My TFSA Update August 2016 - The Non-Obvious Reason Why I Invest In Oil Stocks

Last update on Sept. 13, 2016.

Image Credit: Maximov Denis / Shutterstock.com

In this series, I (Jin Choi) talk about my goal of reaching $1 million in my TFSA account by 2033. If you want to know what a TFSA is, I recommend you read my free book. In this post, I’ll also explain why shale oil and gas companies are often more profitable than they seem.

 

August Results: Down 4.4%

At the end of July, I had $57,324 in my TFSA account, which is down by 4.4% since the end of last month. By comparison, the Canadian stock market went up by 0.3%, while the U.S. stock market went up by 0.7% in terms of Canadian dollars. Therefore, my portfolio underperformed the broader stock market in August.

The majority of my portfolio currently consists of oil and gas producing stocks, so the performance of my portfolio should largely be tied to oil. In August, oil prices went up from $41.54/barrel to $44.68/barrel, and the majority of my oil and gas stocks went up. However, one of my oil and gas stocks went down, dragging the performance of my whole portfolio with it.

The performance of that one stock is interesting because according to my calculations, the company is on the cusp of making a profit, even with today’s low oil and gas prices. However, I understand why that would not be obvious to many investors, so in this article, I will explain why many oil and gas companies are actually more valuable than they seem.

Before I understood oil and gas companies, I wondered why anybody would ever invest in them. As you know, companies are valued based on their profit generating potential. The trouble I saw was that a lot of oil and gas companies never seemed to generate a profit.

Let me take a real example to illustrate this point. NuVista (Ticker: NVA) is a fairly typical shale oil and gas company operating in Alberta. ‘Shale’ refers to oil reservoirs that are accessed through the recently popularized ‘fracking’ technology. As the table below shows, the company recorded losses every year since 2010.

Year

2009

2010

2011

2012

2013

2014

2015

Profit

2,476

-59,655

-143,800

-195,200

-61,144

-58,881

-172,925

If a company perpetually loses money, it sooner or later heads towards bankruptcy. However, while NuVista’s stock didn’t do well from 2010 onwards, its stock price didn’t crash either. As of the time of this writing, the company is still valued at more than $1 billion.

So you’d wonder, why hasn’t NuVista gone bankrupt? Is it because investors keep giving the company more money? If so, are investors dumb? The answer is no and no. The real reason NuVista hasn’t gone bankrupt is because stated profits don’t tell us much about an oil and gas company’s real profits.

 

How Depreciation Obscures True Profitability

In order to see why, you first need to understand an accounting concept called depreciation. When a company purchases a long lasting item, such as a building or a piece of furniture, the company doesn’t record the entire amount of the purchase as its expense. Rather, the company spreads out the expense over many years. This recurring expense of a past purchase is called depreciation. For example, if a company spends $7,000 on furniture, it will typically record $1,000 a year in depreciation for 7 years.

Because of its nature, depreciation is not a cash expense. In the example I cited above, though the company records a depreciation of $1,000 every year, the company doesn’t actually pay $1,000 a year towards the furniture. Of course, depreciation is “real” in the sense that it reflects cash expenses made in a previous year. However, my point is that depreciation doesn’t occur at the same time that the cash payment occurs.

In order to come up with a fair number for depreciation, oil and gas companies typically use the unit of production method. The method works like this: Suppose a company thinks a well will produce 100,000 barrels of oil over its entire life. If the well produce 30,000 barrels in a year (30% of the total), then it will depreciate 30% of all the costs associated with drilling the well. So if the company spent $2 million drilling the well, it will depreciate $600,000. Another way to look at it is that the company records, for every barrel produced, $20 as depreciation in future years.

While this method may seem fair, it can obscure the progress made by oil and gas companies with regards to cost reduction. Let me use an example to illustrate this point.

Suppose that in Year One, it cost a company $20/barrel to drill a well. This means in future years, the company will depreciate $20 for each barrel produced. In Year Two, because of technological advancements and other operational efficiencies, the cost per barrel goes down to $15/barrel. In Year Three, further improvements are made, and the cost per barrel goes down to $10/barrel. By Year Four, the company is producing wells drilled in all the previous years, so depreciation would be calculated based on the average cost of wells drilled in Years One, Two and Three.

Let’s say for argument’s sake that the company records $15/barrel in depreciation in Year Four. Suppose it also costs $20/barrel to pay for all other operations of the company, including taxes, employee salaries, etc. This means the all-in cost to produce a barrel of oil is $35. Now, suppose that oil is trading at $33/barrel. Here’s the question - is the company making money, or is it not?

According to the accounting standards, the answer would be no. The company would record sales of $33/barrel, and record expenses of $35/barrel, giving the company a loss. However, I see this differently. Today’s all-in cost to pump an additional barrel of oil is $30 ($10/barrel to drill + $20/barrel for everything else). If we assume that oil will stay at $33/barrel forever, I would consider this company to be profitable.

To state this concept more explicitly, I believe there is a better way to gauge an oil and gas company’s profitability. Rather than looking at a company’s stated profits, I believe an investor should exclude depreciation as an expense, and replace it with the costs that are necessary to keep production steady. Seasoned investors will recognize this latter number as “maintenance capex”.

Unfortunately, it’s hard to estimate a company’s maintenance capex, and companies don’t usually publish such numbers. This is why I believe it’s so hard for the average investor to analyze an oil and gas stock. However, in most cases, maintenance capex today is much lower than depreciation.

Take NuVista, for example. In 2015, the company recorded roughly $160 million in depreciation, and spent roughly an equal amount on drilling new wells. If NuVista’s costs stayed the same as in previous years, we would expect production to stay flat. But on the contrary, NuVista’s total production jumped by 35%. Had the company merely wanted to keep production flat, I believe they could have done so by spending less than $80 million. Whereas NuVista recorded a loss of $173 million in 2015, I believe their real loss was less than $90 million.

But that’s not all. Due to the production profile of oil and gas wells, many oil and gas companies become more profitable over time as well.



Why Maintenance Capex Goes Lower Over Time

A newly drilled shale oil well typically reaches peak production in the first month, after which its production drops dramatically. The magnitude of the drop varies from well to well, but they typically decline by 70% in the first year - e.g. if a well produces 1,000 barrels/day in the first month, it would typically produce 300 barrels/day a year later.

After the first year, a typical well’s production continues to go down, but at a slower rate. In the second year, production may decline by 40% or so, and in the third year, perhaps by 30%. After the fifth year, however, production typically declines by less than 20% per year.

Now, imagine that a company drilled just one well, and wanted to spend just enough to keep total production flat. Let’s see how difficult that would be in the ensuing years.

Let’s say that the company’s initial well produced 1,000 barrels/day in the first year, and production declined to 300 barrels/day by the second year. In this case, the company would have to drill enough wells to produce an extra 700 barrels/day in the second year. Suppose the company did that; by how much would production drop in the third year? Assuming the first well declines by 40% and the second well declines by 70%, the company would have to drill enough to produce 610 barrels/day (i.e. 40% of 300 + 70% of 700).

You’ll notice that in the third year, the company had to find less new production in order to keep production flat compared to the second year (610 vs. 700 barrels/day). This is because the first well’s production has started to decline more slowly. This effect will continue into the future, so in the fourth year, the company will need to find less production to keep total production steady, and in the fifth year, the amount of new production will be less still. This means  oil companies become more profitable over time because their maintenance capex goes down.

The principles I illustrated apply to most, if not all, shale oil and gas companies in Canada. So while many of them look as if they’re losing large amounts of money today, I believe the real losses are often far less.

What’s more, I believe that many oil companies will continue to find ways to reduce their costs. Technology continues to evolve, allowing companies to extract more oil and gas per well, reducing the cost per barrel. Moreover, companies are finding ways to drill wells more quickly, reducing costs further. This means that even if oil prices stay still, these companies will become more profitable over time.

Now, some people will find a problem with this investment thesis. If everybody lowers their costs, economic theory says the price of oil will come down too. In fact, many point to the development of technology as the main reason why oil prices are low today.

The problem with this argument is that technology has only affected shale oil and gas producers. Even today, shale oil accounts for roughly 5% of the global oil production. On the other hand, the cost to drill conventional wells around the world hasn’t gone down much, and neither has the price of oil that’s necessary to balance oil producing countries’ budgets. Therefore, I’m very skeptical that oil prices will stay low due to shale oil producers.

When a company produces a commodity like oil, the only competitive advantage the company has over others is cost. By continually decreasing costs, I believe that some oil companies will create ever greater competitive advantages over others. This is the reason I invest in them, even if their stock prices are volatile.

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