Canadian Natural Resources: The 'New' Oil Is Still Oil

Apr.16.07 | About: Canadian Natural (CNQ)

About two weeks ago, former General Barry McCaffrey, a West Point professor and veteran of Vietnam and the first Gulf War, released
the results of his report on the current conditions in Iraq and
recommendations for future strategy.  I encourage everyone to read his findings.  Not surprising to those following the Iraq War, the main takeaways from the report included:

1) US troops, extremely overworked and undermanned, have performed heroically amidst a "low-grade" civil war operating environment involving foreign and terrorist forces. 

2) The US cannot leave without likely creating near perfect conditions for a regional war, and the current effort requires a long-term monetary and political commitment to rebuild the military to increase readiness for non-Iraq threats. The US cannot rely upon the current deterrent of "overwhelming" Air Force, Navy and nuclear weapons power as a permanent solution to underinvestment in personnel and equipment.

3) Most importantly, the US should quickly begin discussions with Iraq's neighbors and other Middle Eastern nations to establish a "neutral and permanent political forum in which Iraq's neighbors are drawn into continuing cooperative engagement."

These challenges will require a long-term political and financial commitment, and the well-being of US forces and Iraq's citizens remains of paramount concern. The report's takeaways, however, have significant implications for the energy industry, especially the reliability of oil supply and the continuing effect of elevated prices on inflation levels.

While high refining capacity utilization may alone prevent any price relief, investors may have underestimated the lack of real supply growth for oil. Not only could continuing volatility in the Middle East potentially create supply disruptions, but many of these nations have severely under-invested in their exploration/production infrastructure.

Although ethanol supply may grow in the next decade as a partial substitute for gasoline, global demand will continue to increase for conventional petroleum products. As the WSJ notes, private equity firms have allocated billions to help resuscitate the automotive parts and car industry, capitalizing on demand from a growing global middle class. Tens of millions of automobiles will consume oil-based gasoline well into this century, and global construction firms such as Foster Wheeler (FLWT), Fluor (NYSE:FLR) and Bechtel will remain busy designing and building refining facilities. These stocks are expensive and will likely become more so.

Let me offer some caveats. While it may threaten the West with nuclear technology, Iran has satiated its public with inexpensive, imported gasoline, and possesses little domestic refining capacity. It requires Western technology to bolster oil production and construct refining facilities, currently benefits from the increased cash flow associated with higher prices, and potentially could begin selling its supply to China and India. However, by choosing to destabilize the energy markets by withholding oil shipments, Iran risks domestic instability and international backlash.

In addition, through possessing the largest global, "long life" oil reserves, the Saudi government also has great interest in providing a secure oil supply to the US with minimal price volatility to discourage any focus on alternative energy sources. However, with other nations willing to purchase their supply with very little political/diplomatic requirements (see China-Sudan), they may be less sensitive to US influence.

All said, I believe this uncertainty points to higher, near permanent future oil prices for everyone. While I join many others as a strong supporter of conservation and hybrid technology, the largest nations, including the US, have yet to make a significant commitment to the reduction of fossil fuel utilization. Ethanol and biofuel production/use will mitigate some of these concerns and become a boon to Midwestern farmers, seed and fertilizer providers, and equipment manufacturers.

However, on an international level, without much more significant investment in alternative fuels and dedication to conservation, the "new" oil will likely remain oil, and one of the best investments may be a North American energy producer, Canadian Natural Resources (NYSE:CNQ). The firm holds long-lived oil sand assets (40-year life) in a politically stable Western nation, possesses excellent management, and as Chuck Goldblum of Hurley Capital notes, has 30 times the insider ownership of company shares versus Chevron (NYSE:CVX). In a nod to stockholders, CNQ noted on a recent conference call that it remains flexible in the sale and development of its existing properties with a focus on profitability.

CNQ has assumed several billion in additional debt to make a timely purchase of Anadarko's (NYSE:APC) Western Canada natural gas assets and to initiate the first of three phases of oil sands production in 2008. However, the firm has much of its production growth ahead of it, likely reaching several hundred thousand barrels in five years, and has not diluted existing shareholders with equity issuance/financing. Management recently announced a slowdown in natural gas drilling to better manage equipment and services inflation while continuing strong output at its existing wells, securing sales prices through hedging contracts. CNQ also owns a partial stake in a dedicated oil pipeline, providing a competitive advantage as the US seeks to replace overseas supply with North American production.

The firm will battle emissions and other environmental challenges and equipment cost concerns as it develops its oil sand properties, but as technology enhances its yields and oil prices rise, free cash flow should increase dramatically. Although its stock has appreciated significantly in the past month, its energy resource holdings and management team are worth much more than its current valuation. You can also own the stock through the Fairholme Fund [FAIRX]. CNQ's future and assets remain too valuable to miss.

CNQ 1-yr chart: