Rick Rule: Supply Decrease + Demand Increase = Explosive Oil Upside

Long-time followers of Global Resource Investments Founder and Chairman Rick Rule know he is an energy bull. He sees increasing demand as an inevitable outcome of global mathematical formulas. "Around the world, in emerging and frontier markets, 3.5 billion people aspire to your lifestyle, but haven't been able to compete with you for the last 150 years because they haven't had any money," he explains in a recent webcast. "As those people become more free, they become more rich and increasingly they are able to compete with you. In the process, these 3.5 billion people will increase their per-capita consumption of energy. The demand curve in energy relative to GDP is breathtaking. As people on the bottom of the economic pyramid get more money, what they do with it is very energy-intensive. So, GDP gains at the bottom of the demographic pyramid lead to disproportionately high gains in energy consumption."

Rick sees inverse trends on the supply side. "Energy trades on a worldwide basis are led by oil, the supply of which is declining as a function of peak oil—which is partly a scientific and partly an economic calculation—and, more importantly, by a reduction in sustaining capital expenditures by national oil companies. Mexico, Venezuela, Ecuador, Peru, Indonesia and Iran are large petroleum exporters that may not be exporting any oil at all in five years. When you have worldwide import demand growing at 1.5% or 2%, compounding a supply that is declining by 25% or 30%, the potential intersection of those two facts in the market could be explosive to the upside." He acknowledges some possible supply variables in the world, but believes the overwhelming equation stands. "A million barrels a day of Libyan crude back on the market would provide some moderation of the supply shortfalls. And a return of Iraqi crude on the market would also be useful. But my own personal belief is that neither of those two sources of supply can mitigate the supply shortfalls that we're going to see from the national oil companies."

Rule's bullish oil price outlook extends to liquefied natural gas (LNG). "LNG is, increasingly, a substitute for oil. In light of a combination of the reduction in the Japanese nuclear generating capabilities and South American supplies going off line, we expect worldwide LNG supplies to be fairly tight on a going forward basis." That is good news, he says, for North America, which has a robust domestic natural gas industry. "The consequence of the pricing umbrella led by oil and import substitution of gas molecules will return gas to profitability in the next two years," he predicts.

Rick is not predicting a direct ascent in natural gas prices. The theme of the webcast is volatility. That painful reality goes for the overall market as well as the energy sector. "I think gas will trade in a band between about $3.00/MMBtu on the low side and $7.00/MMBtu on the high side. Any dollar north of $5.50/MMBtu and these gas producers start making real money."

Rule is also bullish on opportunities on the service side in the oil and gas business. "We are going to need to do an awful lot of drilling worldwide to keep up with our demand for oil and gas. Increasingly, the places that produce oil—places like Libya and Iraq—don't have the expertise and services to develop and produce their reserves. Large service companies are beginning to act like mini-majors, providing contract services to national oil companies or multi-national oil companies. Therefore, we are bullish about some of the service companies."

What isn't appealing to Rick in the sector? "We wouldn't be so attracted to companies that have large exposure to North American or Western European refining and marketing because we expect those margins to be continually constrained. But, companies that are leveraged to upside production we like a lot. We particularly like the juniors and we particularly like the Canadian juniors because Canadian institutions are on strike in terms of buying companies producing less than 5,000 barrels a day with market capitalizations less than $500 million." Rule points to a matrix of valuation measures that changes markedly when companies get to a certain size, reevaluating them as they get larger and eventually making big companies out of them, which can yield takeover premiums. "This market cap arbitrage is going to be an important theme on a going forward basis," he says.

Rule is beginning to see uranium stocks return to levels where he thinks they are safe to buy again. Global got into the uranium sector starting back in 1999. "We were spectacularly right," he recalls. "Then, in 2005/2006, when the uranium sector experienced its, sorry for the pun—boom, we were out of the way." Now he sees the tables turning again. "Uranium seems to be a four-letter word now. People's expectations from '05 and '06 were impossibly high and as a consequence, they were disappointed. That disappointment was exasperated by the events in Japan." Rule sees four or five uranium juniors that he thinks are quite attractive. He may not be alone. Apparently Cameco Corp. (TSX:CCO; NYSE:CCJ) agrees as evidenced by its recent hostile takeover offer for Hathor Exploration Ltd. (TSX.V:HAT). "We think this is the first of several consolidations on a worldwide basis in the uranium business," he predicts. "Now is the time to begin to establish positions in the uranium sector." In Rule's crystal ball, uranium energy will contribute a growing share of worldwide electrical generation, not because people are less afraid of it, but simply because when they flip a switch, they want the light to go on. And without uranium, the light won't go on in many parts of the world.

Rick also continues to be attracted to some alternative energy sectors—run-of-river, hydro and geothermal. "People ask me at conferences, 'Rick, what is wrong with the geothermal sector?' The answer is nothing. There is nothing wrong with the sector. What has been wrong with the sector's performance is that the management teams who have entered the sector have been, let's say, challenged—implementation-challenged." Rick sees three issues plaguing geothermal: long lead time to production, capital-intensive preparation and implementation. Rule sees a light on the horizon for all three of these problems. A number of geothermal projects are already five years into their seven-year development cycles. That is two-thirds to three-quarters of the way to completion. At some of these companies, the capital has already been spent and they are selling at discounts to book. That suggests that the cost of capital is extraordinarily low on a going forward basis because it's already been spent. That leaves implementation and management. After a 20-year bear market in energy, precious few alternative energy management teams were left to handle the investments that have been made in the last 10 years. "All other things considered, if you have lost faith in the sector, are disgusted and looking to exit for tax losses, I strongly suggest that you do it now. But, do it with the knowledge that I will be the buyer," he jokes.

Regardless of the sector, Rule sees timing as one of the deciding factors in successful portfolio management. "I would encourage people who have portfolio companies with substantial losses, but other portfolio gains this year, who are going to do tax loss selling, to do it now. Beat the rush," he advises. "The tax loss selling we are going to see in November and December of this year—particularly if we experience more volatility between now and then, which I think is inevitable—is going to be extreme. If you bought a stock for $2.00 and the stock is at $0.50 now and you think you are going to want to sell it, you might want to sell it now because you might only get $0.30 or $0.35 if you sell it later." Of course, the inverse applies on the buy side. "If there are companies that you are attracted to that have gone down in price this year, the existing shareholders of those companies may very well be taking tax losses in November and December. So, build yourself a shopping list—or borrow our shopping list—and look for names that you would like to buy in November or December."

Global Resource Investments (GRI) founder and CEO, Rick Rule began his career in the securities business in 1974 and has been principally involved in natural resource security investments ever since. He is a leading American retail broker specializing in mining, energy, water utilities, forest products and agriculture. Rule's company has built a sterling reputation for its specialist expertise in taking advantage of global opportunities in the resources industries. Last month, Rule closed a landmark deal with Eric Sprott, another famous powerhouse in the arena. With GRI now a wholly owned subsidiary, Sprott Inc. manages a portfolio of small-cap resource investments worth more than $8 billion and boasts a workforce of more than 130 professionals in Canada and the U.S. This article is based on Rule's August 31 Global Resource Investments webcast.

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