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BARRON’SOnline: Oil's Well: “The sense that reserves have peaked appears to be showing up in numerous ways beyond year-end reserves and Royal Dutch Shell's writedowns ( 4 April 05


A veteran energy investor doesn't think opportunities are tapped out


MONDAY, APRIL 4, 2005  


An Interview With Art Smith -- If there's someone more knowledgeable about global oil companies, we don't know who that might be. Heading up John S. Herold Inc., based in Norwalk, Conn., and Houston, Smith oversees a team of analysts and maintains a proprietary database on 400 or so publicly held energy companies that's much in demand by money managers, oil and gas company executives and investment bankers.


Before taking charge of Herold in a leveraged buyout some 20 years ago, Smith studied the ins and outs of the oil patch for a decade. He did stints as an analyst at Argus Research and Oppenheimer and as a mergers and acquisitions banker at First Boston. For a time, he also served as chairman and chief executive of Torch Energy Advisors before returning to lead Herold in 1998.


An English-literature major in a former life, Smith is fulfilling his literary aspirations by penning a biography of Newfield Exploration's founder, Joe Foster. He's also on the verge of launching an energy fund independent of Herold. Drill down to find where he's exploring for values.


Barron's: What do you make of the energy sector?

Smith: The energy sector is basically the whole story of the stock market this year. The S&P energy sector is up 15.3%; everything else is either down or flat. It reminds me of the 1979-81 period, when energy was the only place to be until the bust came, and then it was the place not to be for six or seven years.


Q: You are not predicting another bust so soon, are you?

A: No, I'm not. The curious thing is the profound cynicism that exists among investors and the oil companies, which have not spent every dollar that comes in the door as they have done traditionally. That's best manifested by ExxonMobil, which generated $43 billion last year in cash flow and invested $14 billion, down from the year before. ExxonMobil doesn't seem to believe there is a paradigm shift and that we are in a period of higher energy prices.


Q: Have they explained that?

A: No. They are an outlier. ExxonMobil is not like the rest of the business. They have a remarkable portfolio of legacy assets. They tend to keep to themselves and they don't interact much with the rest of the industry. ChevronTexaco's chairman, David O'Reilly, on the other hand, gave a talk recently in which he said something has changed and that ChevronTexaco is in the camp that believes reserves have peaked and that we are on the other side of the Hubbert Curve [named for M. King Hubbert, a Shell geophysicist who correctly predicted in the 1950s that U.S. oil production would peak in the early 1970s]. The sense that reserves have peaked appears to be showing up in numerous ways beyond year-end reserves and Royal Dutch Shell's writedowns.


Q: What might be the ramifications of ExxonMobil's dismissive attitude?

A: I would think the leading company in the world, with a $400 billion market cap, would be active in improving the supply side. Yet they seem to be very content to grow 2% a year and buy in stock and show a high return on capital, and the rest of the world be damned. Art Smith thinks oil-company shares don't reflect the likelihood of continued high energy prices. One exception: ExxonMobil is "pretty expensive." 


Q: So they are better managers of their stock than their assets?

A: That would be a good way of saying it, though it appears that everyone has capitulated and thinks ExxonMobil is a wonderful company and wants to own it. Quite frankly, we think it is pretty expensive. It is currently the most expensive of all the large oil companies. You can buy Total for a lot better value and, like ExxonMobil, it also buys in its stock and it has a good yield. Most of the companies we deal with have recognized that the current cash flows have been greater than anticipated and many of the companies have adopted the Exxon initiative and started using excess cash flow to buy back stock.

They've also adopted something called a variable production payment, or VPP, where they sell forward some of their production into the futures market and buy back stock. The stocks are not discounting the Nymex futures. Last year we were expecting a $40 oil market going to $35 and a year later it's a $50 oil market. Natural gas last year was $5 and now it is $7.44.

There has been a rather substantial increase in the expectations for futures pricing for oil and gas, which sets up a situation in which the companies can sell forward some of their production to an intermediary -- oil at, say, $50 a barrel -- and buy in their stock, which is discounting $30 oil. Pioneer Natural Resources did that. Apache did that when they bought some reserves from Anadarko. It's an interesting trend.


Q: What about prices in general in the energy sector? Are you looking for a correction in energy stocks?

A: Despite oil prices hitting new highs recently, the stocks have started tapering off. Some would say higher oil prices aren't good even for the energy sector. But somewhere out there, Adam Smith's invisible hand is working and capital is flowing into the sector for the right reasons, because there is a lot of black ink among the oil companies. They are making a lot of money and there appear to be some very good opportunities to invest in for some very high returns. The bad news is we continue to see a slump in exploration and discovery rates. At the same time, there are rising finding or development costs and reserve replacement costs, which are all tied together. IHS Energy, which just bought Cambridge Energy Research Associates, has come out recently with some data that show the number of major oil discoveries continues to decline each year. We are living off of inventory. That's confirmed by all the data we've collected on the industry.

It looks like another lousy year for reserve replacement. All the industry forecasts, from the International Energy Agency to the Energy Information Administration, point to a two-million-barrel-a-day increase in worldwide demand when we are all aware we probably have a one-to-two million-barrel-a-day surplus capacity in Saudi Arabia, which is my view of why OPEC [the Organization of Petroleum Exporting Countries] announced an increase in output, which the market shrugged off because it doesn't believe Saudi Arabia has more than a million barrels a day of capacity to bring forth.

So far, there has been no impact whatsoever on energy demand despite $2 gasoline in the U.S. and high prices in Europe. That is also true in natural gas. We've had a big run-up in natural-gas prices and yet demand hasn't really changed.


Q: Will energy continue to be the place to be in the market?

A: If exploration and production stocks are hot, the hotter sector is the oil-equipment and service and drilling group, which after four or five years of being in the doldrums are now seeing 100% capacity utilization. Pricing is going ballistic. We at Herold are not the best guys to talk to about oil services, but we can see that group heating up. All the rigs in the Gulf of Mexico are utilized, and it is a worldwide phenomenon.


Q: When was the last time the industry saw 100% utilization rates? That's rare in any industry, isn't it?

A: It's rare. The industry came close to it in 2000 and the market immediately collapsed, so it's been 30 years, probably. We see a lot of activity here. We see a shift from acquisitions to exploration, which is somewhat overdue. Most of the companies are being funded now by private equity firms and are more willing to actually drill to develop reserves. About 85% of the rigs that are active in the U.S. are drilling for gas, yet we haven't seen much of a supply response.


Q:What are your thoughts on mergers and acquisitions in the sector?

A: The driving force in the market right now is the national oil companies such as China's PetroChina and Sinopec and China National Offshore OilCorp. Brazil's Petrobras has gotten active. We are seeing an incredible amount of expansion interest by those companies. They are interested in the U.S., Canada and South America and everywhere else. They are setting the tone, and that will continue.


Q: And high prices are not deterring them?

A: Absolutely not. Everyone complains about China being the cause of the oil price run-up, but they are the second-largest importer of oil. The U.S. is the real culprit in terms of thirst for imported oil. Yet China's needs will continue to expand.


Q: Again, though, do you expect energy to be an easy place to make money this year?

A: After a 15% gain in three months, it could cool off for a time. But we come back to the same theme: There are still some quality companies trading at or below appraised value and at decent cash-flow multiples. There is a real search for companies with the right portfolio of resource-development assets. Even though the Oil Sands in Canada is not undiscovered and is still undergoing an incredible investment boom as they rush to develop those resources, the companies involved there are still very economic at these prices. One of the ironies here is that Canada is talking about a gas pipeline that would run from the Mackenzie Delta down through the Northwest Territories in Alberta to exploit some known reserves and perhaps provide four billion cubic-feet a day of production. At the same time, the Oil Sands plants are expected to use up every million cubic feet of gas that comes down. None of that will make it to the U.S.


Q: At what point does supply become a bigger issue?

A: There is a growing appreciation that we have a very thin margin of error and we have some very difficult political issues to deal with. There's Saudi Arabian security and Middle Eastern security. Another big concern is Hugo Chavez in Venezuela. He is just an unpredictable fellow. He just recently caused a big ripple in the oil industry by shutting down a lot of the development that was planned for this year. He denied a bunch of drilling plants for the industry. Then he raised royalty rates on heavy oil. Venezuela is a very important supplier. We need Venezuela not only to continue to provide current levels but to increase its output. Russia was our hope for new incremental supplies, yet post-Yukos there has been a real chill on investment programs there. If the industry doesn't spend money on new resource development, the depletion issue comes back to haunt us. Saudi Arabia has announced plans for capacity expansion. Kuwait has considerable upside from where they are.

Just the idea of getting the world back to having a two- or three- or five-million-barrel-a-day cushion in surplus capacity would take a lot of the what we could call the terror premium out of the current price. Who knows what that is, but it could be easily $10 a barrel because of concerns over not having any oil. 


Q: What's happening on the liquefied-natural-gas front?

A: It is still a great gold rush. There are announced LNG plans every week. A number of the wannabes in the market have faded, however. At one point, there were planned LNG facilities up and down the East Coast and in Baja California and all around, and yet virtually everyone has capitulated and decided to put the plants along the Texas and Louisiana Gulf Coast because they already have refineries there.

There have been a number of plants announced in the Middle East and there's been an incredible boom in engineering construction work. That's an ancillary theme: Halliburton and even Brown & Root will start making money because engineering and construction had been in a depression and now they are bidding on projects and making money.


Q: You recommended a number of stocks at the end of the year. Would you still recommend them?

A: Unocal has had the biggest move of that group. A quick and dirty analysis of the price it might be acquired at, finding costs times reserves, gets you to $85 a share based on the fact their finding costs last year were $11 a barrel. If a full-fledged bidding war erupted, it could be similar to what happened at Conoco when it came into play back in the 'Eighties. You couldn't buy enough of it. It just kept going up. I think that Unocal is in play. Kerr-McGee is another company that has to figure out what it is going to do with itself now that Carl Icahn has arrived. He is not going away.


Q: What are its options?

A: He has already forced some concessions in that Kerr-McGee agreed to divest its titanium-dioxide pigment business, which is a $1 billion business. They have agreed to buy back stock. But they haven't agreed to let Icahn put two people on the board. If I were an adviser to Kerr-McGee, I would ask, "Why not? What are they going to do?"


Q: In December you predicted lower oil prices by year end. Do you still think that?

A: We were just being cautious. Well prices were weakening in December, and after two years of being up 40%, we took a more defensive position. But the market rallied amazingly. So we were wrong. It appears the fundamentals are just so strong.

The other bit of news since December would be the fact that companies' financials for the fourth quarter were better than expected on profitability and cash flow. Still, they were worse than expected on reserve replacement and finding cost. Industrywide, it looked like a pretty horrible year for finding new reserves. The scarcity factor has come into play. Oil is harder to find but it is worth more. That's true of the U.S. and Canada. The royalty trusts in Canada have now started to buy properties in the U.S. The more companies convert to royalty trusts, the more they pay out their cash flows and the less they reinvest in new reserve development. It is just like the big oil companies buying back shares. For 2004 Exxon, Total, BP, Royal Dutch, ConocoPhillips and Chevron bought in $25.8 billion worth of stock. That's about how much they spent on exploration worldwide. It has worked well also for Burlington Resources and Anadarko and others. Some of the large E&P companies have also said we don't know how long these cash flows are going to continue to be this good, but we know no one is going to be mad if we buy back shares. Through the magic of accounting, if you reduce your shareholders' equity, it raises your return on equity.


Q: Any areas in energy you would avoid at this point?

A: I would be concerned about coal, not because it isn't a great resource or that it hasn't a good future. But I would be concerned about it because it is like the automobile industry: It has problems with labor and health-care costs.

The oil-service companies for the next year or two will enjoy great prosperity, but the question is how much of that is already factored into the share prices. The big names there would be Halliburton, Schlumberger, Baker Hughes and rig companies such as Transocean and Global Santa Fe.


Q: What are some of your best ideas?

A: PTT Public, the national oil company of Thailand, is both a reasonable value and a great exposure to a growing area. We like Santos, a big Australian company with a lot of very interesting exploration plays around the world, including the Gulf of Mexico. Pogo Producing is one of the few E&P companies whose share price has underperformed the sector. It announced some disappointing results and low reserve-replacement and took a rather contrarian position in deciding to cut back on their drilling and development projects because prices were up so high. But it's got some great assets and, at $45 a share or so, it is a great value. I should also call attention to a very interesting well being drilled in the Gulf of Mexico called the Blackbeard Well. It was put together by Newfield Exploration. BP and ExxonMobil will carry the development. This is the deepest well ever drilled in the Gulf of Mexico. The well is targeted at 32,000 feet and it will take a $100 million to drill it. They are testing the idea that there are some tertiary rocks under the existing production in the shallow waters of the Gulf of Mexico. It will take about a year to drill, but if they find something it could be wonderful. This was interesting because Newfield was able to farm this out to Exxon and BP. It's not easy for a company to persuade some of the majors to drill a well for $100 million and carry you as Newfield has done.


Q: So you're recommending Newfield?

A: It is a fine company. It is not grossly undervalued, but it has quality operations, much as EnCana and Noble do. If you want to own the sector, you want to be involved there. The founder of Newfield is Joe Foster, who had been with Tenneco as the head of its oil and gas operations until 1988, when it sold its E&P business for $5 billion and he was out of a job at 54. He started Newfield with $9 million and now it is a $4.7 billion company.


Q: Thanks, Art


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