Strategy and value in oil and gas markets

As long as there is no military conflict in the Gulf, Brent is overpriced at $115 and has potential downside to $105-108.

It is ironic that Brent crude soared by $25 since its recent $90 low in June even though Europe is on the brink of recession and Asian industrial demand continues to plummet led by the GDP slowdowns in China and India. Geopolitical risks in Syria have escalated and the oil market also expects a supply shock if Israel-Iran tensions lead to a war, the reason the Brent one year forward curve has steepened. The collision between a US Navy Fifth Fleet destroyer and an oil tanker in the Gulf has only exacerbated the nervousness in the physical oil markets, particularly as sanctions have led to a 20 per cent fall in Iranian exports.

Supply shock risk has also been amplified by disruptions in the Iraqi pipeline networks after disputes on the Petroleum Law with the Kurdistan Regional Government. Maintenance shutdowns in North Sea oilfields and BP’s seasonal pipeline network shutdown have also led to buying in the Brent-West Texas spread and global hedge funds have gone long on oil futures since they expect the Bernanke Fed and the Draghi ECB to lean towards easy money to hedge global deflation risks.

The oil market is also convinced that Saudi Arabia will restrain its own output since the kingdom needs a breakeven price above $100 to implement its $138 billion public spending and social welfare programs. As long as there is no military conflict in the Gulf, Brent is overpriced at $115 and has potential downside to $105 – 108. At these levels, investors could well consider strategic trades in the world’s leading oil service colossus in the 64 – 66 range or Occidental Petroleum (an equity stakeholder in the Dolphin Project), a major operator in Qatar, Iraq, Abu Dhabi and Libya. A far less volatile value share is French supermajor Total SA, whose depository receipts (ADR) in New York trade at seven times earnings and offer a 5.62 per cent dividend yield. After all, the ten year US Treasury note yields a mere 1.60 per cent and, unlike Total, does not offer 5 per cent growth. Caveat, I believe Brent is currently overpriced and would only consider energy shares if Brent falls to $105 – 108.

Halliburton has been one of the world’s most controversial oil and gas service companies in the past decade, since its former CEO was former US Vice President Cheney and its Kellogg Brown Root (KBR) faced lawsuits related to inflated contracting overruns for the Pentagon in Iraq. Yet Halliburton is now a pure play oil and gas service firm as it long spun off KBR in an IPO. It trades at a valuation multiple of 10, almost 50 per cent below its rival Schlumberger and has huge growth potential in reservoir management, deepwater drilling and natural gas outside the US. This is the reason Halliburton moved its global head office from Houston to Dubai. I believe Halliburton shares, if purchased at 28 – 30, have 50 per cent upside in the next twelve months as Wall Street rerates its embryonic international business.

Apache Petroleum (symbol APA in New York) is unquestionably one of the world’s most attractive and misunderstood oil/gas exploration and production companies, with concessions and assets in offshore North Sea, Egypt, Argentina, Texas, Alberta Texas, Kenya and South America. Apache shares have fallen from 112 last February to 85 now on the NYSE as Wall Street is extremely nervous about nationalisation risk in its Egyptian assets, one fifth of its proven reserves of three billion oil equivalent barrels (BOE).

However, post Mubarak Egypt desperately needs foreign exchanges as central bank reserves are only four months import cover. Nationalisation risk in Egypt is simply not credible, though taxes and royalties on Apache’s concession could well be renegotiated, as is routine in the emerging markets. Apache can well deliver 15 per cent production growth, thanks to its unique onshore production US/Canada and global exploration portfolio. The biggest risk is in Argentina, where the Peronist government nationalised Repsol’s local subsidiary YPF.

Argentina is a marginal franchise but Egypt is mission critical to the future production/reserve growth for Apache. President Morsi’s technocratic Cabinet has indicated that foreign oil and gas companies that are long term operators are welcome to develop Egypt’s energy resources, a vote of confidence in Apache. Apache is a beauty in the 76-78 range as its valuation multiples do no justice to its EPS/reserve replacement potential. Apache is also a takeover candidate for a Big Oil supermajor eager to boost economies of scale in its reserves/production portfolio. In that case, I doubt if the Apache will go below $112. This is a risk reward calculus that is compelling as I drill for oil on Wall Street!

Leave a Reply