Will 2010 be the year of inflation, interest rates, commodities and Oil Search?
Welcome back. On Christmas Eve, just before I left for my annual family holiday, I said that this year would be fascinating in terms of inflation, interest rates and commodities prices. Interest rates can be ticked off – the topic has already been front page news and I expect the subject to hot up even more over the coming year.
Inflation and commodities however are arguably even more interesting. When money velocity picks up in the US – that is, the speed with which money changes hands – inflation could be a problem. I don’t know whether that will be this year or not, but I do know that at some point the benign inflation and extraordinarily low interest rates will be nothing but a fond memory.
One of the places inflation presents is in commodity prices, and there is no shortage of very smart, successful and wealthy people – Jim Rogers is one – who believe the bull market in commodities is far from over.
And so my first official blog post for 2010 is about one of those commodities – oil, and in particular, a company the stock market thinks is worth $7 billion and whose revenues have grown from $145 million ten years ago to $800 million last year. But before we look at the company, it is worth noting that the stronger US dollar appears to be keeping a lid on oil.
Over the holidays I received several requests to value Oil Search Limited (OSH), a company engaged in the exploration, development and production of oil and gas in Papua New Guinea.
Up front, I can begin by saying that based on the current price, it seems the market sees something in this company that bears little resemblance to its value. With an average return on equity of 9.3% (I removed a couple of years – 2006 and 2008 – where assets sales boosted returns), there is nothing remarkable about OSH’s economic performance.
What may interest you even more is that while profits have grown from $15.9 million in 1999 to an expected $124 million for 2009, the equity investment required to be put in and left in to generate that growth has risen from $332 million in 1999 to $1.8 billion in 2009. The additional $1.5 billion of equity over a decade has produced additional profits of $108 million – a return on the incremental equity of about 7%. Is 7% acceptable to you as an investor in this business?
With no debt, a relatively stable return on equity, and cash flow that comfortably covers dividends and exceeds reported profits there is a quality aspect to Oil Search, but it’s modest returns on equity are difficult for me to get excited about.
The market obviously disagrees, because I currently cannot get a valuation that exceeds $1.15 and yet the share price is $5.26. It reminds me of when, in 1999, the share price for Telstra was circa $9.00 and I couldn’t get a valuation of more than $3.00, or when ABC Learning was $9.00 and my valuation was less than $3.00; I believed that there could be something wrong with my valuation model (which has changed significantly since then), but there wasn’t. It was just that in the short run the market is a voting machine – a popularity contest.
Posted by Roger Montgomery, 30 January 2009
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.INVEST WITH MONTGOMERY
You may well be right in saying OSH is overcooked but doesn’t OSH have a minority stake in Exxon’s PNG LNG project? Surely you are being too harsh on OSH by ascribing no value to the likely future cash flows of this large project. Also, given the project capital is being spent now and returns won’t flow for a couple of years aren’t you penalizing OSH twice? Once by not counting future cash flows and twice by looking at the current low ROE as reflective of the current business when it’s really reflective of a future project being PNG LNG.
Thanks for the post. Its important to remember Chris that a business is worth the present value of its net cash flows. That means what going IN to the business, not just what comes out. If billions have to be pumped in to generate a few dollars of return, well the business isn’t worth as much. OSH’s returns on equity have been mediocre. Now that may change in the future but it would nice to see some evidence first. The worst kind of business is the one that grows, requiring large amounts of incremental funds and then makes no money. I am not saying OSH is the worst kind of business, however there are many generating much higher returns for the amount of money shareholders have put in and left in.