Canadian oil companies

In today’s trading there are a few oil and gas companies that are tripping my price range thresholds – i.e. they might be worth further research and consideration.

I am generally of the opinion that the markets at this time are greatly oversold, with presumably most of the selling done across the Atlantic Ocean in Europe by panicked investment bankers and hedge funds. Unfortunately (or fortunately), I am still looking for areas to safely deploy cash.

Cyclical nature of commodity markets

A third-hand report about Canadian Natural Resources stating that capital costs to hire critical contractors (e.g. for drilling and such) are increasing and leading to significant project budget overruns.

This is the nature of commodity markets – when prices are high, all companies rush in to expand projects and try to increase capacity so they can sell more product. When they are finished, they dump into the marketplace, depressing prices. Because of the fixed capital investment, it makes better economic sense to keep pumping product out even when the price of the underlying commodity does not make economic sense if you were beginning the project from scratch. As an example, if you include all fixed costs and it comes to $60/barrel, if you expect oil to be above $60 then it makes sense to build the project. If marginal costs of extraction are $40/barrel after that point, then it makes sense to keep operating even if you are below the break-even point for the entire project.

This is how you get commodity busts – even below the cost of marginal extraction. It happens when all of the producers have put in their fixed-cost investments, and it is more profitable for them to mine the product than to idle their machines.

Figuring out when this happens on a global scale is very, very, very difficult to perform. It requires a lot of industry-specific knowledge and a lot of data mining, and a lot of gut instinct. There is also the demand-side of the formula – if you expect consumption to increase faster than the supply expansion then you can still anticipate price increases. However, the big downside risk to the crude oil mining industry is not the increasing cost of providing supply, but rather determining if sufficient demand exists to warrant high future prices. Executives of oil companies are more or less trying to predict whether oil prices will continue to remain high two or three years out, when capital project decisions today are made.

Companies like the newly public Athabasca Oil Sands will not begin production until around the 2014 time-frame; they are incredibly leveraged to oil prices.

The futures markets do give a small hint of what is to come – January 2015 oil futures are at $86/barrel, compared to $72/barrel for July 2010 prices.

Gold is gold

Typically the price of gold is anti-correlated to market fortunes. However, during last week’s market calamity, it has seen a huge price influx, even when adjusted for Canadian currency. When all the world currencies are seemingly being debased, investors retreat into hard assets – this means claims to cash flows (through shares), bonds, and also commodity assets.

My only fundamental issue with gold is that it doesn’t serve much function other than being the psychological crutch of the monetary system. It is a good commodity to store value simply because of other people’s perceptions that it is valuable – paper currency works exactly the same way. When I go to a grocery store and exchange green pieces of paper for actual food I can consume, the person on the other end of the counter presumes they can buy something with the green pieces of paper. The same works for gold.

If you were to take out $100,000 in value in gold you would still have to carry 2.6 kilograms (about 5.7 pounds) of gold. Gold’s density is 19.2 grams per cubic centimeter, so this can be represented in a cube about 5.1 cm on an edge. This is slightly smaller than stacking a 3×3 cube of Las Vegas craps dice. This is quite practical when you consider that the equivalent in paper currency would be 1,000 $100 bills (think about how thick a 500 page laser printer stack is when you shop for office supplies), and you would presumably be able to avoid counterfeiting issues with a gold cube.

I am wondering why a more useful commodity, such as crude oil, has not been bidded up. Maybe one reason is because it would be difficult to stuff a few barrels of oil in your pocket or inside your safety deposit box. Knowing something about regulations concerning the storage of petroleum, it would also be impractical to pump thousands of barrels in a backyard tank.

What is mysterious, however, is why shares of gold production corporations haven’t risen in relation to gold prices:

Maybe there is value somewhere in gold equity?

Chinese investing in Alberta Tar Sands

It’s making the news headlines that Sinopec, a Chinese “crown corporation” is taking ConocoPhilips’ 9% stake in Syncrude, for US$4.65 billion. This will put Syncrude’s valuation at around $52 billion.

Syncrude is a joint venture company with a strange ownership structure. They are one of the large tarsands miners in Alberta, right up there with Suncor.

What’s odd is that Canadian Oil Sands’ market capitalization is about $15.4 billion at this moment and they only have a billion dollars of long term debt. Canadian Oil Sands’ 36.4% valuation of Syncrude would be worth about $18.8 billion at the rate that Sinopec paid for their 9% stake. Obviously I might be missing something here in terms of valuation (not being able to access Syncrude’s financial statements would be an important part of this), but it seems like Sinopec might be overpaying.

China has accumulated a lot of cash (especially US currency) through exports and are concerned that it will be inflated away and are trying to find places to invest it. One way is through minority investments in other corporations, especially ones that serve the strategic purposes of the Chinese government.

Geopolitical risks of foreign operations

Kyrgyzstan is a country that probably was on nobody’s radar before a few days ago when the country went into a revolution.

However, some companies have operations in Kyrgyzstan – Centerra Gold has mining operations located there and correspondingly, their stock price took a drop with the heightened uncertainty:

Whenever having an investment interest in a Canadian-headquartered company with foreign operations, it always pays to keep an eye on the country where the operations are located. I am reasonably sure that if somebody was paying attention to Kyrgyzstan before their revolution hit the news, they could have protected their investment interests.

Steam-Assisted Gravity Drainage

Anybody investing in oil should know the fundamentals of how the oil is extract out of the ground. The traditional (called conventional) method is used in places like Saudi Arabia – sticking a tube in a strategically-located position in the ground and sucking up the contents.

Steam-Assisted Gravity Drainage was an invention that has lead to the opening up of oil reserves that otherwise would have been inaccessible. There are quite a few companies in the Alberta area that use this to mine oil. A very basic example of how this works is on Cenovus’ website, which is semi-education and semi-corporate propoganda.

Cenovus used to be part of Encana, Canada’s largest natural gas producing company. They split off last year.

The other form of mining, taking tar sands (bitumen) from the surface and processing the material, is done by companies such as Suncor, and generally give the industry a perception of being environmentally damaging.

As the price of oil continues to increase, alternative methods become increasingly economical and it is well worth it for an investor to educate themselves on the processes used to extract energy from the earth.

Kitco selling Rhodium

I take a look once in awhile at Kitco’s precious metal store and notice they are now selling Rhodium.

Rhodium is a very interesting precious metal and it is by occurrence about four times less common than gold. Other metals of roughly similar concentration are Iridium, Ruthenium, and Rhenium – all a bit cheaper than Rhodium.

I don’t have any particular love for precious metals other than that they are nice to look at and feel (especially the density), but one big concern as an investor would be – are you actually getting what you paid for? Once you receive the Rhodium in the mail, how do you know you got shipped the precious metal instead of shreds of some other (cheaper) metal? Obviously you are relying on the reputation of Kitco (which is solid) but once you sign for the package in the mail and rip open the container, how do you verify Rhodium?

At least with gold there is a basic non-destructive test you can run at home to knock off all forgeries (water displacement). Unfortunately, the density of Gold is nearly identical that of Tungsten, so to detect Tungsten forgeries you have to resort to an interesting methods (e.g. determining how fast sound waves travel through the metal – sound moves through Gold about twice as slow as it does through Tungsten). Also, working with Tungsten is very difficult (the melting point of Tungsten is very, very high, much higher than gold).

If I ever bought a gold bar, the first thing I would do is the displacement test. It would also be rather fun to perform.

A large component of value for most precious metals is the psychological value that somebody else had to go through a lot of work to mine and refine a lot of ore to concentrate the metal into a nearly pure form. This is contrasted with industrial usage, where you can make a genuine argument with respect to the value of a metal.

For example, if somebody invented a way to repel gravity, but it had to rely on Rhodium, you can be sure that the price of Rhodium would skyrocket and it would quickly replace crude oil as being the most commonly quoted commodity in the news.

Natural gas prices getting slaughtered

The “discovery” of economical shale gas mining has done an extraordinary job of depressing natural gas prices since the price shock of 2008:

It is noted that the spread between crude oil and natural gas prices have reached an all-time divergence, but this is likely to be temporary – it will just be a matter of time before the laws of supply and demand force effective conversion between the two commodities. For example, it makes it more economical to use a higher natural gas input to achieve an output of crude given the price spread. Activities such as tar sands mining are very intense on natural gas (to generate steam) and as a result, the market should equalize over time.

One of the worst ways of playing natural gas is by purchasing a Natural Gas ETF (UNG), as it does not actually hold the physical commodity – traders will eat away at the fund when it has to rollover its futures contracts. Even purchasing calling options or the futures directly still exposes you individually to rollover risk. You could buy long-dated futures, but there is very little liquidity in the marketplace and you pay a significant premium, as the market is anticipating future price increases.

The only real way for people to play natural gas on a long-term basis are to purchase producers with considerable reserves. Which producers to pick is a matter of risk tolerance and market pricing. Typically if an investor wishes to be fancy, they would ideally pick a producer that has a marginal cost structure such that the cost to produce natural gas is that of the present market price; such a company will be losing significant amounts of money and will be trading at depressed valuations. Assuming this is the case and assuming the market has significantly marked down the equity in such a money-losing company, it is a very speculative way of playing for a natural gas price increase.

This principle also works with any other commodity on the planet – including crude oil and gold companies. Again, it depends on doing your homework with respect to valuations and knowing what value you are receiving when you put in the order for shares.

A more conservative strategy and one that relies on other market participants to have done their homework to receive a fair price is to purchase shares in EnCana or Canadian Natural Resources, which are the top two natural gas producers in Canada. After the split-up of EnCana and Cenovus, EnCana is a much more “pure play” on natural gas than Canadian Natural Resources. With either company you will not see your money double over the course of a year or two, but it will certainly be there at the end of the day and also provides a bit of comfort with respect to inflation-proofing a portfolio. Despite all of the media and political attention paid to carbon emissions, it is a given that natural gas and crude oil continue to be consumed in massive quantities for the foreseeable future. The only promise is that, over the long run, it will get more expensive.

China will be sucking the world’s crude supply dry

The title is a one-line summary of what I will be describing in this post. Essentially with the global economic downturn slated to moderate due to the injection of fiscal stimulus, the countries that will continue to face true organic growth will have a need to consume more energy.

There is no economy on this planet growing faster than China, and not surprisingly, one can see from this article that their actual crude consumption has increased, and will continue to increase in the future. Note that Japanese consumption continues to decline, which is lock-step with their economy.

The only two questions that need to be answered is whether North American consumption will decrease and where will the supply come from?

I will borrow a slide from R-Squared (who incidentally knows much more than what he discusses on his blog, and knows much more than your typical politician on the issue of alternative fuel sources) and just say that the supply side looks to be capped in the future:


Since world oil production has probably peaked, or is close to peaking, any supply-side shocks will have a disproportionate amount of impact in price. It is likely that an absolute floor for crude is $35 as seen in late 2008, in the middle of the economic crisis. It is also more likely in ‘regular’ times that the floor for crude prices is higher, likely around $60 per barrel.

Marginal costs for alternative energy sources are still much higher than the price for crude extraction and processing; most of the inputs for alternative energy sources (e.g. corn ethanol) rely heavily on other energy inputs (crude and natural gas).

The only thing that will make alternative energy more viable is higher crude prices. And higher is where crude will go in the medium term. As crude’s price continues to go higher, more and more supply sources start to become economically viable. There won’t be a shoot-up to $1000 a barrel (barring some sort of global conflict) but a climb in prices is inevitable given the demand-supply dynamics.

The only salvation against higher crude prices are energy breakthroughs in other fields, such as the development of sustainable fusion, or less capital expense intense solar energy, or the development of high capacity low-loss energy storage.

A shot across the bow – US Dollar

The US reported that unemployment dropped to 10% in November; the market reaction to this has been swift and adverse to those betting against the US dollar – as of this writing, the Euro is down 1.7% and Gold is down 4.0%.

If it takes just one report to get the market jittery on their ultra-bearish stance against the US currency (and by definition this means pro-Gold), I wonder what will happen when any other “good for USA” news comes through the pipeline – there must be a huge amount of traders out there that are going to get caught in the wrong position and start scrambling for the exits.

This is probably just a shot across the bow for these people – I wonder what will happen when there is a direct hit.