Legendary US oilman Jean Paul Getty was a wildcatter in Texas. However, after the 1929 Wall Street crash he worked out that it was cheaper to buy oil in the ground that had already been found (and was owned by listed oil firms) than it was to take the risk and expense of prospecting for it. A man with a keen eye for value, Getty made himself very rich during the 30s buying oil reserves via the stock exchange. And were he alive today, he would undoubtedly be at it again.
The proliferation of easy credit worldwide has fuelled a boom in private equity that has seen countless small and mid-sized listed firms taken private. This has pushed mid-cap valuations significantly above those of mega-cap stocks, leaving some global mega caps on outstandingly low ratings. Often, this has meant that large, high-yielding, blue-chip stocks are trading below where they were seven years ago, even when some have more than doubled earnings since then.
As the funds flowing into private-equity coffers have ballooned, the size of actual and potential targets has risen and now even FTSE 100 stocks aren’t safe. With the Chinese government planning to funnel some of its huge surplus towards equities (where it’s a safe bet they will target mega-caps, as the Arab states’ oil money investments did before them two decades ago), the catalysts are in place for a period of mega cap out-performance.
A sector that I have long been keen to bring to MoneyWeek readers’ attention is oil. One stock where I see especially good value is Royal Dutch Shell (RDSB). And now at least one major investment bank has seen the light too. Last week, Morgan Stanley European research analyst Neil Perry issued a buy note on Shell, valuing the firm on a sum-of-its-parts basis at £32 a share. With Shell currently trading at around £21 a share, that sounds pretty aggressive. But by the time you get to the end of this page, you may think it rather conservative.
Morgan Stanley believes that, in general, large caps now represent “the cheapest access to energy in the world”. Perry admits that his basic argument can be applied equally to BP and Total, but that “the upside is probably greatest at Shell”. I wouldn’t disagree. Perry’s calculations start with Shell’s downstream businesses, such as the refining, transport, marketing, gas, power and chemical businesses. These are huge; Shell’s non-oil field activities are the largest of any European oil firm. Perry reckons the whole downstream business is worth about $174bn. In other words, if Shell split itself in two, or if another group (BP, perhaps) bought it, $174bn is what Perry and his team estimate that ‘downstream Shell PLC’ would be worth.
This presents us with a great opportunity. Shell’s enterprise value – the market cap plus net debt (ie, what you’d actually pay if you were buying the firm outright) – is $287bn. So if we remove the downstream businesses, we’re paying just $113bn for the upstream business – by which I mean the oil in the ground. Under Securities and Exchange Commission rules, Shell has proven reserves of 11.8 billion barrels of oil and oil equivalents. That’s $9.58 a barrel in the ground. Not bad, when you consider oil is trading at around $71.
But the really important issue is not the SEC’s definition of ‘proven’ reserves, because this isn’t what you or I would consider proven. SEC proven reserves don’t just have to be there and be proved to be there. There also has to be an oil well there, and all the storage and transportation paraphernalia, pumping oil to market. This is expensive, as it usually pays better to work one field down first, gaining economies of scale from your onsite facilities, before moving the whole operation on to a new site.
As such, oil companies tend to work sites that have up to ten years worth of current demand still in them and only open new sites when an existing field starts to run a little dry. So when the press talk about Shell having less than ten years worth of oil left, what they should say is less than ten years worth of SEC proven reserves.
If you want to know how much oil Shell has in terms you or I would use, ie how much oil it can expect to pump one day, then we look at what the SEC calls the 2P and 3P reserves. This is shorthand for ‘proven and probable’ (2P) and ‘proven, probable and possible’ (3P). Shell estimates that its 2P reserves (oil it’s pretty certain it can get out under conservative assumptions) come to about 30 billion barrels. So conservatively speaking (although not as conservative as the SEC), at today’s share price, investors are paying a residual $113bn for 30 billion barrels of oil. That works out at just $3.76 a barrel. Even better, Shell’s own estimates of the 3P oil reserves, the most likely estimate of what they can expect to get out of the ground from existing finds, once developed and drilled, is a whopping 60 billion barrels of oil equivalent. Anyone want to buy a long-term supply of oil for less than $2 a barrel? I thought so.