Thinking strategically about natural gas

Benj Gallander and Ben Stadelmann
Friday, October 14, 2011

A stock on Ben’s Watch List that started blinking “Buy” in September was Daylight Energy. Analysis indicated an interesting prospect at under $7. The speed at which it broached the $6 mark, then below $5, was quite incredible. A purchase was delayed because we like to see the share price stabilize somewhat before jumping in.

Sinopec, an oil company owned by the Chinese government, showed no such reticence, offering to buy the company at $10.08 per share. The premium of 120 percent sounds great, until one considers that the bid price is equivalent to what shares traded at just six months ago.

This is a classic illustration of the difference between voting and weighing machines that value investing guru Benjamin Graham wrote about. In September the prospect of a slowing economy unhinged many of Daylight’s shareholders; gripped by fear, they threw their holdings overboard in a panic. Sinopec instead weighed the substance of Daylight’s vast reserves of natural gas, which will continue to produce for many years to come.

If the Chinese have the ability to think strategically compared to North America’s how-do-things-look-for-the-next-quarter myopia, then good on them. They cannot be faulted for endeavouring to secure energy supplies for future generations.

However, what we should expect from China is a level playing field, and that does not currently exist. Canadian companies wishing to invest over there are limited to a minority stake of 49 percent. Instead of the binary yes/no response to Sinopec’s bid, Canada ought to welcome the investment, but insist on the identical 49 percent limit. Fair’s fair.

For those looking for an arbitrage play, this one looks good. The spread between the current price and the offer price is about 33 cents, reflecting a degree of doubt that the deal will be completed.

Though passing control of such a strategic asset to foreigners will make some nervous, this is a completely different situation from BHP Billiton’s blocked attempt to buy Potash Corp. That bid didn’t have support from either Potash’s management or the Saskatchewan government. Though Stephen Harper had initially suggested he was unconcerned with BHP’s bid, his minority-government position in November 2010 made support for the unpopular proposal untenable.

In contrast, a spokesman for Alberta’s energy department bragged that Sinopec’s investment was a “continuing sign of confidence in the province as a secure energy supply.” Daylight’s CEO Anthony Lambert was pleased as punch announcing the deal, and praised China’s sharp eye for value, stating, “We believe this transaction with SIPC recognizes the highly attractive asset portfolio and exceptional team that we have assembled at Daylight.”

And now that Harper has his coveted majority, his philosophy on such commercial transactions can be given free rein.

Fortunately for investors, there are plenty of other Canadian companies with attractive natural gas assets that are currently trading at bargain prices. The shares are cheap, not only because of fears of a weak economy, but because these producers are essentially victims of their own success. Unlike conventional oil production, which is plateauing in accordance with Peak Oil theory, global natural gas production is accelerating, growing at an annual clip of 2.8 percent.

The industry practice of using horizontal drilling and hydraulic fracturing — or, as it is colloquially called, “fracking” — has been a game changer. Though controversial in some jurisdictions due to environmental concerns, there is no argument about the efficacy of the technique.

That extra production is suppressing the price of natural gas. But its long-term value remains — it is still a non-renewable resource and its energy content has not changed. Eventually, the fact that natural gas is a cheaper source of hydrocarbon than oil will be more fully recognized, and demand will increase sufficiently to absorb the surplus of supply. The Chinese government understands this; investors would be wise to consider this long-term view.