I bought CH Offshore on 25th May 2009

Before I go into the rationale behind my purchase, I will like to share some thoughts on the oil & Gas industry (from the investment context) and value investment in general. I had quite a fruitful discussion on the above topics in one forum thread and exchange of comments with a reader on my blog entry when I purchased SPC.

Oil & Gas Industry from an investment point of view

The first thing that came to mind when one discussed about the industry is crude oil price. As far as investment is concerned, unless one buys a crude oil index exchange traded fund (ETF) or equivalent, using crude oil price as an indicator is not so straight forward.

The meaning behind crude oil price

It is quite easy to miss the forest for the trees. Once the crude oil price surge, the immediate sentiment is that oil and gas industries must be making money but this is not so. Crude oil price is just a barometer for supply and demand. Whether emotional, speculative or real, it just signifies meeting point between them. And it is that simple.

Oil and gas activities can be divided roughly into 3 categories:

1. upstream (oil and gas exploration and production)
2. downstream (crude refining)
3. support (offshore support, rig manufactures etc)

When real or anticipated demand exceeds real or anticipated supply, oil price surges and vice versa. The movement of the supply and demand curve moves the crude price and had varying effect on players in the above 3 broad categories. Note that demand and supply curve (whether real or emotional) must move first before crude oil prices barge.

Upstream

Players in oil & gas exploration and production players are the first to benefit when price surge and first to suffer when price plunge (especially so when price plunges below production cost, i.e.

Profit = function (crude oil price)

Downstream

Players are mostly refiners who use crude oil as raw material and sells refined products. Their profit are heavily dependent not on crude oil price, but crack spread (the profit margin between crude and refined oil). Most of the people I talked to focus on this, but that is only part of the picture. The next part is demand. Profit is a function of sales volume and profit margin:

Profit = function (crack spread, sales volume)

Downstream players are more sensitive to crack spread and sales volume rather then crude price. When economy is booming, the demand for crude generally rises (emotionally or real) more than supply can keep up. The effect is rising prices. The crack spread might suffer, but profit can still go up if the increase in sales volume more than make up for the declining spread. Problems arises when the crude price surges to a point that affects demand, then both sales volume and crack spread drops and hurt profitability. It is these dual factors that gave people the wrong impression that profitability of refiners had nothing to do with crude oil price. It does, but indirectly via demand and supply curve instead.

Support

Support players are very much affected by crude prices but lags crude price cycle a big deal. When the economy starts booming after a recent recession, it will take some time before demand catches up again with supply. It will take even longer before crude price surges again to a point that makes oil and gas exploration or extractions lucrative. Further lengthening the cycle is that support projects typically have long gestation periods. It takes many months to build support vessels or oil rigs and sustained efforts during exploration. Activities can persist for months after oil bubbles burst.

Actions

Thus, once the euphoria for oil and gas industry subside with the collapse of the oil bubble, I believe there are opportunities to look for bargains. First, I bought SPC, now I bought CH Offshore. The former is a typical refiner (though it has some exploration and production segments) and the latter is a typical support player. Compared to other companies (such as Ezra and Swiber) operating in the support segments, CH Offshore stands out with its less (nearly none) leveraged business model. The downside is its growth will not be as speculator during the upturn. I could have got it way cheaper a few months ago, but alas spare cash don't come easy these days.

A few words on Value Investing (and fundamental analysis)

From the forum discussion, it becomes apparent that some believers of value investing would ignore cyclical businesses because they find them hard to value. Value investing preaches buying things below their intrinsic value with sufficient margin of safety. Intrinsic value is an estimate. Just because cyclical businesses's intrinsic values are difficult to ascertain due to the highly fluctuating profits and losses does not mean value investing cannot be applied.

Look at it another way. Highly cyclical businesses have such huge peak to through fluctuations in earnings (and hence share price) and these fluctuations are recurring in nature. Hence, the magnitude in the fluctuations safely assumes that purchases near the through when a cyclical sector collapses (not price bottom since one cannot predict the bottom) should provide the sheer margin of safety.

It is for this reason I bought Courage Marine when BDI crashes below 800 when I believe the shipping bubble had more or less burst.

Conclusion

There are always many routes to a destination. Some are more established while some are less travelled. By sticking only to the established route, one misses out the many hidden opportunities that could have been better.

I bought Singapore Petroleum Company on 27th March 2009

Rationale

Ever since the crude oil prices hit around US$ 30 sometime ago (from a record high of above US$ 140 last year), I believe the business fundamentals for oil companies (e.g. SPC) have made a U-turn.

There are a two main sources pressuring their income statement:

1. Inventory write down (declining oil prices)
2. Declining revenue (from falling demand and refining margin)

Given the speed at which crude oil prices had collapse by Dec 2008 (around US$ 40), the inventory write down should more or less been completed by the last FY report, ending 31st December 2008.

While demand will take some time to recover, the downside will be limited given current widespread dependence on crude oil for basic subsistence.

I could have bought it earlier, when SPC share price languish slightly above $2, but spare cash is a rare commodity nowadays and it is only recently that I am able to scrape enough to buy some.

Potential for more inventory write down

Oil prices trends

The following is the crude oil future contract compiled from Energy Information Association:


For a relatively long time in modern history ( 1986 to 1999), the world seems contented with crude oil around US$ 20. Assuming an inflation rate of around 3% to account for rising living standards (greater convenience in life centred around electricity use and motor transport) and adding another 1% for world population growth, the resultant stabilised oil price is still about US$ 30 (9 years from 1999).

Cutting supply to boost prices?

The following chart is also compiled from Energy Information Association:

Despite a few relatively small crisis, Asian financial crisis in 1997/98 and SARS in 2002/03 (compared to the present) from 1997 to present, there was no notable cut in supply even though prices took a sharp dip (see oil futures chart above) in both periods. In fact, supply continue to grow steadily over the years. Cutting supply to boost income doesn't really make sense unless the surge in price is sufficient to offset the (promised) plunge in volume. Since the volume normally does not drop as much as promised, the price is not boosted as expected. On the contrary, if demand continue to drop, the oil producers instead have to increase production to sustain their income, more so in a bearish oil market.

Taken together, the potential inventory write down in coming quarters is still material but not as significant as when the crude oil price was above US$ 100 per barrel.

Declining revenue

The following charts is the refining margin published by BP, annual average and weekly average respectively:


Given current volatility in crude prices, margins are volatile as well. But generally, on a broader scale, as crude price stablise and demand falls back to earth, a margin of around US$ 2 to 3 should not be too much to ask for. When refining margins were that low (2002, 2003), SPC's downstream activities could still deliver about SGD 30 to 50m operating profit (or about 1.5% operating profit margin).


Upstream activities

Perhaps, the only cushion to the declining revenue (and profit) from the downstream activities is from the exploration and production (E & P) activities. However, with a sharp drop in crude prices, the contribution from E & P will also drop drastically compared to 2008 but still higher than the downstream activities.

Risk

The only risk I can see (other than oil price collapsing to zero and people stay indoors to burn candles) is the hedging activities carried out to hedge against oil price exposure. Despite stating that the SPC adopted a prudent risk management policy, unexpected high volatility in oil prices can render such activities useless and even implicit damage to the income statement.

Conclusion

Not too long ago, when oil price was aiming for the moon as it surge to US $147 per barrel, all sorts of infrastructure investment was launched to increase production. Now, as the price crashed back to earth, many investment was scrapped (also due to the ongoing credit crisis) as the projects are not justifiable at current crude prices. Thus setting the ground for future supply crunch again. Anyway, as fundamentals reach or about to reach a turning point, its about time I collect some for the future.

Analyst's analysis --- to be taken with a tonne of salt?

I read with amusement the morning news about the effect of quitting of Japanese PM on NIKKEI, on Channel NewsAsia on 2nd September 2008:

0846 hrs: Japanese shares open lower after PM's resignation
0917 hrs: Japanese stocks turn higher after PM resigned

How do these analysts know the stocks went up or down due to his resignation? Apparently they didn't, reversing their views just around an hour. This brought me to recall what I heard when I attended the analyst briefing of Surface Mount Technology sometime this year when its CEO commented:

... there are two professions who does not need to take responsibility for what they say, one is the weather forecasters, the other is stock analysts...

As a whole, their hits and misses are seemingly so evenly distributed that it became common sense to take them with a huge tonne of salt. Thus it is rather surprising (at least to me) that people still believe them (else why ask them for opinion) and even more surprising why they are still employed and so highly paid.

Reasons behind salty analysis

I read somewhere, in one of the books on the left column (can't recall which) that it is human nature to attribute cause and effect, e.g. trying to find a pattern when there is none. It works pretty well during hunting, i.e. aiming and throwing a spear ahead of a speeding deer instead of directly at its body when one can almost predict (correctly) that it will run straight.

But it is altogether a different story making forecast in a stock market, especially on a short term basis. It's as good as trying to predict the next roulette spin. The reason is that the sheer number of participants and events affecting a short term outlook in the market make the next price movement almost a perfectly random event.

I do not believe these highly educated professionals, with their training and experience could not understand the fundamentals causes behind macroeconomic events unfolding before them. But many seemingly like to make straight line forecasts. If that is so easy, anybody can become an analyst.

Lastly, being an accredited analyst, market expect them to give an answer, a projection. They have to call a number (any number is better than no number). "oil will hit 400 usd per barrel" sounds much better than "I don't know, probably the oil price will be very volatile".

Layman's view

I do not need to call a number if I don't know and I am under no pressure to kid myself. So it is great to look back at my past comments to see how I fare in my own macroeconomic views.

SGD vs USD (and other foreign currencies)


When USD was fast depreciating in 2007 and most of 2008, many analysts are calling ever lower targets with each record high achieved by Sing dollar against the USD. The lowest target I recall is 1.32. Might as well say parity. But the fundamental events clearly pointed otherwise as I wrote the article on 10th May 2008:

10th May 2008: High-yielding notes a good buy?

In it, I pointed out the limitations on how far US can allow its currency to drop and how badly it will hurt Singapore if MAS continue to strengthen SGD endlessly. Ironically, after being so bullish before the August decline in Sing dollar, many analysts now forecast a steeper decline in Sing dollar. Given MAS's policy of using SGD as an inflation fighting tool and mounting US debt, I doubt there will be a clear trend in SGD vs USD. It will most probably be volatile exchange rates until the dust settle down in the next few years.

On a separate note, my post was actually targeted at the prevailing interest then to buy high yielding fixed foreign currency deposits but I cautioned against the risk involved. There must be a reason for the high interest attached, and it is definitely not risk free.

Since that post, New Zealand dollar, NZD had depreciated about 7% against SGD:

and Australian dollar, AUD by about 7.5%:

Thus offsetting the 'high' interest rate on these fixed deposits (about 6 to 7% then). I'm not the first to see these fundamental changes, I read them somewhere, so can these 'analysts'.

Oil prices --- aiming for the moon?


When crude oil crosses USD 140 a barrel in June this year, analyst again extrapolated crude oil to shoot for the moon. Supporters of peak oil (oil supply had peaked but growing demand will ensure rising prices without conservation or alternative sources) are right to point out that growing global demand (esp. due to rising demand from China and India) will drive up prices.

However the run up in prices are seemingly more of a speculative adventure then a shift in fundamentals. I wrote another article on this back then on the unsustainable crude rise:

1st June 2008: Oil bubble or trouble?

When it hit above 140 a barrel, some predicted a 200 a barrel by year end. Now, when crude collapse below 110, some predicted it to retreat back to 80. In the long run, I do not doubt crude demand will definitely outpace supply unless more economically exploitable fields are discovered or more serious adventure in alternative fuels takes off. The following figures put the key consumers in perspective:

Crude oil consumption per capita per year:

US: 68.81
China: 4.96
India: 2.18

GDP to Crude oil consumption ratio:

US: 1.65
China: 0.94
India: 0.86

Crude oil consumption in absolute terms (1,000 barrels per day):

US: 20.59
China: 7.27
India: 2.53

Crude oil consumption if China & India's consumption per capita matches US:

US: 20.59
China: 100.86
India: 79.86

Even if China & India become as efficient as US in terms of consumption per GDP:


US: 20.59
China: 12.76
India: 4.85

(But this assumes China and India's economy remains unchanged. At the rate they are growing, both economies will match, if not surpass, that of US within the next decade. Thus at the same efficiency, both consumption will exceed US by a significant margin)

However, in the short term, it is somewhat incredible for oil to double in just 2 years. Similar to SGD vs USD, going forward, crude oil price could just be as volatile in the near future before it settles down to a price dictated by fundamental supply and demand.

Conclusion

It is sometimes amusing to read analyst reports on stock valuations. Many like to use P/E ratios. It is a convenient tool because it allows practically any number to be called for a stock valuation. In a bull run, for a forward or historical earnings, just pluck a high P/E ratio and you get a huge target price. Conversely in a bear market, with the same earnings, pick a low P/E ratio and you get a much lower target price. It is as good as a doctor trying to diagnose you with a wheel of fortune.

It is no wonder they are so handsomely paid. Not because their job are difficult to do, but its difficult to keep because any Tom, Dick or Harry can become one. Fortunately I do not depend on analyst reports for my stock picks.

Disclaimer

I am not saying all analyst are not up to mark, but the significant number of black sheep amongst the good ones are indeed bringing a bad name to the collective lot. It is those that can and dare to give better quality comments and reports that will capture the trust and confidence of rational investors.

Oil bubble or trouble?

I refer to 3 articles I came across in the latest issue of The Economist, May 31st-June 6th 2008:

1. Recoil - Painful though it is, this oil shock will eventually spur huge change. Beware the hunt for scapegoats
   
2. Energy - Double, double, oil and trouble
3. Fuel subsidies - Crude measures
   

Oil bubble?

Believers of peak oil (a point in time when oil production rate hits the maximum and go decline from there) would doubt the current surge in oil price as a bubble, pointing to the sluggish crude production last few years while demand from emerging economies (esp. China and India) powers ahead.

In contrast, others believe the high oil price would had dampened demand (signs are showing) and the current surge is just the act of speculators (traders of crude future contracts, funds and other investment institutions).

If it really is the act of speculators that result in the price surge, I'll not be so worried, since all bubbles must come to a spectacular burst one day.

Oil price --- sustainable?

Whether or not its the act of the speculators, after reading the 3 articles above and doing a bit of research myself, I do believe current sky high prices cannot be sustained for long. It would have been better if the speculators are indeed responsible because the eventual price correction when the bubble burst would be substantial and swift. Otherwise, it will be a long and painful journey ahead before any respite occurs when the demand and supply curve rebalances again.

Less demand or more supply?

Sustainability of demand

According to the 3rd article,

...
Emerging economies accounted for more than the whole increase in world oil consumption last year—because demand in the rich economies fell...


While US and Europe are fighting slowing growth (analyst, experts etc kept saying US is in recession but its GDP always manage to scrap through with a positive figure), the emerging economies continue to power ahead.

Growing economies resulting in growing demand for crude oil comes as no surprise. But most of the fuel sold in these countries are heavily subsidised. As the crude price escalates, the government subsidies balloons, diverting resources from areas that the money could have been better spent (education, health and infrastructure). Subsidies as such cannot grow indefinitely and many are already cutting back. The eventual result of a rising crude price will see a plunge in demand, even in emerging economies, either a direct result of more conservation or slowing growth.

I- Increase in supply --- more aggressive search for oil fields

The runaway price of crude oil already spur a surge in oil explorations. Announcements of oil field discoveries are not uncommon nowadays, given such intensive search. However, even with these, supply will not jump suddenly because it takes years before the first commerical drop of oil is extracted, more so for new fields that are found in deep waters or difficult locations, .e.g. the Arctics.

II- Increase in supply --- alternative sources of fuel

As the price of crude oil climbs, alternative sources of fuel become viable. A google search for "alternative sources of fuel" easily turn up 800,000+ results. Research into these areas are already underway ever since the first oil shock.

1. Tar sands
2. Oil shale
3. Coal & gas conversion
4. Thermal depolymerization
   
5. Biofuel (from sugarcane, rapeseed, soya bean, palm oil and even algae!)
   

These alternative sources of fuel are not cheap and requires a sustained crude oil price to remain feasible. If crude prices remain sticky for a sustained period (a few years???), supply from the above sources would obviously jump.

Other factors

Continue weak USD

While the plunging USD was blamed for the initial surge in crude oil price from USD $80++ per barrel to $100++, not one article mentioned about the USD devaluation now. Seems like the search for the scapegoat have moved on. I would wonder when the USD eventually strengthens, would oil price come down? I doubt so, because strengthening USD should be a result of a recovering economy, brining along an increase in fuel consumption again -- another excuse to keep the crude price up.

What this means to me

While I have no choice but taking a much passive reactive approach in my life, i.e. tighten my belt with the current oil spike induced inflation (food, transport etc), I can continue to be active in my investment.

Market sentiment is obviously bad right now and the only remaining sexy sector are the oil and gas (or related) sectors. Thus I would think the Great Singapore Sale on SGX should not come to a close anytime soon, even though it had lasted so long, from August 2007. While I'd avoid the oil and gas sector, I believe there are still bargains to look out for.