Where to Focus in a Tough 2009 for Energy (Morningstar)

Morning Star January 20, 2009 Pat Dorsey: Hi I’m Pat Dorsey director of Equity Research with Morning Star. On Friday night, Conical Philips announced a multi billion write down that may look frightening from the headlines but really there is more there that meets the eye. It involves counting changes with the way that oil and gas firms are counted for things on their balance sheets as well as some acquisitions they made several years ago and an unsustainable environment in a couple of different ways. With me to pick apart the numbers is our Associate Director for energy research, Eric Chenoweth. Thanks for joining me, Eric. Eric Chenoweth: Hi Pat. Pat Dorsey: So big picture this is backward looking and not something you think that’s sustainable. Eric Chenoweth: Sure. It’s a big number like you mentioned and it is looking back at a lot of the deals that they’ve done both a brilliant term resources or deal and the actual Philips acquisition of Conical and the good will getting written down in regards on those transactions. It’s something that I think is; if you want to look for it in a couple o weeks, there’s something that we are going to see more of from other companies. Pat Dorsey: And next because their basically squeezed between low oil prices at the end of 2008 and they cost environment that really haven’t come down yet. Eric Chenoweth: Sure, when they look at the year-end reserves and calculate these press and value 10PV10 numbers that they do every year, they use a snap shot and that snap shot includes a very low oil price. Actually $45.00 I’m going to guess on the old price were a lot easily could shake out on about $5.50 in the gas price but it cost in environment that’s more reflective still of kind of where we were in the middle part of 2008 that hasn’t really fallen to match up with the new price environment. So if I was a betting person and this is not a big bet by any restriction mediation, the cost of mergence is going to fall quite a bit. So even if prices don’t rebound the cause should come down from where we are and these numbers are like I said a little punitive. Pat Dorsey: And for forward basis, what does this mean for the oil and gas investors. Eric Chenoweth: For larger companies like Conaco and for most of the companies, it’s not a big deal. Like you said, it’s a non cash charge but it is something that we’ll see a lot more of. Like I said earlier, we’ll see a lot of companies that have made acquisitions over the last three to five year write a lot of this down. It’s more important pride to look at where the value of these reserves should be in more normalized environment I talked about when the cost come down and hopefully when the price is rebound a year or so from now. Pat Dorsey: And that’ll depend really on sort of the demand environment more than any thing else. Eric Chenoweth: Absolutely and that’s the challenge. It’s obvious that 2009 is going to be a tough year. As you can see right now if you’ll still look at where things stand right now; the prices fall from the past haven’t come down that’s a really tough environment for a producer of oil. But like I said, the big opportunity will be later in this year when you get investment in the price environment where there is hopefully cost coming down and hopefully prices will start to settle and start to increase. Pat Dorsey: And sticking with the forward-looking thing, which something you and I have talked a little bit about is the value of some of the hedges that these oil. And gas companies have on their books and off course many of them walked in much higher prices in 2008 and so those hedges are pretty valuable asset if they have a hedge production at $60.00, $70.00, $80.00 a barrel and with oil at 45, those hedges are pretty valuable I would think. Eric Chenoweth: They are. They are becoming more and more valuable every quarter and that’s one of the important things to distinguish when bankers look at these companies. The bankers take the hedges into account where a year end reserve number doesn’t take these hedges into account these SCC numbers don’t take the hedges into account. So from the banker’s stand point, they’ll still be willing to lend money taking the hedges into consideration which is important. But for some of the companies they haven’t hedged or mostly for the companies they haven’t hedge will start to probably see their borrowing capacities shrink and the banks will be less willing to have a large credit line for them. Pat Dorsey: Yeah because they value their collateral that is the reserves shrinks as oil prices come down. Eric Chenoweth: And that could mean that some of these companies especially ones that got a little too aggressive this past summer in hindsight, they could be faced with a situation that they’ll be selling assets and we could see the kind of the asset market deteriorate in ’09. Pat Dorsey: So that would imply then that sort of a smaller perhaps more leverage DNP company is going to be in a weak negotiating position where as cash rich companies either mid sized or the majors really are going to be the ones in the cat bird sit if some of these force tellers come out of the market. Eric Chenoweth: Absolutely and that’s the thing in October when a lot of these companies had their borrowing bases re-affirmed October, November, and September; oil prices were about twice where they are now and so in March. When we get to another period where the banks re-evaluate these guys, they are going to be looking at a much smaller oil and gas price assumptions and there’s a potential for that contraction in borrowing capacity for these companies to push on these company market. Pat Dorsey: The bottom line for an investor looking to sort of think forward a few years, think about a more normalized price and demand environment perhaps look for opportunities in this area. Where the balance sheet is the key area to focus on because it’s the company’s with cash that are going to be able to sort of make hay during this down turn. Eric Chenoweth: Absolutely and one more thing I’d add getting back to the hedges. That’s the one thing when you’re looking at the balance sheet the hedges are going to become a larger asset these companies this year and it’s going to introduce kind of a new concept which counter party risk. A lot of these hedges are with financial institutions and banks and some financial players that we know aren’t in the healthiest shape right now so there’s always a chance to a counter party risk could come to bite you on somebody’s hedges head positions. Pat Dorsey: Some good thing to keep in mind, thanks Eric. Eric Chenoweth: Thank you Pat. Pat Dorsey: I’m Pat Dorsey and thanks for watching.