Chinese Oil Effect

Cats, the great humorist P.G. Wodehouse once wrote, are snooty because they cannot get over the fact that the ancient Egyptians once worshipped them as gods. Americans, like cats, might also struggle to get used to a changed world. The global economy no longer bows exclusively to the altar of American enterprise. China’s robust economic machine now attracts a genuflection or two. Successful investors will adapt to this new reality.

Fareed Zakaria, editor of the Newsweek international edition, notes that China added more to global economic growth in 2007 than the U.S. That’s the first time a country other than the U.S. has contributed more to global GDP since at least the 1930s. This little history-making milestone typifies a growing list of Chinese economic achievements… and American shortcomings. “On issue after issue,” Zakaria writes, “China has become the second most important country on the planet.”

China is no longer the scrawny puncher that might grow up to be a contender; it has arrived. It is a bona fide heavyweight… and it has the potential to throw even harder punches. Jim Rogers, the celebrated globe-trotting investor and writer, believes the 21st century will belong to China in the same way the 20th century belonged to the U.S. In Roger’s new book, A Bull in China, he expands on this thesis. His conclusion is as simple and direct as scotch on the rocks or a quarterback sneak: “Get out of the dollar, teach your children Chinese, and buy commodities.”

As Rogers says, owning a piece of the things that China’s hot economy simply can’t do without seems like a good idea. One thing it certainly can’t do without is oil. In fact, the thirsty dragon in the East has caused most of the increased demand for oil during the past few years.

The Chinese economy has been growing at a rapid rate in recent years and that has fueled the desire for Chinese to start acting more like their Western counterparts. Once bicycle bound, the streets of China are now cluttered with millions of automobiles.

These millions of new drivers demand oil and are taking the precious resource out of the hands of consumers in Europe and America. This has been a major factor in rising energy costs around the globe. You see, oil is a finite resource, and with a skyrocketing demand, the price has risen exponentially.

Of course, this isn’t the only reason for rising oil costs, but it certainly has helped. That’s why you cannot look into the economic situation in China without examining the staggering effects it has over global oil supply and demand. That’s why we’ll analyze the Chinese emergence with a bend toward oil stocks.

My favorite oil play is Canadian Natural Resources, a stock I recommended one year ago to the subscribers of my investment letter Capital & Crisis. The stock has tacked on about 93% since then. But I think its advance is far from over. This year, Canadian Natural’s huge Horizon Oil Sands project will start pumping out oil for the first time. Unlike conventional oil assets, this one could produce steady cash flow for decades.

In addition to one of the largest oil sands projects on the planet, Canadian owns a vast amount of other energy assets in Canada, West Africa, and the North Sea. Overall, Canadian Natural should gush $2 billion in free cash flow in 2008. The company could double that number in 2009 as the Horizon project expands. If Canadian Natural actually achieves these cash flow totals, its stock could be worth twice what it trades for today.

The stock is not risk free, of course. Oil prices could sink. Tax regimes could get uglier (especially the fickle Canadian tax regime). Currency fluctuations could undermine investment returns. But overall, if you want to own an emerging energy behemoth, Canadian Natural is very strong candidate.

In searching for investments for our well-scrubbed Capital & Crisis portfolio, I look for four things, and Canadian Natural has them all:

1.  A rock-solid financial condition, preferably backed by tangible assets. (Canadian took on debt to acquire Anadarko’s Canadian assets. But ample cash flow means the new debt presents little danger)
2.  An understandable business, including detailed disclosures
3.  Good owner-operators, preferably with a track record of creating wealth
4.  A healthy discount from what private owners would pay to own the whole thing.

That’s what I look for. It is not an easy mission to fulfill. So when we find good investments, it’s important we ride them for all they are worth. Canadian Natural is one of those.

Chris Mayer

P.S. China isn’t the only economy on the rise. There are other parts of the world that are joining our global economy. As these countries rise, investment opportunities will sprout up everywhere. This could be one of the largest moneymaking boom periods since the turn of the last century. New millionaires are being made everyday.

The Daily Reckoning