Now Is the Time to Own the Oil & Gas Leaders
Commodities / Oil Companies May 20, 2015 - 12:18 PM GMT
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.S. shale oil producers have responded to the oil price collapse so quickly, and with such discipline, that they've shown they are able to turn production on and off as if with a light switch. As Keith Schaefer tells The Energy Report, that means it's time to be nimble, and to keep small positions until oil finds a stable new price level.
The Energy Report: Keith, the first U.S. grassroots refinery in nearly 40 years just began operation in North Dakota. Is the growth in U.S. oil production going to catalyze refinery construction?
Keith Schaefer: I'm going to say no. U.S. production has peaked and we're doing just fine, so I don't see any great need for more refineries right now.
There was talk a couple of years ago, particularly in 2012–2013, that with unbridled shale oil growth we would need more refineries. But the producers have been more disciplined than anybody expected in the last three months, with the rig count declining sharply and then staying down. I think we're going to see a drop in U.S. production, so I don't see the need for any new refineries right now. The only thing that could change would be even more demand growth, which we're seeing because of lower prices. Somebody might get the idea that we need another refinery to meet that demand.
Right now, refinery crack spreads are actually very good. They're $20–25 per barrel ($20–25/bbl), which for this time of year is fantastic. But I don't know if that's good enough to warrant somebody spending tens of billions of dollars to build something new. The other thing is that the refinery industry has been pretty good at incrementally adding light oil capacity around the country. A thousand barrels a day (1 Mbbl/d) here, 2 Mbbl/d there—that has added up over the last two or three years. I don't know what the exact number is, but certainly there's been no problem in getting gasoline to market, as you can tell by the big drop we've had in gasoline prices over the last six months.
TER: Is the gasoline price going lower?
KS: No, I don't think the price is going lower. We've had a nice little rally in the last month, with oil prices back to about $60/bbl on the WTI (West Texas Intermediate) and almost $70/bbl on Brent.
I think it's important that investors realize the gasoline price is based on Brent pricing, not on WTI. We're exporting more gasoline-refined products out of the U.S., so we're competing with foreign buyers for our own energy. I think that's why gas prices are a bit higher than people think they should be; they keep thinking about WTI, not Brent.
TER: The new U.S. production is lighter than what U.S. refineries were designed for. Are the U.S. refiners retooling?
KS: Well, a bit. Like I said, you're getting 1 Mbbl/d here, 1 Mbbl/d there, of light oil capacity. Refiners are also trying to increase the amount of distillates they produce, because generally that's a more profitable product—jet fuel and diesel fuel, which is what Asia uses. Asia runs on diesel. That's definitely Brent pricing, so there's more margin in that. Everybody's been trying to reduce heavy oil. The big exception would be BP Plc's (BP:NYSE; BP:LSE) Whiting, Indiana, refinery, which just went from mostly light oil to mostly heavy oil.
TER: How has the delay in approval of the Keystone XL pipeline and resistance to Canadian pipelines going both east and west affected Canadian oil sands producers?
KS: So far there is not much impact. The heavy oil discount is quite tight right now because the Gulf Coast is getting a lot of Canadian oil that it never used to get. Enbridge Inc. (ENB:NYSE) has got the Flanagan South Pipeline moving, so it's able to bring 300–350 Mbbl/d more Canadian crude straight to the Gulf Coast than it used to. That's not quite as big as Keystone, but between what rail has done in the last two years, going from zero to just under 200 Mbbl/d, the incremental oil sands production has been able to find a way down to the Gulf Coast. There's actually more Canadian oil now going to the U.S. than ever before. That's great news for Canadian producers.
As you said, most of the refineries down there are geared toward heavy oil. Keystone probably will start to be important next year or the year after. Rail and the Enbridge Flanagan South line bought Canadian producers one to two years' grace on their growth in production. It's going to hit the wall again very quickly because oil sands production is going to rise anywhere between 50 Mbbl/d and 120 Mbbl/d every year for the next five or six years. Keystone will come back into importance fairly quickly.
TER: Is refinery construction on the table in Canada?
KS: Oh yes. The Alberta government is building a refinery, the North West Upgrader. I think it's relatively small—somewhere around 75 Mbbl/d. But from private industry, there is just no appetite for a refinery in Canada. You need a big petrochemical complex surrounding your refinery complex, and you just don't have that in Canada. The refineries are either in Edmonton, Alberta, or in Sarnia, Ontario. Sarnia has a petrochemical complex, but with the government there now, you're never going to see another refinery in Ontario. You might see one in Alberta, but, again, it's not going be as economic because it would just be producing gasoline, and not as many petrochemical products.
TER: Speaking of Alberta, how will the election results there affect refiners and oil sands producers?
KS: I don't know if it's going to affect oil sands or refineries that much. Because of the dirty oil moniker, if there's one thing the New Democratic Party (NDP) government might go after, it's trying to get the image of the oil sands in better shape. I think stronger environmental rules could really help the industry in the long run. That's going to cost some money, and potentially put a crimp into some cash flows. The producers don't want to disturb their tailings; they just want to plant poplar trees over them and let them go back to nature. I don't know if the NDP is going to allow that.
From a tax point of view, I don't think the elections are going to make much difference. There is talk about raising corporate income taxes, but the reality is that most, if not all, the producers lose money every year on an accounting basis. There's not going to be much impact for the oil patch. Royalties could go a little higher, but I don't see them going much higher. Honestly, the fear is greater than what the reality will be. The bark is worse than the bite.
TER: Has the price of oil found its new level?
KS: I think there's a strong argument the price is going to actually pick up over the next eight weeks. The harsh drop in the rig count in the U.S. should now translate into a pretty significant drop in U.S. production, which we'll see each Wednesday when the U.S. Energy Information Administration (EIA) numbers come out. The EIA numbers for the next 6–10 weeks have the potential to drop quite a bit. The Street is very short-term-oriented right now. I think the market could take oil a lot higher than people would suspect because of the emotion that will follow the drop in U.S. oil production in the next 6–10 weeks.
Here's what I tell my subscribers: Right now there are many crosscurrents in the market, but two things have happened that were a bit of a surprise to the market so far this calendar this year, and both of them were bullish.
One was that demand has picked up way more than anybody expected, way sooner than anybody expected. Before the oil price crash in late 2014, the market was seeing lots of stories about how oil demand was inelastic to price. It didn't matter what the price of oil was, demand didn't change much at all. You can throw that idea out the window. Even by January that had been completely debunked, and we were seeing 300–500 Mbbl/d or more increase in demand in the States. Right now, we are seeing 700–800 Mbbl/d more demand in the U.S. over last year. When you consider that production is up 1 MMbbl/d, the surplus doesn't look like such a big deal anymore.
Internationally, we're starting to see some big stats as well. China's up 250 Mbbl/d. Japan's up. Korea's up 110 Mbbl/d. They haven't been able to see the same benefit in the drop of oil that we have because the rising U.S. dollar has taken a lot of that away. Demand has been a big surprise.
Second, as I said, nobody thought the U.S. producers would have the level of discipline that they've had in dropping the rig counts through this calendar year. The market has been stunned that we're continuing to see rig drops week after week. We had that one big month—February—with 90 rigs a week getting dropped. Even now, it's at least 20 rigs. In Canada, for example, there are only 16 oil rigs working—in all of Canada! That's stunning to me.
So when we talk about where the oil price is going, nobody knows. When you canvass the analysts, the smartest guys on the Street, the numbers are all over the map. The oil price has jumped 50%, from $40/bbl to $60/bbl. Is it over? I don't know, but I would say that demand's been higher, and it looks like supply is going to be a little bit lower than what everybody thought in January.
I think we're going to have relatively bullish production numbers and inventory numbers in the States by the end of Q2/15. The numbers could be bullish enough that companies might start to bring rigs back. It's only going to take one or two weeks of the U.S. adding 30 to 50 rigs to put a big stop in the oil price rise.
I think in the short term—really short term, toward the end of Q2/15 and in early Q3/15—oil can go higher. The U.S. industry has shown that it is so flexible and so adaptable it can bring rigs off and on like flipping a light switch. It's just amazing. Any opportunity these guys have to lock in good margins on their hedging programs at $65–70/bbl oil—if it gets that high—they're going to do it, and rigs are going to come out.
TER: What are you forecasting on the oil price for this year?
KS: This is going to be one of the choppiest years for oil we've seen in a long time. Everyone had such confidence in the Saudis' massaging and managing the oil price for the last four years, and the Saudis did do that. We had a very, very tight range for oil from 2010 through to the end of 2014. That's out the window now. It's going to be a lot more volatile.
I think you're going to see a lot of head fakes, both bullish and bearish, this year. If you talk about whether the price could find a level late this year, I'm going to guess that's somewhere between $60 and $65 per barrel WTI. At that price the big guys have the scale—they can make money. And little guys can't. The high producing core areas of the big plays make money, and the fringe areas don't, so these prices don't warrant spending a lot of money on the fringe.
TER: Let's talk about some of the companies that you are most familiar with.
KS: Rock Energy Inc. (RE:TSX) had a great year last year because of its big light oil discovery. The only problem was that the company spent a lot of money in Q4/14 drilling that up as the oil price was collapsing, so its debt levels got pretty high. But it has just figured out a key component to increasing production out of its wells. The company has been adding a lot more sand and getting much better results.
Rock had to raise money at the bottom, but it still only has 50 million (50M) shares out. You know you're investing in a company that has lots of leverage when it has 50M shares out. The company has been able to hold production steady at 5 Mbbl/d, and actually makes good positive cash flow on that. With Rock, you've got great positive cash flow at these prices, and a real turbo charge in its light oil play if oil prices come back up.
TER: Can you mention another company?
KS: This is a year for small bets. With the uncertainty and volatility around commodity prices, there's no point in making any big bets this year. Legacy Oil + Gas Inc. (LEG:TSX) is a Tier 2 producer in Canada that has just enough debt to be outside the market's comfort zone, but if oil goes back to $80/bbl, its debt levels actually come in line. In addition, the company has an activist investor group with quite a track record of creating value.
TER: FrontFour Master Fund Ltd. is nominating a slate of directors for Legacy. Is that something that investors should be worried about?
KS: No, they should be excited about it. Last year, this investor group ousted the Renegade Petroleum board, sold Renegade to Spartan Energy Corp. (SPE:TSX), and Spartan took that asset and improved production so fast its stock doubled in about three months.
The team at Legacy has lost the Street a bit. For a couple of years, Legacy's reserve reports didn't keep up with spending, and so the Street has slowly abandoned the team. The straw that broke the camel's back for FrontFour, and a few of the other investors in the company, was when the board decided to guarantee CEO Trent Yanko's personal loan for some stock.
Would the company be able to perform better with a different management team? I don't know. But I would say that the market has great respect for the asset base, particularly in Saskatchewan. Even the Turner Valley asset in Alberta is a very low-decline asset, which is what the Street likes right now. I think it's a case where the sum of the parts is greater than the whole. Because of the anticipation of what FrontFour and the other investors might be able to do with the company, Legacy should have an extra bid under it this year.
TER: With the uncertainty in renewable fuel policy and the question of using a food crop for energy, is ethanol a smart investment?
KS: The reality is that ethanol right now makes sense. Even if the renewable fuel standard (RFS) didn't exist, there would still be an ethanol industry. It might not be quite as big as we've got right now, but there would definitely still be an industry, because ethanol produces octane cheaper than anything else.
Valero Energy Corp. (VLO:NYSE) is invested in corn ethanol in 11 plants. Ethanol didn't make any money for Valero last quarter, and the stock still had a fantastic run-up to pretty much all-time highs. The crush spread for ethanol through the rest of this year is actually pretty good. It's in the mid-$0.40 per gallon range. Valero produces more than 1 billion (1B) gallons of ethanol per year. Going forward, ethanol should actually be quite a positive contributor to Valero's top line, and especially to the bottom line. Not only that, Valero has shown that it actually gets better margins and pricing than most of the pure ethanol producers. It's a pretty smart cookie in that division. I think ethanol is going to be a big positive for Valero for the next three quarters.
TER: Can ethanol compete with crude at current prices without mandates?
KS: It absolutely can. But the reality is that it's a political issue. If the renewable portfolio standard were withdrawn, there would be a large contingent that would just stop using ethanol altogether. Certainly the integrated refinery companies would have no incentive to use it; they should use their own oil. But groups like Valero, which aren't as integrated, or the independents, like Marathon Oil Corp. (MRO:NYSE), Northern Tier Energy LP (NTI:NYSE) or Alon USA (ALJ:NYSE), would continue to use ethanol as much as possible because it makes economic sense right now. If we ever went back to a situation like 2012, where there was a drought, corn prices spiked, and it made no economic sense to use ethanol, these companies would drop ethanol like a dirty shirt and go straight with oil. That would absolutely have a big impact on the industry. The RFS really only kicks in when corn prices are high. The ethanol market works on market-based economics when corn is this low in price.
TER: Valero's share price since February has been at its highest 52-week level. What's driven that performance?
KS: A couple of things. Ethanol last year did great. And now Valero and all the other refiners are seeing the pipeline stocks in the last 3-4 years do really well. Those stocks have the best charts in the industry. And there's almost no volatility in them. They have been the best-performing stocks you could ask for in an energy portfolio. The multiples are very high because the Street likes a steady tolling charge. It doesn't like revenue based on commodity risk.
What we're seeing now is refiners saying, "Hey, we want to have those bigger cash flow multiples, like the pipeline stocks. They're stealing our lunch. We're going to integrate our own logistics into a separate company. We're going to take every bit of revenue we get that's not commodity-related and put it into a master limited partnership (MLP) structure, which gets a much higher multiple like midstream or pipeline companies."
Valero, in particular, has a lot of assets. It's one of the biggest refineries in the States. It figures it's going to be able to add almost $1B/year in assets in the next five years to put into these higher-multiple MLPs, where the cash-flow multiple is going to be a lot greater. That's a great extra uplift underneath the stock for the next three or four years.
TER: Has Northern Tier Energy done better or worse since Western Refining Inc. (WNR:NYSE) bought out its managing partner share?
KS: In some ways, better. Fundamentally, the company has outperformed. Northern Tier is a one-refinery company in Minnesota. Before Western Refining took it over, it always underperformed financially against the bigger industry benchmark for that area, which is called PADD 2. Since the Western Refining guys have taken it over, the company has done a much better job at running the business and has been able to outperform the benchmark. I say kudos, because the stock value increase for Western Refining over the last five years is $5/share to $45/share. I'm so excited to have that team at the helm of Northern Tier. I think it's going to do fantastic.
TER: What is the major trend in your advice to your newsletter subscribers now?
KS: Caution and small positions. Pretty much everything we bought in 2015 is up, simply because the commodity prices have done better than I expected on both the oil and gas. Now is a time when I think we need to be very cautious, stay in lots of cash. A fat pitch, as Warren Buffett says, will come into the market that we should be able to latch onto. Right now that's hard to see. Just stay in cash. Stay in small positions, and only own the leaders. They always have a higher valuation, but you always buy up in a down market. Buy the leaders and have patience.
TER: Thank you very much for your time.
Keith Schaefer is editor and publisher of the Oil & Gas Investments Bulletin, which finds, researches and profiles the growing oil and gas companies that Schaefer buys himself, so Bulletin subscribers know he has his own money on the line. He identifies oil and gas companies that have high or potentially high growth rates and that are covered by several research analysts. He has a degree in journalism and has worked for several Canadian dailies, but for more than 15 years has assisted public resource companies in raising exploration and expansion capital.
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