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Ross:
Didn't see a response, this may be a little late - but I'm travelling into
internet never-never land:
>1. Amex XOI and other energy vehicles are in divergences.
No comment re above.
>The talking heads on TV say that the oil companies are still near their
lows
>because they are initially hurt by rising oil prices as much as anyone
since
>it takes time for them to "get ahead of the curve" on retail pricing.
Talking heads are wrong.
The lag time between retail pricing and rising oil prices (I presume you
mean the futures market) is 1 day.
Or the company goes bust.
Oil companies make money 3 ways:
a/ Extracting it from the ground.
b/ Refining & Marketing it to retail end users.
c/ Hedging and Fudging balance sheet exposure; and adjusting inventory
valuations to capture tax shelters.
Regardless of what sort of "oil co" one talks about on TV, typically one
does not see the impact of crude prices on any of the above 3's bottomlines.
The only thing that oil price impacts is research and exploration activity -
fairly long product cycles, immune to day-to-day oil price swings. Again,
R&D is not the same as bottomline on a quarterly basis. Some companies
outsource R&D, some do it inhouse. Those that get the outsourced contracts
are usually diversified enough to withstand the lean cycles - else they go
boom-bust-boom.
Here's how it works:
a/ Extraction:
My data benchmarks worldwide average cost of getting crude from underground
into barrel at about $7 per barrel. Below this, the
Saudis/Indonesians/Nigerians won't extract. To a company, the cost
benchmarks around $9.50 into port of consumption.
Global demand has been growing @ ~2.3% pa past 20 years (post OPEC Crisis) -
stagnant against a world economy growth in 4% range. Regions have been
coming into and out of demand growth (current hot potato = Asia).
Global supply therefore has been growing at the same ballpark range.
Stagnant market, stagnant supply, way to grow a business is through
market-share capture.
Market share game plays out as follows:
Cost of entry is high (capital intensive and geo-political barriers to
entry).
Entrenched competitors, usually shared resources (yes, a BP shares its
Iranian pipeline with an RD because building a new one is stupid).
Competitive focus is therefore on
- increasing operating efficiency (which, beyond a level, cannot be done
since this is a low-tech industry - akin to making soap)
- gaining market share. (consolidations, taking out surplus capacity,
cutting surplus non-productive costs)
Oil majors have sliced up the pie; bigger their share = bigger their
cashflow and the Independents are progressively getting marginalized and
squeezed.
These are market share and corporate strategy dynamics driven by cash
flows - which have a lot to do with oil prices.
High oil prices, same cost of extraction, bumper profits all around because
everyone sells at what the spot market will bear (which is generally -
though not always - in line with the front month futures market).
Bumper profits = increased warchest to acquire (but one cannot acquire like
for like in good markets since the target's profits are also swollen so one
waits for low oil prices and squeeze out the weaker ones).
In essence, extraction related companies pass through rising crude prices to
their consumer - the refinery. Their earnings are price-sensitive, but not
in a negative way - for most of these bumper profits get funneled into
Reserves % & Surplus. Nobody lays out more pipelines, nobody gets into a
price war to win market share, nobody increases dividend or pays down debt.
They build reserves to buy market share in the next down cycle.
b/ Refining and Marketing:
This is the ultimate model to study in flow-through pricing.
They buy crude 3 months in advance, know their output routines, and work to
fulfil it. Average production cycle time from crude order to refined product
delivery is 110-120 days.
These people take no risk - they have crude at known (pre-contracted or spot
market) cost and they sell product at known market price; their production
takes place at known cycle times, with known input-output ratios, and known
destination markets with known seasonality - so their production cycles are
finetuned to almost-perfection save for the occasional cold-snap squeeze or
refinery explosion.
The input price (crude oil) is defined by contract, the output price
(refined product) is defined mostly by spot markets - the heating oil
distributor, the gasoline chain, the chemicals company that buys all the
benzene etc.
In other words, the refiner's margin expands if it has cheap crude on its
inventory relative to currently heavy refined product pricing.
The refiner's margin contracts if it has expensive crude relative to
currently light refined product pricing.
If the spot market for products is light, they cut production to bring down
marginal costs which helps keep their margins in a stable band.
If the spot market remains light for weeks, you start looking at reports of
refinery fires, sudden supply squeezes - et al. In other words, refining
capacity goes down to meet reduced demand at constant price.
The game is one of inventory, of production sequencing, and of hedging
chutzpah.
In other words, it is not one of crude oil prices - it is one of what the
refiner can extract from the spot markets in order to maintain a reasonable,
or a rich, or a poor margin.
This refiner's margin is called the Cracks - and here's how you calculate
them:
1 contract of Crude = 1000 barrels
1 barrel = 42 gallons (thus 1 contract = 42,000 gallons).
This 42k gallons = 1 contract of HO and same qty = 1 contract of HU.
However, the way its chemistry works, the crude can't be refined into just
HO or HU - you get both - usually in predetermined input-output ratios.
So you convert the price of HU/gallon into price of CL/gallon and you have
the current refiner margin on HU. Ditto HO.
Typically you will find refiners make between $x and $y per barrel of
output.
Whenever the number gets into the low $x's, expect something like you've
been seeing in the past 3 weeks in these markets.
Whenever the number stays north of $y's, start expecting reports of OPEC
cheating, over-supply, etc.
Everything in between is "All Systems Hunky Dory" as far as refiners are
concerned.
Again, this has nothing to do with where Crude Oil per se is trading - it
doesn't matter to the refiner that it is at $10 or at $30 per bbl, because
its conversion ratios are still under control and everything it inherits
gets passed on.
This is proven to you by the ebb and flow of retail gas station prices - if
you live in USA, 12 months ago premium gasoline retailed for $0.90 in New
York City. Today it retails for $1.70 per gallon. Both data points are from
the peak cold days of Winter, typically not a driver-friendly season.
Same for Heating Oil.
In sum, we've seen that 2 of the 3 major players in the ground-to-market
cycle do not care where crude oil trades today or tomorrow. The only ones
who get impacted are those who depend solely on R&D handouts.
More details on the Crack (as the refiner margin is called) can be found on
nymex.com.
c/ Hedging/Fudging/Inventory valuation:
I leave this to your digging. I'd recommend configuring a multi-year trend
on any two companies' SEC filings to get a taste of things.
>Higher, yet stable, crude prices supposedly mean an opportunity for their
>profits to grow.
Higher and stable crude prices mean an opportunity for market share games to
begin. Profits for refiners grow from crack margins. Profits for extractors
grow from higher prices, but there is no competitive advantage since the
gains are equally distributed between friend and foe. Sooner, rather than
later, some free-market dynamic causes Player A to break ranks.
And I do mean the ranks of the countries with the oil under their land.
>Certainly their P/Es are below the Techs. Any thoughts?
I would think P/Es of like be compared with like - eg - P/Es of these same
companies from 1980, 1970, 1960 etc.
Tech is a different game - different geopolitical influences, different
rates of organic v/s acquisitive growth, different set of stock market
perceptions....
Please feel free to ask questions if any of this is confusing.
Gitanshu
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