Berman Is Back

Those investors that dabble in the Energy Sector are probably familiar with Arthur Berman, who runs a blog called the Petroleum Truth Report, and has staked his reputation on a bearish point of view on the shale gas resources that are believed by many to be the greatest thing since sliced bread.

Berman comes with impeccable credentials which lends an air of respectability to his writings. He is a Petroleum Geologist that worked for a major oil company for most of his career.

His latest piece was published on the Oil Drum, and I recommend that everyone read it, not because I necessarily agree with everything that he writes, but investors shouldn't fear an opposite opinion.

Here are some provocative excerpts from the post:

"The widespread belief that there is 100 years of natural gas supply in the U.S. because of shale plays is incorrect. Claims that shale gas has resulted in 100 years of supply are based on circular references without underlying documentation, and also do not take high decline rates or anticipated future demand growth into account."

"The current marginal cost of gas production is at least $8/Mcf, and prices will eventually rise to meet that cost."

"The Barnett Shale play is largely non-commercial because the controls on production are complex and difficult to predict."

Read the comments below the post as Berman makes substantial comments in response to readers questions.

An Update on the Energy Patch - Part II

I just returned from an Energy conference in New Orleans and wrote a little on it in this post here.

It seems that investors are waiting for three events before deciding whether to invest in these stocks in 2009.

First, to state the obvious, most institutional investors are waiting for the price of the commodity to stabilize, fearful for how far it will fall before a bottom is reached.

They also appear to be waiting until after the final round of exploration and production companies set capital budgets for 2009. While a decline in spending is discounted in the shares of the services and drilling companies, there is concern about how much more will be cut.

Also, many exploration and production companies will be forced to value reserves at the end of 2008 using a lower price deck than expected. This will cause reserve writedowns at many of these companies. Since "proving" up reserves is the main business model for many, this will also be a painful adjustment.

An Update on the Energy Patch - Part I

I just returned from an Energy conference in New Orleans, and what a difference a year makes. At this same conference last year, if the maid who cleaned my hotel room wanted to raise a billion dollars to start an oil company, she probably could have gotten the capital. Not so this year, as a resigned outlook on the current downturn colored everyone's attitudes.

One company attendee told me that currently there was no spot market for rigs. As soon as a contract ended, the rig was being sent back to the owner. There is not even a conversation about a lower rate. It's basically - here's your rig, we'll call you.

Regional Economic Outlook

The Dallas Fed just released its August 2008 regional economic outlook. It looks like even the booming Energy industry isn't enough to stop the spread of the economic slowdown.

The Texas economy slows to its lowest growth rate since 2003.



Employment growth also slows down - not negative yet like the overall U.S.



Housing prices held up much better than the rest of the U.S. but are starting to roll over.

Japan Export Slowdown

Japan just released its May trade surplus report, and although it beat expectations, it was down for the third straight month, hurt by rising prices for the Oil that Japan imports.

While exports to China and the rest of Asia were strong, analysts said the gain was a little deceptive, as shipments to China were artificially boosted after the recent earthquake on May 12.

Even more important was that:

1) Exports to the U.S. fell 9.5% as demand for Japanese cars and other products slowed.

2) Exports to Europe were down for the first time in 31 months.

Is this more evidence that the decoupling theory is not valid? Last week it was reported that exports from Singapore to the developed world were down as well.

Here is a list of important questions to answer:

Is it possible that the economic recession in the U.S will lead to a decline in Consumer spending on discretionary items?

Is it possible that this decline in consumer spending will be exacerbated by the increasing price of gasoline and food?

Is it possible that some Asian economies, who are heavily dependent on exports, will not be able to export as much as in the past because there aren't as many buyers?

Is it possible that these Asian economies will not grow as fast as in previous years or as much as the market or pundits expect?

Is it possible that when these Asian economies don't grow as fast, they will use less energy (oil) than the market expects?

Is it possible that the supply and demand fundamentals for oil will not meet the market expectations and we will have a surplus of oil over the next 12 months leading to a rapid rise in inventories?

Is it possible that I am out of my mind?

All is Forgiven in Love and War and Energy

Energy is back again as investors seem to have a short memory and despite weakness in North America, they are banking on international growth to bail out the Sector. Sounds a little familiar doesn't it? Here are the rest of the highlights from the Schlumberger call that caused the 10% one day drop. The stock has now recovered half of the loss. Transcript courtesy of Seeking Alpha

Once management comments ended, they were hit with a blizzard of questions on the outlook going forward:

The bane of all cyclical industries - too much capacity coming on line.

"I think pricing deterioration is still single-digit compared to last year. I think it will accelerate slightly in Q-4; and where the bottom is, I really don’t know, because what we have is a situation very different from 2001, in that the bottom is going to be created by additional capacity and not by a drop in the rig count."

And exactly how much extra capacity?

"So what is going to change the pricing profile is the additional capacity. And, you know, we, I’m not quite sure where we stand in the additional that was coming on. But, you know, when we looked at it a few months ago, it was certainly an increment in the high double, in the high teens, if not more."

On the margin effect:

"The biggest effect on margins in the Q-3 in North America was the lack of operating days in the Gulf of Mexico, due to precautionary evacuations, not from land. There was a deteriorating on land but it was not the major part of it. And, in terms of the pricing of services, other than pressure pumping, we have not so far seen the noticeable effect."

This next excerpt might have really panicked the street as Schlumberger almost seemed to be backpedalling on its growth forecast that it headlines at the beginning of every conference presentation.

"What I’m saying is that we won’t get a high teen growth rate in North America in 2008. Everywhere else, we probably will not be that far from it; but in North America we’re not going to get it. Now, what happens through the end of the decade, I, you know, I can’t speculate yet on North America specifically. The rest of the world, I’m perfectly confident."

And then they refused to confirm where the bottom is in North America:

"Overall, do you think that the North American EBIT in ’08 is going to be above, below or in line with the ’07 contribution?"

"Well, I don’t think I’m ready to answer that yet Geoff; but obviously, you know, if there is a big pricing impact on land, then it will have an effect."

"So a decline is a possibility?"

"It’s not excluded, no."

Is the Energy Cycle Over?

I know its heresy to even suggest that a hot sector has seen the peak and I will no doubt be greeted by a chorus of cat calls and boos from the rafters, but is it possible that the Energy Cycle is rolling over? The market was down big on Friday, but the Energy stocks really got hit hard, spooked by an earnings report by Schlumberger. The market bounced back on Monday but Energy did not share in that rebound.

So what spooked the market so badly? Here are some excerpts from the call courtesy of Seeking Alpha:

First up were management comments on the North American market:

"North America pre-tax margin declined 427 basis points sequentially, to 26.9%, due to weather-related disruption in the Gulf of Mexico, the continued erosion of pressure pumping stimulation pricing on land in the US, and a reduction of exploration activity in the Alaska, partly compensated by re-bound in Canada after the second quarter Spring break-up. In North America, activity increased in Canada, but this was off-set by weaker pricing for pressure pumping on land in the US, and by a sharp revenue drop in the Gulf of Mexico, due to the departure of several rigs to overseas locations, and a loss of approximately 15 operating days, due to weather."

This wouldn't have caused a 10% decline in the stock. The market knew that pressure pumping pricing was weak and the down time from the Gulf was also common knowledge.

And then the first bombshell hits:

"In the immediate future, while there will be some recovery from the low activity levels in the Gulf of Mexico, natural gas activity in both Canada and the US is likely to stabilize, as production remains relatively strong and gas storage approaches winter at comfortable levels."

"As a result, pressure pumping pricing deterioration will continue. This situation, however, does not change our view that North American natural gas supply will require sustained activity to combat production decline, and advanced technology, to increase production rates from poorer-quality reservoirs."

I will post again tomorrow on the rest of the Schlumberger call. It will be interesting to see if the Energy Sector will catch a bid from the Apple earnings blowout from last night.

A Typical Energy Cycle

The Energy Sector is inherently cyclical and a typical cycle moves in this fashion (beginning at the top):

1. Companies are flush with cash due to great pricing, and/or high commodity prices. Earnings and price momentum is also superb, and everyone is happy. Most companies can't decide what to do with the excess cash - dividends, stock buybacks?

2. Customers begin letting rig contracts roll over as high day rates and service costs cause exploration to be less economical. Smart money starts to exit positions, while the economy weakens a little bit and demand for the commodity drops due to high prices.

3. Rig utilization and day rate declines start to show up in official reports as capital budgets of customers are cut back due to a further drop in commodity price, possibly due to an unexpected dip in demand. Smaller Exploration and Production companies cut back almost immediately as cash flow decreases. The larger independents swear that they will "drill through the downturn." Integrated oil companies adopt a wait and see attitude due to more diversified cash flows, secure balance sheets, and a more disciplined capital program. Stock prices begin to flatten and even decline in some cases.

4. Sell side begins marketing push to prop up stock prices in the sector during conference season, claiming that "valuations are compelling."

5. Stock prices weaken materially as the sell side begins to cut earnings estimates and commodity price assumptions.

6. Extra supply of oil or natural gas hits the market due to the high level of drilling activity in the preceding 12-24 months. Commodity price weakens further, leading to another round of estimate cuts. Stock prices “fall off the cliff.”

7. Sell side throws the towel in on the sector.

8. Utilization and day rates plunge as contracts rollover and are renewed at lower rates or not at all. Industry starts “cold stacking” rigs. Majors begin cutting capex budgets.

9. Commodity prices bottom and industry bumps along the bottom for six to twelve months as malaise sets in over industry. Drilling falls to an all time low. Late cycle companies (international and construction) see earnings peak.

10. Commodity prices begin to strengthen as demand recovers and little supply is added due to a lack of drilling.

11. Rigs begin to be put back to work again as cash flow improves. Day rates and utilization inches up.

12. Debate erupts as sell side breaks into two opposing camps: (1) Time to invest or (2) Is it too early?

13. Cycle is in full upswing as more rigs are put back to work which leads to increasing day rates for drillers and pricing power by service companies. Commodity prices strengthen further.

14. Majors begin to announce increases in capex budgets.

15. Companies start to beat earnings estimates, and momentum money gets into the stocks.

16. “Boom” mentality takes over in the industry. First articles are circulated claiming “we are running out of oil and/or natural gas.” Alternative energy companies begin to get a lot of press and attention.

17. Federal government announces “Energy Policy.”

18. Go to number 1.

So the two questions I have are - Where are we now in the cycle? And is it different this time?

What is a Value Stock?

I was talking to some one in the business the other day and they asked me if I owned any Energy stocks. My first instinct was to shudder in horror. Energy stocks value? At the peak of the cycle? After 5 years of unbelievable outperformance and with commodity prices higher than ever? And then I started to think about it and realized that value has a very slippery definition.

Value is one of the words like “beautiful.” Everyone has his or her own perception of what beautiful is. So just like the old cliché “beauty is in the eye of the beholder,” so to the definition of what a “value” stock is, is in the eye of the beholder. There have been times where I have looked at quarterly reports from mutual fund companies that are dedicated to value investing and just shook my head in wonder. How could that stock be a value stock? And then I would remember what a great long-term record that manager has.

Here is a theoretical argument about what value means in terms of Energy stocks. Let’s say that you are a believer in the theory of peak oil. I don’t want to get too deep on what that means so here is a good web site if you want to really get into it:

http://www.hubbertpeak.com/

It basically states that the world is at or near its peak in terms of oil production, and we will soon see declines in that production. Since demand is rising due to global industrialization, this mismatch will cause a major step up in prices, etc.

Now if this comes true, and I am not passing judgment on this argument right now, doesn’t that mean that all those oil reserves on the balance sheets of the integrated oil companies and the exploration and production companies are vastly undervalued by the market? That would make them “value" stocks then I guess. If the market is valuing these stocks based on long term prices of oil at $30-$40 but the long term price will be twice or triple that, then owning those stocks is certainly a value play.

Now the stereotype of a value stock is one that has been beaten up in price, the fundamental outlook has deteriorated and most investors generally scorn the stock, but what if that is too narrow a way to look at the issue.

I am not making a call on loading up on Energy stocks mind you. I just wanted demonstrate theoretically how a market darling group like Energy could be viewed as "value."

Howard Weil

So I’m heading down to the Howard Weil conference in New Orleans. I’m passing Laurel, MS right now. This will be the first time I am attending as a hedge fund manager rather than a stodgy old long only investor. Do I think there are any bargains in energy? Not really. The OSX just broke through 200 recently, still below its high of 240 but no bargain either, especially after one company after another misses guidance – with HAL and NBR being the latest. They certainly aren’t value stocks.

So why am I going then? Well aside from the sumptuous food and drink, I feel like I am getting a little out of touch with the market and what is going on. Now this might come as a shock since I do despise the sell side but they are good at providing information and getting clues as to professional investor psychology. This may be of limited use as most of the positions in my hedge fund are too small or esoteric to be covered by Wall Street.

Another first for me is that I don’t have any one on ones set up at the conference. These are meetings with management that are the true purpose of the conference, as the presentations are just holding pens for institutional investors in between meetings.

I also tried to no avail to set up a meeting with the Biloxi Marsh Land Company (BLMC). I emailed them several times and called once but was ignored. It’s too bad because the company continues to fascinate me. Aside from its acreage position in Louisiana, the company has several cryptic entries on its balance sheet, i.e. short term and long term investments that may be carried at historical cost.

They also have some relationship with the Lake Eugenie Land Company (LKEU), another pink sheet company that is even more obscure than BLMC if such a thing is possible. I can find nothing on the Lake Eugenie Land Company, not even a market cap.