Newsletter Q2 2005
April 14, 2005
Another
Transition for the Global Economy
Crude oil prices have
declined from their recent peak due to higher inventory levels. The long-term
supply and demand for oil, however, remains problematic.
In the early 1950’s,
geophysicist M. King Hubbert developed a predictive model for forecasting oil
production decline curves. In 1956, he estimated that U.S. oil production would
peak in 1972. At the time, the U.S. was the world’s largest exporter of oil and
production continued to rise. Hubbert was thought to be another false prophet.
But others failed to consider what Hubbert clearly recognized - while oil
production was rising, reserves were declining. U.S. oil production eventually
peaked in 1970 and has since declined steadily.
Global oil demand has
increased to the current estimate of 84 million barrels per day (mbd) in 2005.
According to the International Energy Agency (IEA), oil demand will grow to 95
mbd in 2010, 105 mbd by 2020, and 115 mbd by 2030. Much of the incremental
demand will come from developing countries, especially China and India which
together have 2.3 billion people. Per capita consumption of oil in the United
States is at 25 barrels per year, while China and India’s per capita consumption
are at 1.3 and less than one barrel per year, respectively. Historically, per
capita consumption of oil increases as economies develop. For example, South
Korea’s annual consumption is now at 15.7 barrels of oil per capita.
Petroleum analysts that
have used Hubbert’s methods estimate that world oil production will peak between
the years 2004 and 2008. Several major OPEC producers are past peak production:
Iran, Iraq, Kuwait, Libya, and Venezuela had their peak production years in the
1970s, while Saudi Arabia and Indonesia peaked in 1981 and 1991, respectively.
Matt Simmons of energy
investment banking firm Simmons & Company, believes that Saudi production may
decline dramatically within a few years. Simmons instituted a study to
accumulate hard data on Saudi Arabia’s oilfield activity by reviewing 200
technical presentations made before the Society of Petroleum Engineers between
1961 and 2003. The world’s largest oilfield, Ghawar, was discovered in 1948 in
Saudi Arabia. It produces about 4.5 million barrels per day and accounts for
about 60% of Saudi production. Five other fields produce the remainder.
Simmons says:
All of these fields are old but Saudi Aramco has
managed them in a gold standard fashion by instituting careful and rigorous
water injection to maintain high reservoir pressures. They’re effectively
sweeping the reservoirs until the easily recoverable oil is gone. In so doing,
they have defied the standard decline curves. With water injection, they’ve
maintained reservoir pressures above the bubble point. The trouble is, once
they finally finish the sweep, they’ve done both primary and secondary
depletion. There isn’t any Act 2.
Simmons goes on to say that
such methods allow companies to extract more oil per well but they also
accelerate the recovery of economical oil, which eventually lead to sharp
decline rates in production.
Jan Lundberg, former owner
of the Lundberg Survey Inc., an
independent market research company that specializes in the U.S. petroleum
marketing and related industries, provides his prognosis:
The end of abundant, affordable oil is in sight,
and the implications are colossal. About now in our hydrocarbon phase of human
history, we have pulled out of the Earth approximately half of the available
petroleum (crude oil and natural gas). The other half still in the ground is
harder to extract and may not – as assumed – fuel the global economy or even
provide a transition to another phase.
Additions
Aspen Insurance Holdings
Limited (AHL) was purchased for most accounts. AHL is a Bermuda holding company
that provides specialty insurance and reinsurance products. The company has
$1.48 billion in shareholders’ equity and an investment portfolio which consists
primarily of high credit quality, short duration bonds. Shareholders’ equity as
a percentage of assets is among the highest in the industry at 37.6%. AHL
currently sells for 6.9X 2005 estimated earnings and 1.2X book value.
Tele Centro Oeste Cellular
Participacoes SA (TRO) is a holding company that owns six mobile telephony
operators in the Federal District and eleven states of Brazil, providing service
to 5.8 million customers. The company has a strong balance sheet and currently
sells for 6.8X 2005 estimated earnings.
Sinovac Biotech Ltd. (SVA)
was purchased shortly after the end of the first quarter. SVA specializes in
research, development, and commercialization of human vaccines for infectious
diseases. The company has three vaccines fully approved for China – Healive™
for Hepatitis A, Bilive™ for Hepatitis A&B combined and another for Split
Influenza. SVA is expected to begin production of Bilive™ and Split Influenza
vaccines in the second or third quarter of 2005. The company is also developing
vaccines for SARS and avian flu. SVA has a low cost structure and currently has
a market capitalization of $88 million.
Preferred stock of
Corporate Office Properties Trust (OFC-Pfd F 9.875%) and Public Storage Inc. (PSA-Pfd
Q 8.6%) were purchased. OFC and PSA are both real estate investment trusts with
steady income from geographically diversified properties. Both preferred issues
have high dividend rates but are redeemable within one or two years by the
companies. They are likely to be redeemed unless interest rates and credit
spread rise substantially. The yield to redemption date is attractive relative
to U.S. Treasury rates.
MFS Government Markets
Income Trust (MGF) and Allmerica Securities Trust (ALM) were purchased for
several accounts. Both closed-end funds sell at discounts to net asset value
that exceed 11%. Dividend yields for MGF and ALM are 4.7% and 5.9%,
respectively. The average credit quality for MGF and ALM are AAA and BBB,
respectively. During the last year, several smaller closed-end funds such as
ALM have been merged into affiliated mutual funds at net asset value by their
investment managers.
The Board of Directors of
Oppenheimer Multi-Sector Fund (OMS) has recommended that it merge into
Oppenheimer Strategic Income Fund, an open-end fund. After the announcement,
OMS was purchased for additional accounts at a discount to net asset value of
3.4%. The merger should be approved by shareholders because the merger will
eliminate the discount to net asset value.
U.S. Treasury bills due in
three months were purchased for some larger accounts as an alternative to a
money market fund. The yield to maturity at the time of purchase was 2.72%.
Deletions
Harmony Gold Mining Co.
Ltd. (HMY) was sold early in the quarter. Earnings estimates declined further
as operating expenses rose at a faster rate than the price of gold due to rand
currency appreciation and wage concessions.
Converium Holding AG (CHR)
was sold at a profit. The proceeds were used to buy Aspen Insurance Holdings
Limited (AHL), another reinsurance company that has a more secure balance sheet
and sells at a lower P/E ratio.
Blackrock Income
Opportunity Trust (BNA) was sold. Its discount to net asset value was less than
8% when sold. Proceeds were used to buy other closed-end funds which possess a
shorter portfolio duration and sell at a larger discount to net asset value.
Argentina Republic bonds
were sold in taxable accounts on the basis of tax considerations. The Argentina
Government has made an offer to exchange the bonds for newly issued bonds that
will pay some interest but have a significant original issue discount component,
which complicates tax reporting.
Updates
The Argentina Republic
bonds that were held in retirement accounts were tendered in response to the
exchange offer. The delivery date for the new bonds was supposed to be April
1. However, the U.S. Court of Appeals in New York issued a ruling to freeze the
swap of the defaulted bonds in response to a lawsuit by some bondholders who are
seeking additional accrued interest.
UT Starcom Inc. (UTSI)
delayed the filing of its Annual Report on Form 10-K for 2004 due to additional
time required for management to finalize its assessment of internal control over
financial reporting as required by the Sarbanes-Oxley Act of 2002. The company
has identified material weaknesses in internal controls and management expects
to conclude that the company did not maintain effective control over financial
reporting, which will likely result in an adverse opinion by the Company’s
auditors on the effectiveness of internal control. The stock declined on the
news, although there has not been any evidence of any material misstatement.
UTSI reported an order backlog of $1.2 billion at the end of 2004, 20% higher
than one year ago. The company expects revenue to increase to $4 billion in
2005.
In February, the Board of
Canadian Natural Resources Ltd. (CNQ) approved the Horizon Oil Sands Project.
The Project has fixed cost bids for roughly 68% of Phase 1 costs. Phase 1
production is expected to start in the second half of 2008 at 110,000
barrels/day of synthetic crude oil. Phase 2 would increase production to
155,000 barrels/day in 2010. Phase 3 will increase production to 232,000
barrels/day in 2012. Based upon $28 to $40/barrel oil, CNQ projects that once
all three phases of production are in place, incremental free cash flow from the
Project will be between $1.6 billion and $2.5 billion or $6 to $9 per share.
If you have any questions
regarding your accounts, please do not hesitate to call me.
Sincerely,
Robert G. Kahl
CFA, CPA, MBA
Sabino
Investment Management, L.L.C.