Description

Statoil ASA (NYSE: STO) may be purchased for 10x 2004 earnings and $9.90 per barrel of proved reserves; these earnings were generated on average Brent crude price of $38 per barrel during ‘04. We will argue that this represents good value because:

A) STO is likely to increase its oil production from 1,100 mboe/d (thousands of barrels of oil equivalent per day) in 2004 to 1,400 mboe/d in 2007; this represents an opportunity for STO to increase earnings by 25 percent in the next two years.

B) Oil is likely to remain above $40 per barrel for the foreseeable future.

We begin with a brief overview of STO’s business followed by a discussion of why we think STO is a good value. We will conclude with a review of the data which suggest that oil is likely to remain at or above $40 per barrel.

Background
STO is an integrated oil company headquartered in Norway. The Norwegian government formed STO in 1972 to develop Norway’s oil and gas resources; until recently, the government owned 100 percent of STO’s shares. In June 2001, the government reorganized STO and sold 20 percent of its shares to the public; subsequently, an additional nine percent of its shares have been sold to the public.

Historically, STO developed oil fields in the North Sea and the Norwegian Sea; recently they have begun developing fields in the Barents Sea. Since Norway’s oil and gas reserves are offshore, STO has gained a great deal of expertise in offshore oil and gas production. STO’s management recently stated that they will maintain current production levels (1,000 mboe/d) from the Norwegian Continental Shelf (NCS) through at least 2010. Their offshore expertise makes STO a desirable partner; as a result, STO has partnered with a number of other major oil companies to develop offshore oil fields in Venezuela, Brazil, Angola, Iran and Azerbaijan.

STO business operates in four segments: exploration and production in Norway (78% of 2004 pretax earnings), exploration and production outside of Norway (6% of 2004 pretax earnings) natural gas (10% of 2004 pretax earnings) and refining and retail (6% of 2004 pretax earnings).

During 2004, STO produced about 400 million barrels of oil, 90 percent of which came from the Norwegian Continental Shelf (NCS).

STO’s reserves have slipped slightly over the last six years (a fate it shares with several other oil companies) while its finding costs have decreased somewhat over the same period. STO has about 10 years of reserves.

Why STO?
There are three qualities which make STO an attractive investment:

1. Valuation: 9.7x ’04 earnings which were earned by selling $38 Brent.
2. Free options: Earnings growth, Constrained gas in the UK and North America, offshore expertise.
3. Location: 86 percent of STO’s assets are in Europe; the Norwegian Krone is a stable currency based on petroleum exports.

What follows is our thinking on each of these three points.

Valuation
At less than 10x earnings and a 4.8 percent dividend yield ($0.51 per ADR regular dividend + $0.34 per ADR extraordinary dividend) STO is one of the least expensive integrated oil companies in the world. Yet the company has solid assets (87 percent of which are located in Norway and Western Europe) and is only modestly leveraged ($3.1 billion net debt as of 12/31/04). The companies that are less expensive than STO tend to be located in bad neighborhoods or, in the case of ChevronTexaco, are in the midst of a large acquisition.

Integrated oil companies as a group are modestly valued, with several companies trading in the range of 10 – 12 times earnings; even ExxonMobil may be purchased for 15x earnings. The inference we draw from these modest valuations is that the market believes that oil prices are likely to fall in the next couple of years i.e., with STO we are paying 9.7x peak earnings. In the section of the analysis entitled Why Oil is likely to remain over $40 per barrel (below) we outline the data which leads us to conclude that oil will remain above $40 for several years.

Free options
One receives three free call options when buying STO shares: earnings growth, constrained gas in the UK and North America, and niche oil production expertise. What follows is a brief description of each of these options.

Earnings growth – Normally investors are asked to pay for potential earnings growth, but in the case of STO, we may purchase the business at a reasonable valuation (~10x earnings based on $38 oil) leaving earnings growth as free upside. It so happens that STO has consistently increased their oil production over the last several years and has a number of new projects slated to come online in the next 24 months. STO management believes they can boost oil production to 1,400 barrels per day in 2007, 27 percent higher that their 2004 performance. All things being equal (e.g., oil prices remaining above $38), one would expect STO’s 2007 earnings to be 27 percent greater than its 2004 earnings. In fact, there is reason to believe their earnings will increase more than this because most of the added production is likely to come from non-Norwegian projects. STO pays 28 percent tax (in lieu of 78 percent taxes) on earnings from non-Norwegian oil production. If we assume that management reaches their production target, oil prices remain at $38 and the added production is taxed as Norwegian production, the implication is that we are paying about 7x 2007 earnings.


Constrained gas in the UK and North America – The Norwegian continental shelf has considerable natural gas reserves which STO is well positioned to exploit. European gas demand is growing while European gas production is falling. The UK’s gas consumption is expected to exceed its production beginning in 2005. This bodes well for STO, which is one of four companies which supply gas to Europe and owner of a 48 percent interest in Langeled, an under-sea gas pipeline from the NCS to the UK. Langeld will begin operating during Q4 2006. STO is also the largest corporate shareholder (22 percent interest) in Gassled, the world’s largest underwater pipeline network which moves gas and oil from the NCS to Norway, the UK and Germany.

North America’s supply of natural gas is also constrained. STO controls assets and expertise which will allow it to exploit this situation. For instance, STO owns 33 percent of the Snøvit Liquid Natural Gas (LNG) production facility located in the Barents Sea. Snøvit will begin producing LNG in 2006. STO also owns LNG capacity unloading rights to deliver 85 billion cubic feet of gas to the Cove Point, Maryland LNG facility. (At $6 per million BTUs, this will generate annual revenue of $510 million). This is valuable because Snøvit’s proximity to Cove Point (4,300 miles) compares favorably with other potential LNG sources.

Niche production expertise – STO has developed considerable expertise in offshore operations from its work on the NCS. As a result, STO is a desired partner for many offshore projects. This is a particularly valuable expertise as oil prices rise because offshore projects become more economical. Note that STO has partnered with other much larger oil companies on all of the significant projects coming online in the next 24 months.

Finally, STO has also developed expertise in the conversion of natural gas to liquids (GTL); in May 2004, STO started a pilot GTL plant in Mossel Bay, South Africa which reportedly is operating beyond expectations. GTL is interesting because, absent a pipeline, liquids are easier to move long distances than gas.

Location
Like the real estate business, location is important in the oil industry. In STO’s case, their core business is based on the Norwegian Continental Shelf, far away from the political turmoil that plagues much of the oil business, yet close to important markets (Europe and North America).

In addition, the company’s securities are denominated in Norwegian Krone. Norway’s accounts are in good order, the Norwegian government is stable and the rule of law is the norm. Roughly a fifth of Norway’s economy is directly tied to the oil and gas business. While inflation was running as high as 3 percent per annum a few years ago, last month Norway’s inflation was running about 1 percent per year. Given these assumptions and to the extent we are correct about oil prices over the coming years, one would expect the Norwegian Krone to appreciate vis-à-vis the dollar.

Since an investment in STO is a bet on the future price of oil, we will now turn to a summary of the data which indicate that oil is likely to remain at or above $40 per barrel for the next several years.

Why oil will stay above $40
There are three data which indicate that oil is likely to remain above $40 for the foreseeable future:

1. Oil futures price: June ’06 oil costs $55.60.
2. Demand for oil has grown faster than supply; supply is constrained and likely to stay so.
3. Dollar inflation: there are 45 percent more dollars today than two years ago.

Below is a discussion of each of these points; we will address them in order of most obvious (oil futures price) to least obvious (dollar inflation).

Oil futures price
The first piece of evidence that oil is likely to remain above $40 per barrel is the most obvious; when we last checked (a week or so ago) West Texas Intermediate is selling for about $55 per barrel and the oil market is in contango i.e., one pays more for delivery of oil in the future than for delivery today. Stating the obvious, the market expects oil to cost slightly more a year from now than it does today, and to our point, the market expects oil to be more expensive than $40 per barrel a year from now.

Demand
Historically, the US was the largest consumer of oil in the world; that changed in the mid 1990s, when Asia became the largest consumer of oil (granted, Asia is not a country!).

More telling, while Asian per capita oil consumption is less than in the US e.g., China consumes 7% as much oil as the US on a per capita basis, consumption growth is higher, and has been for twenty years. We draw the following inference from these data: Asian demand is now driving the oil market i.e., US inventory levels are not useful in determining the supply/demand balance. When consumption met supply (probably a couple of years ago), the price of oil started to go up.

A look at Asian oil inventories indicates that inventories have been consistently falling on an absolute basis i.e., as measured in barrels of oil. On a proportionate basis, the inventory data becomes more extreme because Asia’s consumption is growing rapidly. We conclude that Asian demand is running ahead of supply.

Supply
So what about supply? Inevitably, discussions about oil supply hinge on the OPEC producers, specifically the oil producing countries that surround the Persian Gulf (Iran, Iraq, Kuwait, Qatar, Saudi Arabia, Abu Dhabi and Dubai). This is because of the large oil reserves in these countries (at least 83 years worth at current consumption rates) and the ease of extracting oil in this region. For instance, according to one study, it costs $1.60 to $3.19 (1996 dollars) to produce a barrel of oil in the Persian Gulf. This begs the question, why are oil prices currently at $55 per barrel if countries which have lots of oil can produce it for less than $5 per barrel? The answer is that the supply of oil is currently constrained. OPEC countries are producing oil more or less at capacity. The next obvious question is, why doesn’t capacity increase to meet the demand? In the long run, this will inevitably happen, but for now, there are four reasons why capacity is likely to remain constrained for several years:

1. OPEC producers make more money when oil prices are high, so they are reluctant to increase supply. In fact, the last 20 years proved to be difficult for many OPEC countries due to population growth and depressed oil prices. For instance, Saudi Arabia’s per capita oil export revenue was $4,511 in 2004, down from $22,174 in 1980 (2004 dollars). Given this, there is no reason to expect OPEC countries to be in a hurry to add capacity.

2. Adding oil capacity, even in the Persian Gulf, is expensive and takes time. Oil capacity may be increased in the Persian Gulf for between $2,515 and $4,866 per barrel per day (1996 dollars). Taking the mean of these two costs, it would have cost about $3.2 billion of capital investment in 2003 just to meet Asia’s added ’03 consumption. With the incredible gross margins enjoyed in the Persian Gulf, this is obviously $3 billion well spent, but it is in addition to considerable capital spending needed to maintain the existing production. More importantly, it takes time to add significant capacity. For instance, the last major new capacity added in Saudi Arabia was the Shaybah field (completed in 1999), which took more than four years to construct and cost several billion dollars. The projects currently under construction in Saudi Arabia are of lesser quality than Shaybah and the next meaningful production increment does not arrive until 2007.

3. High hurdle rates. After twenty years of poor returns, oil companies have adopted conservative investment practices based on high hurdle rates. For instance, STO’s 2004 budget was based on earning a 12 percent return on $16 oil – this appears to be normal throughout the oil industry. Obviously, less production will be added when folks are banking on $16 oil. This is changing, but the industry remains focused on $20 oil.

4. Asian demand for oil continues to grow. If one looks at China’s demand growth vs. world production capacity, one sees that China’s growth rate is greater than the growth rate of world oil production. In order to relieve the constraint, supply needs to exceed demand, i.e., production not only needs to catch-up with demand, but surpass it. Eventually this will happen. In the meantime, one would expect the market to remain tight.

In conclusion, the current situation of high demand for oil and tight supply will not persist forever. For one thing, there will be dips in demand driven by the macroeconomic factors, but as of this writing, there is no sign of softening in Asia. In fact, China’s economy grew by 9.5 percent during Q 1 2005. And given Asia’s enormous population and low per capita consumption, the demand growth is likely to persist for many years.

Dollar Inflation
There is evidence that there has been considerable dollar inflation (~45 percent minus economic growth) since Q4 2002. If this were the case, all else being equal, one would expect oil to cost 45% more than two years ago (less the economic growth during the last two years). So, West Texas Intermediate which cost $26.30 during October 2002 would cost $38.14 today (assuming no growth). There are two data which suggest 45 percent as a starting point for dollar inflation:

1. The price of oil has increased substantially more in dollars than in other currencies. For instance, from October 2002 through March 2005, oil appreciated 76.8 percent in dollar terms but only 31.6 percent in Euro terms. One explanation for the difference (45.5 percent) is dollar inflation.

2. Perhaps it is coincidence, but according to an article recently published in The Economist, the world’s supply of dollars (defined as US monetary base plus foreign-exchange reserves) has increased by about 45 percent in the last two years. If that sounds like a lot, it is: this is the fastest expansion of dollars since 1975.

Adding to the glut of money are what appear to be persistent negative real interest rates in the US, despite multiple rate hikes by the Federal Reserve. Some will argue that inflation on the scale we suggest here has not shown up in the Consumer Price Index (CPI) and other such indices. There are several reasons this may be the case, including methodological issues and political considerations. Most importantly, the CPI is a backward facing indicator which relies on lots of assumptions; commodity markets are transparent and come complete with forward pricing. There is also a track record of commodity pricing foreshadowing inflation. (For an excellent analysis of the causes of the stagflation in the US during 1970s, see the paper by Robert Barsky and Lutz Kilian entitled Do We Really Know That Oil Caused The Great Stagflation? A Monetary Alternative, submitted to the National Bureau of Economic Research, Cambridge, MA).

To the extent current oil prices reflect dollar inflation, one would expect oil not to fall below the price implied by the increase in dollars minus whatever productivity increases the economy has produced: this is probably between $30 and $40 e.g., 45 percent more dollars less 10 percent real growth equals 35 percent inflation. No wonder the markets are jittery.

Risks
As with all investments, purchase of STO’s shares includes a number of risks. Probably the most significant risk to STO is their exposure to the price of oil: if our analysis is wrong about the future prices of oil, STO’s shares are likely to fall in value.

There is also a risk that the US Government will sanction STO for its Iranian investment. Since October 2002, STO has invested $219 million into the South Pars gas field; South Pars is located in the Persian Gulf off the coast of Iran. STO’s partner in this project is Petropars of Iran. The Libya and Iran Sanctions Act of 1996 is a US law which authorizes the president of the US to sanction persons knowingly investing more than $20 million in Libya or Iran. We assume STO knowingly made the investment.

The Norwegian Government owns 70 percent of STO’s shares. While we do not see this as a particularly risky situation, clearly the government’s priorities are different than those of outside shareholders. Several sell-side analysts cite this risk as the reason STO trades at a discount to other comparable oil companies. We don’t consider this a more significant risk with STO vis-à-vis other oil companies because, in our view, all major oil companies are subject to considerable political risk. To the extent the perception of this risk persists, STO is likely to be valued at a discount to comparable companies.

Finally, while 86 percent of STO’s core assets are located in Europe, that does not make them immune to sabotage by terrorists.

Catalyst

1. Sustained oil prices over $40.
2. Any disruption of the oil supply from the Middle East or Russia.