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Angelos Damaskos: Juniors that Insulate Investors from Today's Low Oil Prices

Source: Kevin Michael Grace of The Energy Report  (11/13/14)

Angelos DamaskosAngelos Damaskos, principal adviser of the Junior Oils Trust, admits that he finds the recent collapse in oil price a mystery. Nonetheless, he has no doubt that demand will compel higher prices in the medium and long term. In this interview with The Energy Report, Damaskos argues that current prices are dismal news for the majors, shale oil producers and the oil sands but underlines the advantage of investment in juniors with solid, long-term projects.

The Energy Report: The price of crude oil has fallen 30% over the last four months. Are you surprised?

Angelos Damaskos: It's astonishing, considering that the price had been stable for over three years, trading between $100 per barrel ($100/bbl) and $120/bbl for Brent crude.

TER: Why has this happened?

AD: It's unlikely that demand has collapsed so dramatically over the last four months. All indicators point to a fairly stable global economy, and the American economy in particular is enjoying healthier growth than previously.

TER: So has the price drop been orchestrated?

AD: Nothing can be substantiated, given the opacity of the oil market, but there are three theories. The first is that Saudi Arabia is overproducing to hurt the American shale oil industry. Many shale oil deposits are probably marginal at around $75–80/bbl.

The second theory is that Saudi Arabia may be overproducing to starve ISIS of funds. This is a more credible theory than the first, because this result would please the United States, as the oil price fall also hurts Russia, Iran and Venezuela.

The third theory is that China, which has significant control over marginal oil demand, has deliberately curtailed its imports of foreign commodities over the last four to six months, as industrial users are drawing down their inventories. The Chinese are trying desperately to control domestic debt and protect their banks. Chinese institutions have used commodities as collateral to leverage operations, leading to, among other problems, a dangerously overheated property market. This third theory would also explain the dramatic fall in the prices of base metals such as copper, aluminum, zinc and especially iron ore, which is now near an all-time low.

TER: Wouldn't Saudi Arabia cutting the price of oil be a case of cutting off its nose to spite its face? Saudi billionaire Prince Al-Waleed bin Talal pointed out, in an open letter to Saudi Arabia's oil minister, that 90% of that country's revenue comes from oil sales, so that to underestimate the consequences of a drastically lower oil price would be a "disaster which cannot pass unnoticed."

AD: The Prince certainly has a point. However, if we accept the theory that Saudi Arabia has a politically motivated interest to oversupply to harm America's shale oil industry, a significant reduction in new American supply would likely lead to more stable long-term oil prices, and this might actually benefit Saudi Arabia.

TER: Vladimir Putin has said that the global economy will suffer if the price of oil stays at $80/bbl. Putin obviously has a vested interested in higher oil prices, but is there anything to his argument?

AD: His argument simply doesn't make sense. Cheaper oil helps economic growth.

TER: How long will low oil prices last?

AD: Our belief is that the super cycle for oil is still intact. China now accounts for 11% of global oil consumption, versus 21% for the U.S. However, China has 1.3 billion people versus 360 million (360M) for the U.S. Furthermore, China represents 19% of global population. China's GDP per capita has risen by 350% from 2000 to 2013, versus a U.S. rise of only 7.5%. It is evident that China's energy consumption has risen significantly more than any other country's. This is the primary reason for the rising oil and energy prices in the last decade.

As China develops a middle class demanding a higher standard of living, this will require more energy consumption. Energy demand from China is likely to continue to grow at very rapid rates. Shale oil has added 2–2.5 million barrels (2–2.5 MMbbl) per day incremental supply to the U.S. over the last five years. However, conventional oil-source production from the U.S., the North Sea, Mexico, North Africa and the Middle East has fallen, so overall global supply has been more or less stable. The oil price drop is clearly temporary.

TER: When I spoke to you earlier this year, you noted the risky economics of the Alberta oil sands and fracking. Now that oil prices have fallen 30%, and the price of natural gas has fallen from above $4.20/million BTU in September to $3.87 at the end of October, are these industries in peril?

AD: There are certainly question marks about the viability of shale oil developments. Oil shale wells decline 50–70% in their first year of production. Companies need to keep on drilling to maintain production. Oil prices at current levels mean that shale companies will find it much more difficult to finance their capital programs. Management teams will lack the confidence to embark on ambitious, high capital expenditure (capex) programs.

The same considerations apply to Alberta's tar sands, which have marginal costs of $70–80/bbl, and to the deep sea fields in offshore Brazil that have not yet come into production, but are probably even more expensive.

TER: Do you stand by your May prediction that in 10–20 years oil should be well above the 2008 high of $147/bbl?

AD: Yes, based on our assumptions regarding Chinese growth and development stated above.

TER: When will we see a recovery in oil and gas prices?

AD: Oil will likely stay in a very tight trading range for the next three to six months, but oil prices of $70–80/bbl are not sustainable. In the medium term, prices should hit $100/bbl.

TER: You are the principal adviser of the Junior Oils Trust (JOT). Its value rose 18.3% from Jan. 1 to Sept. 30, making it the top-performing fund among the 20 energy funds monitored by Morningstar. Which factors explain the trust's success?

AD: We have three fundamental investment criteria. The first is to invest at relatively low prices in companies controlling large Proven and Probable reserves. This requires expertise in assessing the geology and nature of the deposits and their likely economic value.

The second criterion is avoiding pure exploration risk, meaning that there should be strong evidence of growing production in our investment holdings from well-understood geological settings. We invest in exceptional circumstances in early movers: companies that have secured licensed areas in new prospective territories. These companies are frequently funded by larger players that follow in their steps. Such juniors obtain exposure to high-impact exploration with limited monetary risk.

The third criterion is the consistent avoidance of political risk in operations in areas where the rule of law cannot protect title of ownership.

TER: How has the oil price fall affected how you evaluate the merits of particular junior oil companies?

AD: The price of oil is extremely important in our evaluation of current and future holdings. The lower oil price is extremely damaging to heavy oil companies and unconventional operators, such as the North American shales. Such companies with fixed obligations can get into trouble very quickly.

TER: You mentioned earlier your bias against pure exploration plays. Doesn't the recent fall in oil prices improve the viability for those companies that are already in the game?

AD: The problem we face is that we cannot readily assess the impact the oil price fall will have on the profitability of mature producers. Juniors with longer-term prospects do not have this problem. Obviously, companies with more mature production have better balance sheets, but until we fully understand the implications of recent price changes on profitability, we cannot estimate how their guidance will change in the next quarter.

At this stage, one must be extremely careful in buying mature producers. I would prefer to focus on light oil producers with high netback margins where the impact of the fall in the oil price is proportionally smaller than heavier oil or shale oil producers, which have a much higher marginal cost and much lower netback margins. Such companies face the risk that the oil price fall could potentially destroy their profitability.

TER: Thank you for your time, Angelos.

Angelos Damaskos is the founder and CEO of Sector Investment Managers Ltd. of London, a regulated investment advisory company. He is the Principal Adviser of the Junior Oils Trust and the Junior Gold Fund. The Junior Oils Trust focuses its investments in smaller oil and gas exploration and production companies. An investment banker, Damaskos worked a decade for the European Bank for Reconstruction and Development. He holds a Bachelor of Science in mechanical engineering from the University of Glasgow and a Master of Business Administration from the University of Sheffield.

Email: jluther@streetwisereports.com



Disclaimer: The views expressed in this article are those of the author and may not reflect those of Kitco Metals Inc. The author has made every effort to ensure accuracy of information provided; however, neither Kitco Metals Inc. nor the author can guarantee such accuracy. This article is strictly for informational purposes only. It is not a solicitation to make any exchange in precious metal products, commodities, securities or other financial instruments. Kitco Metals Inc. and the author of this article do not accept culpability for losses and/ or damages arising from the use of this publication.
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