Do you ever have one of those ideas that seems extremely obvious to you, but seemingly to few others?
I’ve got one. And I think I could help the world’s largest oil companies create billions in value for their shareholders. I’m not naïve enough to think that there isn’t something significant that I’m missing. But at this point, I do think it is a pretty solid idea, so I’d like to share it and see what others think.
My portfolio is pretty heavily focused on companies that produce predominately light oil. I’d take that a step further to say that my portfolio is pretty heavily focused towards smaller oil producers that have what I think are very undervalued acreage positions in emerging light oil plays.
Why the focus on light oil? A simple reason really, as I wrote here, the global oil markets are already out of balance. At current daily production rates we are eating into global oil supplies on a daily basis because daily demand is one to two million barrels higher. That problem is only going to get worse as China, India and other populous emerging economies continue to grow. I think 2012 could be really ugly (as in high) for oil prices, but if I’m not right about 2012 I don’t think I’ll be far off.
My search for investments in the oil sector led me through a variety of companies. The super majors, like Exxon (NYSE:XOM), Shell (NYSE:RDS.A) and Chevron (NYSE:CVX). Offshore and international producers, like ATP (ATPG), Cobalt (NYSE:CIE) and Stone Energy (NYSE:SGY). And eventually to what I view as the most attractive opportunities, which are smaller to mid-sized companies with exposure to large unconventional light oil resource plays like Petrobank (OTCPK:PBEGF), Penn West (NYSE:PWE) and Chesapeake (NYSE:CHK).
There were a few things that attracted me to these unconventional oil players. What I liked included:
- Exposure to light oil resources
- Assets are located in friendly North America.
- The resource plays carry very little exploration risk, in fact, they are much more like an assembly line operation.
- The technology being used on these resource plays is improving almost monthly both lower costs of production and increasing the amount and rate at which oil can be recovered.
- These companies are valued basically based on their existing production and booked reserves, with the stock market ignoring enormous upside in undeveloped acreage.
Once I had sold myself that exposure to these resource play focused companies was where I wanted to be, I told myself to be patient and wait for Mr. Market to get depressed. And I was buying patiently through the second quarter a number of Canadian oil focused unconventional players as the Canadian markets took a walloping. Of course, I have no ability to time a bottom, and since then these companies have continued to get shellacked with their stock prices dropping continuously.
I’m ok with being underwater on paper with respect to these investments. I’m a patient fellow and have a multi-year time frame in mind. And to be quite honest, having watched the tech bubble early last decade and then absolute panic in 2008/2009, I don’t have a lot of respect for Mr. Market and don’t believe his short term movements have much to do with the underlying value of the companies the stock prices represent.
But while I can handle drops in stock prices, I am certainly very guilty of watching the stock prices of my investments too closely. And as I’ve done this I noticed something very obvious to pretty much everyone. In the volatile world of investing in oil producers, when the market sells off, the smaller producers' stock prices suffer huge percentage declines. But the large oil companies like Exxon, Shell and Chevron are much less volatile. The result is that the larger companies are much more richly valued than the smaller ones on a multiple of cash flow or reserve basis.
So finally to get to my idea.
We have one group of companies, the super major oil and gas producers. As a group they are enormously valuable. But as a group they have one major problem. They are struggling to even maintain their oil and gas reserves year after year. As they produce their existing reserves, the just can’t find enough new oil and gas to replace production. They aren’t growing, in fact, they are struggling to even tread water. From reading this article I was shocked to discover just how bad the production declines are for these companies:
Here is Deutsche’s summary of the greatest second quarter drops in global liquids production, ranked by the volume decline (percentage decline in parens). Libya was a factor for most though not for BP, which saw the largest drop.
BP (BP) -11% (-254,000 barrels per day)
ENI (ENI) -19% (-187,000)
Total (TOT) -10% (-130,000)
Repsol (REP) -26% (-117,000)
Suncor Energy (SU) -23% (-113,000)
Lukoil (LUKOY.PK) -6% (-103,000)
ConocoPhillips (COP) -10% (-95,000, ex Lukoil)
Canadian Natural Resources (CNQ) -29% (-93,000)
Statoil (STL) – 8% (-76,000)
Chevron (CVX) -2% (-44,000)
Murphy Oil (MUR) – 29% (-38,000)
Hess (HES) -12% (-37,000)
Occidental Petroleum (OXY) -6% (-33,000)
Sinopec Shanghai Petrochemical (SHI) -2% (-16,000)
Woodside Petroleum -26% (-16,000) “
Then we have a second group of companies. Petrobank/Petrobakken, Penn West, Chesapeake and others which do not have any problems replacing their reserves on an annual basis. Each of these companies in fact has decades of drilling locations in emerging light oil plays in North America. As they drill up these locations their reserves and production grow like clockwork.
So one group is struggling to maintain production. The second group has huge land bases amassed which represent certain growth in the years ahead. The head scratcher is that as I look at these two groups of companies (especially after the recent selloff) it appears to me that the non-growth group is actually priced at higher cash flow and reserve multiples than the steady growing group. The market is assigning virtually no value for the huge resource play acreage that the unconventional players have. The market values the no growers more richly than the fast growers.
So if I’m the CEO of an Exxon or a Chevron, the stock price is pretty reasonably valued based on a cash flow and flowing barrel basis, and I can see all kinds of unconventional producers that are valued basically the same or at lower multiples even though they have a huge amount of growth ahead. Isn’t it then a no-brainer that I could create huge amounts of value per share for my shareholders if I go on an acquisition binge using my much more richly valued stock to pick off these heavily discounted unconventional producers?
We have seen virtually every large oil and gas producer jump into the shale gas game by entering joint ventures with a variety of independent producers. These joint ventures generally occur at acreage prices that are much, much higher than what is implied in the stock prices of companies like Chesapeake (CHK) who are selling the properties. How does it make sense for these major oil and gas companies to buy pieces of these properties at fair prices when they could buy the entire unconventional companies themselves at fractions of the price?
The short answer is that it doesn’t. And if the large oil and gas companies also use their much more richly valued stock instead of cash, the acquisitions aren’t just hugely accretive but also do not weaken their balance sheets. A company the size of Chesapeake could be hard for anyone to swallow as it is getting pretty big. But if most of the purchase price is in stock and not cash, it's not such a problem.
As I said, I think this seems like an obvious move to me. I’ll wait and see if some of these big boys decide that paying $10,000 an acre in a joint venture deal makes less sense than buying the entire company at a multiple that is a third of that.
Here is a list of the unconventional players that I currently own:
Petrobank Energy (OTCPK:PBEGF)
Chesapeake Energy (CHK)
Rosetta Resources (NASDAQ:ROSE)
Novus Energy (OTC:NOVUF)
Westfire Energy (OTCPK:WFREF)
Penn West Energy (PWE)
Second Wave (OTC:SCSZF)
Midway Energy (OTC:MELEF)
Petrobakken Energy (PBKEF.PK)
Skywest Energy (SKWEF.PK)