs that future revenue might also be heading south, as can be seen in the falling price of globally-traded steel. A direction comparison between the price of steel and the price of iron ore is easy to make, though not totally accurate because steel is sold on a spot (immediate) basis and iron ore on long-term contract.

Over time, the price of one flows into the other, but that’s not the real issue. The core problem for Mr Forrest is that iron ore (unlike oil) is not in short supply. Sure, there is a squeeze today, but every producer from Australia to Brazil is cranking up production capacity for what is actually a very easy product to mine and ship.

It would not be at all surprising if world iron ore mining capacity was boosted by between 33 per cent and 50 per cent within the next three to five years. Such a rise points to potential over-supply and a sharp fall in price, the second arm of the pincer about to grip Mr Forrest.

As if that was not enough there is the small issue of raising $2.3 billion when you’ve got to explain (a) rising costs to your lenders, (b) the potential for falling prices, and (c) the small issue of a previous debt-servicing issue at the Murrin Murrin nickel mine.

•••

If anyone was in any doubt that control of the Australian media resides solely in Sydney, consider how much rubbish about some dude called Morris Iemma has been forced down the throats of people in Perth over the past week.

Every newspaper, every television bulletin, and countless radio bulletins reported on the life and times of a man chosen to be premier of NSW – but who has absolutely nothing whatsoever to do with WA (or Victoria, or Queensland, or Tasmania etc etc).

To test this hypothesis that other states are inundated with Sydney news whether they like it or not, imagine how much air time would be given to Alannah MacTiernan replacing Geoff Gallop as WA premier (about 15 seconds) as the last item on the nightly news, and never another word (which might not be such a bad thing, actually).

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“Democracy is the theory that the common people know what they want, and deserve to get it good and hard.” – HL Mencken.

STANDING BY BUSINESS. TRUSTED BY BUSINESS.

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