Interview With Daniel Cheng: Bullish on Crude Oil, Bearish on Natural Gas

Includes: DBE, JJE, RJN, UBN
by: Arjun Rudra

With the crude contract for March rising by 72 cents to $85.04 U.S. on the back of news claiming a lesser build in inventories by the U.S. Energy Information Administration, the focus is back on the energy sector. Adding more fuel to the fire (pun intended) was news about Iran sending warships through Egypt’s Suez Canal en route to Syria for the first time in years has elicited comments from Israel’s foreign minister calling it another of Iran’s “provocations.”

Biography: Daniel Cheng, CFA is Vice President and Portfolio Manager at Matco Financial. Mr. Cheng is a Daniel Cheng, CFA is Vice President and Portfolio Manager at Matco Financialmember of the Matco investment committee. He is also a member of Matco’s Canadian Equity Group, which is responsible for the Canadian Equity, Small Cap, and Energy Portfolios. Mr. Cheng was formerly with Ross Smith Energy Group, an energy research firm. He was also a member of the institutional equity research group with Tristone Capital Inc.

Q: What are your thoughts on crude oil for the next 6 months? What price assumptions are you using in your models for earnings and cash flow analysis for 2011 and beyond?

A: I have been constructive on oil prices for the past year and continue to be quite bullish looking ahead in 2011. The fundamentals for oil continue to improve as the global economy recovers with global demand now expected to cross 89 mmb/d in 2011, after reaching a record high in 2010 and completing arguably one of the strongest post recession recoveries for oil demand. Not surprisingly, the recovery in demand was driven entirely by non-OECD countries lead by China. Demand growth remains from the emerging economies going forward and they are expected to account for more than 50% of global demand within the next two years.

Some interesting statistics on China: China currently consumes one of the lowest levels of oil consumption per capita in the world despite the robust growth of late. On a per capita basis, China consumes approximately 2.5 barrels of oil per person per year. Contrast this to the United States which consumes closer to 23 barrels of oil per person each year. I am not saying that China will ever get to the same level of demand as the US, but as incomes continue to rise in China you should see a corresponding increase in oil demand. As well, a lot was made about China surpassing the US in terms of vehicle sales in 2009 but 2010 saw continued robust growth (30%+) in vehicle sales in China. Despite the rapid growth in sales, vehicle penetration in China remains very low at approximately 40 cars per 1,000 people compared to an average of 673 cars for the G7 nations. This increase in vehicles on the road is driving strong transportation fuel demand, one of the primary drivers of global oil demand. So for oil prices, these are the longer term supporters I see.

Shorter term, inventory levels have seen a fairly steady decline over the past year including floating storage levels which has also tightened the supply demand balance. Geopolitical issues such as what is happening in Egypt currently also pose short term upside risk to prices but I think oil prices likely trade in a range of $85-$95/b in 2011. So, longer term I am still bullish. In the next six months could you see oil prices pull back? Absolutely, but I believe they will be temporary pullbacks in a structurally bullish oil price environment. We are long term investors so we continue to be overweight oil producers in our portfolios.

In our modeling we run strip pricing for the first two years and are now running flat $90 long term oil prices after that. However, we always run scenario analysis on a wide range of commodity prices to see the impact on net asset values for the company before making an investment.

Q: When commodities are experiencing a tailwind as in the case of crude oil in 2010, ‘stock picking’ becomes increasingly crucial as valuations on a broad basis tend to inflate. What are the metrics or factors that you look at or use to determine the value of a junior/mid-cap crude oil producer?

A: It is true that stock picking becomes more important, however for resource based companies like oil and gas, higher commodity prices should translate into stronger cash flow and often better valuations depending on what kind of commodity price you are using to run your models. The metrics that I like to focus on when determining the value of a junior/mid-cap producer are related to the assets that they possess and the cash flow that those assets will be able to generate. Production growth and how efficiently the company can generate that production growth is another important factor we asses. Price to net asset value is a core metric that we focus on and a calculated upside net asset value based on the companies prospect inventory. In addition to that, we monitor the more traditional metrics when looking at energy stocks as a barometer of the relative valuation to the peer group and historical metrics we are paying for the company such as enterprise value to debt adjusted cash flow (EV/DACF), enterprise value per flowing barrel a day of production (EV/BOE/D) and enterprise value to barrels of oil equivalent of reserves (EV/BOE). The other key metrics we look at are related to the balance sheet. Debt to cash flow and the amount of debt in general is important to us especially after what happened in 2008 and 2009 when many junior and mid cap energy companies were crushed by their debt load.

Q: It seems that each year brings a new and prolific oil trend or area play, how do you go about evaluating the potential of these plays (why were they not discovered before?) and what is your strategy when it comes to picking stocks in these plays – do you invest in the first mover, derivative plays etc.

A: When we come across a new play, or more likely an older play that has really been unlocked as a result of technical innovation (Cardium for example) it starts a rigorous process. We have a unique relationship with the Ross Smith Energy Group (North Americas leading independent energy research firm) who provides us with in depth technical analysis of the plays from a geological and engineering perspective. They have evaluated almost every play in North America over the past decade and as mentioned, many of the so called “new” plays have been around for a long time but are now being exploited with the application of new technology that didn’t exist previously such as horizontal multi stage, hydraulic fracturing. For true new plays it is even more important to understand the geological profile of the play and how it compares in relation to other plays to understand the viability and ultimate deliverability of that play. There are many plays out there that undoubtedly contain a vast amount of resource but the cost to produce that resource and required commodity price to make the economics work often don’t line up.

When picking companies in certain plays we like companies who are not necessarily the first mover though this is often the case but companies that have the most meaningful exposure to the play and are in what we would deem as the sweet spot of the play. Variability of results in a play can be very dramatic depending on the land position and you are seeing this materialize in a number of resource type plays. Break even prices within the same play can be vastly different as evidenced by the chart below. The Cardium for example is seeing break even prices below $50/b in some areas to over $100/b in other areas of the play. We are also cognizant of how the company entered the play as with a lot of the “hot” plays, land prices can heat up very quickly and the cost for the acreage rises dramatically altering the economics dramatically. The MFi Energy Fund has a bias to small and mid cap producers and generally speaking, these are the companies that have the greatest relative exposure to a play.

[click to enlarge]

Break Even Crude Price For Wells Drilled In Different Crude Oil Plays - Courtesy Ross Smith Energy Group

Break Even Crude Price For Wells Drilled In Different Crude Oil Plays - Courtesy Ross Smith Energy Group

Q: What are your thoughts on natural gas for the next 6 months? What price assumptions are you using in your models for earnings and cash flow analysis for 2011 and beyond?

A: Natural gas continues to face challenging headwinds in my opinion and I don’t foresee them improving in the short term. As I mentioned with oil really being a story of demand, natural gas continues to be a story of robust supply. The application of horizontal multistage fracturing has really opened up a vast amount of resources in North America and natural gas in particular here is a continental product unlike oil. The rig count in the US has remained stubbornly high in light of where natural gas prices are and the focus remains on the more prolific plays. In addition, natural gas storage levels are still elevated and on top of that I have seen estimates as high as 3,000 wells that have been drilled in the US and are just waiting to be tied in. So if natural gas prices find any sort of strength, you have the ability to see a lot of gas come back to market quickly which will keep a lid on prices going much higher. There are a number of reasons that producers have continued drilling through the weak prices and that relates to land retention issues south of the border, strong hedge books and joint ventures with international companies that have a different mandate and essentially unlimited capital. On the demand side the growth is just not strong enough to offset the supply growth currently and weather related demand hasn’t moved the needle much either given we have had a very cold winter thus far. That being said, I do think that natural gas prices will move higher at some point in time as the vast majority of natural gas plays are not economic at current prices.

Price assumptions we are using in our modeling is the same as for oil with strip pricing the first two years and then flat $4.50 after that.

Q: Given your challenged outlook on natural gas and assuming valuations on the downside often find a floor at or slightly above long run F&D costs, what are your thoughts on rotating into some natural gas producers, especially those that are making money at depressed natural gas prices? Is this something you might do or are possibly doing now?

A: I think it is still a bit premature to rotate into natural gas weighted companies in a meaningful way. As mentioned previously, I agree that longer term gas prices likely need to be higher than where they are but likely that won’t happen until the latter part of this year at the earliest. We do own natural gas weighted companies and I think that you can still make money investing in natural gas companies but you must be selective. We have maintained exposure to a number of natural gas companies operating in some of the lowest cost plays in North America and companies that are also drilling liquids rich natural gas. A lot of companies that have oil production or liquids rich targets are now focusing all of their capital in those plays and have essentially abandoned drilling for natural gas in the current price environment. We have not added to our natural gas exposure recently.

Q: Can you talk a little bit about liquids rich natural gas and maybe how it’s similar or different from regular natural gas?

A: Generally speaking, liquids-rich gas is natural gas that also has some heavier hydrocarbon components separated out as liquids, which are referred to as natural gas liquids. Natural gas liquids—used in the petrochemical industry and as diluent for blending heavier crude oil grades and as fuels such as ethane, propane, and butane are more valuable than natural gas as they typically trade in relation to oil prices. This has become a focus of many producers who may not have oil assets as they seek to drill the most economic wells given the large disparity between oil and gas prices. Some liquids rich natural gas plays offer better economics than many oil plays.

Q: What are some of the area plays (domestic or international) that you are investing in and/or keeping an eye on?

A: There are quite a few plays we are invested in and are keeping an eye on currently including the Cardium, Bakken, Alberta Bakken (Exshaw), Eagleford, Red Earth Slave Point, Viking, Swan Hills, and Sprayberry to name a few. We also still have a number of natural gas focused investments in various plays such as the Montney and Haynessville and are watching number of plays that are in their infancy such as the Duvernay. I really believe that we are in a new era for the oil and gas industry and in the Western Canadian Sedimentary Basin with the drilling and completion technology that continues to evolve and improve. It’s a technological revolution in the industry that is opening up previously uneconomic plays.

Q: What would make you shift your weighting and outlook from crude oil to natural gas?

A: A significant reduction in the rig count south of the border. I think some meaningful reductions in natural gas directed capital expenditures from the producers will lead this and you are beginning to see this happen. Additionally, the end of land retention drilling will further support this and the rolling over of hedge books. Until there is a clearer picture on the supply front for natural gas, my bias remains towards oil.