The boom-to-bust era of oil prices is a thing of the past.
Instead, it is becoming a boom and bigger boom kind of world, where price crashes are a relic of the 1980s and 1990s. Now, analysts say even oil price lows will seem high compared to prices in the past.
Investors take note: In this world, the great bull market in oil is only just beginning, holding out the prospect of years more of enormous cash flows for oil and gas companies, and rich payoffs.
"It gets a bit awkward when even the bears have horns on," said Paul Horsnell, head of energy research at Barclays Capital and an often-consulted authority on the global crude market.
Mr. Horsnell said the long-term average price of oil has risen from its historical range of between $18 (U.S.) to $20 a barrel to a much higher level of $28 to $30 a barrel. What's more, the London analyst says, it is extraordinarily unlikely that crude will fall below $20 a barrel -- a price that has until very recently been deemed to be the high-water mark for the long-term average. "That world is over," he says.
Crude prices are holding ground at historically high levels, closing yesterday at $34.39.
The emerging picture of permanently pricier oil will shake up the investing fundamentals for a huge range of energy companies, opening up opportunities for conservative investors looking for dividend income. And the good news: The prices for many large-capitalization Canadian energy equities -- EnCana Corp. and Canadian Natural Resources Ltd. are notable examples -- do not yet reflect the impact of a rise in the long-term price of oil.
Of course, that could just as easily be taken as proof that the market believes that oil prices are headed for a tumble, despite the fact that crude is trading above $28 a barrel through 2009 on the futures market of the New York Mercantile Exchange. Futures markets are nothing if not mercurial, but analysts say their view of a permanent move upward in oil prices is based on some fundamental changes in the structure of the world economy and the inner workings of the oil sector.
"You try to avoid the concept that 'It's different this time,' because often it isn't," says Brian Prokop, an analyst at Peters & Co. Ltd. in Calgary. Except this time, it is different, Mr. Prokop says. He predicts that the long-term average oil price is headed as high as $24 a barrel, a less aggressive stance than Mr. Horsnell's.
The single most important impetus behind this change is the falling value of the U.S. dollar, Mr. Prokop says. Its decline means that the old equilibrium point of $20 has risen to around $25, with the members of the Organization of Petroleum Exporting Countries allowing prices to drift upward in order to preserve the purchasing power of their oil income in Europe.
Even as the dollar has fallen, international tensions have been on the rise, slapping a risk premium on oil prices. There is the U.S.-led war on terrorism and the struggle to pacify Iraq, with the attendant fear of an extremist attack on oil facilities. Political strife in Venezuela and ethnic clashes in Nigeria, both of which are OPEC members, add to the worry of a disruption in crude shipments, particularly in the case of Venezuela, which also supplies gasoline to the U.S. market.
China's torrid growth is helping to fuel higher oil prices. The International Energy Agency cited Chinese thirst for oil when it boosted its estimate last month for the increase in crude demand this year to 1.65 million barrels a day, up nearly 60 per cent from the IEA's projections in October.
Mr. Horsnell, however, trains his attention on the opposite end of Asia, where surging growth in Saudi Arabia's population is exerting intense pressure on the kingdom to head off any major decline in crude prices. It's worth noting that quota cheating has run rampant in OPEC in recent months, with one of the widest gaps on record between the consortium's nominal production targets and the actual number of barrels pumped.
But OPEC's goal is price discipline, and by that measure, the cartel has been remarkably successful. Adjusted for the fall in the U.S. dollar, oil has hovered near the upper end of OPEC's price band, only recently shooting above it. OPEC's determination was on public display this week, as the cartel members vowed to carry through with promised cuts to quotas and production in order to head off any swelling of oil inventories in the second quarter as demand takes its seasonal dip.
Finally, the ability of Western economies to tolerate high oil prices has increased since the price shocks of the 1970s and 1980s, largely because of the energy efficiency measures spurred by OPEC's actions to drive up prices then.
It is a new world for oil, and one that will influence investing strategies for both the conservative-minded and for those more comfortable with riskier plays. "The value, on a relative basis, is phenomenal in the oil and gas sector," Mr. Prokop says.
He points to a potentially lucrative opportunity waiting for the investor with the stomach for a calculated gamble: shares in large and intermediate producers. His analysis of the ratio of current prices to cash flow shows that the shares in many of those companies are below not only the larger market, but their own track record. On the shopping list are big names, such as EnCana, Canadian Natural Resources, Nexen Inc. and Talisman Energy Inc.
Mr. Prokop says some of those companies, particularly EnCana, are fully valued, if only one assumes that oil eventually will revert back to its historical mean of $18 to $20 a barrel.
The investment stratagem is this, according to Mr. Prokop: The moment the market becomes convinced that oil prices are not going to retreat and repeat history, the market should begin to assign a greater price multiple to cash flows, pushing up share prices. He says the ratios for the group would rise to between 8:1 and 10:1 from their current ranges of between 4:1 and 7:1.
But undervalued independents are not the only opportunities. Alberta's oil sands stand to benefit substantially -- and disproportionately -- from a high-oil world. That is because their costs are significantly higher than their counterparts in conventional oil and gas production.
The Canadian Energy Research Institute has pegged $25 a barrel as the minimum price for oil that would deliver a satisfactory enough return on investment to attract the billions needed to turn gooey bitumen into synthetic oil. For investors eyeing the oil sands -- Canadian Oil Sands Trust is the purest play, although all the integrated oil companies and most of the large and intermediate producers have some sort of presence -- volatility in oil prices is less important than the long-term price.
But that is not the case for the integrated oil companies, a list that includes Petro-Canada, Shell Canada Ltd., Imperial Oil Ltd., Husky Energy Inc. and Suncor Energy Inc.Profits in the downstream, or retail, end of their businesses suffer when oil prices are volatile, since they can be saddled with expensive fuel inventories when pump prices are comparatively low, says William Lacey, an analyst at FirstEnergy Capital Corp., while noting that the reverse is true when prices rise. Nevertheless, he said, downstream operations would fare better in a world of modest, but stable, prices. "In an ideal market, you would want far lower volatility," he says.
The good news for these companies, and their investors, is that the Canadian integrateds have a natural hedge against this hit, in the form of their oil sands operations. So, the greater a company's oil sands exposure, the more attractive it becomes in a high-oil-price world. By that standard, Suncor Energy wins the beauty contest.
Even for those investors without the inclination to place aggressive bets on quick appreciation, there is a promise of profits as well, in the form of dividends. As companies grow to believe that prices have hit a permanently higher range, dividends should rise, as firms seek to channel a portion of that cash to shareholders.
There is already some early evidence of that phenomenon: EnCana and Canadian Natural have boosted their quarterly dividends by a third this year, an indication that they believe their higher cash flows are sustainable.
All signs are pointing toward higher oil prices -- and that is about the only thing that gives Mr. Prokop pause.
"The thing that worries you is that everybody's believing this," he says, joking that unanimity among analysts may be a leading indicator that the market is about to head in the opposite direction.
89
Consecutive trading sessions that oil has exceeded OPEC's target range
$6.6-billion
Profits of five Canadian integrated oil firms, in 2003.
1 ¢
Impact of $1 (U.S.) per barrel increase in crude oil on Canadian pump prices.
$54-million
Impact of $1 (U.S.) per barrel increase in crude oil on Suncor Energy's profits
The big caps get cheaper...
Big and medium cap energy stocks have risen significantly thanks to soaring commodity prices, but they're still cheap relative to the cash they're still cheap relative to the cash they're throwing off. The ratio of stock prices to cash flow per share - a key measure of how expensive these stocks are - has been dropping steadily for the majors, and are now just off decade lows.
...while small cap values rise
Whiles shares of the big players in the oil patch have been slow to respond to the higher energy prices, investors have been driving up the shares of companies at the more speculative end of the market. The ration of these juniors company's enterprise value - a popular yard stick of a company's worth - to a measure of cash flow, has been climbing steadily, suggesting they may note be the bargains they once were.
OPEC's hold on oil market slipping
1998
OPEC: 43%
Other: 26%
Western Europe: 9%
North America: 12%
Former Soviet Union: 11%
2002
OPEC: 38%
Other: 28%
Western Europe: 9%
North America: 11%
Former Soviet Union: 14%
Source: Organization of Petroleum Exporting Countries
© The Globe and Mail
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