The Commodity Investor Q&A
Featuring Matt Badiali
February 06 , 2008
Q: Many exploration companies sit idle in terms of pricing and have negative price-to-earnings ratios... How does one go about ascertaining quality? – K.M.
A: Did you ever hear that saying "A boat is a hole in the water where you throw money"? Well, the same can be true for exploration companies... only it takes a whole lot more money to keep them afloat.
But I've come up with a few criteria that you can use to find quality investments: people, finances, projects, and "endgame."
An exploration company's most important asset is its people. Look for a management team of experienced geologists, folks with 15 or 20 years and some discoveries to their credit. I hate to see a board made up of six or seven bankers or financiers... That's a huge red flag. If you don't like the people, walk away.
Evaluating finances can be tough. As you noted, most of these exploration companies have no earnings. Instead, they generate cash by issuing shares. So you need to ask about the burn rate and cash on hand... The burn rate is how fast the company spends money (to keep the lights on at the office, to continue exploring, etc.) If the annual burn rate exceeds cash on hand – how much money the company has in the bank – then walk away.
The hook for every exploration company is its projects... the stories investor relations twists into fairy tales of wealth. These are the trickiest part of the company to analyze, and it helps to have an expert. But two simple things to consider are how many projects the company has and how far they are from roads, electricity, water, people, etc. If a deposit is somewhere north of the Arctic Circle or accessible only by dugout canoe, chances are it won't become a mine in our lifetime. And if a company only has one project, walk away.
A mine is our endgame. We are not treasure hunting here. We want a reasonable chance to make a buck on the stock. That means the company must either develop the project into a mine or continue to find new discoveries to sell to the majors. If it can't do that, then walk away.
Q: What is going on up in Colorado and the Green River Basin? Are we ever going to use some of that oil in our lifetime? – T.
A: The shales in the Piceance and Green River basins of Utah and Colorado contain an "immature" form of oil called kerogen. You can think of this as oil that hasn't been cooked long enough. If these rocks were buried deep in the earth, they'd make an ideal kettle. However, by some quirk of geology, the rocks stayed close to the surface. They still contain trillions of barrels of oil, so someone will figure out how to use it.
A private company called Millennium Synfuels (a joint venture between Oil-Tech and Ambre Energy) claims it developed a retorting process that can produce oil from shale. The company plans to begin production within three years.
Another private company, OSEC (Oil Shale Exploration Company) owns the White River mine in northeastern Utah, which has about 14 million barrels of recoverable shale oil remaining. The company will use a thermal retorting process called ATP to separate the oil from the shale. The ATP process, which originated in Canada for use on the tar sands, proved successful on shale oil at the Stuart project in Queensland, Australia.
So my answer is yes, we will see some production if the price of oil remains this high. However, oil shale isn't cheap to produce. So if another, cheaper alternative arrives, oil shale will fade away until the next spike in prices.
Q: Why have gasoline prices lagged in the face of sustained higher crude prices? Will the refiners rebound? – J.J.
A: I wish I knew, but it's a mystery to me, too.
No kidding. Let me lay out the facts and maybe an economist or a politician will write in and clarify things for us...
First, let's just clear up what oil is used for: transportation. In fact, 70% of every barrel of oil turns into fuel for trucks, trains, cars, and airplanes. Over half (57%) of a gallon of oil goes toward making gasoline. Another third goes to diesel, and about 11% to jet fuel.
This is only a crude estimate (excuse the pun). If, for example, diesel is earning a premium over regular gasoline, refineries will make more diesel. But we can use these numbers to get an idea of how much refiners make...
Today, one gallon of oil costs $2.18. The combined value of the gasoline, diesel fuel, and jet fuel made from that gallon equals $2.83, for a 23% margin. That seems pretty good, right? But over the last 10 years, refiners earned an average 45% margin.
The worst margin in the last 10 years (17%) was during November 2007. The best margin during the last 10 years occurred when oil prices were around $10 per barrel in December 1998. Refiners were making 70% margins on gasoline.
I think refiners will rebound if they can get back to their average margin (45%). That could happen if oil prices fall and refiners keep gas prices steady. But for refiners to hit that margin with $90 per barrel oil, gasoline would be around $4.25 per gallon, and diesel would be over $4.50. File that under BE CAREFUL WHAT YOU WISH FOR.
Good investing,
Matt Badiali
