Category Archives: On the cover

On the cover

The market, the market

Energy, On the cover, Sin categoría,

me_1126

A pretty humorous chart I received last week, with obvious political connotations, but some truth embedded in it.
The basic thing that this chart shows me is that leverage and asset bubbles create huge volatility and will continue to  do so. For the market to stabilize we need debt at all levels to go back to 1981-82 levels, returns to sustainable moderate growth, open market policies, lower taxes for families and industries and liberalization. What European (not only UK) governments are doing is precisely the opposite and why even after a 14% fall in the market year-to-date I see downside… It’s not about “valuation” (most valuation tools, like EV/EBITDA  or Sum Of The Parts are bull market asset inflation tools) , it’s about sustainable returns over a WACC that is doing nothing but increase (cost of debt down, yes, cost of equity and risk premium up) and balance sheets that keep eroding after a period of furious M&A, growth and capex.
Worth a watch:

Intervention ahead

Energy, On the cover, Sin categoría,

“The most dangerous words in the English language are: I am from the government and I come here to help” (Ronald Reagan).

It is starting to get scary. Politicians all over the world are congratulating themselves for tackling the crisis (a debt and gearing crisis) with more debt and more gearing. Threatening banks to intervene if they don’t lend, threatening companies to intervene if they don’t lower prices below their cost of production, threatening hedge funds for using shorts to hedge long positions, threatening to  close borders to save domestic industries. Nice.
The stock market falls again in January and hedge funds are to blame again (de-leveraging and sell-out of long-only funds never was a problem)…. As if banning shorts helped the market in any way.
It is easy. Governments have found in this crisis the perfect storm to do what they always wanted to  do and found difficult: intervene everywhere, regulate to death. And that would not be a problem if the governments and their advisers had constructive solutions and were made accountable and audited. But as a recent cartoon stated, we are bailing out the iceberg to save the Titanic. Governments have created this crisis by giving mass incentives for companies to grow beyond normal levels of debt (in many cases, like in Spain, to fulfill egotistical empire-building desires), by allowing abnormal lending to people that could not afford it, by massively increasing public expenditure and promoting “high growth” industries like construction and subsidy-driven energies. Debt was solved with more debt and now it is expected to be solved with more debt, more money printing and, icing on the cake, government intervention. So who takes care of the revenue problem? You and I and the poor companies that actually made money and good returns without gearing themselves to death.
Wait a minute, so in order to bail out the auto industry, the over geared renewable energy sector, the banks and the construction companies the perfect solution is to tax the oil and gas sector (20% net debt to  equity average) and tax the population to cover the opex of the ever increasing government?. Who is going to invest? Who is going to take the risk of being entrepreneurial if the solution is to subsidise unsuccessful irresponsible management by taxing successful business models?. Why do we have to  save jobs in the auto industry and not save any in small businesses and new enterprises?.
Remember, “a government that is big enough to solve your problems is also big enough to create them”. More and more countries (particularly in Europe) are constantly brainwashing the population into believing that the ones (the Governments) that caused the problems will solve them, and gradually asking them to “let go” of their economic and deciding freedom to “allow the government to undertake the necessary actions”. Obviously, they are not to be monitored or controlled, they are not held responsible for what they do with your (our) money. They just want you to trust that in the end everything will be alright. If it is, the economy will be driven by semi-state owned oligopolies that drown any entrepreneurial  opportunity, if it’s not, the world leaders will shrug off the blame and point at someone else. Pity that hedge funds might not be there to lay the blame. Next task: find the scapegoat. It’s urgent. Suggestions welcome.

The end of investment in oil as we know it

Energy, On the cover, Sin categoría

crude_oil_oilwatch_feb_1

This image from the great www.oildrum.com shows something I believe is very important: despite an increase in capex of 20% per annum in the period, global oil production did not increase significantly.
This unprecedented level of capex in the oil industry happened thanks to a combination of technology and access to credit.  Widespread access to credit is gone, maybe for a very long time, but more importantly, oil companies’ appetite for investment is not going to increase quickly. When oil fell to $10/bbl in the early 90s it scared an entire generation of oil company managers. This is exactly what will happen after this period. 3D seismic, deep offshore exploration, high cost projects, oil sands, … wave bye bye to capex. Remember, Capex in 2001 was $250bn and in 2002 went to $100bn.
Meanwhile the average requirement of oil per capita in the planet is 4.9barrels and 454 cm of gas a year.

In OECD countries with current demand oil consumption is 18.3barrels a year

So if OECD countries slash their demand by 25% it will still be 14.64 barrels a year

However, if oil exporting countries demand goes up by a mere 7% their consumption will be 4.28 barrels a year.

Indigenous population growth in OECD is +0.1%, and growing 1% from immigration (ie going from countries where the average person consumes 2 barrels a year to countries where they will consume at least 4)

Population growth in oil exporting countries is up 5%.

Doing the maths, the demand doom picture is overestimated.

On to Supply:

A) In a tough credit environment, even large and medium sized E&Ps are and will have to drastically cut expenditure in exploration and development. Even worse, service companies are too small and cannot get credit  for large rig projects (look at SBM and PFC).

B) Large caps are cutting expenditure (albeit selectively) already. If they see a weakening of demand all that RDS has to do is reduce the number of trucks in Canada bringing oil sands product from 35 trucks to 5. Boom.

C) Demand needs to fall at least 3%pa to come back in line with the usual demand-supply balance going forward

D) Even if all these things happen the call on OPEC increases, as non-OPEC supply is doing nothing but shrink.

E) 75% of the current projects require at least $40/bbl (technical, not service charge). Companies are not waiting for oil to fall to $20/bbl to revisit these projects which are only being developed because demand exists. If not, these projects can be shut down rapidly (Khursaniyah, Khurais, Genghis Khan, Atlantis, Kashagan, Rosa, Dalia).

Demand NEEDED to fall more than what consensus and sellside expected. I am happy with demand falling  a lot, because the problem is depletion.

Supply is not there, and deffinitely not from non-Opec as consensus estimates (a ramp up of 1mmbpd when year to date it is down). Depletion rates are 4-6%. Even if you consider 0% depletion you need demand to fall a another 5%.

Call on OPEC increases, and self-consumption of producing countries is rising. Price, as such, is adjusting to see where mid term supply, demand and depletion go. That is not an indicator of bearishness.

I bet:

A) 12 month trail reserve replacement will be less than 90%

B) demand will fall accordingly

C) Demand – supply balance will remain the same

More importantly, I am happy that oil falls because the contango curve is steepening again… and bears have yet to explain why, if this is an anomally and fundamentally unjustified, it has continued and widened for seven months at levels never seen before October 08. As the only true safe havens of the equity market, I expect in less than a month investors will come back to revisit high quality, differentiated stocks that discount $30/bbl, trade at 7xPE 2010, 3-4.5x EV/DACF 2010 and FCF yield of 14%.

Tough times for equities

Energy, Oil Market, On the cover,
After years of solid performance, equities are a risk, more than an opportunity. A friend of mine said something very pertinent about the underperformance of equities versus corporate bonds: “If you can earn a 3% risk premium on the bonds why bother with equities”.
The market is on 10.4x 2009 P/E…  So stocks have fallen 45-50% and they are only marginally cheaper (in some cases more expensive!) than in 2007. The market 2009 EPS growth shows expectations of -13.3% , and dividend yield at 4.8% (6.7% for Telecoms, 6% for Oils, 4.6% for Industrials, Basic Materials Consumer Services, 3.8% for Technology, 3.4% for Healthcare and Consumer Goods).
See the picture? yields are at risk as well!. Does one really expect the yield of a 13% falling EPS market to stay sustainable at 5% in the current economic and credit environment? … Cash flows remain under pressure and so will dividend policies.
The new defensives are megacap oils (strong balance sheet, high yield and flexibility on capex) while telecoms and healthcare continue to perform well. However, it is only in telecoms and oils where I see “cycle management” of the balance sheet, true capex management and true focus on ROIC.
I believe this trend will continue. So far long Oils short the market has worked. The steep contango curve has helped, but it’s all about balance sheet today. I believe we will continue to enjoy performance versus the market while we see eranings downgrades everywhere, capital increases and dividend cuts.
But isn’t a 30% outperformance overdone? After all, it’s the biggest continued period of outperformance against the market and the underlying commodity since 1991.
Well, the good news is that the market will continue to find it difficult to “buy something else” but the bad news is that, like in 1991, if oil prices stay low we will see dividend cuts and drastic capex cuts.
In this environment, I cannot agree more with the messages of Morgan Stanley on the “new defensives” in the oil and gas sector: BG (hedged 80% of LNG output to 2010) and Tullow (no refinancing needs after the highly succesful capital increase) versus the highest geared stocks (and I disagree again with consensus) with dividend risk, BP or Statoil.  Stick with Exxon (ongoing buyback, $89bn in cash) and short Conoco.  Buffett was right when he bought into megacap oils in October 2008, but I believe he chose the wrong (relative to peers) stock, Conoco, with the most challenging production, earnings breakdown and growth profile of the US majors.
What? Stick with the expensive outperformers versus the cheap underperformers? Beware of this argument, because the cheap are getting more expensive as downgrades, and cuts in capex and dividend, feed through estimates. Remember that Total traded at 4xEV/DACF and after a 25% fall still trades at those estimated multiples… and the risk of going “nuclear” and putting billions in questionnable EPRs and nuclear plants is not to be overlooked.