Mark Leggett: No Substitute for Oil on the Horizon
Source:The Energy Report 04/08/2010
The Energy Report: Oil is now trading at around $80 a barrel. Is $80 a barrel a sustainable price? Do you expect it to trade higher this year?
Mark Leggett: I think $80 is about the right price, given the current economic conditions. We still don't really have a strong visible demand recovery and we are still sitting on above-average petroleum product inventories. Eighty dollars or just above $80 may be the top end of the range. The average cost to produce a barrel of crude oil globally is above $75. That tells us that the range that makes sense to us on a sustainable basis is $75 to $80.
TER: Do you see us breaking through the January highs?
ML: I don't think so. I think the market is trying to. The only wildcard out there that may try and push oil toward $85, or perhaps higher, is the impact of a weak U.S. dollar. When that is the main story in the market, crude oil does try to push higher. However, the market has to turn back to the fundamentals and it's difficult to see fundamental support at those levels. So don't expect to maintain a sustained higher level.
TER: Where do you see the price of oil at the end of 2010?
ML: I think $80 makes sense. We're carrying $80 as an average price in 2011 and we're being cautious in our outlook and looking for an improvement in demand and inventory levels in the second half of 2011. It speaks to more of an expectation of a modest economic recovery before oil prices move up higher on a sustainable basis.
TER: You said the high-end production cost is $75 a barrel and it's at $80 a barrel. How are these companies surviving?
ML: Just to be clear, $75 includes a 10% economic rate of return on producing that barrel. That’s basically the hurdle rate that the industry needs to make money. Companies can make money at $75 to $80, but if we do see upward pressure on the cost structure, again, over time we do see a rise in oil price—just not yet.
TER: Do you see upward pressure on the cost structure in 2010 or 2011?
ML: Maybe a little bit. It will be up gradually heading into 2011. As you see more confirmation of a sustained gradual economic recovery, that will put pressure on the cost. Over time, we do see cost pressure on producing a barrel of oil, ultimately leading to a higher oil price.
TER: In our last interview with you (Dec. 2008), we discussed oil sands and you noted that because oil prices were down at that point, many companies had scaled back their spending on those projects. Now that the price of oil is back up in the $80-a-barrel range, has there been an increase in those oil sands projects?
ML: Yes there has. We've seen BP (NYSE:BP) enter into two oil sands joint ventures recently and that speaks to the company trying to establish an oil sands portfolio. Also, Athabasca Oil Sands is a private company that's recently announced that they plan to execute an initial private offering. Another major Canadian integrated oil sands company is Cenovus (NYSE:CVE;TSX:CVE). They are accelerating development plans on two of their projects.
TER: If oil sands production was in full swing, how much would that increase the worldwide level of production?
ML: The way we model it is company by company, and add up all the projects' production impact. Given the length of time it takes to bring these projects on stream, it's probably best to look out to about 2015. When we see the bulk of these projects on stream, it would add an increment of 3 million barrels a day of production to the global crude oil supply.
TER: Do you think that would affect the price of oil at that point if we saw that sort of an increase?
ML: No, I think it would be meeting demand. Not necessarily creating excess supply. We do think that non-OECD demand will be strong over time—in particular, China and India and emerging markets.
TER: In addition to the oil sands that you were talking about in Alberta, Canada, are there any other large deposits of oil sands in other parts of the world? If so, are their projects online in those areas?
ML: The other part of the world that does come to mind is the Orinoco Belt in Venezuela. Those projects have recently been nationalized by that government. So the immediate economic impact is a stalled development timeline. Industry now has to renegotiate terms with the government of Venezuela. Usually when you're working with the government's projects, they do take longer to come on stream. That means that while there is other big project potential elsewhere, the timeline is not visible.
TER: Extracting a barrel of oil from oil sands produces more greenhouse gases than producing a barrel of conventional oil. If the current administration in Washington were to clamp down more heavily on greenhouse gases, what effect would that have on all these oil sands projects, or on other oil projects in general?
ML: It definitely would have a negative impact on oil sands producers. It did overhang the market last year and into the early part of this year. Nothing came out of the recent Copenhagen United National Climate Change Conference. That global conference was looking to put an idea on what kind of costs oil sands producers may face.
In terms of what the administration in Washington may be implementing, the market may have tried to assume a similar cost impact on these oil sands producers. As of now, there is no clarity on the environmental impact. That being said, all that will do is just increase the cost of these oil sands projects. That effectively increases the costs of crude oil going forward. As long as there is no tangible visible substitute to meet the petroleum product demand, crude oil will be required from the oil sands. At the end of the day, the environmentalists may be just pushing up the price of crude oil.
TER: Are you suggesting there is no tangible visible substitute on the horizon at this time?
ML: It's interesting to look at the hypothesis of using natural gas. It is becoming very visible, and a lot of respected people in industry are pointing that out. However, when you look at the ramifications of building out infrastructure in places like Pennsylvania, where there are no pipelines or gas plants, it takes a while to build those up. Then more importantly, the infrastructure needed to supply transportation throughout the United States is significant and it will take a long time for that to be put in place. So that day may come, but I don't think that date is visible at this point.
TER: From your viewpoint, should the oil sands from Canada be considered part of the U.S. energy supply because there is no ready substitute for it?
TER: That should be good for those companies.
ML: It should be. Plus you have the various Chinese entities that are continuing to execute M&A transactions to build out their interests in the oil sands. Global oil companies are establishing positions in the play. They see the need for those barrels over time. It confirms demand for oil sands barrels.
TER: Of the companies that have oil sands projects in the works, or maybe just even on the drawing board, are there any that are interesting to you right now?
ML: The ones that we like to highlight are companies with existing operations, strong balance sheets and that have below-average execution risks. The three companies are Canadian Natural Resources (NYSE:CNQ;TSX:CNQ), Suncor Energy Inc.(NYSE:SU;TSX.V:SU) and Canadian Oil Sands Trust (TSX:COS.UN).
TER: And what do you primarily like about those companies?
ML: They all have existing operations that are producing oil sands. As our prior conversations alluded to, the costs of projects in the past have always come in higher than originally budgeted. Sometimes they've been delayed as well. When you have certainty of production and associated cash flows, usually those companies are rewarded with better multiples.
TER: So you tend to not look at the companies that are just in the discovery mode?
ML: You have to be selective and careful. Usually the companies that have existing operations plan to build out additional projects, which will provide that growth element for you. Cenovus is another company that I mentioned earlier that is accelerating development plans on a couple of their projects. Typically, these oil sands companies are always looking to grow their own oil sands production over time. They still do provide the investor with a growth profile and we prefer the risk/reward profile for these types of companies.
TER: As far as extracting the oil from the oil sands, it's a relatively complicated process. It's very energy intensive. Is there any additional work being done in terms of technology to try to find easier and less costly ways of doing that extraction?
ML: You need natural gas to run oil sands mines. Using energy to get energy is a bit of a challenge in itself when the input cost is rising somewhat. Natural gas supplies are up and the price is coming down, and we believe it will be lower long term. That's actually a positive for the oil sands. They're not as desperate to find a different input energy source to natural gas. We'll see over time if industry comes up with modifications to the process. One thing that people tend to underestimate is the oil and gas industry's ability to adapt and create economically viable new technology.
TER: There's been a lot of activity in the natural gas market lately. For example, Royal Dutch Shell (NYSE:RDS-B) and PetroChina Company Ltd.'s (NYSE:PTR) joint proposal to acquire Arrow Energy (ASX:AOE), and the ExxonMobil (NYSE:XOM) merger with XTO Energy (NYSE:XTO). Do you see natural gas as a good place for investors this year?
ML: No. We've been conservative on natural gas and are definitely not suggesting to clients to enter into that segment of the market. We could see another 10% to 15% downside from current share price levels.
TER: With the price being as low as it is right now, do you see some companies starting to take rigs offline?
ML: Not yet. We continue to see rig counts increase very marginally. Louisiana is probably the most robust profile, with the Haynesville Shale Gas developments unfolding. The way the regimes are set up, the companies are required to drill the well in order to hold onto the land. They're being economically incentivized to drill wells when the macro environment doesn't require it. There's a disconnect. We need to see that rig count pullback harder, or at least start declining.
TER: Are there other types of rigs that have been taken offline other than the horizontal that are in production now?
ML: We pretty much zero in on the horizontal rigs for the most part because that's definitely the manner in which those shale wells are drilled. Vertical well productivity is a tenth of what a horizontal rig can do. Even if you see some verticals come off, it won't be significant enough to make an impact.
TER: The reason I ask that question is we chatted with somebody recently who was looking at natural gas rig counts and indicated that the natural gas rig counts have gone down.
ML: Baker Hughes (NYSE:BHI) put out the numbers and there's been a steady climb. From a natural gas standpoint only, we've seen week-over-week increases in rig counts.
ML: Even when we may not prefer natural gas, you have to keep your eye on the ball. When all the negativity is priced in maybe it is a good time to be buying. Progress Energy Resources Corp. (TSX:PRQ) is probably the company that I would highlight. They're 90% levered towards natural gas on a production and a reserve basis. They have built out a significant northeast British Columbia natural gas play targeting the Montney Shales, which can be very economic at low gas prices.
TER: Since the price is relatively low right now with natural gas, how do you explain the activity going on with those mergers and such?
ML: It's a bit of a two-pronged answer. Big oil needs to grow their reserves and they seem to be entering into a number of these joint ventures or M&A transactions. It's partly big oil replacing and growing their own reserves and that is the most visible way of doing it. Secondly, international companies are coming into U.S. shale joint ventures to learn how to apply that technology in other countries.
TER: How much of an impact will other countries such as China, Russia and India have in the natural gas marketplace? Will it drive up demand?
ML: The Chinese are definitely going to be a source of demand growth and so will India, but the international liquefied natural gas (LNG) market is very much well supplied as well. China and India will be a source of demand, but the industry will be able to provide a supply to meet it with no problem.
TER: Natural gas has been trading at or below some prices of coal. It's been suggested that there might be the potential to switch to natural gas over coal for electricity generation. That could increase demand and drive the price up. Do you see that as a possibility?
ML: Absolutely. That transpired last summer and we still filled up natural gas storage. With levels in the $4 to $4.25 range for NYMEX Henry Hub gas prices, switching to natural gas from coal makes sense. We did have a lot of switching last year. You almost need to have that switching happen to prevent any further negative downside. But when you had a lot of gas/coal switching last summer, and you still filled up storage, that tells you industry's capability of putting on a lot of supply onto the market.
TER: So do you see natural gas still being right around $4 by year end?
ML: That's a difficult call to make right now because it really depends on the weather. We could be around $5 in December, but if the winter heating season gets off to a slow start, it could be closer to $4.
TER: If natural gas goes up, will there be a switch back to coal? Is it so easy to switch back and forth that they go with whichever is cheaper?
ML: At the margin. However, in terms of a significant new source of demand, it'll take some time for the utilities to be able to adopt that policy. The historical volatility of natural gas prices has prevented utilities from finding comfort in using natural gas as an energy input source. Additionally, a significant amount of infrastructure is being brought on stream utilizing coal. With billions of dollars already spent for coal-fired infrastructure, it'll take some time before natural gas can replace it.
TER: With a lot of these natural gas plays, the companies are also starting to look for oil. What's your view on that?
ML: Anytime you can get your hands on oil, that is always a positive. Some of the most prolific or highlighted natural gas wells are such because they include high liquids content. It's effectively an oil well within the natural gas well. What that is telling you as an investor is oil is the key. You want to have exposure to oil because that's what drives the value. Companies that are working their way to a 50/50 split between natural gas and oil give you exposure to an oil growth profile.
TER: Where is Progress in that?
ML: Progress is only in natural gas 90%. They're only identifying a natural gas play. So they're sticking to what they know how to do.
TER: Do you have some gas/oil plays that you are recommending?
ML: Crew Energy Inc. (TSX:CR) is 50% oil, 50% gas. They are having very good success on a horizontal heavy oil program that's not capital intensive. It's less than a million dollars to drill their wells. The wells pay out in about three quarters. It's a free cash flow asset. They can generate free cash flow to fund the drilling of more oil wells.
TER: Has the market priced in this free cash flow?
ML: Somewhat. I think they need to see more data. It's still early.
TER: Are there other companies in this gas/oil sector that you're watching?
ML: Crew is the dominant player there. We've just seen other companies begin to license wells targeting the same formation. The Pekisko formation in that region has been successful for Crew. When you see industry follow up another company's success by licensing more wells, it's confirmation that they do see the visibility of a good oil play.
Another company that we also like that is 90% oil levered is PetroBakken Energy Ltd. (TSX:PBN). They have exposure to the Bakken light oil resource play in southeast Saskatchewan. That's a shallow extension of what companies are drilling in North Dakota that's migrated up into Saskatchewan. The company has also recently built out a strong Cardium light oil inventory in Alberta through acquisitions. The stock has actually traded down recently, despite strong crude oil prices. That is largely reflective of the company completing M&A transactions as well as a lack of data points on well productivity levels. We maintain a positive expectation on the Bakken and Cardium plays that we think over time will reward investors, and they do pay a dividend that yields just above 3˝%.
TER: How are these light oil plays in the Bakken compared to the oil sands in terms of the cost of extraction?
ML: I personally prefer the Bakken because you can turn them on and off like a light switch. They're not capital intensive and you have long life reserves. The breakeven requirement in Saskatchewan is typically about $40 WTI. It was a play I liked early in the recovery last year because it didn't need big oil prices to generate a strong rate of return. It's definitely a play I like when we're in the $80 environment. The Petrobakken stock has retraced recently. It's been forming a bottom and it's an opportunistic time to be looking at it.
TER: Any other Bakken plays that you're watching?
ML: Legacy Oil & Gas Inc. (TSX:LEG) is another Bakken player that we like. We're expecting them to unlock the Taylorton area, which is on the Saskatchewan/North Dakota border. We expect the Taylorton wells to be the best Bakken wells drilled over the last five or six years. The Taylorton economics should be top decile and Legacy holds an inventory of about 100 locations. They also have three light oil exploration plays in their back pocket. They're not providing any detail, but management does have a long-standing record of success in light oil resource plays.
TER: If an investor were ready to get into doing some of these oil plays, is the Bakken investment superior to the oil sands?
ML: It is on a near-term basis. The oil sands plays are a bit more of a longer-term view on the commodity.
TER: Thank you for your time.
Oil and gas analyst Mark Leggett joined BMO Capital Markets as an integrated oils associate in 2002. He was promoted to analyst in 2004. Based in Calgary, he covers Canada's intermediate and junior oil and gas producers. A Chartered Financial Analyst (CFA), Mark's previous 12 years' industry experience was primarily at Canadian Natural Resources. The University of Calgary awarded Mark his Bachelor's of Commerce degree in finance in 1990.
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1) Tim McLaughlin of The Energy Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None
2) The folloing companies mentioned in the interview are sponsors of The Energy Report or The Gold Report.: Royal Dutch Shell.
Analyst's Certification: I, Mark Leggett, CFA, personally and/or my family own shares in Suncor and Canadian Oil Sands Trust. I hereby certify that the views expressed in this report accurately reflect my personal views about the subject securities or issuers. I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report.
Analysts who prepared this report are compensated based upon (among other factors) the overall profitability of BMO Capital Markets and their affiliates, which includes the overall profitability of investment banking services. Compensation for research is based on effectiveness in generating new ideas and in communication of ideas to clients, performance of recommendations, accuracy of earnings estimates, and service to clients. Read full disclosure.
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