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Energy / Resources

  • Can you value commodity type companies?

    rogermontgomeryinsights
    December 24, 2009

    Commodity prices…  can anyone predict their movements? Driven by supply and demand, and exaggerated by speculation, predicting the price of oil, iron ore, coal, diamonds and titanium is an almost impossible task.  \It is however a task that is required if you are planning to buy shares in a mining company. Ruling out mining exploration companies that make no profit, and whose race to a valuation of zero is only retarded by the amount of cash remaining in the bank and measured by a ratio called the cash ‘burn’ rate, we are left with the producers.

    For reasons mentioned above, no mining company is easy to value, however some lend themselves to valuations better than others. The best are those that are large, broadly diversified and relatively stable. BHP immediately comes to mind.  Born as a silver and lead mine in Broken Hill in 1885, BHP, following the 2001 merger between it and Billiton, is now the world’s largest mining company with operations from Algeria to Tobago and everywhere in between.

    But even BHP cannot escape the commodity cycle and this can be seen in the swings in its valuations in the past.  BHP’s valuation can be $48 in one year (2008) and $13 the next (2009). This “valuation volatility” is vastly different to JB Hi-Fi, for example, whose value has risen from less than a dollar in 2003 to $20 to $24 today and in a steady ‘staircase’ fashion.

    Many of you have asked me for a valuation for BHP. Using the earnings estimates of the rated analysts on the company, there is clearly some optimism about BHP’s prospects. Returns on equity are expected to rise from 17.5% this year to 24% next year, and circa 28% in 2011 and 2012. These numbers however are still lower than the rates of return the company generated between 2005 and 2007. The estimate I come up with for BHP using the actual estimates of the rated analysts is a value of A$36.56, and if the analysts are right, the value rises dramatically in future years.

    Warren Buffett doesn’t like businesses that are price takers – commodity type businesses. The reason is that it is impossible to forecast future rates of return on equity with any confidence.  BHP reflects this historically.  BHP is big enough now that in some cases it is calling the (price) shots, but don’t forget we are talking about capital-intensive businesses.

    Posted by Roger Montgomery, 23 December 2009

    by rogermontgomeryinsights Posted in Companies, Energy / Resources
  • What is Caltex Worth?

    rogermontgomeryinsights
    December 10, 2009

    For some reason over the last few weeks I have received an influx of requests for a valuation on Caltex. I guess it must have something to do with the share price declines.

    Let me start by saying, you are on a hiding to nothing, trying to value this company. Like any business, the true value of Caltex has nothing to do with its share price and is instead determined by its equity and the profitability of that equity. As you are probably already aware profitability (return on equity) is going to be heavily impacted by input costs and revenues which for Caltex are fast changing. To better understand Caltex profits, have a look at what goes into the price of a litre of petrol that it sells.

    To determine an Australian refiners’ profits you must start with the Singapore refiners’ price for petrol. This is because Australia’s local oil refineries compete with imported petroleum products from refineries in Asia, regardless of the cost of importing and refining crude oil. Consequently, the price of petrol at Australian refineries is based on international petrol prices. If local prices were higher than international prices, imports of petrol would displace local production. The result is “import parity pricing” – in other words, what it would cost to land fuel from Singapore refineries into Australian terminals. In turn, this price includes the Singapore benchmark price for refined petrol or diesel, the addition of an Australian “quality premium” (dubious but said to take into account Australia’s “high fuel standards”), plus shipping costs and cargo insurance. The result is then converted from US dollars per barrel into Australian cents per litre (1 Barrel = 159 litres).

    So, starting with the Singapore petrol price (which is itself prone to wild swings),we have to add shipping (variable), quality premium, shipping insurance (variable), covert to Aud (variable), then add port costs (relatively stable), then add wholesale and retail margins (variable) and freight (variable) and then after GST and the Governments fuel excise we have a retail price for petrol.

    You can see that there are many factors that are out of Caltex’s control and will determine its profitability and I haven’t addressed the factors that will influence the Singapore refiner’s margin, although the cost of crude oil has the most impact in the long term.

    Feel like a break yet?

    The result is that Caltex’s profitability is volatile and this is evident in the numbers. In 2001 Caltex’s return on equity was -20%, while it was 40% in 2004. Based on some of the research I have seen, return on equity is expected to be around 10% for the next three years. Really? Who knows? How could you know? It will depend on the price of oil. In the 2007 year (Caltex has a December year end) oil prices traded between US$49.90 and US$99.29 and Caltex’s return on equity was 24%.  n 2008 the oil price began at US$96, rallied to US$147 and fell to US$32.40. Caltex’s return on equity that year was 1.3%.

    If we assume that the analysts are right with their forecasts of a 10 percent return on equity, then the value of Caltex is somewhere between $8 and $9. My valuation actually comes in at $8.74 but for the reasons I described above, I would not even consider a purchase unless the shares were at a very substantial discount to this valuation.

    You should be aware that if you are trying to value Caltex, you are punting and making a plain old bet. Its a bet you might get right, but it is speculating not investing. Perhaps if you can buy Caltex at a 50% discount to a conservative estimate of intrinsic value it would be a safer bet but even then it is still a bet.

    Posted by Roger Montgomery, 10 December 2009

    by rogermontgomeryinsights Posted in Companies, Energy / Resources
  • Do I invest in commodities or individual commodity stocks?

    rogermontgomeryinsights
    December 3, 2009

    Yesterday an investor who likes his commodities, James, posted the following comment to the blog:

    Hi Roger,

    Following you on the TV shows is really helpful to my investment decisions, so thanks very very much.

    I’d also like to have your view on current commodity bull trend. I understand that you like to value companies based on ROE, RR, etc, but do you ever try to reasonably predict the metal / commodity / gold price for next year? While you may say that is speculation, but a reasonable prediction based on supply / demand would also help in determining the company value?

    James

    Following is my response:

    I am interested in commodity companies.

    There’s something in the fact that billionaire Jim Rogers has been saying expect new highs in virtually all commodities over the next decade. There’s also something ominous in Warren Buffett’s purchase of a railroad company. Both men believe that oil prices will rise substantially.

    I think its impossible to predict prices of anything in the short term, however I do believe that over longer periods there are supply/demand considerations that are easier to discern.

    With regards to taking advantage of this, I have so far been biased to investing in the commodity itself rather than stocks. Companies that mine, plant or otherwise produce a commodity have risks associated with them that are unrelated to the commodity’s price itself.  For example for an exploration company, there are funding risks and execution risks, not to mention management risk and stock market risk.

    It is quite possible that you believe that the gold price is going up, but the gold explorer whose shares you have just bought doesn’t find any gold! You may believe that the oil price will rise and yet the particular company you have bought shares in has an environmentally  catastrophic spill.  The wheat or corn price may be going to go up, but the farm you just bought had its crop wiped out by a flood resulting in no revenue and a higher future capital expense. There are simply risks that aren’t related to the commodity price.

    For these reasons, where I have had a view about a commodity, I have thus far taken interests in the commodities directly rather than through stocks.

    Posted by Roger Montgomery, 3 December 2009

    by rogermontgomeryinsights Posted in Energy / Resources, Insightful Insights
  • Can I value Fortescue (FMG)?

    rogermontgomeryinsights
    November 4, 2009

    On Richard Goncalve’s Market Moves show on the Sky Business Channel last week I mentioned I would estimate a value for Fortescue Metals Group (ASX:FMG). Let me be the first to say that, like IT businesses, companies in the resources sector are notoriously difficult to value. This is not because they are in a fast changing industry whose long term economics are difficult to predict, but because the economics are based on commodity prices that change daily and whose prediction is almost impossible.

    Having said that I should offer a caveat; Buffett’s announcement that he is buying the railroad operator Burlington/Santa Fe in a $44 billion deal – his biggest ever – suggests he truly believes that fuel prices are going up a lot. Indeed while higher diesel prices will raise the costs of running trains, it will raise the cost of operating trucks over trains by a factor of four.

    But I digress, FMG – based entirely on 2010 consensus analyst forecasts – is worth $1.90 to $2.00. Another caveat – consensus analysts predictions could be wrong.

    By Roger Montgomery, 4 November 2009

    by rogermontgomeryinsights Posted in Companies, Energy / Resources