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Clouds and Facts on ConocoPhillips
by Henry Lu
Feb, 2007
Rocky Start in 2007
Oil and natural gas stocks had rocky start in the beginning of 2007,
particularly for the big cap
stock ConocoPhillips (COP), which lost 10% in first 2 weeks of the
year.
Oil stock COP is so cheap that it remain big
bargains in US stock market. It is trading around PE of 6
on after tax earning basis.
Abnormally Mild Winter in Northeast was the Direct Cause for
Oil/Gas Sell off
Northeast of US is the main region for US consumption of heating oil
and natural gas. Northeast's current winter weather has been
abnormally mild. There was no snow in December of 2005 in
Northeast. This never happened for the last 100 years. The first half
of January of 2007 was mild winter as well with no sign of snow in any
area of Northeast.
Due to the weather-caused over-supply of heating oil and natural gas,
natural gas spot price dropped from $8 MMBtu in December of 06 to $6
MMBtu in January of 2007. Oil price also dropped sharply from $75 a
barrel in summer of 2005 to current $53 per barrel out of fear of
increasing US inventory number and fear of over-supply.
Unknown Inventory, Smoothing out Weather
The oil and gas bears tend to point to increasing US oil inventory
number and mild weather as basis for the death of oil and natural gas.
"Inventory checking" was a method used by Peter Lynch and many others
on cyclical stocks in semiconductor sector or other sectors.
Increasing inventory is typically a sign of over-supply and start of
bear market.
While weather and inventory will inevitably cause volatility on oil and
natural gas price, it is wrong to use these data as basis of the
long term analysis in our opinion.
Oil
Weather is the main reason for short term oil inventory built-up in USA
because Northeast's heating oil consumption is the big swing demand
factor in winter. However, oil is not just for heating (through heating
oil), it is diversified energy source for transportation, industrial
use across all the sectors. Essentially, the demand for oil is
economy driven. As long as the economy is growing, the oil demand will
grow year over year.
Further more, it is wrong to check only US oil inventory level. Oil is
global commodity, and oil can be easily shipped from one
continent to another to solve local shortage issues. It is impossible
for US to have long term over-supply of oil if oil is in shortage in
global level. Therefore, to assess supply and demand on inventory,
investors have to check global inventory level in Europe, China, India,
Africa, Middle East, Latin America as well as America. The global
oil supply is mainly from sources outside US, the inventory volume of
USA is negligible compared to total supply and demand volume of oil in
the globe. Unfortunately, many countries will not report their
oil inventory level for various technical or security reasons.
The truth for oil inventory is in fact "unknown" while stock market and
Wall Street analysts are acting as if they know what is happening on
inventory. They are in fact trading on UNKNOWN
information.
There are known information out there on oil. International Energy
Agency reports global supply and demand on oil at its web site at: http://omrpublic.iea.org/
China,
the world second largest consumer country reported 14.5% jump on oil
import in 2006. US government agency EIA also projected US
oil 0.2% annual supply growth and 1% annual demand growth for next 25
years. All the known information and signs are pointing to
continued tight market for quite long time.
We only invest based on the known information, not on the unkown
information such as inventory. We are against using information of US
oil inventory number out of proportion.
Natural Gas
Weather is the sole reason for recent weakness in energy
price
and inventory build up in coal, natural gas. On the historical basis
over the long run, electricity demand and gas demand was not related to
weather because weather factor typically smooth out in the long
run. Therefore, we typically will not see any expert long term
natural gas or oil projection based on the weather factor.
In the short term, weather effect on coal and natural gas is huge due
to weather volatility. Inventory change on natural gas largely reflect
on weather volatility in USA. Because natural gas can not be
easily transported outside USA, natural gas market in North
America remains closed local market, not a global market. Over the long
term, weather will largely smooth out in average so that the net effect
of extreme or mild weather on supply and demand of natural gas will be
canceled out in the long run.
The natural gas business cycle time frame is much longer than weather
caused inventory change. My investment approach on energy is
mainly on the longer time frame in multiple years time frame,
therefore, we do not trade on the volatility of weather.
This long term cycle time and weather volatility is the main difference
between energy and other cyclicals such as semi-industry stocks. Nobody
knows whether those huge inventory of semi conductors can be used in
next cycle. Mostly, inventory of semi conductors are useless
items. But energy is stable business beyond weather issue.
Natural gas, coal, oil inventory can be sold in next year for sure.
Most likely, weather will smooth out in long time frame, this long term
weather smoothness is "mother nature" as well.
Because our investment thesis is on long term basis, we do not believe
inventory or weather changes fundamental of natural gas in the long run.
Critics on ConocoPhillips
ConocoPhillips (COP) is $105 billion
big
cap company and Warren Buffett is its large shareholder. Never the
less, there are quite lot of critics against this stock.
Table 1 - % of OECD oil
fields,
source: Dec 18 issue of Barron's magazine, title "Big Bargain"
Company
|
%
of OECD oil fields
|
ConocoPhillips
|
70%
|
BP/Chevron
|
40%
|
Mobile
Exxon
|
55%
|
Note: OECD countries are list of countries mainly in
Europe/North America, which are typically called "Western Countries".
Table 1 showed that COP has significantly more mature oil fields in
North America and Europe than its competitors. This is one argument
against COP because critics argued that mature oil fields have higher
cost.
Disclosed by Barron's article's, COP CEO Mulva replied that critics
underestimated technological power to extend the mature oil fields
operational life, and underestimated the political risks outside North
America and Europe.
We agree with CEO Mulva's argument disclosed in Barron's magazine. In
addition, our argument is that mature oil fields do not correspond
automatically to higher cost. We believe the critics on the cost issue
against COP are wrong.
Cost of COP Compared to Other Major Oil Firms
Table 2 - Cost Comparison
on
Major Oil Firms
Company
|
PE
|
Market
Cap
|
Revenue
(2005)
|
Operating
Earning
(pre-tax)
|
Operating
Earning /
Revenue
|
BP
|
9.6
|
$213 billion
|
$245 billion
|
$32 billion
|
13%
|
Chevron
|
8.9
|
$153 billion
|
$198 billion
|
$26 billion
|
13%
|
Exxon
Mobile
|
11
|
$424 billion
|
$371 billion
|
$61 billion
|
16%
|
ConocoPhillips
|
6.1
|
$105 billion
|
$183 billion
|
$24 billion
|
13%
|
Table 2 showed the current cost comparison for 4 major oil firms. The
percentage of operating earning over revenue can be used as a benchmark
on the overall cost structure. On this cost benchmark,
ConocoPhillips
has same cost level as those of BP/Chevron, and has slightly higher
cost than that of Exxon Mobile.
COP has significantly higher mature fields than Exxon or BP/.Chevron,
but certainly the cost of COP is not higher than its peers. Table 2
proves our point that COP cost is not higher because of mature fields.
So why does Wall Street critics use such invalid claim against COP?
High Cost that COP does not Incur
Oil E&P business has 2 kinds of cost.
(1) Operating cost on existing reserve, and existing wells. This cost
is predictable and it is getting better with technology. This is one
point of CEO Mulva argument in Barron's. This part of COP cost is
consistent, and performance has been very good as shown in table 2.
(2) Exploration and drilling cost looking for new oil reserve. This
cost is the cost to replace depleted reserve, and typically this is not
reflected in table 2 comparison.
The cost of (2) can be further divided into 2 parts. first is high
flying service/rig cost. The second is cost of high failure rate in
mature area. Therefore, the root of high cost is raw material inflation
as
well as ever challenging geology.
It is extremely costly to drill for
more oil in North America/Europe mature area to find new oil. There
aren't any new oil that can be easily found in North America or Europe
if such new oil reserve exist somewhere. Therefore, spending lots of
money trying to find something close to impossible is going to end up
with high cost with little results.
However, because COP does not do aggressive drilling, therefore, there
is no (2) piece of cost burden. This (2) high cost argument is not
valid for COP because COP is not trying or planning to spend huge
dollar amount to find new oil in mature area. This is trying to blame
COP for high cost that it does not incur.
Advantage of COP over its Peers
This disadvantage of COP blamed by many Wall Street analysts is
precisely the advantage that stock market does not see today. It is far
safer to invest in Europe/North America for same amount of oil profit
than investing into other area with greater political risk. Today'
stock market on oil stocks has irrational measure of risk: it is
cheaper to invest into OECD oil stocks today than investing into
Russia/Africa oil stocks. North America oil stocks COP is cheaper than
politically riskier stocks XOM/BP/CVX. Even more extreme, non-US oil
stocks trading in London and US (such as Russian oil stocks) have
higher PE ratio than American oil stock COP. This is opposite to
historical stock valuation (or today's valuation in non-oil sector).
This is non-sense perception of safety in oil stocks today.
My strategy in oil/gas investing preference is on the opposite of
stock market stock today. We mainly want to invest into North
America/Europe oil/gas stocks at lower valuation. COP is mainly a OECD
oil/gas E&P and
North American refining stock. We precisely go against stock market on
the safety issue. It is far safer to invest into OECD oil fields than
into oil fields sitting in some politically unstable, or even war-torn
places.
COP is better deal. We gets an oil investment focusing on safer
political environment at cheaper stock valuation.
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