Why this reminder?
I covered Oil & Gas companies as a Research Analyst during the great Oil crash of 2014. They were challenging times; but it was better education than any school could offer. For those of us who think about investing in Energy companies, these reminders are meant to keep us in check – so we don’t drain analytical horsepower by succumbing to fear, greed, or “forecasts”. This is not meant to be an exhaustive checklist for Energy Investors. That would require a whole book.
#1: There is no intrinsic value.
When were Oil Prices actually wrong? Was it wrong during the months before September 2014 or has it been wrong over the past couple of years? Surely, a few-hundred-thousand barrels a day of extra supply in oil during 2014 (compared to global supply of 90-95 million barrels of oil a day) couldn’t have caused a 50% drop in oil price within a couple of months? Or is Mr. Market always right? Based on my experience, commodity markets oscillate between prices driven by fear or greed; even more so than equity markets. Also, there’s politics – but that’s a whole new can of…(worms seems too mild of a word these days). And the weather – in the case of Natural Gas. So, is the price ever “rational”? Yes, probably at some point in between fear and greed.
- The underlying confusion and mental mayhem could be eliminated by some smart Economist who can answer the question: “What is the intrinsic value of oil?” What would “Homo-Economicus” pay for a barrel of oil?
- Homo-Economicus is an Economist’s idea of a human being – hyper-rational, emotionless, mathematically brilliant, and omniscient. Kinda like Spock. Fascinating, but not realistic.
- I have a feeling that this will be a never-ending debate. And, as expected, no two economists will agree.
- “It’s hard to analytically put a price on an asset that doesn’t produce income…” – Howard Marks.
#2: It’s daily Change in Excess Supply, Stupid!
So, let’s step back see the big picture. Let’s look at good old Supply and Demand. The Oil “supply stack” is more than just OPEC and US Shale. They make up about 45-50 million barrels of oil per day. That’s about 45-50% of total world demand. So, yes, other producers have a reason to exist. Global demand for oil doesn’t fluctuate much – it hovers around 95 million barrels of oil per day, these days. So, it may not seem like US Shale and OPEC (read as Saudi Arabia) should be the talk of the town. But they are, because that’s where taps are being turned on (or off). They are main the players in this geopolitical game of chess. US Shale changed that game. How? By pumping out a few hundred thousand barrels of Oil per day more than what OPEC would have liked. A few hundred thousand barrels of oil sounds like a drop in the ocean. The thing is: It’s not the change in supply OR change in demand that really drive major price changes.
It’s the Change in Excess Supply or Change in [Supply minus Demand] that causes the type of a violent price dislocation we saw in late 2014. At some point millions of barrels of oil were just stored on ships just off the coast in many places. That’s because when demand doesn’t fluctuate much, a small increase in supply causes like a supply “glut”. So, even if supply increased by maybe 0.5%, the impact on prices (rational or not) was something like 50%. So, the 0.5% number is misleading. We need to look at how much daily Supply minus Demand increases. That picture is much more dramatic.
#3: Same-Same, but different.
The same applies to Natural Gas price dynamics. Look at Change in Excess Supply or Change in [Supply minus Demand]. But the thing with Natural Gas is the supply is still localized, as in, it’s hard (and expensive) to export Natural Gas unless its liquefied or there is actually a physical pipeline. So, maybe price sensitivities to excess supply is less drastic. And the demand for Natural gas is generally increasing these days. So, that’s a little different from the Oil story.
#4: Forecasters are entertainers. And they're not funny.
Basically, listening to Macro “forecasters” is just not a good use of time. Their “forecasts” would involve predicting both demand and supply. And if they get those right, only then would they get the variable that matters – Excess Supply – correct. But that means that they must rely on their “sophisticated” model to predict price based on their prediction of excess supply. So, they must predict the Y variable based on their prediction of the X variable. No, thank you.
- “Market forecasters will fill your ear but will never fill your wallet.” – Warren Buffett
- “Forecasting (n): The attempt to predict the unknowable by measuring the irrelevant; a task that, in one way or another, employs most people on Wall Street.” – Jason Zweig, The Devil’s Financial Dictionary
- …which is why you will notice that most forecasts hedge their language – like “prices could fall to $20/barrel.” Those kinds of statements – without any measure of probability attached to them – are meaningless. Yeah, anything “could” happen, in theory. But without a rough measure of probability, I’ll have to take your forecast even less seriously than I normally do.
#5: Don’t extrapolate.
On a general note on forecasting: Extrapolating is one of the worst habits among financial analysts or “market strategists”. I think it’s because it’s easy to do in Microsoft Excel. You just drag the cursor and the numbers “autofill” – it feels so good. But it’s mostly useless. Extrapolating the price of oil, the cost of capital, revenue, margins, returns, growth in China – from some point in early 2014 – all turned out to be spectacularly wrong. So, let’s not extrapolate the scenario where everyone’s pumping out oil and gas at record levels forever so that the “Change in Excess Supply” remains insanely high, which drives prices low, very low. That wasn’t sustainable for any of the producers. Let the game theory play out. But then again…
- “the market can remain irrational longer than [we] can remain solvent” – John Maynard Keynes (allegedly)
- “In economics things take longer to happen than you think they will, and then they happen faster than you thought they could” – Rudgier Dornbusch
- “…and go much further than you thought they could” – appended by Howard Marks
#6: Comps are useless.
Speaking of bad habits, here’s another classic: valuing companies or estimating risk/required spreads using “Comps” (comparable companies). Analysts do this by comparing P/E, P/B, Credit Spreads, or other such valuation metrics. This is especially useless when things were great – at, say, $100/barrel. Using comps then was obviously not smart. The “market” is less discerning when things are good.
- The implicit assumption in using comps is that the rest of the, well, comps are valued rationally. This is lazy analysis. When things are going gangbusters in an industry, things are probably not rational.
- “Only when the tide goes out do you discover who’s been swimming naked” – Warren Buffett
- So, focus on the company’s cash flows. Don’t worry about what metrics other companies are trading at. And please don’t use an industry “average” ratio based on 6-7 companies.
- “All the shorthand methods—high or low price-to-earnings ratios, price-to-book ratios, and dividend yields, in any number of combinations—fall short. Buffett sums it up for us: Whether ‘an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value for his investment . . . irrespective of whether a business grows or doesn’t, displays volatility or smoothness in earnings, or carries a high price or low in relation to its current earnings and book value, the investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase.’” – Robert Hagstrom, from The Warren Buffett Way.
#7: Micro over Macro.
With the inability to predict these underlying commodity prices, go as “micro” as you can. Don’t buy an oil exploration company because you’ve read a “forecast” that oil prices “should increase by X%”. Go back to the basics: MARGIN OF SAFETY. Is this company trading a significant discount from a conservative valuation? What is a conservative valuation? Do the numbers suggest that this company can survive on cash flows when the tide goes out? And by that, I mean at a level that is not anchored to current price. Anchoring to current levels or some past level is another terrible habit. A lot of forecasts and “models” in 2014 appeared to be “judicious” when they stressed oil prices by maybe 30% from the then current price of around $120/barrel. Obviously, that “stress test” didn’t help. Let’s deal with absolutes. Past distribution of price changes is no guarantee of future distribution of price changes.
- “I’m firmly convinced that (a) it’s hard to know what the macro future holds and (b) few people possess superior knowledge of these matters that can regularly be turned into an investing advantage. There are two caveats, however: 1) The more we concentrate on smaller-picture things, the more it’s possible to gain a knowledge advantage. 2) With hard work and skill, we can consistently know more than the next person about individual companies and securities, but that’s much less likely with regard to markets and economies. Thus, I suggest people try to “know the knowable.” – Howard Marks
- “The function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future.” - Benjamin Graham
#8: But the Moat is narrow. Very narrow.
In commodity industries, when we look at companies, Warren Buffett’s beloved Economic Moat question becomes difficult to answer. They are price-takers, not price-setters. So, if they’re price takers, do they have control over Volume? Usually, the answer is No. If we ask them the question “well, you’re obviously not selling a special product at a special price, so why should you exist? Do you even have a competitive advantage? If so, how do you protect it? What’s your Moat?” The response we’d normally get from a company is something like “because we own this oil and gas field, or we have some kickass contracts, which are very profitable based on current conditions…”. The last bit there – “based on current conditions” – will generally be in the fine-print section of the Unsaid Assumptions Document. Hint: No such document exists. This is an important point about contracts. Many contracts, apparently, can be amended when market conditions are terrible. I didn’t know that. Companies do this to retain big clients and maintain “market share”. I thought contracts were, you know, contractual.
#9: Be a Debbie Downer.
In trying to figure out Competitive Advantage and Economic Moat, there are some specific questions to ask Exploration and Production (E&P) companies and their Service Providers. The point is to not fall for their projections. They’re not selling a special product. That’s why they’re called “commodities”. So, when things get rough, and the price they’re forced to take is low, can they survive? It’s time to be a Debbie Downer. Here are some questions that may help you in sucking the life out of a party:
- E&Ps: What is the weighted-average break-even price (the level at which EBITDA minus Maintenance Capital Expenditure is $0) for wells that require:
- Drilling and Fracking?
- Just Fracking?: This seemed to be dominant source of US Shale resilience in through 2016 – milking existing wells at low operating costs. Some people love looking for things like “DUCs” – Drilled but Uncompleted Wells – or other such unfunny abbreviations. There are many more. PUDs, 3Ps…you can google them.
- But it is, in fact, much cheaper to extract oil or gas from wells that already dug up.
- Service Providers: What is the breakeven price for their clients’ wells that require exploration and/or production? Where do they fall in their clients’ supply stack of oil or gas?
- Midstream and Downstream companies are a little more immune to violent price shocks a la late 2014. That’s because their revenues tend to be more volume-based. Or are they? Draw out details of their revenue contracts as much as you can. Maybe there is some variable price component. That would suck.
- “Backlog” (we’re contracted to make $XYZ in the next 2 years…) calculations are bit of a crapshoot. There are many assumptions built into them. And if the contracts are not really iron-clad, then backlogs calculations are just marketing bullet points. It seems to me that their main purpose is marketing to investors.
- I’ve never found much use for Oil & Gas Reserve Valuation – the P90s and so on. They may provide a very rough “second opinion” on valuation, and on recovery rates if you’re a bond investor (with a substantial haircut). But I’d rather value a company based on estimated cash flows (when things get bad) rather than on cash flow projections of based on other projections of oil or gas price, their futures curves, and probabilities based on projections of engineering variables. Let’s keep it real – when things get ugly, can this company survive on cash flows? If so, what would the company be valued then?
- What is the discount rate applied to those breakeven calculations? What does the company’s management use? Is it a cost-of-capital-type calculation? Or is it an arbitrary 20%, for example. If it’s the latter, there could be some wiggle room for “breakeven levels”. Not that Cost of Capital is an especially scientific measure either:
- I’ve listened to many cost of capital discussions and they’ve never made much sense. It’s taught in business schools and consultants use it, so Board members nod their heads without any idea of what’s going on.” - Charlie Munger
- Because, basically, Cost of Equity is a crap-shoot.
#10: Big opportunities come infrequently.
Ultimately, we should be reasonably comfortable that the company should survive in conditions that are vastly different from the good times when it raises more capital; because they do so mostly when things are good – like oil trading at $100/barrel.
- “Frequently, you’ll look at a business having fabulous results. And the question is, ‘How long can this continue?’ Well, there’s only one way I know to answer that. And that’s to think about why the results are occurring now – and then to figure out what could cause those results to stop occurring.” – Charlie Munger
- …Like, a situation where…maybe, oil prices have fallen by 50% because of a spike in Excess Supply... possibly because of some complex geopolitical move by Saudi Arabia or US.
- But that type of prognostication is usually a futile exercise for Research Analysts and Investors. Forecasters, however, will forecast. That’s what they’re paid to do.
- So, go micro, as much as you can. Think about things you can wrap your head around.
- 3 magic words: Margin of Safety. Because the future, especially in commodity industries, is unknown. So, we may as well pay low price to minimize our chances of losing money.
- You won’t find too many companies with enough Margin of Safety. But that OK.
- “Big opportunities come infrequently; when it’s raining gold, reach for a bucket, not a thimble” – Warren Buffett.