Oil on The Matterhorn

May 18, 2000

Crude oil prices climbed the Matterhorn recently -- first with a spike to $25 in late September, then with a precipitous drop to around $20 two weeks later. Even so, the mood in the energy patch remains as upbeat as it has been in years, and not without good reason. For even after the sharp drop, a barrel of oil still fetches twice the price it did at last December's historical lows. Moreover, interest in drilling and exploration is picking up.

To find out whether the trend has legs, we spoke with Steve King, a well regarded petroleum industry analyst and former Air Force Pilot whose PetroDigest goes out by e-mail to 7,000 subscribers each day. King, an oil and gas specialist who spent over 16 years inside the petroleum industry, now works out of Global Resources' Carlsbad, California, office. He also puts out a monthly subscription newsletter, The Black Gold Petroleum Investment Advisory. While he expects petroleum prices to fall still further, he sees that as cause for even more bullishness. Here is why.

 

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Rick Ackerman: Since February, oil prices have doubled and many equity prices have increased. Is it too late for investors to find bargains in the energy sector?

Steve King: Definitely not. But you need to recognize that oil prices alone don't control the performance of oil company shares and that investors need to pay attention to natural gas prices, too. Also, it's not necessarily true that bargain hunting is the most successful strategy. In fact, it can lead the investor into weaker companies. I think it was Warren Buffet who said he would rather buy an excellent company at a fair price than a fair company at an excellent price. That's why I look for companies selling at a fair price but with superior upside potential.

RA: How does the oil & gas sector as a whole look to you?

SK: Taking a medium- to long-range view, it looks pretty solid. Remember that petroleum -- both crude oil and natural gas -- is a large and fundamental part of the world's economy and it has seen increasing demand year after year, even during the worldwide economic slowdowns.

RA: So the long view is the best perspective?

SK: Yes. Despite current excess energy supplies, investors need to look out over the next ten years. During that time, seventy-five percent of today's supply -- equivalent to 110 million barrels of energy per day -- will cease to exist. The beauty of investing in this industry lies in identifying those companies that will replace that supply at a profit. Future commodity price will be set by the cost of the last replacement barrel, and if your company operates below that cost, and if they can capture enough market share, they should make money and so will their shareholders.

RA: Looking at the current market, did anyone expect crude prices to go so high so fast?

SK: I would like to say that my crystal ball worked perfectly, but even I failed to see the speed of the recovery. But remember, crude prices haven't moved to super high values, they have only moved back into what I think is a normal trading range.

RA: What pushed prices so low in the first place?

SK: Crude was depressed by three factors, two of them worldwide events outside the control of any one country or organization. First was the world's economic slowdown, seen most clearly in Asia, although it affected most every country. Then there were the weather patterns over the major consuming countries for the last two winters. The slowdown seems to have corrected itself, and most people think the second will disappear this winter. Now, the reversal of these two events alone would have moved crude prices up, but the third gave it speed.

RA: What was that?

SK: Saudi Arabia's successful attempt to install some discipline within OPEC and to include non-OPEC producing countries in the cartel's strategy.

RA: The Saudis had been struggling for years to regain the upper hand, but with little success. What tipped the balance in OPEC's favor?

SK: Saudi Arabia was successful partly because the first two events helped drive home the point. Conditions last spring were pulled so taught that crude snapped back faster than many expected. Having said that, I want you to understand that prices came back to where they probably should be, and I don't expect them to go higher. Actually, I expect lower prices in the short and long run. And that is good for the investor.

RA: Come again? How could lower crude prices be good news for the energy sector?

SK: High prices attract too many novice investors. They are encouraged by a Wall Street mentality that seems to focus only on crude prices. Also, a further increase in commodity prices will lead to another crash as OPEC members start cheating and other non-OPEC countries add marginal production. Steadily lower prices on the other hand will cause the weaker companies to fail -- and that, combined with improvements in exploration and production technology, will help the better companies increase their market share and make a profit.

RA: Your thinking goes against the grain of what I've been hearing.

SK: I am not suggesting that commodity prices will re-visit the extreme lows we saw at the start of the year, I am only suggesting that we will not see the extreme highs and that over time prices will go lower. If I am wrong and commodity prices go higher, so what? The weaker companies might survive, but why not own the better companies? If I am right, the investor who didn't heed the warning will get hurt and my clients will reap the rewards. It's a perfect environment for fundamental stock-picking, something I am convinced is in short supply on Wall Street. North American crude discoveries get smaller each year, and domestic companies have to be able to survive in that environment. That means the smaller, leaner and meaner companies should do better in North America than the larger companies. The real upside potential is in the international sphere, where larger reserve sizes can drive the economics regardless of price.

RA: Earlier you said investors should pay more attention to natural gas supplies. Why?

SK: Unlike crude, I see increasing commodity prices for natural gas. Crude is a worldwide commodity but natural gas is now a regional commodity. For example, North American production serves North America. In North America the operating environment is one of decreasing discovery size but increasing commodity prices, and this will continue until North American prices rise to a level supporting LNG [liquefied natural gas] imports. That is very favorable to the mid-sized companies, most of whom are really domestic natural gas companies with upside international crude exploration opportunities. The current environment is also very favorable to the junior exploration and production [E&P] companies, since the majors long ago abandoned domestic exploration, leaving it as an expanding niche for the independents. There are many good companies working here that can look forward to higher prices.

RA: What about natural gas in other parts of the world?

SK: There are other developed markets in the world, but each has unique characteristics. Western Europe depends on high-cost North Sea gas or on politically risky gas from pipeline systems into Russia or across the Mediterranean to Libya. Japan and Korea rely on LNG from SE Asia, but new supplies might be brought in from Eastern Russia. New Zealand has its own supplies; Australia has a pipeline running as far as Papa New Guinea. There are smaller developing systems to Singapore and Bangkok that look economic for the producing companies. However, two obvious local markets still don't have enough demand to justify major project investment. These are India and China.

RA: How do prospects look in those two countries?

SK: Investors need to be very careful when looking at companies with natural gas projects outside of strong-demand markets. I don't care how great the geology and reserves look, if they can't sell the gas at a profit tomorrow it isn't worth anything today. It may be okay for the majors and large independents to invest minimal dollars to stake out a position and wait for demand, but the junior company doesn't have the staying power to play this game. This project will be a money-burner, not a money-maker.

RA: Let's move on to the types of companies you evaluate. Could you describe them in general terms?

SK: I think too much effort is spent on predicting the commodity price and not on picking the best company. Remember, someone will fill the demand, and if your company can find more at a lower cost, it will grow as the weak company withers. My goal is to find those companies.

RA: How?

SK: I divide companies into four groups. First, there are the large integrated companies that are primarily focused on crude but which have large natural gas reserves. Second are the large independents, primarily focused on natural gas but with some interest in crude. Then there are the domestic juniors, primarily exploring and producing natural gas. And finally, there are the international juniors, looking for crude.

RA: How do you evaluate them?

SK: The integrated companies I don't evaluate. I've learned that Wall Street can move the share price -- often for unknown reasons -- in a direction opposite from where I think it should go. I do not like standing in the path of moving trains. The large independents are not as well covered by Wall Street, so fundamental analysis works here. Good-news events, such as a major successful project, can reward such companies and their investors. These companies make up my core recommendations because they are real, and that's a plus when -- not if -- commodity prices go down. I also love to generate extra returns by writing covered calls on companies I own and covered puts on companies I want to buy at lower prices.

RA: Moving through your list, what about the domestic juniors involved in natural gas?

SK: They are not well covered by analysts, and often they are not covered at all. These companies represent the higher reward-to-risk investments over the medium-term. Most are companies that pursue growth with the idea of becoming larger independents, but more often with the goal of being acquired.

RA: And the international juniors?

SK: They offer the highest level of reward-to-risk and have the longest time frame as investments. Their game plan is to be acquired or have their projects acquired, and they often act as the pilot fish for the integrated companies.

RA: Okay, Steve, let's not keep the readers in suspense. When you've done all your filtering, screening and sifted the results through a fine mesh, which companies look like standouts?

SK: Fair enough, but I want you to understand first that a company may be on my radar screen but could still be pricey relative to the value of its proven reserves, plus cash less debt. Let me also emphasize that events may change by the time this interview is published, and investors paying any price for these companies could be disappointed.

RA: Okay, fire away!

SK: A couple of larger independents I like include EOG Resources, Inc. [EOG; NYSE], Burlington Resources, Inc. [BR; NYSE], and Santa Fe Snyder Corp. [SFS; NYSE]. Both have recently undergone major business structural changes, EOG [formally Enron O&G] separating from Enron Corp. and Santa Fe merging with Snyder. I don't think Wall Street has a proper handle on either. I also like Newfield Exploration Co. [NFX; NYSE], a company that I helped found ten years ago.

Some domestic juniors I watch include Evergreen Resources [EVER; NASDAQ], a coal bed methane producer that is close to being a large independent, Titan Exploration Co. [TEXP; NASDAQ], Comstock Resources, Inc. [CRK; NYSE] and Hegco Canada [HEG; Alberta], which actually operates in Oklahoma. All have a strong focus in their own back yards, using advance technology, which I like. In Canada, I like KeyWest [KWE; Alberta], which is a recent start up by a management team that has built two companies before; Berkley Petroleum Corp [BKP; Toronto], Encal Energy [ENL; Toronto and ECA; NYSE], Beau Canada Exploration [BAU; Toronto] and Canadian 88 [EEE; AMEX and EEE; Toronto], which I consider a higher-risk stock. The Canadian companies have an additional upside from a gradual shift in the source of North American gas to Canada, which hasn't been developed to the same extent as the lower forty-eight.

RA: Any others?

SK: A few international juniors include Harken Energy Corp. [HEC; AMEX], despite a recent disappointing well; FX Energy, Inc. [FXEN; NASDAQ] and Gentry Resources [GNY; Toronto]. Harken has the largest upside but higher risk in Colombia. FX is unique with large concessions in Poland being explored by Apache at Apache's 100% cost. Gentry is a cross between a junior domestic producer in Canada and an international explorer backed by Rothchild money.

RA: What about the drillers and service companies?

SK: I don't evaluate this sector for several reasons. First, there are far more companies in my area than I could possibly cover. My degree is in geology, not engineering, and my industry training is in E&P, not in the service and drilling sector. Another reason is that, when Wall Street begins to talk about "oil companies," they usually mean the oil service companies. The Wall Street focus is exactly the reason I do not want to play here.

RA: What is the best way for investors to evaluate individual companies, given the global nature of the industry and the sometimes sharp fluctuations in commodity prices?

SK: Well that's the sixty-four thousand-dollar question, isn't it? First, forget about chasing the one big discovery. That's the path to losing money. The oil and gas business is a cumulative game of drilling enough wells to grow your reserve base without too many dry holes while at the same time investing fewer dollars than the discovered reserves are ultimately worth. The main difference in looking at an oil and gas [O&G] company compared to, say, a manufacturing concern is the O&G company's main asset and source of future revenue is proven production in the ground. This is a limited asset, which generates less and less cash flow as the production undergoes natural depletion. The manufacturing firm's revenue source is the manufacturing process or plant. With maintenance, this shouldn't deplete. This means the Wall Street method of measuring historical performance and projecting that forward at least has a chance of being right. But using that methodology with O&G companies doesn't work.

RA: Is it because the assets they hold and the assets they are trying to find will usually have different values?

SK: That's part of it. When evaluating O&G companies, you want to list them based on their ability to find value, but you want to decide what to pay for their shares based on the value they have already found. My analytical methods are summarized in what I call the "Four Points of Light". I don't think we have time here to explain each point in detail, but anyone who wants a copy of the article can send a message to me at my website.

RA: If you spell it out for me and I'll pass it along to Real Asset Investor's subscribers.

SK: http://www.petroinvest.com, or they can call my office at 800 477-7853.

RA: Okay, now they can find you. To return to your stock-picking methods, doesn't the value of today's production mean that the companies are worth more than they were when petroleum was selling at half the price? And do the companies trust current prices?

SK: I think the companies share my long-term view of prices when they are planning future projects -- at least they better be. Companies that require high prices to justify projects will be in real trouble when -- note that again I do not say if -- prices take another dip. It is during the dips when the better companies get better and the weak get washed out. Even today, with higher prices, there are many walking wounded that are best avoided by investors.

RA: What about companies soliciting investors for limited partnership or direct-participation programs?

SK: This is an important part of the O&G investment landscape but historically one of the most abused. I think a good program can be one of the best investments certain investors can make with the risk portion of their portfolio, but again, the question is which one. Let me say that I am currently looking at this industry segment with the goal of finding one or two that I can recommend to my clients, Most likely, the program I select will have to negotiate a special program for them. This will be absolutely necessary to correct a few major problems I see in most of the programs.

RA: Such as?

SK: First, I want all profits to be captured after payout of the program. This includes sales commissions, management fees or anything else that equals profits. Everyone -- meaning investors, brokers, organizers, and the operating company -- needs to look for profits only after costs are recovered. Second, I want to have solid audit capabilities. Investors need a way to determine whether their trust in an operator is justified. The only way to do that is with auditors working for the investors. Third, I want to have approval authority over critical geological decisions. The direct-participation program has to be treated as an industry partner, not as a captured money pool.

RA: What role does advanced technology play when you analyze oil and gas companies?

SK: The key to new technology is smart people using it to best advantage. Technology by itself will not make a company successful, but it will allow good companies to make money even with lower commodity prices. I look for companies with technical staffs trained in and applying the new technologies, which are readily available from the service industry. Finding more for each dollar spent, or finding the same amount with fewer dollars, is the key to success and should be the focus of the investor's evaluation.

RA: Speaking of focus, I get three or four e-mails a week from oil or mining companies eager for my attention, as I'm sure you do. How do you separate the producers from the promoters?

SK: Industry hype is one of my pet peeves. Part of my sensitivity to hype no doubt comes from my industry background, but another part comes from the same common sense most of your readers possess. A common problem is one-sided reporting. For instance, consider the typical report about increased production and cash flow. I want to know what it cost, and was it economic. Are there enough facts to sink my teeth into? If a company deliberately avoids including logical parts of the story, it makes me suspect that part of the untold story was not good news. Even companies going out of business can generate an upbeat press release. Another press agent's trick is to report projections of upside potential as if this were value today. If we're told that a well has reached total depth, and then that it has the potential to produce gas at rates in excess of 'x' million cubic feet per day, that is hype. "Potential production" implies additional operations and risk dollars before we know if that production is there.

RA: What's the best way for an investor to learn more about the energy sector?

SK: For starters, read everything they can get their hands on. They should also attend investment conferences and seminars. The key is to be skeptical and challenge the source of the information. It's your money and your investment, so don't just be a nice guy. After a while, your knowledge base will build up.

RA: You put out two newsletters yourself, don't you?

SK: Yes, The Black Gold Petroleum Investment Advisory is a monthly letter that was launched last year and now has a subscriber base in the hundreds. The other, PetroDispatch, is available free by e-mail and reaches an estimated 7,000 readers each day. There is information about both at the Web site address I gave you earlier.

RA: You'll be speaking at the upcoming investor conference in San Francisco. Perhaps some of our readers would be interested?

SK: For any investor who wants to learn, it's a great place to start. The Western Investment in Mining Conference will be November 22-24 at the San Francisco Marriott, and your readers should call 800 282-7469 and mention Black Gold for a complimentary admission ticket. There is more information about it on their Website and you can register there also.

RA: And the address?

SK: The URL is http://www.iiconf.com

RA: Thanks, Steve. Don't be surprised if some readers of Real Asset Investor introduce themselves. And thanks for a very enlightening interview.

SK: My pleasure.

The purity of gold is measured in carat weight.

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