Sunday, June 7, 2009

Analyzing oil companies - The economics of the energy, commodity and materials business, and valuation traps

One school of thought is that investing in commodity-processing/resource-owning companies, such as oil majors like XOM, RDS, BP and CVX, and pulp and paper companies like Votorantim Celulose e Papel (NYSE ADR: VCP), is a good way to preserve wealth during periods of elevated inflation. The underlying hypothesis is that the price of commodities will rise in line with the general price level, allowing them to grow their profits in line with inflation.

However as with all investments, it is crucial not to overpay for a stream of earnings or you will end up with negative real returns. We'll look at one way of analyzing and valuing a commodity-processor/resource-owning company's earnings quality. We'll also see why in some cases we are better off buying commodities directly.

The economics of Commodity producing businesses
- they are price takers

Because their products are seen as commodities, customers have no particular reason to pay significantly more for a product from one company over another. In many cases, it is also relatively easy for customers to switch suppliers. This means that commodity sellers are price takers who cannot sell their product for more than the market-clearing price. The implication is that:

  1. The strongest company is the one with the lowest cost of production and cash reserves. One of the worst things that can happen to a commodity company is if the market price for the commodity drops below its cost of production, making it lose money every day it stays in business. (While hedging can ameliorate this, it is only a short term solution) So well-funded companies with the lowest cost of production will have the most sustainable competitive position; if prices drop, the lowest cost company will be able to run with the lowest losses until all other competitors go broke and withdraw capacity from the market, allowing prices to rise to a profitable level.

  2. They are vulnerable to price-irrational competitors. A competitor that decides to sell product below cost could drive the company out of business. This is a particular risk in "essential commodity industries, as governments may run loss-making state-owned competitors for political reasons. This is also a risk if the industry requires large amounts of fixed capital to operate, because ailing competitors may resort to flooding the market with product just to cover some part of their fixed costs (ie. manufacture as much as possible, as long as variable production costs are covered).

Durability of competitive position
- Factors affecting Earnings stream quality

Because they are price takers with an undifferentiated product, they have a durable earnings stream only when (a) the environment minimizes chances of prices falling below their operating costs, and (b) in the event that occurs, they are the best positioned to weather the down period until prices recover.

Industry reports and published financial statements can give you an indication of which companies are the most competitive, and have low production costs. The leading companies typically achieve their competitive position by (1) having economies of scale, (2) acquiring commodity reserves with lowest costs of production, and (3) applying operational efficiency and technology to minimize production and overhead costs. Unless there are disruptive events, it is likely that the leading companies will retain their competitive positions over the short term. However, the long-term durability of their earnings stream depends on 2 principal factors:

(1) The probability of price-irrational competitors emerging (such as government funded competitors). This depends on:
  1. the geo-political environment: For commodities that are considered strategic assets, there is always the possibility that interventionist governments may setup state-funded not-for-profit competitiors. States with resource reserves are especially good candidates for this. The probability of this happening is balanced by the existance of trade barriers and trade agreements which can prevent dumping of commodities into foreign markets.

  2. the cost structure of existing competitors. Competitors that are heavily in-debt and/or have high overheads may flood the market with product, just to cover some part of their fixed overhead costs/debt servicing. They can price product below true (fixed+variable) costs over the short run, just to meet cash flow needs.

(2) the probability that an upstart competitor can achieve lower costs of production. This depends on:
  1. The components of the cost of production. For example, the bulk of the cost of steel production lies in the cost of energy needed to run furnaces. So a competitor could achieve lower costs of production if it managed to find a cheaper source of power, for example by erecting a new dam for cheap hydroelectric power. You would need to analyze the probability of this happening to estimate the earnings quality of a commodity company. Likewise a pulp and paper company's costs could predominatly be in forestry costs, so a competitor who could open up cheap forestry landbanks (because of climate change or changes in government rules) could gain a competitive edge.

  2. Commodity re-cyclablity. Recyclable commodities like gold present the possiblity of a recycler finding a way (through technology, or finding an untapped source or cheap recycled gold) to produce re-cycled commodity at a lower price than extracting it out of the ground. For example in the gold market, it is conceivable that gold prices can fall below the cost of production of even the lowest cost miner, because there is a huge supply of gold which is already in the hands of consumers. Because gold is indestructible, there is always the possiblity that existing consumers may flood the market with their gold, and depress the market price of gold below it cost of extraction from the ground.

  3. Probability of changes in the company's competitive sphere. The "competitive sphere" is the range of competitors who can serve the customers that the company is serving, and it varies according to the nature of the commodity. For example, a perishable commodity like fresh milk has a local competitive sphere (as long as customers aren't open to ESL milk or UHT milk which can be supplied from thousands of miles away e.g. by Fonterra in New Zealand). Competitive spheres can change with technology. For example, natural gas used to be a local product which could only be transported along a pipeline to nearby consumers. However, with technology advances and the build up of LNG processing facilities worldwide, natural gas can now be converted into LNG and shipped anywhere across the world, making its competitive sphere a global one. The lowest cost producer in a particular region might find itself displaced from the lowest cost position when compared with producers across the globe.

  4. The Company's ability to keep acquiring lowest cost reserves. Resource owning companies constantly need to find new resource reserves to replenish reserves depleted by production. Otherwise the company will be operating in run-off mode, and will cease operations once its existing resource reserves are depleted. If the company is unable to find reserves with low extraction costs, or a competitor finds a motherlode of easy to extract reserves, then its future competitive position and earnings quality will deteriorate.

Valuing commodity/resource companies
- buying commodities, instead of resource companies, may be a lower risk way for investors to preserve wealth

To a long term owner looking at a company as an income producing asset, the valuation of any company is based on the present value of the expected stream of earnings which the owners can take out of the company. (We exclude earnings which need to be retained in the company, since they are needed to keep the goose alive to continue laying its golden eggs)

To arrive at a risk-weighted estimate for the future earnings stream, we need to combine all of the following:
  1. the earnings that will flow from its current commodity reserves

  2. the risks to those earnings, arising from changes to its competitive position (costs relative to its competitors) and the likelihood of non-economic competitors

  3. the ability of the company to continue adding to its resource reserves without changing its costs of production relative to its competitors

In the short run the company's earnings will likely grow in line with inflation (assuming it also drives commodity price rises), because the company's costs of production (reserve extraction costs and reserve acquisition costs) are based on yesterday's prices while revenue is based on today's inflated commodity prices.

However over the long run, the ability of resource companies to grow earnings in line with inflation is not a sure thing. In fact, their earnings behavior over the long term is likely to be no different from the average of a basket of companies across industries. Why? Because (a) as inflation sets in, their cost of acquiring reserves and the costs of extraction will also likely go up, and (b) like all companies, they face competitive risks to their earnings. And as we have seen, as commodity producers they can face more earnings risks than non-commodity producers.

So if you are looking to preserve the value of your wealth during inflationary periods, you may be better off investing directly in commodities, if you hold the view that commodity prices will rise in line with inflation. (which is the same premise in the "invest in resource companies" hypothesis)

Valuation traps and mistakes
- particular to commodity/resource companies

One mistake is to value a company by extrapolating its future earning stream from its recent earnings history. Commodity prices tend to be cyclical in nature, because of the oscillating boom-bust feedback loop that develops; increasing production causes prices to drop, which causes production capacity to be withdrawn, which causes prices to go up, and so on. These cycles can span many years, so you need to look at the 10-year earnings history (or longer) to get a feel for the company's earning power.

For resource-owning companies, this approach also ignores the fact that the company's reserves are not infinite and will run out at some point. Management will continue acquiring new resource reserves to keep the company viable as a going concern, and the new reserves' cost of production will determine the company's earnings quality down the road. For example, an oil company with low-cost reserves may have a high quality earnings stream today. But if it cannot replenish its reserves with equally low cost resources, it will gradually slip into a weaker competitive position and become more vulnerable to losses in future. This should reduce the valuation placed on the company.

Another valuation mistake is to take the enterprise value of a commodity company as = the amount of commodity reserves they have, multipled by the prevailing commodity price. (i.e. valuing the company in run-off mode, where the company will cease operations once its existing reserves are depleted). The problem with this approach is that it assumes that it is possible to extract and sell the entire reserves all at once. In practice annual production capacity is limited, so if you want to value the company as a run-off company, you need to base your value calculation on the NPV of each year's production, until all reserves are depleted. (It is not uncommon for resource companies to have only 10-20 years of resource reserves if production rates are maintained.) You may be surprised that the NPV value expressed as a PE ratio can be in the low single digits.