Seeking Alpha
Long only, newsletter provider, oil & gas, small-cap
Profile| Send Message|
( followers)  

I’ve written a few articles for Seeking Alpha discussing how higher oil prices are our future. Jeremy Grantham of GMO just wrote a quarterly letter titled “Time to Wake Up: Days of Abundant Resources and Falling Prices are Over Forever”

Interestingly, though, he is not advising that investors pile into oil and other commodities at this point as he thinks that there is a least a 1 in 4 chance that China could trigger a major selloff in commodities. This from his recent letter:

Quite separately, several of my smart colleagues agree with Jim Chanos that China’s structural imbalances will cause at least one wheel to come off of their economy within the next 12 months. This is painful when traveling at warp speed – 10% a year in GDP growth. The litany of problems is as follows:

a) An unprecedented rise in wages has reduced China’s competitive strength.

b) The remarkable 50% of GDP going into capital spending was partly the result of a heroic and desperate effort to keep the ship afloat as the Western banking system collapsed. It cannot be sustained, and much of the spending is likely to have been wasted: unnecessary airports, roads, and railroads and unoccupied high-rise apartments.

c) Debt levels have grown much too fast.

d) House prices are deep into bubble territory and there is an unknown, though likely large, quantity of bad loans. You have heard it all better and in more detail from both Edward Chancellor2 and Jim Chanos. The significance here is that given China’s overwhelming influence on so many commodities, especially in terms of the percentage China represents of new growth in global demand, any general economic stutter in China can mean very big declines in some of their prices.

You can assess on your own the probabilities of a stumble in the next year or so. At the least, I would put it at 1 in 4, while some of my colleagues think the odds are much higher. If China stumbles or if the weather is better than expected, a probability I would put at, say, 80%, then commodity prices will decline a lot. But if both events occur together, it will very probably break the commodity markets en masse. Not unlike the financial collapse. That was a once in a lifetime opportunity as most markets crashed by over 50%, some much more, and then roared back.

Personally I have been finding it impossible to pull the trigger on some oil companies that I am looking at, with oil over $100 as I think a quick pullback is quite possible on any sign of relief to Middle East tension. Grantham sees a massive pullback from a China bust as being possible and thankfully lays out his exact plan in his letter for commodity investing with that in mind:

How does an investor today handle the creative tension between brilliant long-term prospects and very high short term risks? The frustrating but very accurate answer is: with great difficulty. For me personally it will be a great time to practice my new specialty of regret minimization.

My foundation, for example, is taking a small position (say, one-quarter of my eventual target) in “stuff in the ground” and resource efficiency. Given my growing confidence in the idea of resource limitation over the last four years, if commodities were to keep going up, never to fall back, and I owned none of them, then I would have to throw myself under a bus. If prices continue to run away, then my small position will be a solace and I would then try to focus on the more reasonably priced – “left behind” – commodities. If on the other hand, more likely, they come down a lot, perhaps a lot lot, then I will grit my teeth and triple or quadruple my stake and look to own them forever. So, that’s the story.

I like this approach a lot. If his commodity investments go straight up he will do ok because he has a position. If they come down in a big way he will likely do even better because he will have dry powder to buy in size. Going forward I’m going to let cash accumulate and wait for a better opportunity to add to or initiate positions in a number of oil companies.

If you trust Grantham and think high oil prices are here to stay the best way to take advantage may be through the Canadian Oil Sands (OTCQX:COSWF) and Suncor (NYSE:SU) which has incredibly long-lived reserves.

In 2011 Suncor had 90% of its production from crude oil. It is a producer that gives direct exposure to oil and little dilution from natural gas.

Suncor offers exposure to a vast amount of oil reserves that will allow for clear unimpeded production growth for at least the next decade. Suncor has 7 billion barrels of proven and probable reserves. Today the company sports an enterprise value of roughly $70 billion. That means you are paying roughly $10 per barrel of proven and probable reserves, which at $110 WTI is not unattractive.

More importantly, you get exposure to a lot of reserve upside. Suncor has contingent reserves of over 20 billion barrels and proven, probable and possible reserves of almost 30 million barrels. Simple, back of the envelope math means that you are paying something like $2.33 per barrel of contingent resource in the ground.

That sounds attractive to me.

From just over 500,000 barrels a day of production currently, Suncor is targeting over 1,000,000 barrels a day by 2020. That would rank Suncor amongst the larger producing countries in the world.

The important part is that we know exactly where the production growth is coming from. There is no exploration risk here, Suncor doesn't need to be continuously searching for new reserves; it already has them locked up. The entire company production is projected to grow 8% per annum from 2011 to 2020. The company's oil sands production will grow at 10% per year and conventional production at 4% per year.

One unappreciated aspect of a company like Suncor, which has very long-life reserves, is that the technology that is being implemented today is not likely going to be the production technology in place 5 or 10 years from now. So over time, the amount of oil that this company can recover will increase as technology improves and the cost of that recovery will decrease as production methodologies also improve. That is going to provide some juice to your investment returns.

Disclosure: I am long OTCPK:PBEGF, PWE.

Source: 2 Energy Picks for Extended High Oil Prices