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Investing in Oil: Five Questions to Ask the Management

Source: [Oil & Gas Investments Bulletin]-"Most of these answers can be found in the middle of the Management Discussion and Analysis (MD&A) in quarterly financial statements."

The North American oil market is going through a fundamental change that will affect the price of oil for the rest of this decade—fast-rising shale oil supplies from North Dakota and Texas.

(Other shale oil plays will contribute as well, but none will come close to the revolution happening in those two states.)

This could mean lower oil prices for the next several years. I don't foresee the collapse in oil prices like what happened to natural gas, but even a 30% permanent drop to $70/barrel from $100 will impact junior and intermediate producers who spend all their cash flow.

And folks, almost all of them spend all their cash flow.

To me, this situation has two outcomes:

1. The juniors/intermediates will reset to a lower valuation/lower multiple to take into account lower profitability from lower oil prices. That is happening now and is almost done, IMHO.

2. Balance sheet will become more important than it was in a bull market, when juniors could raise money with no problem to fill the gap between cash flow and spending. Now the financing market is very fickle—one day it's open; the next—no way.

With this in mind, here are a few questions for you to ask management teams in your research. Most of these answers can also be found in the middle of the Management Discussion and Analysis (MD&A) in the quarterly financial statements.

QUESTION #1 – What price deck are they basing their cash flow on? Because if it's above $75, I would expect downward revisions this year. OK, maybe they can use $80, but that would be, IMHO, a bit optimistic (especially north of Cushing, Oklahoma, which includes all of Canada ).

The price of oil in 2012 may average better than that, but moving forward from now, it's tough to see North American oil improving much more than $10 a barrel (i.e., over $80-$85) for the next 18-24 months.

I hope I'm wrong and we all make buckets of easy money in the next year at $95 oil, BUT the fast-growing supply in the US is competing with Canadian oilsands for pipeline and refinery capacity, which is already close to being full. Whoever is willing to take the lower price gets to sell their oil.

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