Investor sentiment seems to turn on a dime. Only a few weeks ago, oil was touching $80 per barrel, and pundits were predicting that $100 oil was around the corner. Today, oil is around $60 a barrel, and the financial press has recruited a new set of “experts” who are bravely predicting that an imminent recession will drive oil below $40 a barrel.
As a professional investor, my only response to these wild mood swings can be “who cares.” Oil is a commodity with extremely inelastic short term supply and demand. In addition, its production is concentrated in some of the most volatile regions in the world. It is only natural for oil prices to gyrate wildly on very minor changes in outlook.
There gyrations may be entertaining, but they are unpredictable, and serious investors should avoid speculation regarding the near term price of oil. Rather, the focus should be on long term trends in energy, and what it means for portfolio strategy.
Long run, nothing has changed. Oil is likely to continue to trend down from current levels and “stabilize” somewhere around $40 a barrel. The reason is simple. There are technologically feasible approaches to substituting away from oil that are economically viable indeed quite profitable at around that price.
Much has been made in the press about two of these alternatives ethanol and oil derived from the Athabasca tar sands in Canada. Does it make sense to invest in these technologies?
Ethanol, to be sure, can be made economically viable if oil is at $40 a barrel. That said, most ethanol investments are in firms converting corn into alcohol. This technology is not particularly competitive, and requires both government subsidies and high import tariffs even at today’s oil prices. Adding insult to injury, corn based ethanol producers like Aventine, Verasun, and Pacific Ethanol are all valued quite aggressively by the stock market, even after recent steep declines in their share prices. These firms are best avoided.
What about the tar sands? Well, there are huge quantities of oil trapped in frozen Canadian goo, but it is extremely expensive to extract. Currently, tar sand producers such as Suncor or Canadian Natural Resources are not really profitable with oil below $50 a barrel. True, there are likely to be incremental improvements in the efficiency of these operations. Offsetting this, the extraction of oil from tar sands requires huge amounts of natural gas, and it is likely that natural gas prices will trend upwards over the long run. This will marginalize the tar sands business.
A more promising bet is on technology that converts coal and natural gas into liquid fuel that can easily replace oil. These technologies, known as CTL (coal to liquids) and GTL (gas to liquids) exploit vast deposits of coal and natural gas that are currently priced (per BTU) at a small fraction pf the price of oil due to their poor characteristics as transportation fuel. Currently, coal and natural gas can be converted profitably into liquid fuel with oil prices at $25 per barrel. Of course, as this technology catches on, the price per BTU for these fuels will rise, but a safe bet would be that they will rise only sufficiently to render GTL and CTL projects profitable with oil in the $40 a barrel range.
How does an investor play coal and gas liquification? The largest and safest way would be to invest in South Africa’s Sasol (NYSE: SSL). Sasol has been running CTL plants for years, and is developing large new projects in Nigerian, China, and the Persian Gulf. Not only are growth prospects strong, but Sasol is currently quite profitable, and trades at a ridiculous PE valuation of 10.
A somewhat more speculative choice would be Headwaters (NYSE: HW). Headwaters in also profitable, but is not yet really involved in the production of synthetic liquid fuel. It possesses technologies, however, that may play a key role in the widespread commercialization of CTL and GTL, so it also possesses considerable potential upside.
Truly speculative choices would include Rentech (Amex: RTK) and Syntroleum (Nasdaq: SYNM). There firms possess truly revolutionary technologies that could greatly enhance the efficacy of CTL and GTL efforts. Neither firm, however, is profitable, and no one can be sure if these technologies are commercially viable.
Dr. Jonathan Lipow is the chief economist of Forum FIE, the Israeli distributor of Vanguard and Wellington portfolio management products in Israel. In addition, Dr. Lipow manages the Forum International Equity Fund, a global hedge fund.
Published by Globes [online], Israel business news - www.globes.co.il - on November 14, 2006
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