China and Russia Fuel Global Energy Growth

Buy-recommended PetroChina (PTR) is the leading oil and gas resource owner in the most populous consuming country, China, and buy-recommended Gazprom (OGZPY.PK) is the leading natural gas resource owner in the largest producing country, Russia. The five stocks in our Brazil/Russia/China group have the most investment growth potential measured by McDep Ratio. Recent stock price declines might seem alarming in isolation, but less so in a broader market context. In fact, PetroChina is one of only three stocks of 36 in Meter Reader coverage trading above its 60-day average. Gazprom has recovered as much as the median stock by the 60-day average measure.

Taxable investors with higher cost stock and who wish to take a tax loss while maintaining investment in a stock with similar characteristics might switch PTR for sister Chinese producer, hold-rated CNOOC Ltd. (CEO). Investors in OGZPY could switch partially to hold-rated Lukoil (LUKOY) for similar country exposure and partially to buy-recommended Statoil (STO), a depressed European producer stock, for natural gas exposure. Though the hold-rated stocks have attractive potential, we are waiting for stock price to move back above the 200-day average or for another event to recommend buy outright. For an unrated stock like Petrobras (PBR) we are alert to signs of a potential repeat of its past stock price cycle when after bottoming in October 2002 the stock crossed above the 200-day average in March 2003 and continued a long march upward until recently.

Asia Pacific Leads Global Growth
Just released last week, the annual energy outlook by hold-rated ExxonMobil (XOM) reaffirms a widely held expectation that the Asia Pacific region, with China as the most important country, will overtake North America and Europe for the largest share of global gross domestic product by 2030. To fuel growth, China needs increasing supplies of energy - domestic and imported. We believe that PetroChina, 86% owned by the government and China’s most important oil and gas company, will reward investors as it furnishes clean fuel for China’s sustainable economic growth.

New Diplomatic Opportunity in Russia
While China has a generally positive image among investors, in our experience, Russia has a less positive image. We were surprised recently to hear Harvard Expert on Russia, Marshall Goldman, express his view that President Bush and Prime Minister Putin continue to have a remarkably positive personal relationship. Yet political and economic relations between the U.S. and Russia have deteriorated in the later years of the current presidential term. Though the fault may be on both sides, we think that much U.S. diplomatic behavior seems unnecessarily provocative. We are hopeful that a new U.S. Administration will be successful in improving cooperation with Russia. The humbling experience of the recent global financial situation may help catalyze a fresh start.

Stock Prices May Lead Oil Prices
Oil and gas stock prices have been hitting rolling lows. Large companies made their lows in October. Canadian oil and gas stocks made their lows in November. Small stocks and income stocks made their lows last week. Presuming those lows hold, an oil price bottom may not be far away.

Value, measured by the McDep Ratio, justifies buy recommendations, we believe, but stock prices do not confirm a positive trend yet. XOM is the stock closest to turning positive in trend relative to the 200-day average. Should XOM cross to positive territory, it would be an encouraging sign for other oil and gas stocks and for oil price.

Bottom by Historical Comparison
In earlier times that felt like today in oil, 1986 and 1998, $10 a barrel was the bottom for the price cycle. Compared to the preceding high price of almost $40, the bottom was one-fourth the high. Back then it took more than five years from the high in 1980 to the low in 1986. Today prices move faster. The high of $147 was only a few months ago. If the same magnitude of drop were to repeat, one-fourth of the high of $147 would be $37. By that measure the bottom is practically here with the current near-month price of $43.

High Cost of New Capacity and Sunk Cost of Developed Capacity
The wide range from high crude oil price to low crude oil price partly reflects the cost structure of the industry. Oil and gas production is generally a high cash flow margin, low cash cost business. A high margin is necessary to induce investment in finding and developing new sources. Today's price is below the $70-$90 that is representative of the full-cycle exploration and development cost of large new sources of oil production outside the Middle East. Thus, that part of the business is uneconomic at near-term quotes, but it takes time for people to react. New large scale investment may not take place until the price recovers.

Once an investment is made, the costs are “sunk” and the minimum financial requirement is to cover out-of-pocket daily costs. Most current production can continue to cover cash costs. Conventional production may have cash costs near $10 a barrel. About $30 a barrel may be a practical cash break even for oil sands.
As a result of the cost structure, production management is required to tame price swings. That will be the topic for the mid-December meeting of producing countries. Without management, the imbalance between supply and demand ultimately self-corrects because of the steady decline in existing capacity as it is not replenished and/or a revival of demand.

Originally published on December 9, 2008.

Comments

[BrotherMaynard]

"Should XOM cross to positive territory, it would be an encouraging sign for other oil and gas stocks and for oil price."

On the contrary, Credit Suisse reported yesterday:

"At $40 [per barrel] oil and $5.50 [MMBtu] gas (closer to current spot prices), the E&Ps are trading at a 65% premium-to-proved NAV with the gas names at a 75% premium versus 55% for the oilier names."

2008 Dec 30 11:50 AM