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-- Posted Thursday, 10 June 2010 | | Source: GoldSeek.com
When folks want the straight goods on the oil and gas sector they go to Oppenheimer's sage Managing Director Fadel Gheit. That's what we wanted, too, when we asked him to spend some time with The Energy Report. In this upfront interview, Gheit rails against government inaction on oil price speculation and predicts low gas prices will soon lead to more M&A activity. Gheit's market commentary is frank and insightful and could certainly impact your investment decisions.
The Energy Report: The oil spill in the Gulf of Mexico (GOM) continues to get daily headlines. Is the spill affecting the oil price or only the prices of companies with exposure to the Macondo accident?
Fadel Gheit: The spill really did not have any impact on oil prices. Oil prices are basically reflecting increased concern about global economic growth and China slowing down its economy; Europe is obviously having problems with the bailout of Greece and the expectation of bailouts for Portugal and even Spain. That casts a shadow on global economic growth and therefore demand for oil is likely to be a lot lower than earlier forecasts. That's why oil prices came down from $86 to $70. The Gulf incident really did not have any impact.
TER: You were on MSNBC the other day talking about supply and demand fundamentals in the oil price. In another piece you said that some of the big financial players like pension funds are manipulating the oil market. Can you tell us how that works and what sort of role this price manipulation is playing in the oil price right now?
FG: I truly believe that speculation is driving or has driven oil prices in the last four or five years. Congress believed it too that's why there were hearings. I testified before Congress on that subject. The CFTC (Commodity Futures Trading Commission) chairman, who is a former partner of Goldman Sachs, believed exactly what I believe. The question is can we get Congress to really limit speculation by financial speculators. That becomes a tall order because of politics and lobbying and all these sort of things. I believe that if we put limits on commodity trading by non-principals—basically the financial players—I think you are going to see little volatility. I think you are going to see the restoration of supply/demand driven markets instead of future speculation driven markets, which we have right now and have had for the last five years.
TER: Do you believe the government will step in?
FG: I'm not sure. Elizabeth Warren, who is overseeing financial regulation in Washington, said publicly that the financial lobby and the financial industry is extremely powerful. Basically, when there are bought politicians on both sides of the aisle it becomes really difficult for Congress to push through this kind of regulation. The fact is even the CFTC chairman could not convince Congress to impose restrictions because his own staff shut him down. I am not hoping for change.
TER: Are you saying that consumers can expect artificially inflated oil prices for the foreseeable future?
FG: It's not only in oil prices. We've seen it in real estate and look what happened—we had the financial meltdown. We're seeing it in commodities because of knee-jerk reactions, because of misinformation, because of a lack of government regulation. It's sad but this is the environment we live in. Government is either incompetent or corrupt and they put us in debt as a result. Like I said I'm a realist; I don't daydream a lot. If we believe that we are going to have (oil price) regulations, then we will be daydreaming.
TER: In your view what should the oil price be?
FG: Theoretically speaking, in my calculations I don't see oil prices justifiable above $60. There is an old rule called the one-third rule. Basically the replacement cost should be about one-third of what the oil price is. Right now the industry replacement cost is less than $20, so the commodity price should not exceed $60. This rule has been in place for 30 years and we haven't really changed much. Actually a company like Occidental Petroleum, they limit the replacement cost of a barrel of oil to 25% of what they think the price of the commodity is likely to be. Having said that, they'd love to see $80-$90 oil but they'd like to keep the replacement cost under $15.
TER: What is Oppenheimer predicting for oil in the next six months and then the next 12 months?
FG: We really don't predict too much because if you play the game by the rules and everybody else is cheating you're guaranteed to lose. I don't enjoy losing so in our income model we tell people what we fear and what we think. When we do our earnings estimate, we basically link our benchmark to whatever the NYMEX is telling us. If the futures index is telling us it's going to be $80 next year, we use 5% discount on that number. Right now we're looking at oil prices on average to be about $77 this year and about $80 plus dollars next year.
TER: How do investors profit from $75-$80 oil?
FG: There are a couple of things. Stable or lower oil prices will always favor larger companies, but if oil prices or natural gas prices increase significantly for whatever reason, whether through speculation or market events, investors usually flock into the stocks of the independent oil and gas producers because they have a higher beta. On the way down they decline the most and on the way up they gain the most. So I'm still very bullish longer term on domestic oil and gas producers.
TER: What do you see happening in the domestic oil and gas producer space?
FG: I think two things will take place. The survivors will get bigger. They will acquire smaller companies. Apache is buying Mariner at a decent premium, but they will extract good value out of it. I'm very surprised that we have not seen more mergers and acquisitions. If natural gas prices remain close to the current level and oil prices don't go much higher, I think we are going to see a lot of pressure on the smaller companies that have been waiting for a very, very big payday that might not come. These companies will probably settle for a lot less than what they had in mind; we are going to see a lot of mergers and acquisitions. As a result the independent oil and gas producers are very ripe for the picking by larger companies, whether domestic or international. And, as I said before, that will create value. These smaller companies have real growth. The larger companies have little or no growth. So I still like the oil E&P (exploration and production) stocks. I think this is the future. Investors are basically thinking the same way.
TER: Are there any high percentage takeover targets that you're looking at?
FG: Companies don't buy other companies for one or two reasons; they want to see the best fit. They look at value, not necessarily what they are paying for the company. I mean one plus two should not be three. It should be 3.5 or 4 or even 5. Then you're creating shareholder value. I would say most if not all the independent oil and gas producers are potential takeover targets. It's unrealistic to think all oil E&P companies are going to be taken over. Probably 10% of the independent oil and gas companies—if oil and gas prices don't move much higher from the current level—are likely to be acquired over the next couple of years.
TER: Are we more likely to see takeovers of onshore E&Ps? Offshore E&Ps? E&Ps in the oil sands? E&PS in the Bakkens? What's the focus going to be?
FG: The consolidation onshore is going to accelerate because I don't see any real spike in natural gas prices any time soon. It's going to be survival of the fittest. We are going to see consolidation in the major and unconventional plays whether the Bakken Shale in North Dakota or the Marcellus in Pennsylvania or the Eagle Ford in Texas or Haynesville in Texas and Louisiana. Timing will depend on where the commodity prices are going to be six months or a year from now.
TER: You see most of the consolidation in the gas and shale plays?
FG: Yes, because this is the area where people were betting on higher prices that never materialized. Most of them are beginning to think realistically. I mean don't hope for $10 gas because it's not going to come any time soon. You have to readjust your valuation of your assets so you're most likely to accept a much lower bid than you had in mind.
TER: What sort of models are you using for the gas price?
FG: Almost everybody thinks that gas prices at best will reach $6 in two or three years. Might even reach $7 but that's about it. Any higher prices would bring more supply because everybody has perfected the technology—everybody. This is no longer an exclusive, private club. The smallest of the companies drilling in Haynesville or Eagle Ford or wherever can do a better job than the largest player in that play. If prices rise, supply is going to come at much faster rate. The market will have to reach an equilibrium. Every time we see higher prices, you're going to see more production. More production will bring the price back down and so forth. The $5 to $7 range is probably good for the next four, five, six years.
TER: A recent Oppenheimer report stated that replacing reserves at competitive costs is by far the biggest challenge facing oil and gas-producing companies. To what extent does this make secondary oil companies more likely to be takeover targets?
FG: This is the basis for our thesis that there are fewer and fewer areas for the large companies to go. National oil companies have taken over. They are no longer in the passenger seat—they are doing the driving. The oil companies basically serve those companies. Nationals want to pick their brains of the oil companies and give them whatever.
TER: Why is that?
FG: Because there is no access to large resources anywhere in the world. Russia is learning very quickly. Five years ago they were inviting every company to go over there and invest a lot of money. They learned the game. Now they want to play it, so they try to push companies out. Venezuela! The fiscal regime is getting tougher. Terms are getting tougher. The profit per barrel in North America as a result of these changes is now the highest in the world for the large oil companies or for whatever companies. After all is said and done, companies make more money per unit of production in North America than in any of other country.
TER: Are you more bullish on natural gas or oil producers at this point?
FG: You have to recognize the fact that oil is trading at 200% premium to natural gas. It's an undeniable fact. A lot of companies, if they have a choice, will increase their drilling on oil deposits instead of gas. They will keep gas until the price is right and to them the price is not right. Why waste the resource in an overcrowded and oversupplied market? Longer-term I think we should all be more bullish on gas. It's cheaper. It's cleaner. We should have plenty of it. The technology has been perfected by E&P companies and now the big and mighty from all over the world are coming to the U.S. to learn the technology at the hand of the masters. The masters happen to be the small E&P companies. It is really the future of this country. It's a commodity that relative to oil is undervalued and in more abundance now than oil and less political, which is very important. If the blowout in the Gulf of Mexico had been a gas field, we might not be in the mess we are in now.
TER: Are there any thoughts you'd like to leave us with?
FG: I think price volatility will continue. I think it's a shame that the government knows what's going on and either does not want to do or cannot do anything about it. I think market transparency should be the norm, not the exception. I think it's the volatility that really hurts planning and future investment. Companies do not know how to budget if they don't know where gas prices will be a week from now or a year from now or whenever. Unfortunately, financial players can gain at the expense of consumers that have to pay dearly for the commodities that they are using.
Fadel Gheit is a managing director and senior analyst covering the oil and gas sector for New York-based Oppenheimer & Co. He spent six years with Mobil Oil and five years with Stone & Webster. He has been an energy analyst since 1986 with Mabon Nugent and JP Morgan and has been with Oppenheimer & Co. Inc. since 1994. He has been named to The Wall Street Journal All-Star Annual Analyst Survey four times and was the top-ranked energy analyst on the Bloomberg Annual Analyst survey for four years. He is one of the most quoted analysts on energy issues and has testified before the U.S. Senate and the U.S. House of Representatives about oil price speculation, and is a frequent guest on TV and radio business programs. Fadel holds a B.S. in chemical engineering from Cairo University and M.B.A. in Finance from New York University. Streetwise - The Energy Report is Copyright © 2010 by Streetwise Reports LLC. All rights are reserved. Streetwise Reports LLC hereby grants an unrestricted license to use or disseminate this copyrighted material (i) only in whole (and always including this disclaimer), but (ii) never in part. The Energy Report does not render general or specific investment advice and does not endorse or recommend the business, products, services or securities of any industry or company mentioned in this report. From time to time, Streetwise Reports LLC and its directors, officers, employees or members of their families, as well as persons interviewed for articles on the site, may have a long or short position in securities mentioned and may make purchases and/or sales of those securities in the open market or otherwise. Streetwise Reports LLC does not guarantee the accuracy or thoroughness of the information reported. Streetwise Reports LLC receives a fee from companies that are listed on the home page in the In This Issue section. Their sponsor pages may be considered advertising for the purposes of 18 U.S.C. 1734. Participating companies provide the logos used in The Energy Report. These logos are trademarks and are the property of the individual companies.
-- Posted Thursday, 10 June 2010 | Digg This Article | Source: GoldSeek.com
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