Sunday, November 20

Week 20 - Mining & Drilling for Key Commodities: Oil & Gas

Situation: The key commodities extracted from the ground (oil, natural gas, copper and gold) are heavily traded on regulated futures exchanges. Open interest amounts to almost $100 billion but many more contracts trade “over the counter”, i.e., removed from the prying eyes of competitors and regulatory agencies. Some of the companies that find and extract commodities also refine, transport, and/or sell their product. Other companies provide additional services and equipment.

Goal: Orient the ITR investor to dividend-paying companies that produce (or support the production of) key commodities.

This week’s blog takes the ITR investor beyond the Master List into cyclical companies that take more chances with more up-front money. Why? Because these companies supply us with essential commodities. High fixed costs characterize every company that extracts materials from the earth by mining or drilling. When commodity prices are high, new companies are tempted to enter the fray, which then drives prices down. The companies that survive the melee can’t afford to continue innovating and expanding; production remains flat or declines until the economy re-expands enough for the survivors to “pick up the slack”. Most companies that dig commodities out of the ground are dependent on investors who are willing to lose everything in the hope of a big return. If it’s a young company that hasn’t had a chance to expand into safer sidelines (refining, transporting, merchandising), it will likely fail. However, these “junior miners” have enormous upside potential and therefore attract investors who want to gamble.

To analyze companies that mine gold & copper, or drill for oil & gas, it is helpful to focus on a particular geological province that attracts a typical grouping of companies. The Western United States is rich in such provinces with the current favorite being the shale formations that mainly yield natural gas. The recoverable oil & gas in these formations is 3 times that known to be present in Saudi Arabia. 

To take a closer look, we will focus our attention first on natural gas plays west of the continental divide. Drilling activities there have expanded rapidly for two reasons: new discoveries and technological breakthroughs that allow formerly marginal geology to be drilled anew. Drilling has increased dramatically since the advent of horizontal drilling and hydraulic fracturing (“fracking”). The Piceance Basin in NW Colorado is the most active recent find but production is rapidly expanding in the well-mapped Green River Basin in SW Wyoming and NE Utah.

The accompanying spreadsheet <click here to open> provides information about 9 companies active in exploration and production (E&P), plus 4 others that provide services and equipment (CAT, NOV, BHI, and SLB). The 6 pure E&P companies are riskiest (APC, NBL, EOG, DVN, ECA, COG) but the 3 companies with refineries (XOM, CVX, and RDS-B) do well through thick and thin, with significant fluctuations in share price because of being tightly tied to the economic cycle. The 4 servicing companies show the fastest earnings growth in each business cycle but with even more marked fluctuations in share price. This pattern (of mining & drilling suppliers reaping the most profit) has held true since as far back as the 1849 California Gold Rush.

All 13 companies pay dividends and are followed by S&P.  XOM, ECA, CVX, and NBL are active in Piceance Basin; DVN, RDS, COG, EOG, APC, APC, and CVX are active in Green River Basin. The drilling activity is hard to miss if you’re driving along I-70 in Colorado between the towns of Rifle and Grand Junction. You’ll see many oil service trucks plus the roadside buildup of servicing depots (e.g. near DeBeque). Driving I-80 west of Rawlins, Wyoming, is even more revealing because there is little else to see. An entire city (Wamsutter) has been built for oil workers where only a single gas station existed 15 years ago. Driving through that barren stretch at night is otherworldly because of lights and mists around drilling rigs that are hard to see by daylight.

The big problem with investing in E&P companies is that there always seems to be a wide variation in the quality of management and a shortage of skilled workers. These problems are related because good workers tend to follow good managers. If you’re investing in Exxon (XOM), Chevron (CVX), Shell (RDS-A) or Schlumberger (SLB), that problem has likely been solved. Here at ITR, we’ve been trying to get a handle on the others. We’ll keep you informed of our progress looking at shale plays.

Bottom Line: Drillers have to make a large up-front investment in order to make a lot of money several years down the road (living with a big “maybe”). Most drilling companies are small and don’t last long but do start strong by using money from impatient investors who are attracted to the potential for great rewards. The drillers that do succeed typically look for sidelines with more stable revenues, i.e., lay pipelines, refine petroleum & develop commodity chemicals, transport those products, and open service stations to fuel planes, ships, trucks, and cars.


Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com

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