Commodity bulls only tell a compelling, but oversimplified story. They envision globalization and rising affluence causing increased demand for a limited supply of commodities. Though demand will increase, what they don't mention is that these forces also increase the supply of commodities. A global economy means a global pool of capital is being spent to develop energy projects. With more regions starting to produce oil and gas, investors should have a healthy fear of supply.
The Brazil Experience
The commodity bull story really isn't consistent with events in Brazil, an emerging market. The government energy company, Petroleo Brasileiro's Petrobras (PBR), is operating at a loss because its projects have been delayed, not merely because of rising demand. Its refining unit is losing over $8 billion this year as it continues to sell imported gasoline at 8% below cost. Due to increasing local demand without a corresponding increase in refining capacity, gasoline imports increased to 84,000 barrels per day - a 65% increase as of the third quarter. Losses from 2011 almost doubled to $8.4 billion. Project delays and cost overruns kept Petrobras from increasing its refining capacity to keep pace with surging demand, especially from first-time car buyers, aggravating the need to increase energy imports. The increased efficiency and improved production brought by the change in management of the refinery unit is not enough to keep up with demand.
Petrobras CFO Almir Barbassa hinted that the oil producer may be forced to sell assets or reduce investment if its government-run board doesn't raise prices soon. The company plans to raise $14.8 billion in five years from asset sales and restructuring.
Although Petrobras was allowed to increase prices for gasoline by 7.8% in June and a cumulative 9.9% increase in diesel for June and July, the government-run board prevents the company from further raising fuel prices to prevent similar rise in inflation, which has already topped Brazil's 4.5% target since last year. Petrobras shares decreased 11% to 19 reals ($9.16) as of November 22.
Bank of America (BAC) cut its recommendation for Petrobras to hold from buy in November due to the continuing discount in imported fuel prices. SLW Corretora analyst Erick Scott Hood said, "It will take three to five years for Petrobras to build enough refineries to reduce imports and make the division profitable."
Petrobras's management will probably push for a price increase this year and another in 2013, but Eurasia Group's director for Latin America, Christopher Garman, thinks a 6% to 8% raise would probably slow, but not stop, the hemorrhaging.
This seems more like a problem with government-controlled industries than a commodity-bull demand story.
Producers Pump Faster
Energy companies tried and failed to cut drilling and production in response to low natural gas prices. Active U.S. gas rigs drastically fell 49% this year. The number of gas rigs stood at 413. This is the fewest active rigs since June 1999.
Unfortunately for energy companies, these efforts have failed. Despite attempts to restrict supply, U.S. prices this year are estimated to be only one third of their 2008 price levels. Ziff Energy Group director Edward Kallio said, "As the gas price goes down, it's almost like they need to produce twice as much to keep their cash flow where it was." Gas stockpiles surged to an all-time high this month to around $15 billion using current spot prices. Oklahoma based Chesapeake Energy (CHK) reported third-quarter gas production rose 9.8% from second quarter to 302 billion cubic feet.
Gas companies remain positive that a rise in gas prices would yield from a diminishing number of gas rigs. This optimism could be baseless in an industry that competes almost exclusively on price.
As you might imagine, lower energy prices make it harder to sell oil and gas properties at attractive prices. Chesapeake announced that it would delay asset sales to seek out new buyers.
The price drop has forced companies like Encana (ECA) and BHP Billiton (BHP) to write down the value of their North American gas properties. Though drilling in many oilfields is becoming unprofitable, Argus Research Analyst Phillip Weiss thinks there might be light at the end of the tunnel. He said, "Eventually they'll be able to put those resources back on the books when prices recover and they become economical."
Chesapeake is also denying that it could run out of cash in 2013 and is trying to encourage investors by saying that it would record about $2 billion in surplus cash flow before the close of 2012. The company is planning to borrow $2 billion and use proceeds from the sale of the 5-year loan to finance a credit pact in May. Also, Carl Icahn and Southeastern Asset Management have been able to influence a change in Chesapeake's board. This new board line-up is overseeing an inquiry former chairman McClendon's borrowing.
Rational investors should require remarkably cheap valuations to be lured into energy investments. Price multiples for large cap oil and gas stocks follow:
Enterprise Products Partners
Canadian Natural Resources
Pioneer Natural Resources
Cabot Oil & Gas
Investors should consider Exxon Mobil and Chevron as buy candidates and ignore the rest. Chesapeake is more expensive on a price-to-sales basis and is currently searching for liquidity, so investors should look elsewhere until its price-to-sales ratio drops below the other stocks on this list.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.