Category: Commodities

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.

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.

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?

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.