The Commodity Investor Q&A
With Matt Badiali
December 10, 2008

I received a snowstorm of questions about Penn West, an oil and gas producer I featured in the S&A Oil Report in September and mentioned again in a recent Q&A. Generally, readers wanted to know:

Q: What made Penn West a promising investment in September if it's a sucking hole in the ground today?

A: Oil production companies are simple businesses. They pump oil out of the ground and receive money for it. As oil analysts, we pretty much need to know two pieces of information:

1. How much money does it cost to produce a barrel of oil?
2. How many barrels are left in the ground?

When you break that information down, you see that some companies are great at producing low-cost oil and others are not. Now, you might think owning the lowest-cost producers is always the best idea. It's not.

Sometimes, you'll make far more money owning a slightly less efficient business. Here's why...

Let's say Company A is an oil producer that's been around forever. Its big old fields can produce oil for around $10 per barrel. Company B is a newcomer. It operates offshore and spends a lot of money finding and pumping new oil – about $50 per barrel.

When oil sells for $55 per barrel, Company A earns $45 per barrel and Company B earns $5. If the price of oil rises to $60 per barrel, Company A's earnings rise from to $50 per barrel, a gain of 11%. However, Company B's earnings rise from $5 per barrel to $10 per barrel – that's a double.

So marginal companies, like Company B, did well over the last seven years, as oil prices climbed. Now, those same companies' shares are falling hard.

Penn West is a marginal oil producer. At $100 per barrel, which was the price of oil when I recommended the company, it had plenty of room to pay a fat dividend. At $80 per barrel, that's still true. My mistake was not expecting oil to fall quite this far.

Oil sells for less than $45 a barrel. But it costs Penn West $48 per barrel to cover its expenses. Right now, it's fighting for survival.

These days, a better bet is Company A: an oil producer that can make plenty of money with low oil prices. ExxonMobil, for example, pumps oil for under $8 a barrel. And it made money back in the late 1990s, when oil bottomed around $10.

Q: The global economic downturn has hit Russian energy companies harder than their peers. P/E's are at ridiculous levels, and I'm feeling sorely tempted. My guess is, whatever happens to the Kremlin, the world is going to have to buy its energy. What's your take? – R.B.

A: Your question actually hits on two important points for energy investors...

First, price-to-earnings (P/E) ratios in the energy sector are completely out of whack. You are comparing post-crash share prices with pre-crash earnings. That's why they look so small.

You need to recalculate the earnings based on $50 per barrel of oil and $5.50 per 1,000 cubic feet (mcf) of natural gas. That'll give you a more accurate picture.

Second, you need to know one crucial fact about Russian oil companies before you buy: The government taxes the living daylights out of them.

Something Terrible Is Headed for Royalty Trust Shareholders Whose Oil is Better, the Bear's or the Dragon's?

According to the Oil and Gas Journal, in October, Russian oil producers received just $1.43 per barrel after taxes. In November, the government had to step in twice to adjust the tax rate. Oil prices fell so rapidly that the tax rate actually exceeded the oil price by $15 per barrel.

You're right... the world needs to buy Russia's oil. But it's not a tempting investment right now.

Good investing,

Matt

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