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Author: hartmanbirge Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 211960  
Subject: OT: What's in the Sand? Date: 9/11/2006 5:59 AM
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For many reasons I intend this to be my last post for a long while – I now realize that there's too much going on in the world that requires that I reprioritize how I spend my time. As the saying goes, we don't choose our circumstance – only our response. This isn't a good-bye - but more of a “see you later.” Before I go, I wanted to leave you all with my most current idea. It's long, so be forewarned. As is custom, feel free to pick apart and “kill the idea” as the saying goes - sorry but I can't respond.

As I mentioned a little while ago, I assume that my days of purchasing Berkshire Hathaway are probably at an end unless something drastic on the valuation front transpires. There have been two major periods in my nearly eight years of ownership where I have been afforded the luxury to load the farm and bet huge chunks of net worth – the GRN scare and the latest where intrinsic value continued to rise appreciably as the price stagnated around $85,000. I've made my move onto the horse and now intend to enjoy the ride – that decision is now a done deal. But new capital comes in as well… So now is another time to look for the next great opportunity in something dramatically undervalued with high degree of certainty. I remind myself - Three of these in a life – and I'm set.

Many ideas I steal from the managers and leaders whom I have grown to respect as I think that's a great qualitative filter. For the most part, “respect” is derived from philosophical similarity – I've spent too many hours and days coming to my philosophical nirvana and I'm not about to deviate now. This quest begins as the others do – I scan my own list of 20 or so multi-national franchises that I have invested in over the years – I like Wal Mart but don't want to make it any larger at this point. I then look at what Sequoia is doing, Lampert, Oak Value, Fairholme, Weitz, etc. I go through the holdings and for the most part cross most of them off that fall inside my circle of competence for one reason or other… Many of the other holdings just have no appeal for many reasons.

I pull out some old copies of Tilson's first class product – Value Investor Insight - and soon find my favorite – Berkowitcz and Fairholme and read it once more… The Fairholme team is talking a lot about Berkshire of course and how they place a nifty “conservative valuation” of $150,000 on it but this time I pay more attention to the rest – they're doing most of their interview discussing an oil company up in Canada which back in May just hadn't caught my imagination… afterall, oil is a commodity and the price has had a huge runup… Amongst the literally hundreds of ideas the net and media have already thrown my way I've managed to filter all of them out. On first glance I ask myself, where's the competitive advantage of an oil company? I almost toss it.

The company in question is Canadian Natural Resources (CNQ) and on second read, Berkowitcz and co have a lot of interesting things to say….I summarize below:

THE BERKOWITCZ BULLISH CASE

1. Berkowitcz discusses how he won't buy a stock unless FCF yield is at least 10% (eliminates WMT, BUD, KO etc.). But for CNQ he says current FCF is around $6.50 per share which at 10x puts value at $65.00 – at time of Berkowitcz's piece CNQ was priced at $60.00 – (It currently sells around $47- $48.00 or using Berkowitcz's FCF yield – 13.5%)

2. Management has proven itself over numerous market cycles - buying up a bunch of lucrative assets when they were dirt cheap. Long track record of delivering what they say….

3. Management has over $1 billion of its own capital invested in company

4. Moving from current gas and heavy oil company to light, sweet crude company (higher prices)

5. To get the crude, they're doing MASSIVE development in their "horizon project" in Alberta oil sands…. Stage one will cost $6 billion…. Total cost probably around $15 billion. All funded with free cash flow without need for debt financing. (or a place to invest all that capital at high rates of return)..

6. Just made a find off coast of West Africa – so it has traditional plays as well

7. Currently produce close to 500,000 barrels per day in "traditional production"….

8. Once Horizon is on line they project operating costs for the sands to be $18 per barrel…. The entire project is based on "economics" of $28 oil…. Which will give them double digit investment return. I note, $28.00 is still a LONG way from current prices…

9. Company can double its production (to 1 million bbd) and triple FCF over next 8 years…. All without the need to add any additional assets…

10. They have 6 billion bbl in recoverable reserves in the oil sands (the Horizon project); They have 3 billion bbl in the heavy oil/bitumen projects; They have conventional reserves of 2.5 billion bbl…. 11.5 billion bbl in reserves all added together…


OK….so I'm interested – and decide the above is now worth my time to dig some more.

WHERE'S THE VALUE?

OK so it all sounds interesting… but what's so compelling about it? Afterall, many oil companies have juicy cash flow yields – look no further than Conoco's yield to understand Buffett's interest… why not just buy Conoco or something else if I want to buy an oil company at all? So I see that the company is producing a lot of cash which is what we're looking for – so far so good. What about those assets? The market has a value on CNQ of $25.61 billion = or $2.23 billion per bbl of proven reserve... I wonder why that is? For comparison's sake let's take a look elsewhere:

COMPANY………….Proven Reserves……….Market Value……….Price per bbl p-rsv
Anadarko (APC)……2.36 bbl………………..$21.32 billion………. x9.03
*Devon (DVN)……….2.29 bbl………………..$29.8…………………x13.01
Occidental (OXY)…...2.49 bbl………………..$39.55……………….x15.88
Apache (APA)……….1.90 bbl………………..$21.32……………….x11.22
Encana (ECA)……….2.6 bbl…………………$40.65……………….x15.63
Kerr-McGee………….1.22 bbl………………. Acquired by Apache for x13.11 bbl reserves

* - Not counting anything recently discovered in GOM

Of the above, the average price per proven reserve = x12.98 proven bbl reserves.
As an aside, Apache recently paid BP up to $22 for rig rights in Gulf of Mexico – well above the average market value above for proven reserves… so there's a range of value right there....and on first glance, I initially think that Apache just pays high prices and must be insane with its capital allocation…Some other examples are revealing. Conoco paid close to $18.00 per barrel of proven reserve for assets acquired in March from Burlington..or about 2 billion bbl. Which purportedly increased COP's reserves by about 25%. At a low of $57.00 this would mean COP's price per bbl of pr would be around $11.77 per barrel. Buffett must have bought COP above that.

Back of the envelop shows that If priced “properly” in today's market, the Market value for CNQ should be a lot higher – if you use the small sample of companies I've provided above it should be closer to $149 BILLION - close to 5.8 times than what it is today.... And if one follows the Apache pricing then the market value would be $253 billion or call it 9.9 times current value.... These are just rough figures of course.. Not all barrels of reserve or Barrel Equivalents (BOE) are created equal of course. If a company's BOE are heavy on natural gas or West Texas crude then they're worth less than if they're heavy in pure light sweet crude which gets a higher price in the market. Many other factors come into play – location of the reserves to consumer markets, political stability in the region, extractability etc.

SO IS IT CHEAP OR NOT?

Why such a massive discrepancy between CNQ's reserve value and some of the others? If one looks at Canadian's “conventional sources” of proven reserves (North Sea, Africa, etc.) the company owns 2.5 billion of BOE (Barrels of Oil Equivalent)… which if priced at the above proven reserve average places a market value on the company around $32.45 billion – much more in line with where the market is valuing the company. Though this hypothetical value for the 2.5 billion bbl is more “in line” with the average I've listed above it's STILL above today's market value for CNQ by about $7 billion (alas a margin of safety begins to emerge)… or one can say that a part of the market is valuing Canadian's conventional source proven reserves at $10.24 per barrel (right there with COP). So even at CNQ's current valuation, we probably have some margin of safety if one were to buy all of Canadian's 2.5 bbl proven “conventional reserves” (non sands) as $10.24 per bbl is over 21% cheaper to the above average that the market puts on some similar companies. So to me this starts to become interesting… But here's where it gets REALLY interesting. If one buys Canadian today they are essentially getting the remaining 9 bbl of PROVEN reserves in the sands and bitumen fields for FREE – plus a 21% discount on the traditional 2.5 billion bbl of reserves… Hmmmmm…. There is no premium in the market price whatsoever for that oil... all they have to do is go get it… and one gets the traditional reserves at a huge discount as well. So what's the catch?

WHAT ARE THE BUSINESS RISKS?

What's the risk? In his “Hot Commodities” book Jim Rogers had this to say on the tough to get Canadian oil: “Those companies are spending billions to expand, and I own tar sands shares. Certainly it would be fabulous if they could produce huge quantities of oil, but not even the bulls expect it.”

OK… so the risk is perhaps historical to the industry (if not the company) in that these projects tend to be complex, labor intensive, and subject to cost over-runs…Below is a link from previous Fool article which discusses risks (environmental, legal etc.) in these sands projects… as one can see it's not a pretty sight:

http://www.fool.com/news/commentary/2006/commentary06060511.htm?logvisit=y?logvisit=y&source=estmarhln001999&npu=y

So one needs to dig a bit more. Despite these harrowing environmental concerns, in January 2004, the Joint Review Panel of the Alberta Energy and Utilities Board and the Canadian Environmental Assessment Agency released its report on the Horizon Project. The panel determined that the project is actually “in the public interest” - www.eub.gov.ab.ca Or then again, perhaps Rogers is right about the sands… there may NEVER be “huge quantities” of oil produced from the tar sands of Canada, but to a company like CNQ, what is irrelevant to the global supply picture in terms of barrels produced per day – is a MASSIVE influx to what the company currently produces – more than double. However, other issues remain. Berkowitcz states that operating costs will come in at $18 per barrel…and that they get a double digit return on their capital with $28 oil. But the recent report from Canada's National Energy board (linked just below) at least brings those figures into some dispute – saying that it will now take $30-$35 oil to get double digit returns. This discrepancy they attribute to a significant rise in natural gas costs as these sands recovery projects take prodigious amounts of gas to develop:

http://www.neb-one.gc.ca/energy/EnergyReports/EMAOilSandsOpportunitiesChallenges2015_2006/EMAOilSandsOpportunities2015Canada2006_e.pdf

HOW IS THE COMPANY MANAGING THESE BUSINESS RISKS?

Again, according to Berkowitcz, the company expects to double its per day output by 2012 and triple its free cash flow. His confidence in that statement stems from management's credibility and Berkowitcz more than most money managers seems to place a premium on management. He says that these guys think longer term, more strategically, and have an impressive paper trail on what they do. Fairholme talked to geologists and hired consultants to get arms around the risk. This is something that I just can't do as a little individual investor so I have to place some degree of faith in what these guys told Fairholme and knowing that Berkowitcz does not suffer fools. Berkowitcz and co. also tore through the company's history of decision-making to see the track record of credibility and capital allocation decisions. The level of credibility is very high – looks to be a first rate management team with good decision-making and a well established track record. They bought many of their assets at dirt cheap levels. The management discusses how they can swing capital allocation on a dime across their production portfolio to put it where returns are highest – enormous capital allocation flexibility. I start to become a lot more comfortable.

A quick check-up begins to confirm what Berkowitcz says. It shows that the company is proceeding with the Horizon Project according to plan – even better than planned. They're below budget and ahead of time schedule.... under-promising and over-delivering as all the great managments tend to do.... labor which is the tough thing on these projects is not an issue (at least yet)... they have great labor relations....good contractors.... great lifestyles established - everything is first class....But sands projects are subject to cost overruns and delays right? Here's a snipet of management comment ref cost and time trends on phase one:

“During Q2/06, the Company awarded a further C$400 million of contracts, including several that were previously deferred in order to optimize pricing. As such, with C$4.4 billion in awarded contracts and a budgeted C$900 million for internal costs, Canadian Natural already has a high degree of cost certainty on C$5.3 billion of Phase 1 construction costs. Additionally all major plants have been passed through hazard/operability review without requiring major scope changes, providing even greater cost certainty on these items. Of the remaining elements, the Company has received initial indications on an additional C$400 million in contract work currently in the tender process and has a good sense of these costs, leaving about C$400 million of cost exposure on several hundred smaller contracts to be let.”

So they only have C$400 million of C$5.3 billion allocated for Phase I which is subject to fluctuate. Seems to me that most of the costs were locked in at cheap prices. I like what I see here..

IS IT AN INVESTMENT OR NOT?

So here's a CLASSIC Munger problem.... place your bets... what's my upside vs. the potential downside? Well I know that the upside is massive.... don't even need anything close to a precise number. No growth projection needs to be calculated… If things go right, it's all gravy and probably massive - because the CURRENT value even on conservative basis is also cheap it seems as if I have a rather large and growing margin of safety. And if they ever have to stop pumping so much capital into Horizon it's probably coming my way in dividends or share buybacks… The cash flow yield has now increased 30% from the market high reached earlier this year. And if the company has some inexplicable disaster on the Horizon project I doubt that my downside is any greater than any other oil producing company – because the current value is below the average for the 2.5 billion bbl conventional production. On the other hand, if Horizon is successful then CNQ doubles its output by 2012 or thereabouts. And there is always the possibility that once the market begins to see oil coming from the sands, that it starts to value the sands more in line with other proven reserves. What's 6 billion bbl of light sweet crude worth that sits just above the world's major oil consuming market?

MACRO SITUATION AND OTHER NON-BUSINESS RISKS / OPPORTUNITIES

OK.... so if I buy CNQ at today's value I get a current FCF yield above 13% and a free flyer on the Horizon project - that is taking little debt to develop....that is being funded by current cash flow.... What's my downside risk? The price of oil? Perhaps… On the demand side, if the US goes into deep recession it will also hit Chinese demand and this baby is going to go down right along with it. On the supply side oil production is projected to rise over the next decade as new exploration begins to bear fruit. But I'm also buying a commodity that is perhaps the most exposed to all this global turmoil...the most likely to be disrupted....I quickly think back to all the strategic studies and analysis I've seen… Al Qaida is out to bankrupt the West and cripple us economically – oil supplies in Gulf if disrupted would certainly help and threaten regime survival in places like Saudi Arabia – a double coup. It will be a huge target for decades. Chavez is out of control. Bolivia nationalizes its supply. Iraq is dicey. Iran could be blockaded or cut off its own supply in crisis… On and on… it's fragile and chaotic at best.

On the other hand, CNQ hails from a country of extreme political stability situated just north of the world's largest consumer of oil..... Why again did Apache pay that $22 for oil in the gulf? Why did Conoco pay $18 for Burlington?

I've previously discussed the global oil situation a bit here (1/19/05 – “oil going higher…. Let's see what it is 2 years from now..”)

http://boards.fool.com/Message.asp?mid=21933544

And here: (3/31/05 – Global supply/demand balance)

http://boards.fool.com/Message.asp?mid=22293878

And a further look at the global situation is absolutely STRIKING. According to Businessweek in the 1960s oil companies had access or rights to 85% of global oil and gas reserves. Today they have full access to 16% of global reserves, and “limited access” to 19%. Nationalization of global reserves is unmistakable and pervasive. And we all know that government run facilities are more inefficient. And the evidence proves this out – production of bbl per day goes way down once nationalized (Saudi, Venezuela, etc.). So that's an ongoing and persistent decline in production derived from stupidity and greed… at the same time demand is exploding.

The large company players also face a nasty dilemma… Their reserves are being depleted faster than what they are being replaced. Businessweek again reports that reserve replacement ratio from 1990-1994 for Total, COP, BP, Chevron, XOM, and Royal Dutch were all above 100% save for Royal Dutch which was just under 100%. And the estimates for 2005-2010 show only Chevron as being (just barely) above 100% (perhaps recent find bumps that quite a bit – maybe 1 million bbl/day).. But the days of finding cheap oil are most likely over. The average extraction cost of around $10 per barrel is only going to rise – this will place a natural floor on the cost of oil. It's going to take time and tons of capital for the above companies to acquire new discoveries and to put oil onto the market – and the promising areas are getting harder and more expensive to reach. With CNQ though, there's zero exploration risk – we KNOW where the oil is and the technology to reach it is there.

Perhaps NOW I understand why Apache forked over $22 for the BP wells in the Gulf – politically stable situation in a location right next to world's largest consumer at a time of declining global access to reserves, and dearth of any new major finds, and resultant decline in replacement ratios, all with rapid increase in global demand. Which logic dictates should force price per bbl of proven reserve for a company like CNQ way up as well. Seems only a matter of time…

And if oil price collapses in a big recession? Is that permanent? Does demand forever stay reduced? Nope..... temporary.... What about new discoveries ala Chevron's mother lode in the gulf? A little perspective is needed – current global demand is around 83 million bbl per day… demand is increasing over 1-2 million bbl per day each year…1 million per day new oil from gulf is great – but what's the significance? If it turns out to be a lot more HUGE than 1 million then our supply crunch may be over for awhile. There are other discoveries coming on line as well – which is just as well if demand continues its ascent. But is this all bad? I argue no…

Because stabilized prices ameliorate political risk which worries me more than business risk. I would think that a stabilized price supply/demand situation just might stabilize prices and take some of the political heat off of these companies and insane talk of windfall profits taxes etc. Afterall, the investor wants stability and being off the radar… Even if oil goes to $40 and stabilizes at that level - this thing is still a good bet to be a gusher.... And if that happens then gas should drop as well – dropping operating costs to well below that level…

PULL THE TRIGGER OR NO?

In my mind CNQ is an asset that is currently undervalued on what I think are conservative projections.... with a huge flyer on massive upside kick that you're getting for FREE.... why wouldn't I want to load up on that bet? Do I care that Berkowitcz got there first? Hell no. And I'd bet that the market won't recognize it until the light sweet crude from the Horizon project begins to flow - late 2008.... which means I've got perhaps another year to keep pouring capital into it....and can build a very meaningful position by dollar cost averaging into any yield at 10% or greater.... (I note that Berkowitcz has bought more this year at prices here and up). . Seems to me that a buyer is very much on the right side of time…with the right people… with a commodity that unlike gold at least people have a tangible use for.

Later;

HB
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