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Henry Bonner

Rick Rule: Not ‘Rushing in’ to Buy Oil Juniors for 5 or 6 Months

Should we steer clear of the oil sector or look for ways to profit?

On December 29, 2014, investors with our firm tuned in to hear from Rick Rule, Chairman of Sprott US Holdings, discussing turmoil in oil and gas. Click here for the full audio.

He warned investors not to expect an oil price recovery this year, but said we could still see decent returns from lending to oil companies at low oil prices.

High Supply and Low Demand for Oil

The oversupply we’re seeing now is a result of a high oil price and advances in oil drilling techniques, he explained.

New technologies include fracking but also seismic imaging techniques that allow producers to model underground reservoirs.

This has re-vitalized old oil fields in the US:

“The incredible advance in technology has increased production in the most over-drilled piece of real-estate in the US (oil fields in Texas) by 100 percent in 5 short years.”

Although high oil prices have helped bring back the US oil sector, it has also resulted in an oversupply, which is contributing to the price plunge:

“These periods of very high oil prices led to increasing inventories at the same time that the high prices made the oil less attractive to consumers. Increased supply and reduced demand gave you the outcome that you expect, which is lower prices.

“To turn this around, we need to see either resumption in economic growth worldwide, or else the gradual de-capitalization of the oil business (where companies use up their cash due to lower profits and fewer ready sources of funds).”

If oil demand does not start picking up soon, then the industry will have less money to invest in new production.

This is important for US shale plays, because they require ongoing re-investments to maintain their output.

Disappearing Oil and Gas Capital

The process whereby capital for new wells becomes scarcer is called ‘de-capitalization.’ It occurs because profit margins go down, leaving less cash on company balance sheets, while at the same time sources of capital like banks and investment firms become less willing to put capital to work in the sector.

One of the most common means of financing a new well is to promise future proceeds from the well to the creditor until debt has been repaid.

At a high oil price, operators could pay back their loans quickly and keep a greater portion of the proceeds for themselves. At a lower oil price, they have to wait longer until they are able to keep the cash flows for themselves. As Rick explained:

“What looked like 8-month payouts to creditors at $90 per barrel are now two-and-a-half-year payouts.”

This leaves oil field debt ‘locked into’ projects much longer than expected, because it must be paid back from diminished cash flows. The total amount of capital that could be affected by longer payback times is estimated at around $500 billion.1

An alternative means of financing is to issue new shares – but share prices among ‘junior’ oil producers have plummeted. The Dow Jones North America Select Junior Oil Index, which tracks small oil stocks in the US and Canada, is down over 40% in the six months ending January 5, 2015.2 This means that raising cash by issuing new shares will be greatly dilutive and potentially harm existing shareholders.

US Oil and Gas Could Burn through Capital for Years

Despite ‘de-capitalization’ of the sector, production might take years to drop off substantially. The reason is that the period from ’08 to ’14 was so profitable it has left many companies with ample supplies of cash and assets, according to Rick.

In fact, the oil and gas industry – like the mining industry – might deplete its capital to keep its production going, even if the production is uneconomic:

“The industry might produce down to break even, or even below that in order to generate the cash to keep the lights on and – importantly – to pay management salaries.”

This has happened before in the energy sector:

“The natural gas industry in 1983 was selling its product below the cost of production, and they continued to deplete capital reserves for 7 years until 1989.”

The sector might not deplete its capital completely, says Rick, because a rebound in the price of oil is still possible.

Cheap Oil Could Spur Growth

Rick believes that lower oil prices could stoke demand enough that it takes the price to higher levels:

“In developed economies that use a lot of energy, such as Western Europe, the US, and Japan, the decline in oil prices acts like a tax cut. It increases the disposable income of consumers, which lead to increased economic activity.

“A lower oil price might stimulate demand in the near term, because people have more money in their jeans thanks to lower gasoline and energy costs. This begins to seed the overall economy for a recovery. It hastens the situation where lower prices take care of themselves.”

This would be a real recovery unlike the manufactured recoveries that are based on cheap credit in the developed world:

“The recovery that we’ve supposedly seen is an odd one. It would appear to be interest-rate driven. While in the United States we are seeing growth in the number of jobs, we don’t seem to be seeing increased labor force participation or upwards pressure on real wages. Real incomes don’t appear to be rising.”

In the very near term, though, the oil price decline might also weigh on the economy:

“Until a few months ago, the sole exception to the overall weak growth in the US was the oil and gas industry where real wages were rising rapidly. That party of course is coming to screeching halt.”

National Oil Companies

Besides shale production in the US, we’re likely to see cuts from several national oil companies, says Rick. Unlike shale producers in the US that have been over-capitalized, government-owned oil companies have been drained of capital over the last decade:

“The countries in question include Mexico, Venezuela, Peru, Indonesia, Ecuador, Iran, and we might add Russia. During the last 6 or 7 years, these countries have diverted significant amounts of cash flows from their oil and gas industries into more politically expedient social programs, starving their oil and gas industries.”

The oil price will have deeper consequences for these countries, besides harming their national oil companies:

“Given how these countries are run, with a significant portion of national budgets coming from national oil industries, it is unlikely that they will be able to balance budgets at $55 per barrel when they were already in deficits at $90 per barrel.”

OPEC

Rick addressed whether Saudi Arabia is trying to make the price of oil go down (Sprott’s Mishka vom Dorp recently explained why this is a rational theory). Rick says he understands why people make this case, but that the real issue is weak demand:

“I understand that the Saudis would want to maintain market share as the world’s most efficient producer. They need money to maintain their social welfare programs that keep these aging Sheiks employed.  I also understand that they want to undermine their sworn enemies the Shias across the Persian Gulf, and in Russia.

“But if demand had continued to grow at its normal rate between 2008 and 2014, there is no doubt that the Saudis would not have the ability to produce enough to depress the price of oil.”

Steer Clear or Look for Ways to Profit from Oil Pullback?

Some producers are still making money, says Rick:

“It’s amazing how robust the returns from the oil and gas industry have been. Calculations on projects we’ve looked at have shown that 25 to 30 percent returns might go down to 10 or 15 percent rates. Even at the lower oil prices, those are still attractive returns.”

In fact, those returns might improve because other costs of the oil and gas sector are going down:

“There are indications that all the costs associated with production are falling and going to fall further. That means land, seismic data, services, wages, professional salaries are all getting cheaper.”

Therefore, the North American producers might do OK overall, says Rick. On the other hand, conventional oil producers might be more leveraged to high oil prices, and therefore more fragile.

Still, Rick’s only nibbling on the lending side, and not buying stocks just yet:

“My inclination is that when everyone else is selling, it’s time for me to come in. But I’m not going to rush back into the junior oil producers for at least the next 5 or 6 months.

“Banks that lend money to the juniors use a loan structure called a revolving credit facility with mandatory repayments of interest only, not principle. The amount provided through the credit facility is determined by the bank’s estimate of the reserves held by the junior as collateral. Re-evaluation of these reserves by the banks will come in May and June.

“Naturally, at an oil price point of $55, down from $90 a year ago, the value of those reserves will be lower. This will negatively impact the ability of oil and gas companies to borrow further. The revolving credit facility will become a ‘term’ credit facility that must be paid back over 3 to 5 years. This will re-direct cash flows from the company towards servicing debt, leaving nothing for replacement, growth or dividends.

“I’m waiting until then to see how they can all deal with a lower price deck, and even then, I’ll be early.”

Beware of Dividend-Payers

Watch out if you bought a company for its investor payouts and not its balance sheet strength and revenue growth:

“Many of you have owned some of the smaller companies for dividends and see these distributions as attractive. Unfortunately, these distributions will likely be cut, or (perhaps worse) they will keep paying them by cannibalizing cash.”

Some of the Majors Look Attractive

Rick might act sooner on some of the bigger names:

“In the first or second quarter I’ll be looking at the major oil producers. Integrated oil companies can make money when prices are high through ‘upstream’ oil production. At low prices, they make money ‘downstream’ from refining, marketing, and fabrication. These divisions benefit from lower input costs.

“The major oil companies have been through the same ‘baptism of fire’ twice in the last two decades and have become extraordinary capital allocators, and they are all over-capitalized.

“We’ll be looking very closely at companies like Exxon Mobil Corp. (NYSE:XOM) or closed-end funds like Petroleum & Resources Corp. (NYSE:PEO).”

P.S.: Interested in putting to work Rick’s ideas on oil investing? Contact us to discuss investing in oil and natural gas with Sprott Global Resource Investments Ltd. 

P.P.S: Not yet subscribed to Sprott’s Thoughts? Subscribe here.

1 http://www.forbes.com/sites/christopherhelman/2014/12/19/who-will-get-caught-when-the-oil-debt-bubble-pops/
2 Bloomberg

 

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