I’m a big fan of Bruce Berkowitz and the Fairholme Fund. I also believe that oil prices will generally through cycles trend higher in the coming decade. As I reviewed the Fairholme Fund portfolio recently I was struck by what was missing. Where had his large energy holdings gone and why ?
In 2006 Berkowitz had a large amount of exposure to oil primarily through oil producers with the largest position being Canadian Natural Resources (CNQ). In fact at one point CNQ made up over 15% of the Fairholme Fund.
In April 2006 Berkowitz did an interview with Value Investor Insight. This interview is posted on the Fairholme website. Below are some interesting comments by Berkowitz from that interview.
On why they got interested in energy companies:
Energy is a great example. Our original thesis was that certain oil companies, because of hedges they’d made, were still earning as if oil were at $20 per barrel, even through oil was at $40. As the hedges came off, earnings would go way up and so would the stock prices.
We got particularly interested in Canadian companies, which we found to have more impressive management than most U.S. firms. They were engineers, more down-to-earth and more long-term, strategic thinkers. While the big majors were talking about how they couldn’t replenish reserves fast enough, you had these Canadian companies that appeared to have endless resources.
On their opinion on future oil prices:
Our only macro view about energy was that the supply of cheap oil was disappearing. There’s plenty of oil, but you just can’t find it and produce it cheaply. That makes the likelihood we return to $20-per-barrel oil very low.
The physics make sense to us that this is a resource that’s being used up. Every major field outside of Saudi Arabia is in decline. Those people who talk about this endless supply of oil regenerating andbubbling up from the center of the earth, where is it?
Then we started working through the alternatives: nuclear power, solar, wind, oil shale, coal-to-gas. I made myself crazy one weekend trying to figure out the potential for ethanol. All of these have their own problems – from safety, to capacity constraints, to cost, to lead times – and it’s going to be hard for any of these to compete with oil even at today’s prices.
The only scenario we see where you get excess supply is a deep U.S. recession, which probably also slows down China and would temporarily decrease demand. Other than that, it’s hard to see what creates enough supply over the next five to ten years to make prices go down much.
Specific Comments on Canadian Natural Resources:
This is a diversified oil and gas company that I’d never heard of before we started looking into it, even though it had about a $10 billion market cap at the time. As I said earlier, we’re very impressed with the management, which has an outstanding track record of success across several market cycles and now has over $1 billion invested in the company.
We think this will be a household name one day. The company is moving from a reliance on natural gas and heavy oil to being a light, sweet-grade oil company. That will happen as they continue to develop their Horizon oil-sands project in Alberta, which has no exploration risk. The upgraded oil from the sands will be a light synthetic crude oil that will get a premium price to West Texas intermediate.
Right now Canadian Natural produces more than 500,000 barrel equivalents per day in traditional production, which will roughly double over the next seven years as Horizon starts up and they develop other conventional assets.
On Oil Sands Economics:
They’re looking at an operating cost of less than $18 per barrel coming out of Horizon. They’ve based the economics of the project on $28 oil, and at that level expect to earn a double-digit IRR.
We’ve already talked about our macro view of the price of oil, but we bought here into a management and at prices that made us not worry too much about the price of oil. We certainly don’t need prices to stay at current levels for this to be a great investment.
We’d argue now that further oil-price increases wouldn’t be welcome. You don’t want to push the world into recession, or to prompt governments to start slapping tariffs and surcharges on oil.
On Canadian Natural Resources Valuation:
It still trades at less than 10x free cash flow of about $6.50 per share, for a company with the ability to double production and triple free cash flow over the next eight years without having to add any new assets.
This is one where we don’t really have an upward value range on it, because the numbers get crazy. They have six billion barrels of recoverable reserves in the oil sands and another three billion barrels in heavy oil/bitumen properties. That’s nine billion barrels of oil before you even talk about their conventional oil and gas reserves, which are approaching the equivalent of 2.5 billion barrels.
The assets aren’t exactly the same, but Chevron bought Unocal in 2005, on average, for $12 per barrel in the ground, although much of that related to lower-value gas reserves. Apache Corp. announced just last week that it paid the equivalent of $22 per barrel in the ground to buy 18 Gulf of Mexico properties from BP. Applying anything like those numbers to Canadian Natural’s assets, and, as Bruce said, the upside does get crazy.
A great interview with Berkowitz by VII. At that time CNQ was $30 a share (split adjusted) and oil was in the $60 to $70 range. Today CNQ is $34 (split adjusted) with much higher production than 4 years ago, a $75 oil price and higher 10 year strip pricing.
So why doesn’t Berkowitz still own CNQ or any other energy position ? Has his view of future oil prices changed ? In the interview you will note that they correctly predicted what a recession would do to oil prices, and you will also note that oil prices have quickly bounced back. Is it something about the company that he now doesn’t like. Perhaps he is worried about government adding taxes to oil producers as Australia is trying to do to miners.
From where I’m sitting Canadian Natural actually looks more undervalued now than it did at the time of this interview. I’d love to know what has so dramatically changed Berkowitz mind on holding the stock.
I own a small position in CNQ and am actively buying PWE and hoping it drops so I can add more. PWE was also a Berkowitz position at the time of this 2006 article. Here is a brief recap I wrote about PWE which I think has become much more valuable thanks to new drilling techniques: