Keith Schaefer's  Instablog

I have noticed valuations in the junior oil sector creeping up – sometimes to the point where I have to blink.  But it’s not just the increase in the price of oil this year that has driven up valuations. 

Canadian production of natural gas has dropped 20% from its peak in April 2006 – or 3.6 billion cubic feet per day (bcf/d) – First Energy Corp. analyst Martin King reported last week.  So the supply drop that the natural gas bulls have been waiting for is finally happening now – at least in Canada. 

What are the questions that educated investors ask in oil and gas?

Thursday’s buyout of Harvest Energy Trust by the Korean National Oil Company (KNOC) typifies the difference on how the East and West are looking at oil.

And it’s as simple as supply versus demand.

Big investors in the East are concerned about their supply of oil.  Investors in the West are more concerned about the lack of demand.

In an October 18 research note, Goldman Sachs echoed this theme, explaining that China cannot produce enough oil to meet their domestic needs, and will need to consistently acquire foreign reserves.

The Goldman analysts who authored the report also say that in their opinion, China’s growth and infrastructure build out will continue for many years.  And so nervous investors in Europe and North America who are fretting about a collapse in China and oil prices will be miss the boat on oil stocks.

The report stated: ”China-based investors focused on supply side of our bullish view as opposed to demand in sharp contrast to most investors in US and Europe we meet with that are focused on demand uncertainty as opposed to oil supply…Given that China is emerging as an economic super power at a time of limited oil supply growth, we think it is likely to lead to the country adding to its SPR (Strategic Petroleum Reserve) continuously for many decades to come.”

Oil bulls are quick to point out that China only used 2.2 barrels of oil per person in 2008, versus the 23.3 barrels used in the USA.

Supply versus demand.  East versus West.  And with oil at US$80, it looks like the Eastern philosophy is winning out.

There is another huge benefit to national oil companies (NOCs) buying oil assets, and it is this: they get to spend their large currency reserves in US dollars into an asset that basically hedges against the greenback’s decline.

Asian countries like China and South Korea run a large trade surplus with the US.  They then use those excess dollars and buy US Treasuries, the largest, the most liquid, and the most transparent investment vehicle in the world.

But the US dollar is moving steadily down, eroding value for Treasury buyers.  So instead, they diversify and buy hard assets like Canadian oil companies such as Harvest Energy Trust. 

Harvest’s stock was a huge laggard compared to its peers, because of the high debt levels in the company.  But KNOC didn’t care about that – not with South Korea running a trade surplus of $5 billion in September alone.

KNOC’s $4.1 billion bid values Harvest at $77,700 per flowing barrel of production, which is almost exactly the average for the energy trust valuations in BMO Nesbitt Burns coverage universe this week.  (Peters & Co. out of Calgary called it $63,000 after removing value for Harvest’s downstream assets.)

Regardless, it was a 47% premium over what western investors thought it was worth.

How typical.


DISCLOSURE: I own zero shares in Harvest Energy

In my first issue for subscribers in June, I interviewed money manager Philip Treick, Managing Partner for Thermopolis Partners out of Jackson Hole Wyoming.  He has an interesting theory on the how and why of the global economic collapse in 2008, and specifically how investors should prepare themselves for the future.