Re-pricing Energy's Common Denominator?
Back in the dear, dead days beyond recall . . . on a field trip as an oil analyst to Oklahoma, hosted by one of the major industry producers of the day, I was driven past a gas station that advertised gasoline available at eleven cents ($0.11) a gallon.
Of course, that part of the trip was sort of a rigged tour; other local stations were at 15 cents a gallon.
These were the days of declining influence of the US as an oil price-setter, a role it had held world-wide for many decades. The key metric was the "Texas Allowable" ratio. That was the proportion of a defined "capacity" of production that was allowed to be produced, under the regulatory role of the Texas Railroad Commission.
Up to that time, the vast sea of easily-tapped sweet (low-sulfur-content) crude oil in southern mid-US states could be produced at costs far less than anywhere else, except in the Persian Gulf area, and that mid-eastern oil had to be shipped long distances to markets, and contained a lot of troublesome sulfur.
But as so often happens in extractive industries, the high-margin, cheap stuff, got depleted. The Texas allowables ratio went from 35% to 65% to 95% and at 100% became meaningless. Meaningless as a restraint.
But to OPEC it was a bright green traffic light on the pricing highway. The Organization of Petroleum Exporting Countries took over that role, eager to capitalize on their various national heritages, freed of US competitive interferences.
The next several decades saw costs of production, compared to OPEC's, rise significantly as lower quality reserves (like Canadian Tar Sands) and difficult-to-reach pools (some ten miles deep, often under angry ocean water) were exploited. Prices rose accordingly.
Through it all, the US continued to be the dominant world consumer of energy in all forms. That has been one of the keys to our national productive growth.
What else often happens in extractive industries is that ways are found to use lower grade reserves or get at the good stuff at lower costs. By working smarter, not (just) harder.
That is what has been happening in the Oil industry. The most notable clue to a coming change was the corporate acquisition a few years ago by Exxon (XOM), of a major independent exploration and production company whose principal interests had been in natural gas, not oil.
Natural gas up to that time was generally regarded as a product whose nuisance cost was often irregularly offset by widely varying market prices. Poorly regulated production from occasionally discovered large reservoirs created "gas bubbles" of a few years duration that were unreliable as a continuing energy source.
Advances in drilling technology (and skills) have made horizontal boring at depth a highly-prized practice. That is so, because shale lies in horizontal layers, often many, many times as wide in area as their vertical thickness.
Drilling into a geologic dome where oil is trapped has typically been a vertical exercise, productive in relation to the reservoir's "pay zone", or height, at depth. But shale is very different.
It turns out that the horizontal drilling, when coupled with hydraulic fracturing, "fracking" in oilfield jargon, is an extremely economic means of releasing the natural gas entrapped in the shale layers. It also develops that petroleum deposits are liberated as well in the process, further adding to the value of the recovery. Where NatGas used to be referred to as "associated gas" in an oil well, now "associated oil" is coming from the gas wells.
These valuable shale deposits cover large areas of the United States. Enthusiastic assessments are putting extractable reserve estimates at over 100 years of our present rate of natural gas consumption. And in those terms, the estimates may turn out to be conservative. In terms of the ultimate energy consumption from these resources, they may not be so endless, but their presence has national significance in terms of our energy independence.
The immediate impact on energy pricing here in the US is striking. The common denominator metric in energy is the BTU, a measure of heating capability. Crude Oil, the starting point for refined products, is sold by the barrel, containing about 6,000 BTUs. NatGas is sold by the million cubic feet, containing about 1,000 BTUs. So crude should sell for six times the NatGas price?
But Crude oil on the NYMEX is about $85 a barrel, and NatGas is going for $2-3+ an mcf. The ratio is over 25x, not anywhere near 6x. That is certain to change.
Part of the now low NG price may be due to an inadequacy of transport capacity to take huge developing supplies to consuming markets. Most likely to go first to the electric utilities - by pipelines yet to be built, and with midstream processing facilities also required. Meeting those needs will take some time, though.
Still, Crude prices have come down from over $100 a barrel recently to around $85, and futures prices suggest that the trend is likely to go lower.
For a number of years the futures-options market provided a useful insight into the expectations near-term for coming crude prices. Now we are inclined to believe that for the present at least, what is being expressed in the futures-options market is not a realistic free-market expression of what is likely to be coming in Crude Oil pricing. That is a discussion for another time.
Because Crude pricing is under strong negative pressure, and because it is not entirely clear by how much, the principal providers of crude-refined products are likely to be hurt by an ongoing transition. That makes most oil and energy stocks potentially dangerous investments. It's quite a change from vehicles usually regarded as safe havens in times of market turmoil. Coal-hauling railroads are also in for a pinch.
Those energy stocks with net upside potential are most likely to be seen among the Exploration and Production (E&P) independents that are finding and developing the shale-source reserves. Other lesser potentials lie in the midstream processors who will grow with the volume of NatGas to be handled.
As always, our interest lies in what may happen to existing stock prices, not what kinds of promises may lie in future earnings projections. The two may be related, but the key question is how much of the future promise is already embedded in the present price.
For that, we turn to the appraisals of the well-informed market-makers, told by their hedging actions taken as they go about their highly-paid work. Here is how they see the upside and downside prospects for leading E&P stocks, in contrast to the major integrated international producers.
Save for Petrochina (PTR), the major producers (in the upper picture) have limited near-term downside exposure reservations by the market-making community, but also lack much upside prospect. In contrast, many of the E&P stocks are seen to have double-digit price gain potentials beyond the best of the big integrateds.
Since the market pros' appraisals are of potential coming stock price changes, they incorporate the entire relevant economic and competitive minutia that makes each stock unique. Their judgments, thus reduced to the most basic common denominators, allow very direct comparisons between otherwise widely differing situations. To us, this ability to compare is essential to intelligent investing.
Lots of room exists for disagreement between equity value appraisers; that's what makes markets work. But keep in mind that it is money that moves markets, and the community of transaction facilitators whose outlooks are compared here are in constant contact and activity with clients whose big fund money is usually behind the next meaningful stock price moves.
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